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Are You a Stock or a Bond?

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Pensions Are Dying; Long Live Pensions”…At present, the only way a company can manage the risk of long-lived workers is to work them so hard that they die within a few years of retirement; this is not a good way to retain staff….”Financial Times, editorial, September 30, 2006

On Tuesday, March 7, 2006, General Motors (GM) issued a press release that was distributed to newswires and the usual business channels. In a briefly worded statement, it announced that all new employees hired by GM after January 1, 2007, would no longer be entitled to enroll or participate in the company’s traditional pension plan. The plan was being closed and frozen to all entrants. Instead, new GM employees would be given the option of participating in the company’s enhanced salary-deferred, tax-sheltered savings program, also known as a 401(k) plan. Employees who elected to join the 401(k) plan would have their contributions or savings matched by GM, up to a limit, as is usually the case with these ubiquitous plans. They would be given the ability to manage and diversify their investments across a wide range of stocks, bonds and other funds. In a sense, they would all become personal pension fund managers.

In the technical language of pension economics, GM had replaced its guaranteed defined benefit (DB) pension plan with a defined contribution (DC) pension plan. Like many other companies before it, and many others since, GM “threw in the towel” and went from a DB to a DC plan.

Oddly enough, despite the rather arcane nature of the news, GM’s stock, which before the announcement on Monday afternoon was trading around $19.80 per share, jumped up just as soon as the press release hit the newswires. By the end of trading on Wednesday, it settled at almost $21.30 per share. Clearly then, the shareholders and the market liked the news and rewarded GM by bidding up its share price.

Hundreds of companies have made the same move as GM in the last few years, and most of them have been similarly cheered on by the market. Major corporations are basically moving away from providing pension income for life. They are shifting the responsibility to you personally. This is why it is now more important than ever for you to take a very careful look at the myriad of assets on your personal balance sheet and answer this question: Are you a stock or a bond?

How Do Pensions Work, Exactly?At its essence, a traditional defined benefit (DB) pension plan is the easiest way of generating and sustaining a retirement income. When you retire from a DB plan, the employer via the pension plan administrator uses a simple formula to determine your pension entitlement. They add up the number of years you have been working at the company — for example, 30 years — and they multiply this number by an accrual rate — for example 2 percent. The product of these two numbers is called your salary replacement ratio, which in the preceding example is 2%x30 = 60%. And so, your annual pension income, which you will receive for the rest of your life as long as you live, is 60% of your annual salary measured on or near the day you retired. In the preceding case, if you retired at a salary of $50,000 per year, your pension would be 60% of that amount, which is $30,000 of pension income as long as you live.

Now sure, a number of DB pension plans have slightly more complicated formulas that are used to arrive at your pension income entitlement. The accrual rate of, say, 2% might vary depending on when you joined the plan, how much you earn, and perhaps even your age. In some cases an average of your salary in the last few years or perhaps your best year’s salary is used for the final calculation. Some pension plans adjust your annual pension income every year by inflation, whereas others don’t, which then results in the declining purchasing power of retirees over time. Nevertheless, regardless of the minutia, your initial income under a DB pension plan is computed by multiplying three different numbers together. The first number is the accrual rate, the second number is the number of years you have been part of the pension plan, and the third and final number is your final salary, or the average of your salary during the last few years of employment. Hence, the term, “defined benefit.” Here is the key point: You know exactly what your income benefit will be as you get closer to the golden years. This knowledge provides certainty, tranquility, and predictability. This arrangement was the norm for most large North American companies and their employees for more than 50 years. In fact, the earliest defined benefit pension plans have more than a 100-year history.

A defined contribution (DC) plan is the exact opposite of a DB plan and is a broad term that includes self-directed accounts such as 401(a), 401(k), and 403(b). There is no guaranteed benefit, or for that matter, any guarantee at all regarding pension income. As the name implies, only the regular periodic contributions are known and determined in advance. The future benefit that you will receive upon entering retirement is completely unknown. If the stock market, or the particular mutual fund in which your money is allocated experiences a bad month, year, or decade around the time of your retirement, then your nest egg will be much smaller. In general, the responsibility, risk, and yes, the possible rewards, are in the hands of the employee as opposed to employer.

Once again, DC plans contain no formulas or income guarantee. In fact, they don’t really focus on retirement income at all. They are salary-deferred, tax-sheltered savings plans, where you and your employer contribute a periodic amount. Your final retirement nest egg will depend on how much you (and/or the company) contribute to the plan, how your investments perform on the way to retirement, and what you do with the money when you retire. Remember that a 401(k) is a number, not a pension. The amount of money in your 401(k) plan, at the time you retire, is unknown and unpredictable in advance. In language of probability theory, it is a random number. Indeed, you might experience a bear market just before your retirement date, and the nest egg might lose 20% to 30% of its value, as most plans did during the bear market of 2001 to 2003. The 401(k) plan is, therefore, not a pension. You, the retiree, have to figure out how to convert this into some sort of pension — similar to the defined benefit pension I described previously — as you transition into retirement.

I don’t mean to single out GM and their difficulties. They are certainly not the only company taking this course of action with their retirement promises. Indeed, it is difficult to miss the evidence of the decline of traditional private-sector defined benefit (DB) pensions. Countless company press releases, government studies, and scholarly reports have been documenting that DB plans are being frozen, replaced, and converted into defined contribution (DC) plans such as 401(k), 403(b), and other hybrid structures. Just in the last year, venerable companies like Boeing, DuPont, Fidelity, Sears and Verizon — just to name a few — have done the exact same. This is the new reality of personal finance. The responsibility for retirement income is shifting to you.

Agenda for BookMy objective is to get you to think differently about the many decisions you make on a daily basis, and to highlight the financial and investment aspects of those decisions. The reason this type of thinking has now become more important than ever is precisely because of the very large responsibility that has now shifted into your hands, namely the concern of creating a sustainable income for the rest of your very long life. My bias, if I do have one, is to move people away from short-term investing-by-speculating to a more prudent long-term investing-by-hedging or investing-by-protecting. What risks do you really face over the long-run of your financial life, and how do you manage all of your economic assets to protect against those risks?

For now, unfortunately, many individuals make financial decisions thinking they can outguess the market, their opponent or nature. The truth is that few if any of us are endowed with this ability. And while it’s perfectly fine (and fun) to spend a few thousand dollars betting on whether a given penny stock, mutual fund, or economic sector will outperform another penny stock, fund, or sector, this technique is not the way to manage your personal pension, which must last for the rest of your life. I touch upon this theme — call it the “stop speculating and start hedging” theme — in a number of places within the book. As you contemplate the possibility of a 30-year or possibly longer retirement, it is very important to start thinking about managing your financial capital more effectively over your lifecycle. This is more than just about creating a pension or sustainable retirement income. It is about proper risk management practiced by major corporations, applied to your personal life. And so, the next few chapters will be devoted to personal financial risk management early in life, which can then prepare you for prudent risk management later in life. Of course, on the way to creating a secure pension, I must start by examining precisely how to measure the value of your own net worth. I will first introduce you to the concept of human capital and why it is likely the most valuable asset you currently own or have on your personal balance sheet. With that in hand, I then move on to discuss very carefully how you should think about risk and return over very long horizons and to understand the role of hedging versus investing or speculating when it comes to managing our human capital. Then, after I get the preliminaries out of the way, I discuss how to properly convert and manage the risk of going from a number in your 401(k) or IRA plan to a pension that will last for the rest of your life. With the decline of traditional DB pensions, retirement income planning is more than just having the right mix of investments or saving enough in your 401(k) plan. A large sum of money in an investment plan — however you define large — doesn’t guarantee you a secure retirement. The strategy you employ and the products you purchase with your nest egg will be more important than the size of that nest egg.

Moshe Milevsky, Ph.D., is a finance professor at the Schulich School of Business, York University, and is head of the IFID Centre (for the study of individual finance and insurance decisions) in Toronto. He has published more than 50 research articles, which can be found at His previous book is The Calculus of Retirement Income (Cambridge University Press, 2006).


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