PWL Capital November 18, 2014 Living in Retirement Market Research The Crisis in Retirement Planning Retirees don’t need assets, they need income The title is from a recent article in the Harvard Business Review1, by Robert C Merton, a Nobel prize winner in economics and Professor of Finance at MIT. The crisis he refers to is not what you might expect: this is not another plea from the financial industry for investors to save more. The crisis Robert Merton is referring to is in the way portfolios are managed. To quote from the article: “Our approach to saving is all wrong: we need to think about monthly income, not net worth” Investors who are saving for retirement have a simple question: “Will I have a sufficient income in retirement to live comfortably? ”The too common response from the investment industry is “yes, if you accumulate enough assets”. This propels a focus on asset growth as synonymous with higher income. This is a risky bet. Consider the situation where you wish to buy an income stream of $1 each year for the next 312 years. You could, of course, put $31 under a mattress and remove $1 every year. In reality you need to set aside less than $31 if you exploit the interest earned on holding $1 for 1,2,3 ..31 years. Over the past 5 years, the cost of buying such an income stream has varied from a low of $17.26 in Jan 2010 to a high of $22.30 in July 2012, a difference of 29%. In the chart below we show the daily change in the cost of buying the stream of income over 31 years. The main message from the chart is that the amount of future income that can be purchased from cash held today varies significantly over time. Although cash is risk free, if risk is defined in terms of price variation, it is quite risky when translated into future income units. Over the period Jan 2010 to July 2012 a balanced (60% equity, 40% fixed income) investment portfolio grew by 14.60% but the cost of buying a pension of $1 per year had grown at twice that rate: despite the asset growth, the investor experienced a decline in her ability to purchase future income. One way to buy future income is through an annuity. For a lump sum, an annuity will provide a regular income for as long as you live. However, few people buy annuities for a variety of reasons that are discussed here. Given that people are unlikely to change their behaviour, then we should focus on the best way of using common portfolio assets such as bonds and equities to provide the income that retirees want. Merton’s main target is the pension industry and the increasing reliance on defined contribution pension plans where plan participants, if they are provided any information at all, are encouraged to think about asset accumulation as the goal and risk as market volatility. However, individual investors are in exactly the same boat if they expect some portion of their investment capital to generate retirement income. In future articles we will explore how to plan for retirement income using the familiar mixture of stocks and bonds, but changing our perception of risk to focus on protecting income. ———– 1 See https://hbr.org/2014/07/the-crisis-in-retirement-planning (subscription required) 2 We chose 31 years so we can reference the historical data from the Bank of Canada on their benchmark 31 year bond. Share: Facebook Twitter LinkedIn Email