These days the retirement scene is changing, around the world. More and more, the onus is placed on individuals, rather than on pooled arrangements. But it’s possible for new forms of pooling to be made available by employers, associations and unions, and they would help employees enormously.
Our session at the World Pension Summit focused on the role of employer, in these changing times, in retirement planning for employees. In discussing these ideas after I returned home, I was reminded that employees can belong to many groups – not just their employer, but also to employer associations and unions – and it’s the collectivity that’s the key to providing pooled solutions. So in this post I generalize to the collectivity responsible for the retirement arrangements.
Remember the traditional “three pillars” on which retirement finance is based?
The first pillar is the state pension, increasingly under stress these days as we live longer and have fewer children. But that’s not my focus here.
The second pillar is workplace arrangements. Those are changing rapidly from “defined benefit,” under which you receive a guaranteed amount of retirement income for as long as you live, to “defined contribution,” under which you have an account in which you accumulate assets, and typically you take it as a lump sum on retirement and go your own way.
The third pillar is personal saving. And here of course you make your own arrangements.
So it’s easy to see how “do it yourself” is coming to dominate retirement.
It doesn’t have to be that way. Here are some ideas that collectivities can implement, to help their plan members.
They’re based on ideas from the old second pillar with its defined benefit. This had two huge advantages for the members:
- It removed the impact of uncertain individual longevity. How long does your money need to last? It doesn’t matter; your retirement income is guaranteed to last as long as you do. This is typically a retiree’s greatest fear, removed.
- It substituted institutional investment experience for individual investment inexperience. Individuals are typically not knowledgeable about investing. But the fiduciaries of the defined benefit arrangements typically are, and make more suitable decisions.
Overall, the cost of those retirement arrangements are dramatically less expensive, for two reasons:
- It’s only necessary for an individual to save enough money to last an average lifetime, not the let’s-be-safe idea of investing for a longer-than-average horizon.
- Institutional investment arrangements are much less expensive than individual ones.
All those old advantages can be brought back, to benefit individuals in the new world. I’ll explain how, after I explain why it’s so very important.
First, a little-known fact, one that I’ve been writing about for many years, since I discovered it when planning for my own retirement. It’s that, after age 75, longevity uncertainty has the biggest financial impact on retirees. What does that mean?
Investment uncertainty is something we understand. We know we can invest for safety and certainty, or we can invest for growth. Investing for growth can be scary, because we’re unsure what the outcome will be. Of course, we hope it will be favorable – and more often than not, it is. But it’s uncertain. The outcome could be good, it could be bad. One way that techies have devised to measure the extent of the uncertainty is to compare the range of possible outcomes to the best expectation of the outcome. For example: after a specified number of years, you could reasonably expect to receive $100 from Investment A, give or take $10. Or, from Investment B, $100 give or take $30 – and that comparison makes it clear that Investment B is more uncertain, more risky, than Investment A.
We can think of longevity uncertainty in the same way. We can calculate the amount we need to accumulate in order to lock in our desired spending for any given horizon. But our lifetime is uncertain. We obviously need less if we don’t live as long as average. And we need more if we live longer than average. We can express the effect of this uncertainty in our longevity in the following way: at our age, we need to save $100, give or take some amount. Of course, the question is: give or take how much?
I won’t go into the details, but it turns out that the “give or take” amount becomes greater, once you’re age 75 or older, than the “give or take” amount when you invest in equities, which are the traditional growth investment.
At age 75 most people are much too scared to invest their entire retirement pot in equities. Well then, they should be even more scared to take the risk of living with longevity uncertainty. In other words, even more than wondering about your investments, you ought to be thinking about how to hedge (that is, reduce the impact of) your longevity uncertainty.
One obvious way is to buy individual longevity insurance. Unfortunately, it’s available in very few countries around the world. (One such country is the US. My wife and I have bought longevity insurance there.) But there’s an alternative that a collectivity can provide anywhere, though it isn’t well known.
It’s to create a longevity pool. (Or of course to join someone else’s pool, if you can find one.)
The principles underlying a longevity pool are well known, to techies. In fact, it’s very similar to providing what’s sometimes called a “target benefit.” This is like a defined benefit in that it’s guaranteed to last as long as you live; but the amount is not totally guaranteed. It could fluctuate up or down a little bit, depending on whether the group of people in the pool seem to be living a bit longer or a bit shorter than average. Those fluctuations, however, are typically very much smaller than would be caused by investment value fluctuations.
The amount you should be able to draw out of the pool each year is probably much higher than you would draw from your own (unpooled) assets. Why? For the reason that reader MT identified, in his comment on Post # 12. In the example there, you would only need to save for your expected 30 years of withdrawals, rather than for the more cautious approach of planning for 36 or 40 years of withdrawals. When I made calculations for my wife and me some years ago (when, admittedly, interest rates were much higher), for us the difference amounted to more than 30%.
That’s huge. And the cost of running such a pool should be much less than the implicit cost of buying longevity insurance, because there’s no need to provide a guarantee, the way insurance companies have to.
Please … some employer, association or union, start a longevity pool!
The other aspect I mentioned at the start is investment experience. Collectivities and the fiduciaries appointed to run them are well used to making investment decisions. Individuals typically are not. That’s one reason why, for most people, default investment arrangements such as a so-called “glide path” make sense when you’re working and accumulating your retirement pot.
It would make just as much sense for collectivities to offer you the chance to keep your money in the plan/scheme/fund (whatever the name is, in your country) after you retire.
The main benefit would be cost savings. Typically the cost of pooled investments for collectivities is dramatically lower than the cost that individuals are charged. The difference could be anything up to 1%, perhaps even 2%, a year. Calculate for yourself how much that would be, based on the amount you’ve accumulated or are likely to accumulate by the time you retire. Again, typically this has a huge impact on the amount you can draw down from your pot each year.
Those are two extremely helpful pooling ideas that collectivities could make available, even in times when the scene is changing to place the onus on individuals.
In private correspondence, which he gives me permission to quote, World Pension Summit panelist Alwin Oerlemans of APG broadens the discussion to include working arrangements. This was before I expanded the focus to the role of collectivities, and so he refers in this note to the employer – but adds additional angles: “In this blog you point to the role of the employer. The role of the employer will remain crucial in the future because pension deals are very much long term. Because circumstances change over time it is important to have those who designed the pension contract involved in how to deal with changing circumstances. To the benefit of both employers and employees. Both benefit from a pension design that allows employees to be productive and innovative as longevity and retirement at higher ages lead to more experienced workers in the workplace.”
I know that among my readers are both ordinary people and retirement techies. Permit me to ask the techies: are you aware of any arrangements available, in your country, that permit individuals to join pools, whether for investment purposes or for longevity purposes? Do let me know. I have no financial interest in any such arrangements. I’ll be happy to let my readers know about them, so they can tell their relevant collectivity. Thanks!
And for you, the reader, as an individual for whom life after full-time work is or one day will be a reality: if you aren’t already in some form of collective retirement arrangement, it might be worth your while to see if you can join one.
Employers, associations and unions can form or join longevity pools, to spare their members the risk caused by uncertain longevity. And they can permit retirees to benefit from the lower cost of pooled investment arrangements.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.