A looming global retirement crisis threatens the three pillars of retirement due to insufficient funding, improper investment decisions and transferring risk to individuals least capable of bearing it. Many private-sector workers do not have coverage and are not saving enough for retirement. Governments, federal and state, and the financial industry must innovate to stem this multifaceted crisis.
Many states are trying to extend coverage to uncovered workers, and even the federal government and Congress are attempting to address the coverage issue. However, the fundamental challenge is that all these programs offer a basic defined contribution structure, which results in complex, costly and risky offerings to participants, further exacerbating the retirement crisis.
As Robert C. Merton and I noted in an Other Views commentary (Pensions & Investments, May 4), target-date funds, with qualified default investment alternative status — in which many investors have put their savings by default — are risky retirement strategies. Target-date funds are not a panacea, and often compromise retirement security.
Offering a government bond fund as the sole option for the federal government's new myRA program is an inadequate investment fix, as noted in P&I's Nov. 16 editorial. This investment option protects the nominal principal, but does not fulfill the goal for retirement income.
Taking a step back, what is the major challenge to retirement investing? What is the main problem with investing in target-date funds, followed by an annuity purchase before or at retirement?
A well-structured, defined contribution retirement plan should provide participants with a targeted, inflation-indexed, guaranteed income stream, ideally through death. The key challenges are the time gap between saving and retirement, and the absence of a guarantee. We save through our working lives, but require retirement income to begin many years into the future, e.g., a 25-year-old would need retirement income some 40 to 45 years later.
Finance theory ignores the uses of funds, as I noted in a P&I letter to the editor Dec. 8, 2014, “Adding liabilities as a reference point to MPT.” A majority of defined contribution investment products focus on maximizing wealth rather than maximizing retirement income and, like myRA, treat nominal bonds as the safe asset. This shortcoming leads to a fair amount of risk, relative to a target retirement income, and inordinate cost and complexity, even in well-designed target-date funds. The other major problem is that none of the available assets or products in the market today — stocks, nominal bonds or even target-date funds — has the desired cash flow profile needed for retirement-income security. To add to the complexity of the problem, as one nears retirement one is expected to purchase an annuity. These instruments are opaque, complex, illiquid and often expensive, leaving retirement plan participants with the credit risk that the entity providing the annuity will exist till their death. To summarize, the current assets and investment approaches leave a complex menu of choices on how much to save, how to invest, and how to decumulate.
The simple solution is to create a U.S. Treasury-issued bond called “bond for financial security,” or BFFS, a single instrument that encompasses both the accumulation and decumulation phases of a defined contribution participant. By matching the desired retirement cash flow pattern, BFFS distill retirement planning into a single decision: how much to save. It eliminates intermediary fees that cut into the retirement income pot. The main characteristics of BFFS would be inflation-indexed, coupon-only, that start to pay only at retirement, and that, too, only for a period tied to average life expectancy. The BFFS can be staggered to offer starting payments at five-year intervals, e.g., 2020, 2025, 2030, much like the current target-date funds. While BFFS do not offer a complete hedge against longevity, the risk of outliving the average life expectancy is easily overcome by staggering the bond purchase. Similarly, early death allows heirs to inherit the residual BFFS.
Guaranteeing a return on contributions is the simple way to make defined contribution plans look identical to defined benefit plans. BFFS do so by bridging the time gap between saving and retirement, and are ideally suited to unsophisticated participants as the only safe, low-cost, simple, liquid, default savings option for defined contribution plans. BFFS also eliminate credit-risk issues, as long as the government does not default on them. The best part of having BFFS is that the annual statement provides total clarity on the participant's real income at retirement, based on current savings and investments. Current defined contribution statements do not provide such clarity.
At today's rates, these bonds will offer a low real return, but pension reform requires a long-term view. In setting a target retirement income, a 25-year-old today will dollar-cost average rates over a 40-year horizon and lock in a guaranteed, inflation-indexed income stream for the subsequent 20 or 30 years. Further, those participants seeking a higher retirement income, without saving more, can invest in risky stocks, other nominal bonds or, ideally, other issuers, such as insurance companies, that can enter the market to offer a credit premium over BFFS. BFFS can greatly facilitate the development of effective retirement products and ensure retirement security.
BFFS are a good deal for governments, too. In fact, governments are the biggest beneficiaries. BFFS not only improve retirement outcomes for all defined contribution plans, but also have spillover benefits for the Obama administration and future governments. Cash flows from BFFS reflect synergistic cash flows for infrastructure spending; namely, large cash flows up front for capital expenditure, followed by delayed, inflation-indexed revenue once projects are online. Financing infrastructure has been a challenge and a priority for the Obama administration and other countries. BFFS can help many developed and developing countries achieve two key long-term goals for their citizens: more secure retirement income and better infrastructure.
Arun Muralidhar is chairman and co-chief investment officer of AlphaEngine Global Investment Solutions LLC in Great Falls, Va.
