From CRM2 to MiFID, in many OECD countries, efforts are afoot to change the way advice on retirement planning is offered to investors. Timothy Noonan, managing director of capital market insights at Russell Investments, calls them “avatars of the same god.” The god is the coming retirement crisis that, in some sense, is a consequence of a technical error Noonan himself made some
20 years ago. That error involved a technical specification. In rocket science, he notes, “if you’re two degrees off on the launching pad, you don’t wind up on Mars, you wind up on Jupiter.” Noonan was tasked, in the early 1990s, with translating asset allocation software produced for a DOS environment into something that could be used on a graphical user interface such as Windows.
The problem was that such programs, originally engineered for defined benefit pensions, had a utility function whose role was to seek a “best fit” between assets and liabilities. But in the world of individual investors, there were no liabilities in the conventional sense against which to optimize. So, to facilitate the application
of asset allocation models from the institutional to the individual investor setting, the primary goal of balancing assets and liabilities became re-translated into a secondary goal of efficiently trading off risk and return.
“In determining that, we would show an entire generation of advisors that the way they should invest was through their sense of risk, rather than by matching their liabilities, he explains. This sowed the seeds of a crisis: “millions face financial insecurity because of the way they are taught to invest and how they are presented investment opportunities,” he says. They invest based on their attitude about risk, rather than knowing how much risk they need to take to pay for their future spending.
When the asset allocation programs were set up, a diversified 60/40 portfolio had a reasonable prospect of yielding 8.7%. Twenty-five years on, the return expectation is now 4.6%. That’s a 40% reduction.
“How much do you think that the rate of reduction is in the expectation of consumption?” he asks. “It’s 40% in the other direction. The baby boomers are a generation taught to believe that they solve problems by consuming things.”
Add to that the extension in lifespans, which is outpacing the accumulation of assets. For the typical investor, “I’m going to have a retirement that’s going to last 19 years. Terrific. I think I’ve got assets to cover 11 of those years,” he adds.
“If they’re not able to make the money last a lifetime, we’ve failed.”
That makes it incumbent for plan sponsors, in lining up portfolio managers, to consider how they are going to squeeze out extra returns, beyond the 4.6% predicted. “If they’re innovating, how plausible do you think it is that they will find this increased amount of return? If you don’t find it, there’s going to be a lot of disappointment.”
Avoiding disappointment also means “closing the gap” in other ways. But the tendency for money managers, Noonan argues, is to think solely of money.
Retirement represents far more than a monetary challenge, particularly for those with inadequate social networks. Instead, the focus should be on “total wellness,” of which money is a part.
“We have to widen our lens,” Noonan says. “All of us need to see that the final goal is not simply not running out of money but being able to enjoy life as well.”