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Pension Promise to Oneself

Stephen Sexauer and Laurence Siegel penned a most useful and practical retirement-planning saving and investment article in “A Pension Promise to Oneself” in Volume 69 Number 6 of the Financial Analysts Journal (“FAJ”). Readers will comprehend the authors’ distinctions and comparisons of defined benefit (“DB”) and defined contribution (“DC”); noting that DC plan participants can learn much from understanding the general structural elements of DB plans. The functional similarities of the plans, as described by the authors, are noted in the following 2 paragraphs:

“In a DB plan, there are two intermediaries: (1) the sponsor, who performs the savings and payout functions and may also guarantee the payout with her balance sheet, and (2) the financial markets themselves, which provide the time shift in consumption. As investment gains or losses become apparent and as other changes in the environment occur (e.g. life expectancies lengthen), the sponsor adjusts the contributions to the fund accordingly. Finally, the sponsor pays out benefits as promised.”[1. Paragraph one column two of page 14 of FAJ]

“A DC plan does exactly the same thing except that you, the investor, are the ‘sponsor’. DC plans have only one intermediary – the financial markets (with employers playing a minimal role). Participants first project the cash flows they are going to need in retirement. Then, they develop and execute a savings plan in an amount sufficient, when investment returns are taken into account, to fund the retirement income requirement. (Savings or contributions to DC plans, whether from participants or an employer match, are analogous to sponsors’ contributions to DB pension funds.) Next – and this is a key concept – DC plan participants make adjustments along the way for investment gains and losses and for other changes in the environment. Finally, participants use the money when they are retired.”[2. Paragraph two column two of page 14 of FAJ]

The authors set forth a three-part rule for a sponsor’s (investor’s) effective management of his or her DC plan:

(1) “Liabilities must be appraised and discounted back to a present value.” The calculation determines the required value of the portfolio at the outset of retirement assuming a highly risk-averse investment strategy is implemented during the consumption phase of the plan. This figure is determined by applying a retirement multiple (“RM”) to a desired retirement income – net of Social Security payments in the authors’ model and provided examples. “For most investors, the RM will have to be provided externally – that is, by a data provider that calculates the relevant RM on the basis of interest rates and other market data.” [3. See page 17 and 18 of FAJ describing the authors’ derivation of RM]

(2) “Assets must be accumulated according to an economically sound plan, and wishful thinking about markets must not be allowed to substitute for rational savings rates.” The article provides examples of phased savings rates according to alternative retirement income goals and accumulation-stage investment risk profiles.

(3) “Assets must be spent or paid out (during retirement) in a sensible manner.”

The suggested framework describes a dynamic process for investors requiring periodic Personal Fiscal Adjustments (“PFAs” which represent “decisions to increase or decrease consumption or production or to shift the time period in which consumption or production occurs”). “PFAs differ in the short run and long run. In the short run, the main adjustment is to consumption. In the long run, however, one can work harder, increase the number of workers in the family, work smarter (by pursuing strategies to enhance one’s human capital, or plan to work longer.”[4. Paragraph one column two of page 17 of FAJ] The authors additionally state that “much effort is going into looking for bulletproof systems and turnkey solutions that will make retirement ‘work’ without the ability to make ongoing adjustments. There aren’t any.” This statement underlies a central point of the Sexauer and Siegel article that investors should take an active planning and monitoring role with respect to accumulation of their retirement portfolios.

Sexauer and Siegel state that “much ink has already been spilled on the pension catastrophe we are facing” and the authors identify many unrealistic assumptions underlying retirement planning scenarios: “people work from age 20 to 65 and then magically – almost mystically – transition to a state called ‘retirement’, wherein they live for another 20 – 40 years with a minimal, or at worst modest, drop in consumption. “ The implication of combining suitable retirement income objectives with appropriate investment risk profiles is that most individuals’ savings rates should materially exceed what is commonly reported on the part of U.S. investors. While that fact may be generally well established, the authors nonetheless provide an excellent framework and useful recommendations to help an investor perceptively compose and fulfill his / her “Pension Promise to Oneself.”