From the December 2008 issue of Research Magazine • Subscribe!

December 1, 2008

Product Design

In February 2009, the Managing Retirement Income (MRI) conference -- sponsored by the Retirement Income Industry Association (RIIA) -- will focus on the design and development of retirement income products and processes. As a preview, let's look at the following question: What specific features and attributes should those who design retirement income products and processes seek to emphasize?

Cash FlowsBehavioral finance describes human nature and the limits of evolutionary control. This was the focus of Terry Burnham's keynote address during the 2008 MRI conference. Evolutionary change moves slowly. The pace is measured in centuries and millennia. Yet we live in a technological world that is changing faster than we do. The natural controls provided by our human nature often seem outdated in the face of the demands of modern life.

One of the consequences of our having evolved in a world of scarcity is that we are built to work hard, day after day. We are built to keep striving, no matter the accomplishments, no matter the setbacks. Those who worked like that were more likely to survive and we are their descendants. As a result, it is our nature to never be satisfied. This can be expressed in the form of an equation: (S)atisfaction equals (P)erformance minus (E)xpectations, or S = P - E.

Sadness or happiness may largely come from the difference between what we expect and what we get. Every day, perhaps even every minute, we reset our expectations. We are happy when we get more than we expected. Happiness does not derive primarily from having a set amount of things. Much happiness derives from the process of achieving and acquiring. Continuous flows make us happy; static amounts of things, not so much.

We do not have an upper limit to most, if not all, of our behaviors, because they were formed in an environment of constant insecurity and scarcity rather than the current feelings of safety and abundance that are easily taken for granted. We still seek to maximize what was once scarce. Consuming is a great way to feel happy. Hurray for capitalism as it fits our nature. For many, however, consuming means buying liabilities more than it means buying assets.

Liabilities take money from your pocket. Assets put money in your pocket. The house you live in is a liability given the mortgage, tax, insurance, maintenance and other regular payments that go out of your pocket. The house you rent to somebody else is an asset if it puts more money in your pocket than you need to take out of it. More importantly than at any other point in one's life-cycle, when planning for retirement we need to think about assets that put money in our pocket, i.e., retirement income. How can we redirect our natural thrill to acquire so that we buy assets rather than liabilities?

TransparencyAs we learned from the 2007 MRI keynote speaker, Ray Kurzweil, technologies change faster than evolution. In fact, Kurzweil demonstrates the accelerating pace of technology-driven change. Not only does it move faster, it is still accelerating. This is where both Bruce Sterling, the keynote speaker for the 2009 MRI conference, and his book Shaping Things come into the picture. Bruce stresses the importance of good product design in order to deal with our behavioral limitations. He also explains how to do it in the context of the future rather than past practices.

Because of technological change, there are ever-changing, lower thresholds for behaviors that make us lose to competition. Product developments that increase the transparency of product functions can help overcome ineffective or counterproductive investor behaviors and decisions. Transparency is most valuable if it reveals the impact of threshold behaviors and their matching consequences. In discussions and presentations during RIIA's 2008 Annual Meeting and Awards Dinner, industry executives, including Chris Raham from Ernst & Young, have noted a growing interest for transparency in process and product mechanisms that reveal, concretely and plainly, the consequences of our decisions.

We need product and process transparency because we need to avoid under-reacting or over-reacting when we face behavioral thresholds. Chart 1, "Four Ways to Meet a Threshold," illustrates the point.

The tentative nature of our knowledge should not be discounted, especially when transparency is low. We seek comfort with confirmations of what we already know or believe. As Nicholas Nassim Taleb puts it, seeing a thousand white swans does not prove that all swans are white. Further, it does not prove that black swans do not exist. However, seeing one, single black swan proves that not all swans are white and that black swans exist. It is psychologically hard to seek knowledge that disproves our cherished beliefs. We shy away from the added cognitive load. We may need to spend time, money, and mental effort to learn something new -- e.g., we may have to travel to Australia where black swans live. Also, the opportunity costs may be too high. The time spent could be used elsewhere -- e.g., we could be running a business, or even writing an article, rather than traveling to Australia in search of the snark(y) black swan. Clearly, more easily accessed product transparency would be a good thing for retirement investors by encouraging an open mind over an open, and emptying, pocket drained by cherished beliefs.

RedundancyIn his book The Black Swan,Taleb makes a critical distinction between "mild randomness" and "wild randomness." Luck can happen and it does happen. Sometimes, luck creates wildly unexpected outcomes. It is the combination of rare events with outsized consequences that can change the nature of our game. For instance, Taleb benefited greatly from the 1987 market drop. His positions exposed him to the right side of the trades. He was prepared for this wild opportunity. Keeping this mild-versus-wild randomness distinction in mind, we can map retirement income risks as best we can to expand our view of the possible (see Table 1), knowing that our maps may not reflect the true wildness of the terrain in front of us.

As we develop a healthy form of skepticism about our risk-mapping abilities, we can gain a new perspective on the distinction between seeking guarantees and keeping options open. The problem of generating income in retirement has interesting similarities with the cash-flow problem faced by entrepreneurs: Do you have "strong hands that bleed slowly" in order to hang on? Can you complete the project you started? Can you avoid forced liquidation? Will you outlive your resources?

Besides the limitations of our human nature and besides the limitations imposed upon us by the competitive actions of others, there lie forms of randomness that can upset our best-laid plans and risk mappings. We can seek to avoid the traps of behavioral finance and we can try to diversify away the effect of other market participants. We must also avoid the brittleness of over-optimizing in the face of wild randomness and acknowledge the costs of some redundancies. While accumulation portfolios may benefit from a focus on optimization in the hope of better performance, retirement portfolios may need more built-in redundancy to create a floor under one's income risk.

As an illustration of redundancy, it is interesting to note that Taleb recommends investment portfolio strategies that would have about 90 percent in "safe" assets and about 10 percent in risky -- scalable -- assets. This may look like an extreme position and clearly any portfolio recommendation must be made in the context of a specific investor. No recommendation, "Talebian" or otherwise, is right for all investors. To strike the best balance, advisors need to understand the investor's varying endowments of human capital, social capital as well as financial capital. Transparency and redundancy in products and processes are two important keys for advisors and investors seeking to strike the best balance.

Questions to ConsiderSpecific questions that retirement income product and process developers may want to consi der include:

How can retirement products and processes...

o work with (rather than against) our human nature in order to create positive cash flows in retirement;

o provide greater transparency to better protect us from our own mistakes as well as the competitive impact of other market participants;

o favor redundancy over optimization in order to increase the investor's resilience against unexpected shocks?

It is likely that these questions can only be answered with a combination of both products and processes. Products can provide the key ingredients of risk and upside management. Processes can combine them in the right mix for the right investor types.

This is where the changing role of the financial advisor becomes clearer, becoming a broader life advisor. Taleb's recommendation is an example of the many ways advisors and product designers can provide a balance between the creation of an income floor and the creation of investment upside for retirement-focused investors. It is likely that the financial industry will develop many other ways to achieve this balance. The proper ratio between safety and upside will differ markedly between types of available products, trained advisors and the specific investor segments they serve.


Francois Gadenne is chairman and executive director of the Retirement Income Industry Association in Boston; see

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