What Will Retirement Products Look Like?

This article does not claim to see the future of retirement products in a clear crystal ball, nor will it reveal dark secrets. It seeks to achieve three goals: (1) set our expectations with regard to the pace of change; (2) map the demographic tipping point just ahead of us; and (3) highlight the potential paths that new product developments may take.

Change Is AcceleratingOur first instinct is to look at our future in light of our past. Our memories and behavioral proclivities are readily available to create a first-order approximation. During his keynote presentation for RIIA’s 2007 MRI conference, Terry Burnham clearly showed the limits of such instinctive memory and behavioral proclivities. Human nature evolved in an environment that is not the environment that we currently live in. We live in abundance when human nature was forged in scarcity. For instance, we live in a world where food can be preserved and stored in great quantity.

Contrast this with our evolving in a world where the currency of the day, food, lost its value quickly as it spoiled. As a result, many of us instinctively prefer to consume now rather than to save for later. This may no longer be the proper behavior to have in a world of plenty and readily available refrigeration. This may also not be the optimum behavior when it comes to finance.

On the other hand, during his keynote speech for RIIA’s 2006 Managing Retirement Income (MRI) conference, Ray Kurzweil presented another idea: The Law of Accelerating Returns. The Law of Accelerating Returns applies to businesses that are subject to the economics of information. It states that the power of information technologies doubles every 18 months. This doubling of power can be measured in a variety of ways and is plainly visible in the world of electronics. This also accounts for a large amount of our unusual productivity increases over the last few decades.

It is interesting to note that this doubling of power is the equivalent of a large deflation rate. This is why we are used to seeing many important electronic devices such as computers and TVs, become cheaper over time.

As we can see from our increasing use of computers and models, the financial industry is fast becoming subjected to the economics of information. This observation helps us calibrate the pace of change that we are likely to see in the future: If Ray is right, we may see the equivalent of the last 30 years worth of change, not in the next 30 years but in the next 6 years. If Terry is right, we are not naturally prepared to handle it well.

Demographic Tipping PointNot only are we living through accelerating change created by the impact of information economics on our lives, but the economies of the developed world in general and the U.S. in particular are also moving towards a demographic tipping point as the boomers prepare to retire.

Over the last few decades, the lifecycle of boomers has had a well-documented center-of-gravity-shifting impact on business. As illustrated in Chart 1 below, boomers nearing retirement are shifting their interest from accumulation to distribution in a predictable way. This chart maps the investor’s life cycle on the X-axis ranging from early accumulation to late retirement against the Y-axis where we show the generic types of products that can be provided ranging from best-efforts to those that are guaranteed.

Interestingly, as shown on the chart, there is an in-between transition phase that is worth exploring in more detail. This phase is often called the “transition management” phase.

The identification of the transition management phase arises from observations of the particular needs of investors as they move into retirement. To quote from RIIA’s 2006 white paper: “In the late accumulation phase, or pre-retirement, the investor is completing an accumulation career that may have spanned 30 or 40 years. Due to the compounding nature of accumulation, half of the dollar accumulation is achieved in the last 8 to 10 years of the typical accumulation career. This highlights the risk that investment returns on retirement assets may fall below expectations.”

What that means, the paper continues, is that “there may be a shift in investor psychology from what is usually a superficial intellectual understanding of risk in the context of probabilities, the odds of success and percentage-based evaluation, to an intuitive, common sense understanding of income and dollars. Such a change may move investors from being somewhat risk-averse to becoming more clearly loss-averse.”

As Elvin Turner explains, summarizing the paper’s academic flavor into money quotes for financial advisors, the bottom line is that investors need downside protection during the final 8 to 10 years of the accumulation phase because so much of their total retirement dollar accumulation is at stake.