11. Conclusion: Plan for Managing Your Retirement Risk
Professor Richard Thaler from the University of Chicago and Professor Shlomo Benartzi from UCLA have devoted a substantial part of their careers to studying the financial mistakes and monetary blunders that people make in their daily lives. Apparently even smart people are not immune. These two researchers are leaders in the nascent field of behavioral finance, which argues that consumers are not cold, calculating machines that optimize their decisions in a rigorous mathematical fashion, but instead they adopt simple general rules for financial decision making, which often leads them far astray.
One of the most egregious behavioral “sins” these two researchers have identified is the tendency of too many Americans to allocate too much of their 401(k) plan—and even their own investments—to company stock. Apparently, more than five million Americans have more than 60% of their retirement savings invested in their own company stock. Table 11.1 illustrates this lack of diversification by showing investing habits for employees of a selection of companies. Note that this is well after the notorious cases of Enron or WorldCom, where employees discovered the ruinous risks of such a myopic strategy. Americans also tend to heavily invest in industries that they are familiar with. Looking at Table 11.2, we see that people disproportionately invest their money into the sectors that they are employed in. Even more surprising, ongoing surveys and focus groups conducted with these same employees indicate that they simply do not view this behavior as problematic. They think it is normal and healthy to invest in “things they know” because they can keep an eye on their investments. This optimism stands in contrast to the fact there is absolutely no evidence that employees have any superior ability to outguess the market or the experts regarding the performance of the stocks they hold and the companies they work for.
Table 11.1. Are You a Company Stock?
Source: Pensions and investments as quoted by Forbes on August 30, 2010.
Table 11.2. Investing in What You Know
Source: R. Gerhardt, “The Influence of Investors’ Jobs on Portfolios: Is there a Job Industry Bias?” 2008
One of the main arguments in this book is that many of these five million Americans who are engaging in this risky practice might be dead wrong. They are improperly investing their human capital and financial capital in the same economic basket, and their retirement might be at risk. Indeed, the evidence suggests that we have a long way to go before individuals truly consider the risk and return characteristics of their human capital and invest their financial capital in a way that balances their comprehensive risks. Hopefully, this book can help along this path. Remember, your 401(k) is a number, not a pension. Managing and growing your nest egg so that it can eventually be converted and allocated into a pension is up to you.
So, in this concluding chapter, I try to bring the previous chapters together by reviewing the main highlights and then explaining how to formulate a proper retirement plan given all the tools we have discussed along the way.
Retirement Income Planning Is the Goal
At York University in Toronto, I teach a popular 12-week course on personal financial planning to third- and fourth-year undergraduate students. During the semester, I try to cover the entire life cycle of financial issues, from cradle to grave. In the first few weeks, I spend quite a bit of class time on basic topics such as financial budgeting, managing credit card debt, coping with student loans, and so on. I usually get full attendance and engaged interest during these early lectures. In fact, sometimes I get even more than full attendance from nonregistered, yet interested students, who want to learn whether leasing is in fact better than buying a car, or whether ETFs are better or worse than index funds for the cost-conscious do-it-yourself investor. They are surprised when I preach that debt can be good, as I explained in Chapter 4, “Can Debt Be Good at All Ages?.” They absolutely resonate with my message that human capital is valuable and should be treated as an asset class to be hedged and insured. In fact, even the topic of life insurance, which I mentioned back in Chapter 2, “Insurance Is a Hedge for Human Capital,” appears interesting to them, perhaps due to some morbid curiosity.
Then, somewhere toward the latter part of the semester, as things are winding down around week number eight or nine, I get to the topic of pensions and retirement income planning. Here I tell them about the pension annuities I introduced in Chapter 9, “Annuities Are Personal Pensions,” as well as some of the demographic trends in aging. And, as much as it pains me to admit this, the attendance isn’t great for that lecture. I’m lucky if I get 60% of my enrolled students, and many of those who do bother to show up spend much of the time text-messaging, podcasting, and whatever else they can do to pass the time. The following week, which is devoted to estate planning, is even worse. In fact—and I’m only half joking here—if you have some extra altruistic energy on your hands and want to take on a challenge, try spending time with a bunch of teenagers explaining the minutia of calculating Social Security payments early on a Monday morning, no less.
To be honest, I can’t say I blame them. These kids are just not interested in retirement income planning. It is 40 years ahead of its time for them. To many of them that might as well be infinity. They are concerned with finding their dream job, getting rid of their student loan debt, and hopefully accumulating some savings. Even the topic of buying a home is distant to them. The pension is outside their realm of experience.
Yet, when I have the occasional chance to interact with students’ parents and grandparents, the situation is very different. When I mention that I also teach and do research on pensions and retirement income planning, I feel like the only doctor at an evening cocktail party. Everyone wants free advice.
In fact, the personal interest in pension matters extends to my academic colleagues at the university. Around the age of retirement, all members of our pension plan must decide whether to take a lump-sum settlement and invest and manage it themselves, or whether to keep the money in the plan and instead receive a monthly income. Many of these professors have heard that I might “know something” about this issue, and I get a steady stream of biology, chemistry, and engineering professors visiting my office for a consultation around the time of their big decision. They are wondering whether they should take the money and run, hoping to get a better deal themselves. (Interestingly, I don’t get many humanities professors. I’m not sure why.)
But yet, the topic of pensions is more than just a matter of demographic interest. When I pose the question to my undergraduate students—which retirement arrangement would you rather have, defined benefit (DB) or defined contribution (DC)?—most of them select the DC plan. Some of them justify their decision with some fairly persuasive arguments. They point out that they will likely be working for a number of different employers over the course of their life. Some of them will be spending time in different countries, or at least industries. Few, if any, believe (or even dream) they will be working for one company over the course of 30 years. Therefore, they need retirement savings with mobility and flexibility. Alas, a defined benefit plan with its rigid formulas based on years of service and final salary would make little sense to them. It is a relic from an industrial past. Indeed, this is likely why so many employees are content with 401(k) and IRA plans. The employer’s only responsibility is to contribute 5% to 10% of their annual salary cost to this piggy bank, and the employees are responsible for everything else. They take the risk and get the reward.
The statistics I presented in the Introduction confirm this way of thinking. Many of the companies freezing or converting their defined benefit (DB) pensions and replacing them with defined contribution (DC) plans are doing so partly as a result of the demand from employees.
And yet, as the trends in aging, which I discussed in Chapter 7, “Longevity Is a Blessing and a Risk,” continue to develop over time, the topic of pension and retirement income will only grow in importance. Remember that retirees face a number of unique financial risks that are not (as) relevant earlier on in life. As I explained in Chapter 7, retirees face longevity risk, which is the uncertainty of their life horizon and its costs. Retirees face unique inflation risk, based on the data I presented in Chapter 5, “Personal Inflation and the Retirement Cost of Living.” Finally, they have to deal with a particular type of financial market risk, which has been dubbed the term sequence of returns. So, the risks are new and different, and you will need a different strategy.
As you can see from Table 11.3, approximately 80% of the income being received by individuals above the age of 85 is longevity-insured. The remaining 20% of their monthly income might be exhausted prior to the end of their life. For younger individuals the percent that is longevity insured is even lower.
Table 11.3. What Fraction of Elderly Income Contains Longevity Insurance That Can’t Be Outlived? (Average for U.S. Population)
Social Security, pensions, and annuities. Source: Employee Benefit Research Institute, 2006.
Last Words: Developing and Protecting Your Personal Balance Sheet
The ultimate financial goal should be to prepare, build, and then create a sustainable source of income before, during, and through retirement. The journey begins as a teenager and in your early 20s, when you try to develop your human capital. This stage of your life involves choosing a college major and subsequently a career. This might be the most crucial decision of your financial life, because your human capital makes up the majority of your personal balance sheet until retirement.
Table 11.4 illustrates the importance of picking a college major. Over the first year of work, the return on investment (ROI) of your degree is naturally negative. However, after a five-year time span, for all professions in the table with the exception of public defenders, the annual ROI is positive. The data gives us some interesting insights. As expected, the more lucrative, technical careers such as medical doctors and software engineers have a higher rate of return than social workers and paralegals. However, someone with a law degree (J.D.) is earning a negative rate of return on their education. Why is their ROI negative after they have spent over $250,000 on their education and secured a valuable source of human capital? Well, depending on the profession you choose, your human capital might be valued differently. It is no surprise that a public defender, who is employed by the government, makes considerably less than a corporate lawyer. Therefore, be mindful that the value of your human capital not only depends on your education level, but also the career path you select with your human capital.
Table 11.4. Is Your Degree Worth It?
Source: Citi Student Loans
After you have built up your human capital, your next goal is to protect it. Purchasing basic life insurance when you are young and have many dependents is a prudent way to hedge the considerable human capital you have developed. Conversely, as you reach retirement, you want to hedge against your financial capital running out before you die. This can best be achieved through longevity insurance and annuities.
As you age, your human capital will begin to diminish in value, and you will hopefully convert enough of it into financial capital. A sound principle to heed with both sources of capital is diversification. As was previously shown in Table 11.1 and Table 11.2, Americans tend to deploy their financial capital into the industry and company that they are employed by. This is not a sound diversification strategy and your capital should instead be spread among a variety of investments, industries, and products. One allocation strategy is based on how much your human capital resembles a stock or a bond. If your job is closely tied to the stock market, then the present value of your future earnings (that is, your human capital) is very sensitive to shocks in the equity markets. Consequently, to eliminate risk and be fully diversified, your financial capital should be invested in fixed income or money markets. Remember that diversifying across time (not trying to time the market) and space (investments that are independent of one another) is also important to help reduce risk.
Although we are conditioned to avoid debt at all costs— especially in the wake of the Great Recession—I have argued that it can indeed be useful and might even help with the development of your personal balance sheet. For example, two-thirds of college graduates had loans in 2010, with average student debt of $25,250. By pursuing higher education, these students were able to develop their human capital, making the debt ultimately worthwhile (assuming they were employed after graduation). Furthermore, if your human capital is bond-like, then you might be overexposed to bonds, and leverage—which is like selling bonds—might be your best course of action to achieve smart diversification. Despite the benefits of debt, caution is always advised because the downsides of leverage can be disastrous.
After you have a sizable amount of financial capital, being cognizant of some of the risks affecting it is important. First, inflation should be a major concern. If the return on your financial capital is unable to exceed the rate of inflation, then your real wealth will slowly erode. When you are in retirement, the effects of this are even more potent, as you no longer have human capital that rises in tandem with inflation. Instead, your personal balance sheet, which predominantly consists of financial capital, is exposed to an inflation rate that is often higher than the one affecting the average wage-earner. Remember that the CPI-E tends to exceed the broader CPI-U and CPI-W in the U.S.
In addition to inflation, the financial capital of retirees is impacted by market volatility and especially sequence of returns risk. If you are a retiree who regularly withdraws money from your nest egg and are hit with the misfortune of negative returns at the start of your retirement, then you might exhaust your portfolio much earlier than you expect.
The final risk to consider is longevity. Life expectancy is constantly increasing and a high chance exists that you might live into your 90s. With only financial capital remaining on your personal balance sheet when you retire, a legitimate concern of yours should be whether or not this nest egg will last for the rest of your life.
Given these risks, you must manage your financial capital to create a sustainable retirement income. The more human capital you are able to convert into financial capital throughout your lifetime, the less likely you will risk what I call “retirement ruin.” One way to determine whether your retirement plan is sustainable is to use computer algorithms (known as Monte Carlo) to simulate both your longevity and the behavior of the market. This can give you a good indication of whether or not your nest egg will last. If you find that your nest egg is insufficient for a sustainable retirement, then you should consider delaying retirement, reassessing your desired consumption level, and reevaluating your risk profile.
Shielding against these risks is also possible with the use of annuities. They can help you protect your financial capital against inflation, sequence of returns risks, and an uncertain life expectancy. A variety of financial products can achieve these goals, many of them sold by insurance companies. Choosing the one right for you depends on your goals regarding liquidity, behavioral discipline, and how much you plan to leave to your estate.
The financial crisis has complicated retirement planning while also wreaking havoc on the personal balance sheets of many Americans. As you saw in the first chapter, assets have dropped by 10.7% since the financial crisis, while debt has climbed by 7.5%, eroding 23.4% of Americans’ net worth. For many retirees, this has put the sustainability of their retirement income in jeopardy.
The Great Recession has also compounded the risks inherent to financial capital. Inflation is more of a threat than ever because of negative real rates of return, sequence of returns risk has been exacerbated by the most recent bear market, and longevity risk has increased due to rising life expectancies. Nevertheless, some lessons were learned from the financial crisis—it reaffirmed the importance of diversification and demonstrated the danger of too much leverage.
Although your financial capital might have taken a hit during the Great Recession, you must remember that this is only a fraction of your net worth. Your personal balance sheet also consists of your human capital, which has emerged relatively unscathed after the financial crisis. You are wealthier than you think!
The bottom line is that you must protect both your human and financial capital. Diversification, life insurance, annuities, and some debt can all help you achieve your goals. But before you take any course of action you must first ask yourself: Are you a stock or a bond?