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Meet 2 thought leaders who aim to revamp retirement planning

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The education that financial advisors receive today, while providing the tools and skills needed to help workers build a nest egg, is inadequate to a critical task of planning: ensuring a sufficient income throughout retirement.

This shortcoming, say Dirk Cotton and François Gadenne, can be attributed to the fact that traditional financial planning concepts fail to incorporate, among other things, retirement risk allocations and thus income protection products like life insurance and annuities  into their models.

To learn more, LifeHealthPro Senior Editor Warren S. Hersch interviewed Cotton and Gadenne, two thought leaders who are endeavoring to plug the protection gap in advisors’ education. Cotton, a retired executive of a Fortune 500 technology company, researches and publishes papers on retirement finance and regularly posts on retirement finance issues at his blog, The Retirement Cafe.

Gadenne is co-founder, chairman and executive director of the Retirement Income Industry Association (RIIA). The Boston-based non-profit provides discussions, communications, research, education and standards to help investors, distributors and manufacturers transition from investment accumulation to retirement management and income protection. The following are excerpts from the interview.

Hersch: Dirk, my congratulations to you on winning the 2015 RIIA Practitioner Thought Leadership Award for your new paper, “Sequence of Return Risks: A New Way of Looking at Spending or Saving Scenarios with Path Dependence.” What do you discuss in the paper?

Cotton (pictured at right): My paper is about the difference between probability of ruin and path dependence, a distinction often overlooked in financial literature focusing on sequence of return risk.

To some people, sequence of return risk refers to the probability that retirees will outlive their retirement savings — the probability of ruin — due to poor portfolio returns soon after retiring. To others, the risk describes the variance of terminal portfolio values or TPVs resulting from “path dependence” — an outcome determined by the order of events — irrespective of whether the variance leads to portfolio failure.

Thus, you can have path dependence without portfolio failure and portfolio failure without path dependence. You could, for example, run a 30-year period of returns through an SWR [sustainable withdrawal rate] model and come out with a successful portfolio result. You can reverse the same returns and have a poor result. The order of investment returns determines, to a large extent, whether or not you will run out of money. Hersch:  This paper, I understand, is appearing in the spring 2015 issue of RIIA’s industry publication, Retirement Management Journal. Francois, what’s RIIA’s overarching mission?

Gadenne (pictured at right): RIIA is charged with discovering, validating and teaching the new realities of retirement.  The founders, of which I’m one, draw an important distinction between retirement and investment management, a difference that other associations serving advisors often fail to make because of their biases and imprecise use of language.

A prime example of the last is the term “decumulation.” The opposite of accumulation, the word clearly betrays a bias of the investment management world.

Yet, an analysis shows that many retirees are net savers and do not “decumulate” in retirement. What we’ve observed of this demographic is, rather, a series of disconnects — disruptions like unexpectedly high healthcare costs in retirement— that can negatively impact what we call the household balance sheet.

Hersch: Is the investment management bias you describe reflected in the training financial planners receive?

Gadenne: The short answer is yes. At RIIA, we’ve endeavored to counter this educational bias with the development of the curriculum for our Retirement Management Analyst or RMA designation. Underpinning the curriculum are three big ideas: (1) measures of fundedness, (2) the household balance sheet and (3) retirement allocations.

The first, fundedness, characterizes assets under management as overfunded, constrained or underfunded, the category determined by the ratio of household assets to household liabilities.

The household balance sheet is an extension of the familiar net worth statement, but with important differences. For example, it focuses on assets to be used for providing retirement income. And it records values for all financial products held by households. These include retail and tax-advantaged securities, mutual funds, annuities and cash value life insurance; households outstanding debts; plus protection products, including life, health and property/casualty insurance.

Retirement allocations encompass four concepts:

  • Risk retention, addressed by diversification among risky assets;

  • Risk management, which entails forgoing future potential returns to limit downside losses;

  • Risk pooling, which involves the purchase of insurance policies and product guarantees; and

  • Risk avoidance, which is achieved using risk-free assets like cash and cash-equivalents.

Hersch: The development of the RMA program strikes me as an implicit criticism of existing educational programs for advisors, including those leading to the CFP and ChFC designations. Are you and Dirk suggesting there are big holes in these programs?

Cotton: Yes. I have on my shelf textbooks from Boston University’s CFP program. Though they have chapters on risk and insurance, none of them address spending in retirement.

There are lots of models for retirement financing, but none are very good in my opinion. Probably the worst is SWR, which assumes you’ll live a certain number of years and that market returns in the future will be the same as market returns in the past. The model assumes that you will spend the same amount — a flat and not declining amount — throughout retirement, even in the face of obvious financial ruin.

Hersch: So…most retirees and pre-retirees who meet with financial planners are being ill-served by poor advice?

Gadenne: They’re being incompletely served. When I review my financial planning textbooks, I’m oftentimes reminded that it’s like looking at countries. As with countries, there are hundreds of books. And like the United Nations, RIIA brings the collective knowledge of those books together; we think of the association as the U.N. of the financial services industry.

As such, RIIA synthesizes different schools of retirement research. They include the traditional school, which uses certain quantitative techniques, including linear regressions and Monte Carlo simulations, to draw conclusions about investments. This school of research is extremely investment management myopic.

What we did in collaboration with PwC [PriceWaterhouseCoopers] over the last few years is to develop a new school of retirement research. The PwC paper published in February, “Leveraging Behavioral Simulation to Enhance the Four Percent Rule,” is the first public statement on this research; there will be many more.

The focus of the research analysis is not the market, but the client. Our school of retirement research, which we call agent-based simulation, operates along the same principles of a video game I once played, Sim City. In this game, you play the mayor of a city. The collective behavior of the city’s citizens — the aggregate impact of their little sims — emerges as they interact with one another. That’s what an agent-based simulation does. Similarly, using RIIA’s retirement research tools, we can simulate the actions of the U.S. population or employees in a retirement plan.

Every agent in our model is represented by its own balance sheet, income statement, life history, risk aversion, risk profile, and so on. And we can run simulations both forward and backwards. This capability — akin to scrambling and then unscrambling eggs — is not possible in a traditional model. Thus, we now have a financial laboratory where we can test the effect of, among other things, legislation, regulation, and new product features and launches. That’s the power of agent-based simulation.

Hersch: Can you speak in practical terms as to how RIAA’s research and tools will translate into the work that life insurance and financial service professionals do in the field and how they can more successfully serve their clients?

Gadenne: Very simply, it means they need to work with a complete household balance sheet: all of the assets and all of the liabilities. And they need to be able to deduce from this comprehensive data set the appropriate product and plan recommendations for clients.

To that end, we urge them to get the RMA designation. This is part of our mission at RIIA: to identify, develop, validate and avail advisors of the tools they need to work with a comprehensive household balance sheet.

Hersch: In respect to life insurance and annuities, will we have to see new products or techniques to better leverage RIAA’s research findings and tools?

Gadenne: The existing products are fine. What’s needed is a framework for broadening the traditional retirement asset allocation of stocks, bonds and cash to incorporate retirement allocations: risk-retention, risk management, risk-pooling and risk avoidance. And it’s within these retirement allocations that guaranteed protection products — solutions that can ensure that a client’s fixed expenses in retirement are met — have a place.






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