“With DBization as a core objective to strengthen the current DC design, but aware of the difficulties pure sponsor-guaranteed DB plans encounter as pension funds mature, the authors eloquently describe building blocks for a sustainable and satisfying retirement solution. These experienced writers have produced a work that is comprehensive yet accessible.”
—THEO KOCKEN
CEO, Cardano, The Netherlands, and author of Curious Contracts: Pension Fund Redesign of the Future
“This is not just another retirement planning book. The authors turn sound theory, common sense, hands-on experience, and a friendly, conversational writing style into a transformative vision of how to design and implement strategies for financing retirement in the 21st century. Policy makers, employers, and employees alike will find much wisdom in this work.”
—KEITH AMBACHTSHEER
Director of the Rotman International Centre for Pension Management, University of Toronto, Canada
“Ensuring a dignified retirement is an imperative for any society that dares call itself civilized. In The Retirement Plan Solution we finally have a roadmap that lays out how we get from here to there. This is a must-read for the retirement industry.”
—CHARLES RUFFEL
Founder and Director of Asset International and Founder of PLANSPONSOR
“Improvements in DC plans are essential for us to meet tomorrow’s demographic challenges. This book is really well thought through and makes a big contribution to this cause.”
—ROGER URWIN
Global Head of Investment Content, Watson Wyatt, United Kingdom
“This book provides an invaluable roadmap from which to explore key characteristics of best-of-breed pension design. It contains important concepts and messages that will inevitably improve the evolution of pension products.”
—DAVID ELIA
Chief Executive Officer, HOSTPLUS Superannuation Fund, Australia
Copyright © 2009 by Don Ezra, Bob Collie, and Matthew X. Smith. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Ezra, D. Don.
The retirement plan solution : the reinvention of defined contribution / Don Ezra, Bob Collie, Matthew X. Smith.
p. cm. – (Wiley finance series)
Includes bibliographical references and index.
ISBN 978-0-470-39885-2 (cloth)
1. Defined contribution pension plans. 2. Retirement–Planning.
I. Collie, Bob, 1966– II. Smith, Matthew X., 1961– III. Title.
HD7105.4.E97 2009
331.25’20973–dc22 2008053368
This book is dedicated to:
My extended family
—Don
Corinne, Alex, and Kate
—Bob
Karen, Rachel, Emily, and Matthew
—Matt
The biggest pension system in the world is in the United States, where for decades the defined benefit (DB) plan ruled the roost. But since the 1980s the defined contribution (DC) plan has taken root, and as many corporations have shied away from the cost of a DB guarantee, DC now dominates the scene in the private sector. In fact, the trend from DB to DC is virtually universal, not just an American phenomenon. We have not devoted this book to a discussion of the sustainability of social security systems around the world, or bemoaning the triumph of DC over DB, or calling for new legislation that will miraculously solve all problems. Our approach is more pragmatic. We point out where the DC system, as it currently operates, is inefficient, and show how improvements in two areas can make it an extremely productive force for generating postretirement income.
The two inefficient areas are in accumulating assets, where investment returns are unnecessarily lower than they could be, and in the payout or decumulation phase, to which far too little attention is paid.
We use the United States as the basis for our arguments. But exactly the same principles apply to DC systems elsewhere, and, in fact, we use the experience of other countries to make our points, focusing on the DC system in Australia and on the “collective DC” approach in the Netherlands and Canada.
We are pleased that part of the solution is already coming into play. That makes us all the more eager to show that what is happening is part of a larger solution that requires a change in mindset, a different kind of education, and a new set of investment products. And all of these three things have started to show up. Improvement is achievable and likely. We are enthusiasts, not doom-and-gloom merchants.
We aim the book at five potential sets of readers, falling into two broad groups. One group looks at the world from the institutional point of view: plan sponsors, their consultants, and opinion leaders and policy makers. The other group looks at the same issues from a personal perspective: individual DC plan participants and financial planners.
In a sense, the main readership is the community of plan sponsors: typically employers, mainly in the private sector but increasingly in the public sector. There is one important section aimed at individuals; apart from that section, the rest of the book is directly addressed at sponsors. “Here’s how your DC plans operate today. They’re inefficient. You ought to get better value for the money you contribute to them. The solution is in your own hands.” And a bit of: “This is now becoming part of public policy. Why not do it before it’s done to you?”
We think that employers will also be interested in the section aimed at individuals, for two reasons. One is that it takes the shape of: “Here is what your participants face. Once you understand their problems, you will see why the solution improves their lives.” The other is this angle: “You are a participant yourself; these are your personal issues, too.” We know from experience that this angle is one that excites interest, because we have used it with our clients to great (and popular) effect.
Any book aimed at sponsors will inevitably interest the community of consultants to sponsors. This group is always interested in ideas, seeing what is new, what is in accord with their own thinking, what they disagree with, what they feel they can improve on.
An implicit group of readers is the community of opinion leaders and policy makers. We hope they will find this a short book, easy to read, with analysis and directions to follow—although we hope that the solutions will be adopted voluntarily by the sponsor community, after reading the book, discussing the issues and the solutions in industry conferences, and so on.
We address the average participant directly in one important section. “These are the issues you face and the choices you face. They are particularly difficult when your income from work ceases and you are left with your DC accumulation and you have a number of conflicting goals. Here is how to think your way through the issues and the conflicts.” We are DC participants ourselves, and developed this perspective by thinking about our own situations. We believe participants will also be concerned to read a chapter that explains the studies that show how very inexpert they are as investors.
We think the financial planning community will also be interested in the chapters on individual postretirement issues and choices. We work with planners and have been told that our ideas are both original and useful. This is the first time that the ideas will have been widely published.
We aim the book directly at an American readership. But with extensive references to other countries, it will be easy for readers in other countries to identify with the issues and the solutions. That is our experience with literature in this field.
All the authors have spent a meaningful portion of their careers at Russell Investments. But this is not a “help Russell” book. Nothing in the book is aimed at favoring Russell’s business or products. We came to Russell by different routes, in different countries, with different backgrounds; and we found a culture that encouraged us to think and debate and write and test our ideas in practice. We are grateful for that culture, but the book that has emerged is our own responsibility. Indeed, no one firm ever has a lock on excellence of thinking, and we have no doubt that our ideas have developed as much from discussions with clients, competitors, and other notables as they have from internal challenge. That is how our industry is, and it is all the better for it. Perhaps our only original contribution is to assemble all of these ideas and make a logical presentation of them.
We acknowledge separately many people who helped us. Their comments on our first draft made us realize two things. One is that our approach is to discuss ideas in principle and show how they can be applied in practice, but we do not prescribe a single solution as the only possible way to go. That leaves readers with the freedom to think about the issues themselves, and choose their own solutions. The second thing we realized is that we have not been driven by ideology. Our reviewers interpreted our text as supporting their own predilections, even when these pointed in opposite directions. Not, they told us, because we were not clear, but rather because we have left open the possibility of a range of different solutions—some favored by one set of experts, some by another. Our agenda is the improvement—the reinvention—of defined contribution, and our role in that is to set out the challenges as clearly as possible. There is more than one way to respond to those challenges.
Go ahead, then, and use this as a thought piece and reference book that should enhance your identification of the issues and your understanding of the possible solutions, as society strives to create the retirement plan solution. The job is crying out to be done. You can do your part.
We finished the body of our book just as the markets—equity markets, credit markets, currency markets—went crazy at the end of October 2008, and we felt we could not ignore the greatest financial panic our generation has seen. We write this addendum in mid-February 2009, not knowing whether the worst is behind us or still ahead of us. Logically, these observations should go after the book, which is itself written with a long-term perspective; but adding a chapter at the end diminishes the intensity of the experience. So we’re placing this at the start.
What might otherwise have become a theoretical collection of ideas becomes very practical at a time when the whole financial system is being tested as it currently is. And looking at what we’ve written through the lens of these events sharpens the perspective. So we now touch on those ideas that appear to have grown in importance.
The first is the contrast in risk bearing between DB and DC. In a sense, the individual is always at risk, but in DB there are three buffers. The first is the pension fund itself; then there’s the solvency of the sponsor; and finally (in the United States) there’s the Pension Benefit Guaranty Corporation. Yes, after those buffers, the individual is still at risk, but the directness of the DC risk is in sharp contrast. In what we’ve called collective DC, that risk is shared by all the participants, whereas in the traditional individual-account DC there is no risk sharing. Plan design affects the incidence of risk enormously.
We devoted a chapter to the notion that retirement is expensive. This is not a new idea. But the uncertainty of how expensive it is arises from the uncertainty of investment returns (among other factors). This tie-in isn’t often mentioned. We felt that it needed some elaboration, but because it’s such an unusual concept we relegated some details to an appendix. The notion that markets might show no positive return over a 20-year period seemed outlandish to many of those we asked about it. It doesn’t seem quite so outlandish now.
In the same chapter, we mention the choices available when you haven’t accumulated enough money to support your desired postretirement standard of living. One is to postpone retirement. We suspect that it will now be the unhappy but necessary choice of many DC participants. In fact, when we discussed who would be affected by the stock market downturn, we knew that those close to retirement would feel it the most; but one of the many unfortunate impacts of a bear market is that a lot of people turn out to be further from retirement than they thought.
Wouldn’t target date funds provide some protection? Yes, but the operative word is some. For the 12-month period ending December 31, 2008, the average return of the three largest target date fund families’ 2010 funds (the fund for those nearest to retirement) was −24 percent.1 This is less bad than the average return shown by global stock markets for the same period of –43 percent.2 But “less bad” is all one can say. One ought to be at least partially grateful for whatever protection these funds provided. But the fact of risk exposure was undeniable.
The only way to avoid that risk exposure would have been to be completely out of the equity markets. You might have chosen to be out of the markets because you had low risk tolerance or because you indulged in market timing. Market timing is a dangerous tactic and very difficult to get right, because it requires you to be right twice: once in knowing when to get out of equities, and once more in knowing when to reenter the asset class. That’s a tall order, beyond the consistent capabilities of most investment professionals.
If you were out of equities because of low risk tolerance, this would have been one of those times when you could have slept more soundly than most. But then you would have denied yourself much upside opportunity over the years. Stocks rally from time to time; cash doesn’t rally. The right time to decide how much exposure to the volatility of equity markets you can bear is the time you set your strategy. Once you’ve done so, it can be doubly damaging to get out in midstream. That’s why “stay the course” has been the message of most experts.
Of course, this is not always the natural response of human beings, driven as we all are by emotional reaction. Risk tolerance itself comes into much sharper focus when you feel the downside of risk in your gut. We were reminded of our experience with DB clients in 2000–2002, when equities last tanked. Many representatives of sponsors hadn’t personally experienced such a sharp down market before. Yes, they had read about the 1970s, and some remembered October 1987, but that one-day drama got lost in the calendar year charts. They looked at the standard projections of possible outcomes 10 to 15 years into the future and intellectually weighed up the pros and cons of taking different levels of risk. Then, when they lived through 2000–2002, many felt that they had overestimated their risk tolerance. We say this not to criticize them, but to remind us all that we are human and prone to overconfidence, and that not until the amygdala in our Stone Age brains triggers a feeling of panic do we really know what is the limit of our risk tolerance.3
The chapter on the behavioral tendencies we inherit along with our DNA seems more significant to us now.
There’s one aspect of risk we simply shunted aside and ignored that now looms dramatically larger than when we were writing. It’s too late for a retreatment of the issue, but we can at least bring it to your attention here—counterparty risk. Yes, we mentioned it (well, of course—who wouldn’t?). But with the serial collapses of firms that had been thought of as financial powerhouses, we now know that no financial institution is immortal, and the potential demise of any financial institution with whom you do business becomes a factor worth considering.
We don’t know, as we write, the extent to which governments will feel obliged to offer blanket guarantees to restore confidence. But risk has a cost. In our everyday lives we call it a premium, and pay it year by year, whether or not the risk materializes. But governments traditionally don’t take the cost into account. Few, if any, expense an annual premium in their budgets. They typically carry the risk with no reserve, and then cough up huge amounts if the risk materializes. Risk does not go away, even if its incidence is deflected or postponed. Government underwriting really means collective risk sharing for all taxpayers.
For those already in the decumulation phase of their lives, we think our ideas about the three dials they can turn, and how to prioritize them, would have been helpful if they had been adopted. Those we describe as being in the “essentials zone” wouldn’t have had any exposure to stock markets. Those in the “lifestyle zone” should have had a large chunk of lifetime annuities, subject to counterparty risk (though as we write, no American life assurance company has yet collapsed) but not to equity market risk—unless these individuals or families deliberately took that risk in order to attempt to rise into the “bequest zone.” Those already in the bequest zone can afford equity risk exposure, as long as they monitor (as we advise) whether they are in danger of falling into the lifestyle zone. And those in the “endowed zone” can afford a very large amount of risk exposure before their day-to-day lives are affected in any way.
We find it comforting that this approach seems every bit as sound now as it did when we wrote it up.
Somehow society manages to fill in whatever holes it finds itself in from time to time and rises again. When that happens, the ideas in this book can be considered more calmly again.
DON EZRA
BOB COLLIE
MATTHEW X. SMITH
This book reflects the collective experience of the three authors over many decades practicing in the fields of pensions and investments. No one learns in a vacuum, and we have certainly been blessed by our associations over the years. The people we have had the good fortune to interact with—plan sponsors, advisers, consultants, fellow researchers, colleagues, competitors, individuals planning for their own retirement, lawmakers, regulators—have all aided our knowledge along the way. This book, and our careers for that matter, would not be possible without such a rich association.
When you want something done, ask a busy person to do it. Over the years we have come to know a number of the leading lights in the pensions industry in many countries. We took the opportunity to send our manuscript to them and asked for their comments—at short notice, of course. Where they found the time we don’t know. But they responded with insight and speed. We must have made a hundred changes as a result: some technical corrections, some clarifications, even some changes in direction. We didn’t follow every piece of advice they offered, but we think the book is much better, thanks to their efforts, and we are very grateful to them.
Those who have given us permission to thank them publicly are: Michael Barry (President, Plan Advisory Services); Richard M. Ennis, CFA (Chairman, Ennis Knupp + Associates, and Editor, Financial Analysts Journal); Wichert Hoekert (Watson Wyatt in the Netherlands); Lori Lucas, CFA; Fred Reish, JD (Managing Partner, Reish Luftman Reicher & Cohen); Dallas L. Salisbury (CEO, Employee Benefit Research Institute); Steve Schubert, FIAA (Russell Investments–Australia); Roger Urwin (Watson Wyatt, Global Head of Investment Content); and Jack L. VanDerhei, PhD, CEBS (Research Director, Employee Benefit Research Institute).
We also want to thank the professionals at John Wiley & Sons for their help and guidance. The speed and professionalism they exhibited made this project smoother than it might have been otherwise. Thanks especially to Meg Freeborn and Laura Walsh.
Finally, thanks to those to whom this book is dedicated—our families. The time we spent writing this book is time we could have spent with them. Their patience and understanding during this project were invaluable.
DON, BOB, AND MATT