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sample pages e-book It's the Income, Stupid: The 7 Secrets of a Stress-Free Retirement
Confusing the need for a pot of money with the need for income can lead to very expensive mistakes.
Defined Contribution (DC) ,
CD is Certificate of deposit,
Description: A certificate of deposit is a time deposit, a financial product commonly sold by banks, thrift institutions, and credit unions. CDs are similar to savings accounts in that they are insured "money in the bank" and thus virtually risk free.
its principles are readily transposable
a viewpoint well worth hearing
Forget fund values – income is all that matters, and it should and can be delivered through scalable annuitisation and drawdown strategies tailored to the individual’s needs, without the necessity of delivering full financial advice. That is the message of Professor Robert C Merton, resident scientist at Dimensional Holdings.
You could be forgiven for thinking ‘well he would say that, wouldn’t he’, given the fact that Dimensional launched a managed DC liability-driven investment product last autumn. But a glance at Merton’s CV, which reveals credentials such as a Nobel prize for economic sciences for his work on derivatives and his post as School of Management Distinguished Professor of Finance at Sloan School of Management, MIT and it becomes clear he’s worth listening to.
His first premise is that DC needs to be completely redesigned, with the focus on growth in fund values needing to be almost entirely purged from our system. Confusing the need for a pot of money with the need for income can lead to very expensive mistakes he argues.
“You cannot say wealth goals are approximate to income goals. Imagine you are a 45 year old and you are going to retire at 65. In returns of income, what is the risk free asset? It is an asset, fully guaranteed, that 20 years from now starts paying you a level income for the rest of your life, corrected for inflation. I created one of those, called a real annuity, and from 2003 to 2012 I ploughed the monthly returns and we saw swings of -17 per cent and +15 per cent, on a risk-free asset. Yet when you measure this asset in terms of income, there’s no risk. So when someone says we can approximate an income goal with a wealth goal, as a practical matter, it doesn’t even come close,” says Merton.
“Or since 2008, suppose someone was lucky enough to have £1m to live off. If they had been very conservative and had bought bank CDs, six or seven years ago they would have told you their income was 4.5 or 5 per cent and they would have got £45,000 to £50,000 a year. Now you say to them, congratulations, I have preserved your £1m. But they say, yes and I am getting £4,000 to £5,000 a year. I can’t live on that,” he adds.
Merton argues that the culture of interpreting pensions in terms of fund values has developed because the DC sector has emerged from the mutual fund industry.
“The government benefit doesn’t give you a pot. The most intuitive thing for people is income. Income correlates with standard of living, in every aspect. Even in Pride and Prejudice, when Jane Austen evaluates Darcy and all the other men, she didn’t say he was worth £200,000. She said he was worth £10,000 a year,” he says.
Merton envisions a DC system whereby the focus is shifted towards achieving the real, inflation-corrected retirement income that retirees need. That means a move away from the risk concept typical in current DC schemes of investment risk or capital loss and the volatility of returns, towards income outcomes.
Individuals’ own tailored strategies can be assessed by asking four key questions – what is your desired income target; what is the minimum income that would be acceptable if you do not reach your desired target; how much money are you willing to contribute on top of employer contributions and when do you plan to retire. These questions can be asked through simple online tools.
For those members who will not even be engaged enough to answer these four questions, default answers can be constructed from information held about them, including age, gender, salary, current balances and possible other sources of income including state benefits, other pension rights and future contributions.
All this data is then used to create an asset allocation strategy targeted to an inflation-linked duration-matched fixed-income portfolio that will be required to achieve conservative target income with 96 per cent probability. Excess available assets, for those savers lucky enough to have them, are used to target desired income. Shortfalls are flagged to the individual.
Then when the individual reaches retirement, Merton’s strategy continues seamlessly, with the individual securing income in three tranches, dependent on how he or she can afford to risk being without it. Level 1 is guaranteed income for life, the minimum the individual can afford to live off. Level 2 is conservative income, managed on the basis of a 96 per cent probability of achieving that income. Most retirees will life off level 1 and level 2 income in Merton’s world. But those with more than enough can elect to take greater risk through a third tier of more aggressive assets.
Merton’s solution introduces the potential for both annuitisation and draw down being offered through defaults where the individual has either asked for or had imposed on them a tailored solution that is, arguably, more suitable for their needs than a simple vanilla default fund. While today’s small DC pots may almost all end up in annuities, it won’t be long before something more complex will be required.
Merton proposes making decisions on behalf of individuals to the extent that the law permits, arguing that doing the best you can for people is better than simply washing your hands and saying it is too complicated and risky.
He says: “I would propose setting the default level 1 income based on two factors – the available academic research about the replacement rates that will be required for different salary levels to meet their basic needs in retirement and the years of service from enrolment until retirement, or earlier termination, and other variables, including contributions and account balances.”
The remainder of their assets would be moved into level 2 income, which could be interpreted as meaning it is placed in some form of managed draw-down strategy. Such a non-advised, low-cost managed draw down strategy is understood to be in the long-term plans of the product development team at Dimensional.
His thoughts reflect ideas bubbling under in UK workplace pensions, yet they come at a time when auto-enrollment is being put in with a very light focus on outcomes. It is as though providers and policymakers are scared to tell people just how little they are going to get for fear they will leave their scheme immediately.
This approach, says Merton, is not only misguided, but also dishonest and irresponsible.
“From a regulator, politician or employer’s point of view there will never be a time when it’s a good time to tell them the truth,” he says.
“Our system kicks out a report saying if your plan drops below a set level, this is what you have to do to get to this goal. You may not like it but you at least can do something about it. It’s like a doctor’s report. All of us want to hear we are in perfect shape. But do you want the doctor to say that if there is something wrong with you?” he says.
He argues a dose of honesty might not be as unpleasant as we might think. “For young people who say they don’t want to save now, the message is that one way or another they are going to have to pay for their retirement, so they may as well start early and make the most of tax breaks and employer contributions. That way they will have more to spend in your thirties, forties and fifties.”
And the UK’s auto-enrolment project means we have an opportunity to start getting things right.
“All these people coming to pensions for the first time are virgins. That is a good thing because you can take them and say what income they are going to get. Yes there is a page saying what the fund is worth if they liquidate it, but that is at the back, not at the front.
“Take these virgins and don’t let them learn bad habits. Particularly for the groups that matter most, talk to them about income. If you don’t do this right, everything you have to do is going to be an uphill battle. This is actually a great opportunity.”
The report from the Office of National Statistics earlier this year showing a further fall in the overall level of pension saving in defined contributions schemes made for depressing reading. It may be that the widening out of pension saving through the process of auto enrollment will eventually reverse this worrying trend, but it leaves me feeling uneasy about the overall direction of pensions in the UK in the early decades of the 21st century.
Half a century ago, in the late 1960s and early 1970s, we had a thriving private and public sector defined benefit culture in the UK. Admittedly it only extended to that half of the workforce working for the very largest employers (including the largest of all employers, the Government), but for a very long time we had a real and widely-held culture of paternalism and business pragmatism on the part of such employers.
From an individual’s point of view this strong employer covenant meant, in effect, that those covered by defined benefit pension schemes were paid every month or week with two forms of income: ready money that they could spend on daily living and deferred pension money that they could not access until they reached a relatively old age.
Such people were building up substantial pension wealth while their neighbours who were not in defined benefit pension schemes were not. This is something that was not apparent to many people at the time and is only now becoming widely known because of recent pension reforms, giving people wider access to and rights over their accrued defined benefit pensions – the so-called pension freedoms.
For decades, two families in neighbouring houses could well have thought that their lot in life was much the same. But if one family had a parent or parents accruing pension wealth through a defined benefit pension scheme and the other did not then their lifetime financial realities were likely quite different.
Pension wealth, though, is invisible while people are of working age. These neighbours may well have had similar cars on the driveway over the years, spent similar amounts on household luxuries and holidays, and felt their lives were the same.
But in reality they were not. A defined benefit pension scheme promising pension benefits based on a sixtieth of near-final earnings for each year of employment would have required funding at the level of something like 23 to 25 per cent of earnings every year. While some employees were lucky enough to be in schemes that required no contributions from the employee – non-contributory schemes were commonplace in the banking and insurance professions – most employees would have been required to pay 5 or 6 per cent of their earnings towards the cost of the pension benefits. That level of contribution though would still have left the employer making the lion’s share of the annual contribution required.
For people who have been members of defined contribution pension schemes for all of, or many decades of, their working lives, the invisible pension wealth accrued can have been quite substantial. It is not at all uncommon for such people to find that the pension wealth they have accrued over the course of their working lives is worth more than the houses they have spent most of their lives paying for through their mortgage.
Their invisible wealth may in practice mean they have accrued lifetime assets of double the value of those of their neighbours. Something nobody in the 1960s and 1970s would ever have thought credible.
Today, this quite shocking reality is beginning to become widely understood, but is doing so at a time when the commitment of employers to their employees’ pensions is diminishing.
While it is understandable that employers have closed down defined benefit schemes because of the risks they entail for businesses, the switch to defined contribution schemes has been made with a corresponding reduction in the amount employers seem prepared to contribute to such schemes.
Many see this as a failure of the schemes themselves, but I do not go along with the demonisation of defined contribution schemes.
sample pages e-book It's the Income, Stupid: The 7 Secrets of a Stress-Free Retirement
Confusing the need for a pot of money with the need for income can lead to very expensive mistakes.
Defined Contribution (DC) ,
CD is Certificate of deposit,
Description: A certificate of deposit is a time deposit, a financial product commonly sold by banks, thrift institutions, and credit unions. CDs are similar to savings accounts in that they are insured "money in the bank" and thus virtually risk free.
its principles are readily transposable
a viewpoint well worth hearing
Forget fund values – income is all that matters, and it should and can be delivered through scalable annuitisation and drawdown strategies tailored to the individual’s needs, without the necessity of delivering full financial advice. That is the message of Professor Robert C Merton, resident scientist at Dimensional Holdings.
You could be forgiven for thinking ‘well he would say that, wouldn’t he’, given the fact that Dimensional launched a managed DC liability-driven investment product last autumn. But a glance at Merton’s CV, which reveals credentials such as a Nobel prize for economic sciences for his work on derivatives and his post as School of Management Distinguished Professor of Finance at Sloan School of Management, MIT and it becomes clear he’s worth listening to.
His first premise is that DC needs to be completely redesigned, with the focus on growth in fund values needing to be almost entirely purged from our system. Confusing the need for a pot of money with the need for income can lead to very expensive mistakes he argues.
“You cannot say wealth goals are approximate to income goals. Imagine you are a 45 year old and you are going to retire at 65. In returns of income, what is the risk free asset? It is an asset, fully guaranteed, that 20 years from now starts paying you a level income for the rest of your life, corrected for inflation. I created one of those, called a real annuity, and from 2003 to 2012 I ploughed the monthly returns and we saw swings of -17 per cent and +15 per cent, on a risk-free asset. Yet when you measure this asset in terms of income, there’s no risk. So when someone says we can approximate an income goal with a wealth goal, as a practical matter, it doesn’t even come close,” says Merton.
“Or since 2008, suppose someone was lucky enough to have £1m to live off. If they had been very conservative and had bought bank CDs, six or seven years ago they would have told you their income was 4.5 or 5 per cent and they would have got £45,000 to £50,000 a year. Now you say to them, congratulations, I have preserved your £1m. But they say, yes and I am getting £4,000 to £5,000 a year. I can’t live on that,” he adds.
Merton argues that the culture of interpreting pensions in terms of fund values has developed because the DC sector has emerged from the mutual fund industry.
“The government benefit doesn’t give you a pot. The most intuitive thing for people is income. Income correlates with standard of living, in every aspect. Even in Pride and Prejudice, when Jane Austen evaluates Darcy and all the other men, she didn’t say he was worth £200,000. She said he was worth £10,000 a year,” he says.
Merton envisions a DC system whereby the focus is shifted towards achieving the real, inflation-corrected retirement income that retirees need. That means a move away from the risk concept typical in current DC schemes of investment risk or capital loss and the volatility of returns, towards income outcomes.
Individuals’ own tailored strategies can be assessed by asking four key questions – what is your desired income target; what is the minimum income that would be acceptable if you do not reach your desired target; how much money are you willing to contribute on top of employer contributions and when do you plan to retire. These questions can be asked through simple online tools.
For those members who will not even be engaged enough to answer these four questions, default answers can be constructed from information held about them, including age, gender, salary, current balances and possible other sources of income including state benefits, other pension rights and future contributions.
All this data is then used to create an asset allocation strategy targeted to an inflation-linked duration-matched fixed-income portfolio that will be required to achieve conservative target income with 96 per cent probability. Excess available assets, for those savers lucky enough to have them, are used to target desired income. Shortfalls are flagged to the individual.
Then when the individual reaches retirement, Merton’s strategy continues seamlessly, with the individual securing income in three tranches, dependent on how he or she can afford to risk being without it. Level 1 is guaranteed income for life, the minimum the individual can afford to live off. Level 2 is conservative income, managed on the basis of a 96 per cent probability of achieving that income. Most retirees will life off level 1 and level 2 income in Merton’s world. But those with more than enough can elect to take greater risk through a third tier of more aggressive assets.
Merton’s solution introduces the potential for both annuitisation and draw down being offered through defaults where the individual has either asked for or had imposed on them a tailored solution that is, arguably, more suitable for their needs than a simple vanilla default fund. While today’s small DC pots may almost all end up in annuities, it won’t be long before something more complex will be required.
Merton proposes making decisions on behalf of individuals to the extent that the law permits, arguing that doing the best you can for people is better than simply washing your hands and saying it is too complicated and risky.
He says: “I would propose setting the default level 1 income based on two factors – the available academic research about the replacement rates that will be required for different salary levels to meet their basic needs in retirement and the years of service from enrolment until retirement, or earlier termination, and other variables, including contributions and account balances.”
The remainder of their assets would be moved into level 2 income, which could be interpreted as meaning it is placed in some form of managed draw-down strategy. Such a non-advised, low-cost managed draw down strategy is understood to be in the long-term plans of the product development team at Dimensional.
His thoughts reflect ideas bubbling under in UK workplace pensions, yet they come at a time when auto-enrollment is being put in with a very light focus on outcomes. It is as though providers and policymakers are scared to tell people just how little they are going to get for fear they will leave their scheme immediately.
This approach, says Merton, is not only misguided, but also dishonest and irresponsible.
“From a regulator, politician or employer’s point of view there will never be a time when it’s a good time to tell them the truth,” he says.
“Our system kicks out a report saying if your plan drops below a set level, this is what you have to do to get to this goal. You may not like it but you at least can do something about it. It’s like a doctor’s report. All of us want to hear we are in perfect shape. But do you want the doctor to say that if there is something wrong with you?” he says.
He argues a dose of honesty might not be as unpleasant as we might think. “For young people who say they don’t want to save now, the message is that one way or another they are going to have to pay for their retirement, so they may as well start early and make the most of tax breaks and employer contributions. That way they will have more to spend in your thirties, forties and fifties.”
And the UK’s auto-enrolment project means we have an opportunity to start getting things right.
“All these people coming to pensions for the first time are virgins. That is a good thing because you can take them and say what income they are going to get. Yes there is a page saying what the fund is worth if they liquidate it, but that is at the back, not at the front.
“Take these virgins and don’t let them learn bad habits. Particularly for the groups that matter most, talk to them about income. If you don’t do this right, everything you have to do is going to be an uphill battle. This is actually a great opportunity.”
The report from the Office of National Statistics earlier this year showing a further fall in the overall level of pension saving in defined contributions schemes made for depressing reading. It may be that the widening out of pension saving through the process of auto enrollment will eventually reverse this worrying trend, but it leaves me feeling uneasy about the overall direction of pensions in the UK in the early decades of the 21st century.
Half a century ago, in the late 1960s and early 1970s, we had a thriving private and public sector defined benefit culture in the UK. Admittedly it only extended to that half of the workforce working for the very largest employers (including the largest of all employers, the Government), but for a very long time we had a real and widely-held culture of paternalism and business pragmatism on the part of such employers.
From an individual’s point of view this strong employer covenant meant, in effect, that those covered by defined benefit pension schemes were paid every month or week with two forms of income: ready money that they could spend on daily living and deferred pension money that they could not access until they reached a relatively old age.
Such people were building up substantial pension wealth while their neighbours who were not in defined benefit pension schemes were not. This is something that was not apparent to many people at the time and is only now becoming widely known because of recent pension reforms, giving people wider access to and rights over their accrued defined benefit pensions – the so-called pension freedoms.
For decades, two families in neighbouring houses could well have thought that their lot in life was much the same. But if one family had a parent or parents accruing pension wealth through a defined benefit pension scheme and the other did not then their lifetime financial realities were likely quite different.
Pension wealth, though, is invisible while people are of working age. These neighbours may well have had similar cars on the driveway over the years, spent similar amounts on household luxuries and holidays, and felt their lives were the same.
But in reality they were not. A defined benefit pension scheme promising pension benefits based on a sixtieth of near-final earnings for each year of employment would have required funding at the level of something like 23 to 25 per cent of earnings every year. While some employees were lucky enough to be in schemes that required no contributions from the employee – non-contributory schemes were commonplace in the banking and insurance professions – most employees would have been required to pay 5 or 6 per cent of their earnings towards the cost of the pension benefits. That level of contribution though would still have left the employer making the lion’s share of the annual contribution required.
For people who have been members of defined contribution pension schemes for all of, or many decades of, their working lives, the invisible pension wealth accrued can have been quite substantial. It is not at all uncommon for such people to find that the pension wealth they have accrued over the course of their working lives is worth more than the houses they have spent most of their lives paying for through their mortgage.
Their invisible wealth may in practice mean they have accrued lifetime assets of double the value of those of their neighbours. Something nobody in the 1960s and 1970s would ever have thought credible.
Today, this quite shocking reality is beginning to become widely understood, but is doing so at a time when the commitment of employers to their employees’ pensions is diminishing.
While it is understandable that employers have closed down defined benefit schemes because of the risks they entail for businesses, the switch to defined contribution schemes has been made with a corresponding reduction in the amount employers seem prepared to contribute to such schemes.
Many see this as a failure of the schemes themselves, but I do not go along with the demonisation of defined contribution schemes.
