The Scholar | Pension360

Are Affluent Households As Worried About Retirement As Everyone Else?

Are affluent households worrying about having enough money to last through retirement? According to a survey from Bank of America, the short answer is “yes” – in fact, it’s one of their biggest concerns.

Bank of America polled 1,000 “affluent” people with investable assets of between $50,000 and $250,000. The results were published in the October issue of Pension Benefits:

“More than half (55%) of the mass affluent (defined as individuals with $50,000 to $250,000 in total household investable assets) fear going broke during retirement-far more common than other stress-inducing pressures such as losing their job (37%).

More women than men (59% versus 51%) are frightened about the possibility of not having enough money throughout retirement, and the fear of an uncertain retirement is also most common among 61% of Gen Xers (aged 35 to 50) and 61% of Boomers (aged 51 to 64). Only 41% of Millennials (aged 18 to 34) feel this way.

Despite their fears about future finances, many mass affluent won’t consider cutting back on indulgences today to save for retirement-from entertainment (33%) to eating out (30%) to vacations (28%).

Even if they were faced with a hypothetical milliondollar windfall, fewer than one in five (19%) would make it a priority to set aside the ‘found money’ for their retirement years.

More Boomers (27%) than Gen Xers (16%) and Millennials (6%) would first consider allocating a million-dollar lottery prize to their retirement funds.

Additionally, the most common factors competing with respondents’ regular retirement savings are unexpected costs (33%) and paying off big debts (31%). Paying off large debts (such as student loans) has competed with the retirement savings of more Millennials (38%) than any other generation.

On average, retired respondents stopped working at age 68; however, those who have not retired plan to at age 65. Single mass affluents, on average, plan to retire or have retired at age 62. More than two in five (41%) mass affluents who have not retired yet imagine that they’ll need an annual income somewhere in the $50,000 to $99,999 range when they retire.

About a quarter of Millennials (24%) and Gen Xers (25%) believe they’ll need at least $150,000 annually when they retire-far more than Boomers, with just 11% believing they’ll need that much income in retirement.

As for when people began saving for retirement:

Most (90%) of the mass affluent have retirement savings and began saving at 33 years old, but Millennials are planning for the future at a much younger age, with more than half (54%) starting between the ages of 18 to 24- Eighty percent of Millennials currently have retirement savings.

The most common trigger for those with retirement savings to begin investing for retirement was an account being offered at work (48%). Far fewer were spurred to invest due to major life events like getting married (18%) or having their first child (12%).

More millennials (36%) and Gen Xers (32%) than Boomers (15%) and Seniors (12%) were motivated to save for retirement when they started their first jobs. Almost three in ten (28%) Millennials first started saving for retirement after a raise or promotion at work, versus 10% of older generations.

The article can be read in the journal Pension Benefits. The report can also be viewed here.

Photo by 401kcalculator.org

The Role of Diversity in Investment Committee Effectiveness

A recent Vanguard survey looked at the diversity of investment committees of pension funds and endowments – diversity in gender, race, education, age and professional background.

The survey also gauged the opinions of committee members on a variety of topics: How much do they value diversity? Are they satisfied with the level of diversity on their board? How does diversity impact committee effectiveness?

The results were published in a Vanguard report and in the September issue of Pension Benefits.

From the report:

Four in ten respondents to our survey said that committee diversity was either ‘not’ or ‘not very’ important, and another 37% remained noncommittal in terms of diversity’s role in driving committee effectiveness. Few respondents placed a high level of importance on diversity of any kind-65% were ‘extremely satisfied’ or ‘very satisfied’ with their committee’s level of diversity.

Respondents considered their investment committees to be most diverse in terms of members’ professional experience-more than 60% of members indicated their committee was ‘very/extremely diverse’ in this respect. Nonprofit committees reported a higher level of diversity than retirement committees in terms of professional experience and investment committee experience. Overall, committee members reported the least diversity in terms of race/ethnicity.

When survey respondents were asked to rank the top three diversity elements that positively contributed to the effectiveness of a committee, diversity in professional experience and diversity in committee experience ranked highest. Based on these findings, committee members tended to point to job-related diversity as the main driver of committee effectiveness, whereas biodemographic diversity again played a more secondary role.

Fewer than one in ten investment committee member respondents said that they have a formal, written policy in place to develop and foster diversity within their committee. The importance placed on developing such a policy moving forward is relatively low, as just 6% of committee member respondents said this was ‘very/extremely important.’

Just one-quarter of our survey respondents said their committee had become more diverse than five years previous-with the majority (70%) indicating that their committee had not changed one way or the other.

One-third of our survey respondents ranked being ‘fully engaged in the committee process’ as the most valuable trait among effective committee members.

The entire report can be read here.

Do Older Americans Have Enough Money Saved To Last Through Retirement? An Analysis

Do older Americans have enough money saved to last through retirement? It’s a question asked often, but a definitive answer is hard to come by.

An article published in the October issue of Pension Benefits takes aim at answering that question using a metric called the Retirement Readiness Rating (RRR), developed by the Employee Benefit Research Institute.

The analysis, which originally appeared in the EBRI’s June newsletter, was conducted using several different scenarios; the first scenario and the resulting analysis can be seen in Figure 1, above. More on the results:

Figure 1 shows the results assuming that 100 percent of the simulated deterministic expenses are met; in other words, 100 percent of the average expenses (based on post-retirement income) for components likely to be encountered on a regular basis (e.g., food, housing, transportation). In addition to these relatively predictable expenses, the stochastic costs arising from nursing home and home health-care expenses are assumed to be covered in years when the model simulates their existence.

Note that in Figure 1, while 5 percent or less of those in the second-, third-, and highest-income quartiles would run short of money in the first year of retirement, more than 2 in 5 (43 percent) of those in the lowest-income quartile would, based on deterministic and stochastic costs. Moreover, by the 10th year in retirement (assuming retirement at age 65), nearly 3 in 4 (72 percent) of the lowest-income quartile households would run short of money, while fewer than 1 in 5 (19 percent) of those in the second-income quartile would face a similar situation. Only 7 percent of those in the third-income quartile and 2 percent of those in the highest-income quartile are simulated to run short of money within a decade.

By the 20th year in retirement (again, assuming retirement at age 65), more than 4 in 5 (81 percent) of the lowest income quartile households would run short of money, compared with 38 percent of those in the second-income quartile that would face a similar situation. Only 19 percent of those in the third-income quartile and 8 percent of those in the highest-income quartile are simulated to run short of money by the twentieth year. These values continue to increase until all households either run short of money or there are no surviving retirees. By the 35th year in retirement (age 100, assuming retirement at age 65), 83 percent of the lowest-income quartile households would run short of money and almost half (47 percent) of those in the second-income quartile would face a similar situation. Only 28 percent of those in the third-income quartile and 13 percent of those in the highest income quartile are simulated to run short of money eventually.

A summary of the full results:

The results presented in Figures 1 through 6 show that the years of retirement before Baby Boomer and Gen Xer households run short of money vary tremendously by:

Preretirement-income quartile.

The percentage of average deterministic costs assumed paid by the household.

Whether or not nursing home and home health-care expenses are included in the simulation.

However, even when 100 percent of average deterministic costs are paid by the household and nursing home and home health-care expenses are included (Figure 1), only the households in the lowest-income quartile eventually end up with a majority of the households running short of money during retirement.

Each of the six analyses with results presented in Figures 1 through 6 show the same stark conclusion: The lowest preretirement income quartile is the cohort where the vast majority of the shortfall occurs, and the soonest. When nursing home and home health-care expenses are factored in (Figures 1, 3 and 5), the number of households in the lowest-income quartile that is projected to run short of money within 20 years of retirement is considerably larger than those in the other three income quartiles combined. Indeed, as the results across multiple scenarios and assumptions show, the lowest-income quartile is the most vulnerable, while longevity and long-term care are the biggest risk factors across the entire income spectrum.

The full analysis, including all six scenarios, can be read in the October issue of the Pension Benefits, or the EBRI’s June newsletter.

Fiduciary Capitalism, Long-Term Thinking and the Future of Finance

John Rogers, CFA, penned a thoughtful article in a recent issue of the Financial Analysts Journal regarding the future of finance – and how pension funds and other institutional investors could usher in a new era of capitalism.

From the article, titled “A New Era of Fiduciary Capitalism? Let’s Hope So”:

From my perspective, a new era of capitalism is emerging out of the fog. What I define as fiduciary capitalism is gathering strength and needs to become the future of finance. An era of fiduciary capitalism would be one in which long-term-oriented institutional investors shape behavior in the financial markets and the broader economy. In fiduciary capitalism, the dominant players in capital formation are institutional asset owners; these investors are legally bound to a duty of care and loyalty and must place the needs of their beneficiaries above all other considerations. The main players in this group are pension funds, endowments, foundations, and sovereign wealth funds.

Fiduciary capitalism has several attractive traits. It encourages long-term thinking. As “universal owners,” fiduciaries foster a deeper engagement with companies’ management teams and public policymakers on governance and strategy. In textbook terms, they seek to minimize negative externalities and reward positive ones. Because reducing costs is easier than generating alpha, we can expect continued pressure on financial intermediaries to reduce costs. To be sure, there are considerable gaps to bridge between today’s landscape and fiduciary capitalism. Transparency and disclosure, governance of fiduciaries, agency issues, and accountability are all areas that need more work.

On barrier in the way of fiduciary capitalism: lack of transparency. From the article:

Too many institutional investors are secretive and do not disclose enough about their activities. Their beneficial owners (including voters, in the case of sovereign funds) need more information to make reasonable judgments about their operations. Similarly, far more transparency is needed in the true costs of running these pools of assets. Investment management fees and other expenses often go unreported. Too much time and energy is spent comparing returns with market benchmarks, and not enough is spent defining and comparing the organizations’ performances against their liabilities—or against adequacy ratios.

Pension governance itself needs to be improved. As Ranji Nagaswami, former chief investment adviser to New York City’s $140 billion employee pension funds, has observed, public pension trustees are often ill equipped to govern platforms that are effectively complex asset management organizations. Compensation remains a complicated issue. In the public sector, paying for great pension staffers ought to be at least as important as a winning record on the playing field, yet in 27 of the 50 US states, the highest-paid public employee is the head coach of a college football team.

Rogers concludes:

The future of finance needs to be less about leverage, financial engineering, and stratospheric bonuses and more about efficiently and cleanly connecting capital with ideas, long-term investing for the good of society, and delivering on promises to future generations. In the public policy arena, governments that promote long-term savings, reduce taxes on long-term ownership, and require transparency and good fiduciary governance can help hasten this welcome change in our financial markets.

The era of finance capitalism wasn’t all bad, and an era of fiduciary capitalism wouldn’t be all good. In a time when leadership in finance is desperately lacking, fiduciaries have the potential to reconnect financial services with the society they serve. Let’s hope it’s not too late.

Read the entire article, which is free to view, here.

The Effect of Age On Portfolio Choices

Does a person’s willingness to hold risky assets diminish as they grow older and get closer to retirement? How does aging affect portfolio choices?

A paper published in the October issue of the Journal of Pension Economics and Finance aims to tackle those questions.

The authors analyzed administrative data from an Italian defined-contribution plan spanning 2002-08. Here’s what they found:

We studied investors’ portfolio choices in a very simple real-world setup. Some results prove quite robust across all the empirical exercises we performed. In particular, we found a pronounced tendency to choose safer portfolios as people age. This effect is still there after controlling for several demographic factors, for time effects, and for the sub-fund chosen in the previous period. This result is broadly in line with other micro-evidence from the US market, and is consistent with models of life-cycle rational portfolio allocation.

[…]

The effect of age is more pronounced in the last years of the sample. This might be due to the fact that investors learn form the experience of their colleagues. Indeed, in our sample there have been periods of disappointing stock market performance. Having seen that people who retired during these bear market periods have been severely hit might have pushed investors toward a more active behaviour. A better understanding of this form of learning appears to be an interesting issue for further research.

But not all plan participants reduced risk as they approached retirement. From the paper:

Not all elderly people in our sample reduced their exposure to risk. Looking at the ones present in the sample from the start, it turns out that more than 30% of the elderly workers who were exposed to stock market risk in 2002 were still exposed to it in 2008. As the stock market events of the last decade show, an elderly worker taking risk on the stock market could pay a high price if stocks fall. This evidence suggests that life cycle funds could be a valuable instrument, given that they automatically bring all the participants toward less risky allocations as they get near to retirement (Viceira, 2007). In the Chilean system, for example, a lifecycle fund is the default option for all the workers. Moreover, the riskiest sub-funds are closed to individuals older than a certain age.

The authors also found that job position and education are factors that play into people’s risk choices:

People with a higher position tend to take more risks. This tallies with previous empirical analyses and can be consistent with optimal portfolio allocation. We also found that education has no clear impact on portfolio choices, even if it slightly increases the likelihood of switching for those in the zero-shares sub-funds. The weakness of this effect could be due to the easy set up provided by the fund, and/or to strong social interaction effects, in which the financial skills of the educated employees who make up most of our sample also benefit the few uneducated participants.

Read the entire paper, titled “the effect of age on portfolio choices: evidence from an Italian pension fund”, here.

Photo by www.SeniorLiving.Org

How Financially Sophisticated is America’s Older Population?

As people grow older, they start paying more attention to their retirement.

But evidence suggests that much of the United States’ older population is ill equipped to take responsibility for their retirement security – because their financial sophistication falls short of where it needs to be to make the complex financial decisions retirement requires.

A paper, authored by Annamaria Lusardi, Olivia S. Mitchell, and Vilsa Curto and published in the Journal of Pension Economics and Finance, takes a closer look at the financial sophistication of older Americans.

From the paper:

In 2008, we subjected around 1,000 randomly-selected HRS respondents in the United States to a special module of questions assessing knowledge of the stock market and asset prices, investment strategies, risk diversification, the importance of fees, and related topics. Respondents averaged age 67, with about half (55%) female. Some 15% had less than a high school education, 32% had completed high school, 24% had some college, and 28% had college or advanced degrees. Most (81%) of the respondents were White, with 9% African-American, and 8% Hispanic.

[…]

The 10 questions of key interest here are grouped into four categories, according to the topic they cover: knowledge of capital markets, risk diversification, knowledge of fees, and savvy/numeracy.

The results:

Older Americans displayed a deep lack of understanding about key concepts related to risk diversification, bond prices, and portfolio choice. For instance, many respondents expressed a support for holding own employer company stock, despite the fact that it is unlikely to be wise to hold much own employer stock from a risk diversification viewpoint…

A large majority of respondents (60%) also did not know about asset pricing, which we explore by asking whether people knew about the inverse relationship between bond prices and interest rates. This is a particularly good question to assess financial sophistication because it is difficult (if not impossible) to know or infer the correct answer to this question without having some knowledge of finance.

[…]

When presented with the statement ‘If the interest rate falls, bond prices will fall’ (second wording), only about one-third (35.7%) of respondents answered correctly; when the wording was reversed (first wording: ‘If the interest rate falls, bond prices will rise’), more answer correctly (44.7%) and this difference is statistically significant.

[…]

Many respondents were aware that ‘Even if one is smart, it is very difficult to pick individual stocks that will have better than average returns.’ But here, too, responses varied depending on how the question was asked: in one case 73.7% got the correct answer, but only 37.6% got it correct using the reverse ordering. In other words, this question, too, was poorly understood by respondents.

The authors also posed questions about risk diversification and fees:

Almost two-thirds of respondents knew that ‘it is not a good idea to invest in a few stocks rather than in many stocks or in mutual funds,’ which might be thought to imply some sophistication about risk. Yet this question jointly tests knowledge of risk diversification and awareness of mutual funds, as indicated by results when we reversed the question wording: responses proved quite sensitive. The second risk question sought to avoid this by simplifying the question and using less financial terminology; and now we find that most knew that spreading money across 20 stocks rather than two decreased the risk of losing money (and here, word order did not matter).

[…]

Several prior studies have found that investors often overlook fees when deciding how to invest…In our sample of older Americans, around two-thirds seemed to know that mutual fund fees are important when investing for the long run. Nonetheless, responses were again sensitive to question wording, perhaps due to the fact that respondents needed to know both about mutual funds and investing for the long run. Additionally, a large majority of respondents said they would find it difficult to locate mutual funds charging annual fees of less than one percent of assets, suggesting that many respondents may not know about low-cost mutual funds. The fact that again there is some sensitivity to question wording confirms that, here too, respondents have difficulty with financial terminology (fees, mutual funds, etc.).

The paper, titled Financial literacy and financial sophistication in the older population, features much more analysis and discussion of the survey data, and can be read in full here.

When Given A Choice, Why Do People Choose DC Plans Over DB Plans?

In many states, newly hired public employees are faced with a choice: enrollment in a traditional defined-benefit plan, or a 401(k)-style defined-contribution plan.

What drives the decision-making of those who choose DC plans? Scott J. Weisbenner and Jeffrey R. Brown examined the topic in a recent paper in the Journal of Public Economics.

They studied employees in the State Universities Retirement System (SURS) of Illinois, a system that gives every employee a one-time, permanent choice between enrolling in a DB or a DC plan. Here’s what they found about why people might choose DC plans:

First, we find sensible patterns with regard to economic and demographic factors: the probability of choosing the DC plan decreases with the relative financial generosity of the DB plans versus the DC plans and rises with education and income. However, while the relative generosity of the plans does have a nontrivial effect on pension plan choice, it certainly is not a “sufficient statistic” in explaining that choice nor is it the most important determinant in terms of its economic magnitude.

Second, we find that the ability to control for beliefs, preferences, financial skills, and plan knowledge – variables that are not available in standard administrative data sets – increases the amount of variation in plan choice that we are able to explain by approximately seven-fold, relative to using standard economic and demographic variables alone. Specifically, as measured by adjusted R-squared, economic and demographic characteristics such as gender, marital status, presence of children, education, income, net worth, occupation, and (self-reported) health can explain only 6.2% of the overall variation in the DB versus DC plan choice (adjusted R-squared = 0.062). When we expand our regression to include information about beliefs, preferences, financial skills, and plan knowledge, the adjusted R-squared rises to 0.471. Among the important factors in the DB/DC plan choice are respondent attitudes about risk/return trade-offs, financial literacy, beliefs about plan parameters, and attitudes about the importance of various plan attributes.

Third, we note that beliefs about plan parameters are important even when these beliefs are incorrect. In general, people seem to make sensible choices based on what they believe to be true about the plans, but they do not always have accurate beliefs (and thus may not be making optimal decisions). Finally, we provide evidence that preferences over the attributes of the retirement system (e.g., the degree of control provided) are also significant determinants of the DB/DC plan decision.

The paper is titled “Why do individuals choose defined contribution plans? Evidence from participants in a large public plan” and can be read in full here.

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Do Pensions Help Bring Talent To The Public Sector?

An oft-cited argument in favor of generous public pensions is that it helps the public sector recruit and retain high-quality workers.

But is that the case? That question is the subject of the latest report from the Center for Retirement Research at Boston College.

The findings of the report, as summarized by the CRR:

– Research shows that pensions help recruit and retain high-quality workers; thus, cutbacks in public pensions could hurt worker quality.

– One indicator of quality is the wage that a worker can earn in the private sector.

– Using this measure, states and localities consistently have a “quality gap” – the workers they lose have a higher private sector wage than those they gain.

– The analysis shows that jurisdictions with relatively generous pensions have smaller quality gaps, meaning they can better maintain a high-quality workforce.

– The bottom line is that states and localities should be cautious about scaling pensions back too far.

The report talks further about the correlation between cutting pensions and a widening “quality gap” between the public and private sector workforce:

As states grapple with challenges facing their pensions, many have taken steps that reduce benefit generosity for their new employees. The analysis suggests that states and localities with relatively generous pensions should be cautious, because reductions in benefits may result in a reduction in their ability to maintain a high-quality workforce. To the extent the quality gap already exists for many of these employers, reducing pension generosity may widen the gap.

A couple of caveats are important. First, some variables that may be correlated with both the quality gap and generosity of pensions – e.g., health insurance benefits – were not included in this analysis due to data limitations. If these factors (rather than pension normal costs) drove the result, then changes in pension benefits may have more muted effects than estimated here. Second, the non-linearity in the result is intriguing, but its source unclear. Why do plans at the bottom of the generosity distribution have smaller quality gaps than plans in the middle? Will reductions in these plans have any effect on the quality gap? Future research will seek to shed light on both the causality of the main result and on its apparent non-linearity.

Read the full report here.

Photo by Kate Hiscock via Flickr CC License

Cutting Investment Fees – A Key To Secure Retirement?

Charles D. Ellis wrote a thoughtful article in the Financial Analysts Journal recently about the hard choices that people– and institutions – must face sooner than later regarding retirement and pension systems.

One of the main facets of the article’s thesis:

We need to make hard choices on how much to save, how long to work, how to invest, and how much to draw from our savings for spending in retirement.

The article is full of great discussion on these points. After someone stops working, a big part of their financial security stems from controlling costs – not just living expenses, but investment expenses, as well.

From the article:

Most investors somehow believe that fees for investment management are low. Fees are not low. Here’s why: By convention, fees are shown as a percentage of the assets, say, just 1%. But that’s seriously misleading. The investor already has the assets, so the manager’s fee should be stated as a percentage of the benefit (i.e., returns).

If returns are 7%, then the same fee in dollars is 15% of returns. And because index funds deliver the full market return with no more than the market level of risk for a fee of 0.1%, the real cost of active management is the incremental cost as a percentage of the incremental benefit of active management. That’s why the true cost of active management is not 1% or even 15%. Because the average active manager falls short of his chosen benchmark, the average fee is more than 100% of the true net benefit.

Increasingly, investors are learning that one way to reduce costs—and increase returns—is to save on costs by using low-cost index investments, particularly with their 401(k) or other retirement plans.

How your retirement funds are invested is important because many of those dollars are invested for a very long time—20, 40, even 60 years.

The article, titled “Hard Choices: Where We Are”, is available for free from the Financial Analysts Journal.

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How Does Implementation Cost Affect Private Equity Performance?

A recent paper in the Rotman International Journal of Pension Management analyzes the costs and performance of private equity investments of large public pension funds.

There were a few interesting findings, but the authors admitted that the “most interesting” was how drastically implementation style affects performance.

The paper finds that “higher-cost implementation styles resulted in dramatically reduced net performance”.

But a larger problem is that this cost isn’t often adequately reported in financial statements. Further analysis from the paper, titled “How Implementation Style and Costs Affect Private Equity Performance”:

Our findings confirm those of other CEM research indicating that the highest-cost implementation styles have the worst net returns. We believe that since costs have such a significant impact on performance, fund managers should understand the true costs of investing in private equity. However, CEM experience indicates that costs are underreported in the financial statements of many funds. This is unfortunate, because what gets measured gets managed, and what gets poorly measured gets poorly managed. This underreporting is not intentional. In fact, the accounting teams of many funds believe they are reporting all costs.

The four most common reasons that private equity costs are underreported are the following:

• Accounting teams often rely on capital call statements to collect management fees. Yet these statements often show management fees on a net basis, whereby the management fee owing is offset by the LP’s share of transaction and other revenues (commonly called rebates) generated and kept by the general partner (GP). Therefore, accounting teams have no record of their share of the gross management fee paid to the GP.

• The repayment of management fees before the carry has been paid is treated as a reduction in cost. This is an accounting shift; no money is coming back. For every dollar of repayment, there is a dollar of carry.

• Carry (e.g., performance fees) is excluded.

• For FOF LPs, the costs of the underlying funds are excluded. The underreporting in financial statements is material. For example, the cost of private equity LPs is frequently reported to be less than 0.70% by funds’ financial statements, whereas Dutch funds that are beginning to collect and report all private asset costs are reporting a median of 3.03% (0.12% internal monitoring costs + 1.66% management fees + 1.10% carry or performance fees + 0.15% transaction fees. For a fund with US $5.0 billion in private equity assets, the difference between 0.70% reported and 3.03% actual represents US$116 million in costs.

There’s much more analysis available in the full paper, which can be read here.

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