Discussions with Retirement Income Industry Association board members, such as Tom Johnson from MassMutual, often start with this question: What are the core discussions that should take place in the industry? As the industry’s focus shifts from hopeful accumulation to protected income, core discussions seem to take place at several levels including:
What are the new building blocks (e.g., longevity alpha) and who are the new component suppliers?
What are the winning retirement products/processes and who is providing them?
What are the key retirement distribution channels and who are the emerging leaders?
Where is the state of economic science for retirement and who is delivering the education?
What are the new standards and benchmarks and who is validating them?
Given its “view across the silos” foundation and continued development, RIIA has members and standing committees that can and that do address these questions. RIIA is indeed a special place where one can have these discussions.
For the purpose of this article, let’s focus on the education discussions. In his 2005 book, Why Most Things Fail: Evolution, Extinction and Economics, Paul Ormerod presents an important observation for those of us who think about retirement plans: “From simple games to more complicated ones like chess to the real-life world of decision making in business and politics, no matter how carefully researched and planned, the future consequences of decisions made today are frequently surprising. To have the intention of securing a particular outcome is usually no guarantee at all that it will be achieved. Intent is not the same as outcome.”
Jeffery Kluger in his 2008 book Simplexity explains why this is so by showing that we are easily confused by the actions of other people as they respond to our own actions. It is one thing to plan and act in today’s world as we may best understand it. It is another to plan for tomorrow’s world where other people plan and react to what we did yesterday. Our own careful actions create reactions that can invalidate our earlier planning. For instance, can you think about what happens to a great investment opportunity when “everybody” gets it and piles into it at the same time? When does it cease to be a great investment opportunity? How and when can you tell?
What should a prudent planner do when plans seem so fundamentally and structurally fragile because of the reactions of others to our own actions? Interestingly and from this perspective, there may be a silver lining as investors change their focus from pre-retirement accumulation to retirement income generation. Much of pre-retirement investment planning focuses on managing total return/risk exposure.
In contrast, retirement income planning should first focus on creating a floor under the investor’s income risk. Planning for retirement is about creating outcomes rather than hopeful expectations. This very change in focus from expecting returns to creating outcomes may help us deal with the structural fragility of planning. Important dimensions of financial plans may become less brittle with the increasing use of targets, floors and guarantees.
Planning for accumulation focuses on the investor’s exposure to risk modified by processes designed to allocate financial capital among risky assets classes that reflect individual investors’ risk tolerance. This is what a friend amusingly calls “un-standard deviation” from the benchmark allocation. Income generation, if applicable, is typically handled as a fine-tuning of the process. The investor retains the risks. The planner works on a best-efforts basis.
Renowned Ratio This approach is famously summarized as 60/30/10. Average investors with a sufficiently long time horizon should allocate their financial assets 60 percent in stocks, 30 percent in bonds and 10 percent in cash. Consensus and experience-driven individual adjustments based on a variety of dimensions (such as time horizon, liquidity requirements, unique circumstances, etc.) help advisors increase or decrease allocations from the riskier to the less risky assets. The process, its extensions and its limitations are well documented by academics as well as by the industry and its regulators.
The 60/30/10 marker has long functioned as an empirical validation that justifies the asset allocation practices of investment management professionals. It straddles the public work of academics and the proprietary work of commercial e nterprises. Informed by peer-reviewed academic theory as well as successful commercial and regulatory experience, 60/30/10 has become a dominant empirical validation framework (EVF) for the investment management industry during the accumulation era. Can it also function as a dominant EVF of the retirement management industry during the distribution era?
Let’s remember that the purpose of a plan is to create better outcomes than would be available in the absence of a plan. To paraphrase Nicholas Nassim Taleb in his 2007 book The Black Swan, good maps, like successful theories (and good plans), introduce great simplifications that bring their scale to a manageable level. Good maps and good plans retain the most important features of the terrain and discard the noise.
Philosophical BalanceInsufficient simplifications as well as excessive simplifications make maps useless or dangerous. The most complicated map would not be useful since it would soon become a more or less exact replica of the terrain, and therefore would need to be at the same scale as the terrain. An excessively simplified map would fail to show important problems in front of us. The point is to avoid what Taleb calls “Platonicity.”
This seems to be a fundamental tension that has been documented at least since the ancient Greeks. Painting with broad strokes, Aristotle (384-322 BC) was a practical man who trusted his “lying eyes” and the power of gathering observations over theory. With Aristotle, life is full of things that we can observe, understand and catalog from the bottom up. Plato (c. 429 – 347 BC), on the other hand, was a mystical man who mapped pure “essences” into top-down ideologies. Plato favored theory over observations. He was fully prepared to dismiss contradictory information if it did not fit the theory.