Investing in retirement

The $15 trillion question

Many retired people don’t have proper pensions any more. The financial-services industry may end up cashing in

Jul 12th 2014


WHAT to do with your money when you retire? It is a question that worries many workers in their late 50s and early 60s as they prepare to forsake the daily commute. And it is a question that fascinates the financial-services industry, which would love to get its hands on people’s retirement pots.

The question is all the more urgent because pensions as people used to know them are disappearing in the private sector. The traditional defined-benefit (DB) pension was paid by a company on the basis of an employee’s length of service and final salary

Companies are retreating from such promises because of the cost; investment returns have been poor and people are living longer. Instead, staff are being offered defined-contribution (DC) plans, in which both employers and employees put money into a pot.

A pot is not a pension. It can be turned into one by buying an annuity, an income that will last until death. But outside Britain, few exercise this option. And the British government is in the process of abolishing the requirement to turn a DC pot into an annuity. Folk will be free to use their money as they see fit when they retire.

The sums are huge. According to TowersWatson, an actuarial consultant, 58% of all American pension assets are in DC schemes. In Australia, the proportion is 84%. In 13 countries studied, DC assets comprise 47% of the total, or around $15 trillion.

Some people may celebrate retirement by blowing their money on a world cruise or a sports car and then rely on the state to care for them. But the vast majority will be more responsible and will try to convert their pots into an income. This will involve a bunch of difficult questions, the answers to most of which are not knowable in advance, and on which they will struggle to get independent advice (many intermediaries get paid more for selling higher-charging products). 

How long will people live? How much will they need to set aside to cover the cost of nursing care? What will be the rate of inflation? What is the outlook for investment returns?

The finance industry has a whole range of products for retirement, all of which involve a certain degree of trade-offs. For example, most retired people would like some certainty about their future income. But that certainty comes at a cost; financial-services companies can provide it only by investing in assets with lowish risks and correspondingly low returns. Britons complain about poor annuity rates, but those rates seem disappointing because bond yields are close to historic lows.

A lot of retirement products accordingly invest in riskier assets, so as to offer a higher return. But that can be dangerous when stockmarkets tank. One of the most popular American schemes—which earlier this year had around $650 billion of assets—is the target-date fund (see chart): workers choose a fund with a date close to their expected last year of employment. Such funds follow a “glide path”, taking less risk as the retirement date approaches. But this method offered little comfort in 2008, when Lehman Brothers collapsed: the average target-date fund by fell 23%, according to Morningstar, a research firm.

Nevertheless, target-date funds may be better than the alternatives. A study by Vanguard, a fund manager, has found that within five years of stopping work most Americans transfer their assets from their employers’ DC plans into individual retirement accounts (IRAs). These are often recommended by brokers who are paid well for selling them. But the clients end up paying more for advice and investing in funds with higher fees than if they had stayed put. Mercer, a benefits consultant, says that fees on large corporate DC plans are 20-50% lower than those on IRA accounts.

For those who choose to manage their own money in retirement, what are their options? The nearest equivalent to target-date funds fall into two categories; balanced (or managed) funds and “absolute return funds. Both attempt to offer a steady return by investing in a wide range of assets, or by the use of derivatives to reduce risk. Neither is specifically aimed at the retired but both have an obvious appeal to older people.

But even here, balancing risk and return has been difficult; since early 2007, just as the financial crisis was beginning, the average British absolute return fund has barely kept pace with inflation, according to FE Analytics, another research firm. The snag is that people pick funds on the basis of past returns, only to find that their choices have a risky mix of assets and fall sharply at the least convenient moment.

Another problem is the level of income (or drawdown) to take from the pot. With an annuity, the income is certain. But other funds offer no such guarantees and may offer only a modest income which investors have to top up with regular withdrawals. Investors who withdraw money too quickly (or are too pessimistic about their lifespan) risk running out of money in their 80s. The issue is made more complex by regulations and tax laws which affect the pace at which withdrawals can be made.

Variable annuities are an American product that aim to give both returns and certainty: when the pot is being filled up, the schemes invest in risky assets, but on retirement, the investor can opt for a set income. But these products have been criticised for inflexibility and high fees. FINRA, an American securities-industry regulator, says that investorsshould be aware of their restrictive features, understand that substantial taxes and charges may apply if [they] withdraw [their] money early, and guard against fear-inducing sales tactics.”

Britons used to buy products that had similar features: “with profitspolicies, which invested in a diversified pool of assets and paid bonuses each year. Like the biblical Joseph, the policies kept back profits in the fat years in order to maintain bonuses in thin ones. But high fees and disappointing returns have dented their popularity. Although the design of with-profits funds looks ideal for retirement, few choose them any more.

A radical alternative, used in the Netherlands and recently promoted by the British government, is the “collective DCscheme. Under DB plans, all the investment risk fell on the employer; in normal DC plans, it falls on the employee. Collective DC schemes allow risks to be shared: instead of an individual pot, members receive a regular income from the common pool, although that can be cut if investment returns are poor.

It seems unlikely that collective DC schemes will catch on in Britain or America, where the freedom to control their own retirement pot is so appealing to workers. But the danger is that this freedom translates into a licence to print money for the financial industry. What people need is truly disinterested advice, so they can pick inexpensive, diversified products to keep them in their old age.


The Full-Time Scandal of Part-Time America

Fewer than half of U.S. adults are working full time. Why? Slow growth and the perverse incentives of ObamaCare.

By Mortimer Zuckerman

July 13, 2014 6:47 p.m. ET

The Obama administration and much of the media trumpeting the figure overlooked that the government numbers didn't distinguish between new part-time and full-time jobs. Full-time jobs last month plunged by 523,000, according to the Bureau of Labor Statistics. What has increased are part-time jobs

They soared by about 800,000 to more than 28 million. Just think of all those Americans working part time, no doubt glad to have the work but also contending with lower pay, diminished benefits and little job security.

On July 2 President Obama boasted that the jobs report "showed the sixth straight month of job growth" in the private economy. "Make no mistake," he said. "We are headed in the right direction." What he failed to mention is that only 47.7% of adults in the U.S. are working full time. Yes, the percentage of unemployed has fallen, but that's worth barely a Bronx cheer. It reflects the bleak fact that 2.4 million Americans have become discouraged and dropped out of the workforce. You might as well say that the unemployment rate would be zero if everyone quit looking for work.

Chad Crowe

Last month involuntary part-timers swelled to 7.5 million, compared with 4.4 million in 2007. Way too many adults now depend on the low-wage, part-time jobs that teenagers would normally fill. Federal Reserve Chair Janet Yellen had it right in March when she said: "The existence of such a large pool of partly unemployed workers is a sign that labor conditions are worse than indicated by the unemployment rate."

There are a number of reasons for our predicament, most importantly a historically low growth rate for an economic "recovery." Gross domestic product growth in 2013 was a feeble 1.9%, and it fell at a seasonally adjusted annual rate of 2.9% in the first quarter of 2014.

But there is one clear political contribution to the dismal jobs trend. Many employers cut workers' hours to avoid the Affordable Care Act's mandate to provide health insurance to anyone working 30 hours a week or more. The unintended consequence of President Obama's "signature legislation"? Fewer full-time workers. In many cases two people are working the same number of hours that one had previously worked.

Since mid-2007 the U.S. population has grown by 17.2 million, according to the Census Bureau, but we have 374,000 fewer jobs since a November 2007 peak and are 10 million jobs shy of where we should be

It is particularly upsetting that our current high unemployment is concentrated in the oldest and youngest workers. Older workers have been phased out as new technologies improve productivity, and young adults who lack skills are struggling to find entry-level jobs with advancement opportunities. In the process, they are losing critical time to develop workplace habits, contacts and new skills.

Most Americans wouldn't call this an economic recovery. Yes, we're not technically in a recession as the recovery began in mid-2009, but high-wage industries have lost a million positions since 2007. Low-paying jobs are gaining and now account for 44% of all employment growth since employment hit bottom in February 2010, with by far the most growth3.8 million jobs—in low-wage industries. The number of long-term unemployed remains at historically high levels, standing at more than three million in June. The proportion of Americans in the labor force is at a 36-year low, 62.8%, down from 66% in 2008.

Part-time jobs are no longer the domain of the young. Many are taken by adults in their prime working years25 to 54 years of age—and many are single men and women without high-school diplomas. Why is this happening

It can't all be attributed to the unforeseen consequences of the Affordable Care Act. The longer workers have been out of a job, the more likely they are to take a part-time job to make ends meet.

The result: Faith in the American dream is eroding fast. The feeling is that the rules aren't fair and the system has been rigged in favor of business and against the average person. The share of financial compensation and outputs going to labor has dropped to less than 60% today from about 65% before 1980.

Why haven't increases in labor productivity translated into higher household income in private employment? In part because of very low rates of capital spending on new plant and equipment over the past five years. In the 1960s, only one in 20 American men between the ages of 25 and 54 was not working. According to former Treasury Secretary Larry Summers, in 10 years that number will be one in seven.

The lack of breadwinners working full time is a burgeoning disaster. There are 48 million people in the U.S. in low-wage jobs. Those workers won't be able to spend what is necessary in an economy that is mostly based on consumer spending, and this will put further pressure on growth

What we have is a very high unemployment rate, a slow recovery and across-the-board wage stagnation (except for the top few percent). According to the Bureau of Labor Statistics, almost 91 million people over age 16 aren't working, a record high. When Barack Obama became president, that figure was nearly 10 million lower.

The great American job machine is spluttering. We are going through the weakest post-recession recovery the U.S. has ever experienced, with growth half of what it was after four previous recessions. And that's despite the most expansive monetary policy in history and the largest fiscal stimulus since World War II.

That is why the June numbers are so distressing. Five years after the Great Recession, more than 24 million working-age Americans remain jobless, working part-time involuntarily or having left the workforce. We are not in the middle of a recovery. We are in the middle of a muddle-through, and there's no point in pretending that the sky is blue when so many millions can attest to dark clouds.

Mr. Zuckerman is chairman and editor in chief of U.S. News & World Report.

Markets Insight

July 14, 2014 6:24 am

Investors beware: economists at large

In a perfect world, investors would turn to economists for predictions on two key issues supporting equity prices at current valuations: productivity trends and the effectiveness of macroprudential policies. In the real world, however, I suspect many investors have yet to grasp the extent to which these arcane topics will influence the next stage of the market cycle; and those that do may get insufficient guidance from economists.

Let’s start with some context.

While counterfactuals are tricky, most market analysts would agree on two related market hypotheses: first, that unusually sluggish economic growth has not harmed stock market performance as much as would have been expected from traditional models; second, that hyperactive central banks have boosted asset prices using experimental measures, not as an end in itself but as a means of stimulating higher economic activity through the “asset channel”. The result has been a notable gap between a buoyant Wall Street and a struggling Main Street.

Fortunately, as illustrated by the recent set of US employment reports and the modest pickup in growth in Europe, economies heal over time. While such healing continues to fall short of the economic lift-off everyone seeks, it poses a growing policy dilemma for central banks, in particular for the Federal Reserve, given America’s economic outperformance relative to Europe and Japan.

Fed’s beliefs

Up to now, Fed officials have been comfortable keeping their foot on the accelerator while engineering a skilful transition from balance sheet purchases (known as “quantitative easing”, which they are likely to exit completely in October, according to last week’s release of the FOMC Minutes) to aggressive policy guidance on low interest rates. They have maintained a gradualist policy approach while recognising that certain assets are approaching bubble territory. Indeed, Fed chairwoman Janet Yellen recently noted that the risk-taking induced by unusually low interest ratescan go too far, thereby contributing to fragility in the financial system”.

There are two major reasons why most Fed officials are in no rush to take the punch bowl away, and they are critical to supporting current market valuations.

First, they feel that, notwithstanding the decline in the unemployment rate to 6.1 per cent, there is still slack in the labour markets. As such, they are not worried about inflationary wage growth. Second, they believe financial market excesses can be effectively countered by the recent revamp of macroprudential policies, both nationally and internationally.

Both hypotheses are just thathypotheses. And they are subject to notable risks given that the Fed, and everyone else for that matter, is in uncharted policy waters.

Should the recent disappointing productivity performance continue, the Fed may find wage pressures increasing at a faster rate than it finds comfortable. Also, strengthened macroprudential measures may have failed to keep pace with investors who believe the collapse in market volatility occasioned by economic and policy conditions is a green light for leveraging every risk factorbe it credit, default, duration, equity or liquidity.

Prediction failure

Judging by past experience, economists are not well placed to make confident predictions about the risk of greater economic and financial instability. Productivity trends are hard to measure accurately, let alone predict. The record on assessing financial instability is even worse. It is not just that most economists misjudged the run-up to the 2008 financial crisis; even Fed officials, who arguably are a lot closer to markets, were shocked by last year’s severe taper tantrum”. And if all these people cannot get their arms around the underlying fragility of the financial system, it is difficult to be confident about the effectiveness of macroprudential measures.

All of which is to say that the analytical underpinnings of the current phase of risk taking in financial markets are far from robust. Yes, the Fed’s policy approach could succeed in the next few quarters in engineering a handover from financial excesses to economic lift-off, thereby validating high market valuations and pushing them even higher, especially if the world has indeed transitioned to a paradigm of significantly and permanently lower levels of nominal and inflation-adjusted growth.

But the timing is inherently uncertain. And the probabilities of doing so may not overwhelmingly dominate those of a less pleasant scenario that of stagflation and greater financial instability. This configuration of more balanced risk is not yet reflected in asset prices and the levels of implied and realised volatility.

Mohamed El-Erian is chief economic adviser to Allianz, chair of President Obama’s Global Development Council and author of “When Markets Collide”

Copyright The Financial Times Limited 2014.