The Future of Life-Cycle Saving and Investing

Dear Readers,

I had the wonderful opportunity to attend a conference titled The Future of Life-Cycle Saving & Investing held at the Boston University School of Management from October 25th to 27th. The event was sponsored by Boston University with co-sponsorship by the U.S. Federal Reserve Bank of Boston’s Center for Behavioral Economics, and the Research Foundation of the CFA Institute. The rationale for holding this conference included:

1. We live in a time of great changes in the way Americans save, invest, and manage the risks of protecting their standards of living in their retirement years.

2. The Baby Boom generation (the leading edge- born in 1946- is now within 5 years of the traditional retirement age) is the most prosperous, healthiest and longest-lived generation ever. And this generation (median age 50) faces an unprecedented number of choices and challenges regarding their retirement saving and investing.

3. With the revolution in financial markets and technology since the early 1970’s, and advances in research on behavioral finance since the early 1990’s, we finally have the intellectual foundations to create a new field of science for life-cycle savings and investing

The conference was fascinating both in the diversity of participants who attended and the shared sense of urgency among attendees that new theories, concepts, models, tools and (ultimately) financial products and services will be necessary to address the needs of a huge segment of population (over 20% of the total population in the U.S. alone) who hope to retire comfortably within the next twenty-five years.

Among the participants were senior representatives of the insurance industry, the investment management industry, the commercial banking industry, a major international trade union, several retirement policy and advocacy groups (e.g. The American Association of Retired People- AARP and the Employee Benefit Research Institute), the U.S. Department of Labor (Employee Benefits Security Administration), the actuarial science profession and many senior academics in finance and economics (including two Nobel laureates, Professor Paul A. Samuelson of MIT and Professor Robert C. Merton of Harvard, each of whom provided a keynote address at the dinners over this three day event).

Professor Zvi Bodie of Boston University (and co-author of Worry-Free Investing) was a key figure in organizing the conference and encouraging all attendees to participate in the lively debates that followed the presentation of papers. The conference sessions included “Can Personal Investing Be Rational?”, “Innovative Retirement Income and Old Age Insurance Products”, “The Role of Government in Life-Cycle Saving and Investing” and “The Theory of Optimal Life-Cycle Saving and Investing”. (Most of the papers from the conference can be downloaded at http://smg.bu.edu/exec/elc/lifecycle/).

The Need for A New Approach to Retirement Planning

Many of the post-World War II working generation accepted an implicit lifetime employment contract with their employers (often large corporations). They exchanged lifetime loyalty to the employers in return for defined-benefit retirement plan. The benefits were largely determined in the last 3 to 5 years of employment prior to retirement tied to a formula based on number of years of service and the wages/salary in the last years of employment. And there were significant penalties for violating this implicit contract including forfeiting all future benefits if one left prior a defined ‘vesting period’ which was up to ten years as recently as the early 1980’s.

Today, significantly fewer of today’s pool of future retirees (including those aging baby-boomers) are offered by this option. And current participation in defined benefit pension plans also continues to decline as many companies terminate these plans and shift current employees into defined contribution plans where their past, accrued and vested defined benefits are converted into a monetary value along with the promise of future employer contributions that the employee is now responsible for managing. As for Social Security, this defined benefit plan run by an agency of the U.S. government will come under increasing pressure as the ratio of employed contributors to retired beneficiaries’ declines over the next three decades.

An Excellent Start to a Difficult Challenge

The conference was a start- and an excellent one- for tackling the future challenges and problems millions of people face with this tectonic shift in responsibility for retirement security from employers to employees. And the current challenges are great indeed. This brave new world for retirement planning rests on two critical decisions by individuals: (1) How much should one save for retirement over the course his/her working career; and (2) How should he/she invest these retirement savings in order to ensure a secure and comfortable retirement.

In terms of individual retirement savings decisions, a paper presented by Beshears, Choi, Laibson and Madrian (based on a confidential analysis of recent employee participation rates in defined contribution retirement plans) indicated that employee participation in these plans is not rational based on current economic theory. Many employees forego making contributions to company-sponsored defined contribution retirement plans-sometimes for three to ten years, and this despite the promise of employer matching contributions (on a tax-free basis). And from a behavioral finance standpoint, many participating employees in these defined contribution plans opt for legally required ‘default’ option for the type of investment and minimum matching employer contributions- currently 2%- when many alternative investment options are offered, and higher employee contribution rates would be matched dollar for dollar on a tax-free basis. Clearly, this form of economic choice and incentive for employees is not working.

In terms of individual investing decisions, Professor Bodie argued that some retirement investment advice currently being offered is wrong. As an example, consumers are being told that the way to protect themselves against inflation in retirement is to invest in stocks. In fact, US Treasury inflation-protected securities are a far better hedge against the risk of inflation. Indeed the reason given by the US Treasury in 1997 for starting to issue these securities was to provide consumers with a safe way to protect their retirement savings from the risk of inflation. Many employers are beginning to offer these securities-called TIPS-as one of many investment choices to their employees.

Another issue Professor Bodie raised is the flawed concept of "Time Diversification" which he believes is being used by some investment advisors to encourage people to accept extremely high levels of equity investments in their retirement portfolios under the mistaken notion that what is proven to work in asset class diversification (reductions in overall portfolio risk) can also be achieved simply by holding a single risky asset class "long enough" (hence the term time diversification- with 'long enough' is never explicitly defined) to smooth out and reverse the declines of value that come with periodic equity market declines.

Underlying all the discussion on saving and investing for retirement was the recurring question of life expectancy. It has historically increased in the U.S. and future advances in medical technology could possibly have a dramatic effect on future life spans, even among those now fifty and over. And so, t