Are You a Stock or a Bond?

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.

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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 www.ifid.ca. His previous book is The Calculus of Retirement Income (Cambridge University Press, 2006).