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Models and Reality

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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.

Aristotle represents the provisional knowledge of the empirical skeptic. Plato represents the absolute theories of the coercive utopians. The Closing of the Western Mind by Charles Freeman (2002) is a great source for those of us who like to read antiquities because of their potential relevance for the present inequities.

It is not like we need to choose Aristotle to the exclusion of Plato. It is not like we need observations to the exclusion of theories. The difficulties arise with excesses one way or the other. The difficulties arise when we lose our ability to navigate between the two as circumstances warrant. Taleb points out that excessive mapmakers run into problems when they meet the “Platonic Fold,” the “place where our Platonic representation enters into contact with reality and you can see the side effect of models.” The sub-prime mortgage lending crisis is a good reminder of this age-old tension as we, once again, can see the effect of marking-to-model rather than marking to reality.

Mapping RetirementA retirement plan — as well as economic science for retirement and matching retirement education — should act like a good map that helps us navigate unfamiliar terrain. In contrast to pre-retirement investment planning, planning for retirement income goes beyond allocating an investor’s financial capital among risky assets to include additional risk management techniques such as income guarantees (e.g. income annuities), exposure transformations (e.g. hedges, options, derivatives) and appropriate risk-free assets (e.g. TIPS).

This suggests that 60/30/10 is not likely to provide the complete empirical validation framework for retirement income planning. One can see that while asset allocation is part of the picture, it is only one of, at least, four useful risk management techniques.

For retirement income planning to blossom, it may be necessary that its practice become summarized in ways that are analogous to 60/30/10 but also reflect the other relevant risk management techniques. Retirement planning may need an EVF summary all its own. Instead of 60/30/10, a retirement planning EVF may have four rather than three components. These four components would include allocations of the investor’s financial capital:o Diversified risky assets.o Income guarantees.o Exposure transformation.o Suitable risk-free assets.

To develop and promote such an empirical validation framework (balancing the academic as well as the commercial and regulatory perspectives) RIIA’s standing committees in general, and the Research Committee in particular, are managing and funding research programs focused on the issue. These research programs seek to refine the definition of the necessary risk management techniques; how these techniques apply to various investor types; and the matching guidelines and rules to make investor-specific adjustments.

As described by Greg Cherry (American Century Investments), the chair of RIIA’s Research Committee: “A recently approved project uses one of the industry’s best databases of investor holdings to identify on an annual basis — and starting with the year 2004 — the products that U.S. households hold in these categories of risk management techniques. This research will help determine what percentages of households’ financial assets are invested in them.”

Other committees and affiliated organizations plan to compare the results of commercial research with the matching expectations derived from academic theories in order to integrate these findings in the research committee’s “Retirement Management and Retirement Income Body of Knowledge.”

If you have an interest in this topic, please join RIIA and participate in the work of its committees including the Education Committee and the Research Committee.

Professor Zvi Bodie, whose work has been discussed in this column, points out that when a liability, such as a retirement income guarantee, is perfectly matched with risk-free assets, one does not require additional capital to protect from contingencies. By contrast, when liabilities and assets are not perfectly matched, one does require additional capital.

For instance, should an investor moving from a perfect match between assets and liabilities place 50 percent of the assets in risky investments, more capital would be needed to match the liability. This additional capital is called buffer capital.

Such buffer capital requirements can be estimated when one sees that shortfall risk must include both the percent risk of shortfall from risky investments as well as the dollar consequences of such shortfall. Insurance against such shortfall risk is effectively a put option.

This put-like option is the option to insure against earning less than the risk-free rate of interest. This option has a cost that can be calculated. The cost of such a put option increases with the time horizon.

Professor Bodie first explained these important insights in a paper titled “On the Risk of Stocks in the Long Run.” The paper can be found in the Financial Analysts Journal of May-June 1995. The paper shows that if the proposition “stocks are less risky in the long run” were true, then the cost of insuring against earning less than the risk-free rate of interest should decline as the investment horizon lengthens. The paper shows this is not the case, even if stock returns are mean-reverting in the long run.

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


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