The planning and investment advice, much like that offered at this website, has been rolling along on a framework based on wealth accumulation by saving and investing for the long-term. The emphasis is generally heavily slanted toward equities, which historically delivered much higher average return than fixed income investments; this of course is due to the fact that the higher volatility (risk) is rewarded by higher returns. The effect of average historical inflation is included by working with “real” dollars. The analysis to estimate required savings rates to achieve certain standard of living and withdrawal rates or methods once in retirement, tends to be built on historical average returns of different asset classes, largely disregarding the potential impact of volatility of equities around the expected retirement date (and start of de-accumulation); the implication being that stocks are a safe investment in the long-run. More recently, Monte-Carlo methods started to be used to include the effect of historical or predicted volatility, and then calculating the probability of exhausting your actual/expected assets at retirement, given various withdrawal rates or methods.
During the past few years a faint though growing rumble has been emerging. It remains to be determined if this is a revolution or just an evolution, but under the heading of “life-cycle investing” many are starting to challenge both the fundamental framework and implementation that is used in investing in preparation for retirement. This matter has taken on increasing urgency as the demise of traditional Defined Benefit pension plans and the corresponding transfer of risk from plan sponsors (professionals) to individuals (mostly untrained, undisciplined and incompetent in the financial field).

Zvi Bodie of Boston University is one of the earliest and most in-your-face advocates of this new framework. (The first time I came across his work was around the technology stock crash after I read in the papers that my lifetime employer had a $2.5B pension plan shortfall, and I started reading about how pension plans should be managed; contrary to practice he was advocating significant reduction of equity component in pension plans). One has to pay attention because he is a well respected financial economist of long standing and he challenges the current ‘common wisdom’ that leads to the following fallacies:
-stocks are safe in the long-run (not) -diversification is the only way to reduce risk (not) -wealth is about assets (not quite) -stocks overcome the effect of inflation (maybe) -target-date funds solve asset allocation/rebalancing problem (maybe)
In fact the whole starting point of the new framework is about the definition of wealth (Total Capital), which in this new framework is defined as
TC (Total Capital) = HC (Human Capital) + FC (Financial Capital)
and Human Capital is defined as the present value of future earnings. Typically, we start out with a mix of 0% FC and 100% HC and ends up with 100% FC and 0% HC. Wealth is not about assets, but about sustainable ‘real’ spend-rate. Looking at wealth through the entire Life-Cycle as HC and FC forces us to rethink what is an expense vs. an investment (e.g. cost of higher education). But even more so, it forces us to think about risk.

 

 

So let’s look at risk, or rather risks and their changing nature/emphasis throughout the life-cycle:
– disability (initially most wealth is HC, so loss of earning ability can be disastrous) – death (with young family/dependents, death of (a) breadwinner can lead to poverty) – investment/market (especially near the start of de-accumulation, when volatility around retirement can result in significant reduction in retirement income and/or delay in the start date of retirement) – longevity (not only are people retiring earlier, but life expectancy has increased to 19 and 12 years, for 65 and 75 year olds and is growing; of course about 50% of individuals live past the life expectancy indicated. For a 65 year old couple, there is about a 50%, 25% and 10% probability to one of them living to 90, 95 and 100, respectively).The net effect is that people are spending more time in retirement) – inflation (this is scourge throughout the life-cycle, but it especially

severe during retirement, eating away at your predominant financial capital) Other risks are: are you saving enough? are you annuitizing at the ‘right’ time (interest rates, mortality credits, costs)?

 

Now let’s look at some of the solutions proposed for each of these risks:
– disability: disability insurance – death: life insurance – market/investment: diversification/asset-allocation (including futures and options), hedging (including options), single vs. multi-period investment horizon (i.e. in the long-run you appear to be OK, but on the way, as you are withdrawing funds annually during a succession of negative returns, you may become insolvent), cap investment in employer – longevity: DB plans, (delayed) SS/CPP, immediate or deferred annuities (especially if inflation indexed), estate/bequest plan – inflation: inflation indexed bonds, inflation indexed annuities Other solutions may be reverse mortgages, life settlements (assuming the need is dire and costs are not prohibitive).
So you will note that diversification is part of the plan, but it is only a small part of the story in this framework. In addition the mechanisms (insurance and hedging) that are used to reduce/eliminate these various risks, introduce new problems: higher costs (e.g. insurance is not free) and counterparty risk (e.g. will the insurance company be solvent when the claim must be paid). So we’ll have to figure out what is the right mix of saving/investing, insuring and hedging and perhaps, as professor Bodie seems to suggest, a smaller but more certain piece of cake is what we should settle for!?! Pretty tough to swallow, considering that we’ve gotten used to believe that we can have it all if we do the right things.
This new framework is more complex (not that today’s planners don’t worry about inflation, insurance and longevity), but it also make life-time sustainable income (not assets) as the focus of wealth, and it makes everything more explicit. Much of the ‘financial engineering’ mechanisms proposed as the solution are already used for HNWI, the challenge will be to get it delivered to the average investor.

You can learn more about life-cycle investing in the following papers/webcast:
1. In the FPA Journal of Financial Planning, Paula Hogan in “Life-cycle investing is rolling our way” discusses what life-cycle planning is about and the implications for planners.
2. Zvi Bodie in “Retirement investing: a new approach” appearing in Financial Engineering News, illustrates application of life-cycle investing principles using inflation protected bonds, determining suitable asset allocation based on investors’ willingness to postpone retirement and call options to protect downside while maintaining upside opportunity.

3. October 2006 Boston University Conference on “The future of life-cycle saving and investing” includes a whole series of life-cycle investing related presentations: theory, behavioral aspects, practical models, products and the role of government. This includes webcast of the various presentations.
4. Still on the conference, there is Anna Rappaport’s post-conference update on “Expanding solutions for retirement income management- risks, barriers and dreams” where she looks at the various implications/perspectives of the stakeholders in retirement benefit delivery: individuals, insurer/financial services company, employer and regulatory.
5. And finally the related “Lifetime financial advice: human capital, asset allocation and insurance” by Ibbotson, Milevsky, Chen and Zhu tackles an integrated view of life-cycle finance. They also have an excellent presentation on annuities and show the principles of how to create an asset allocation composed of risk-free and risky assets, and annuities; they also show the impact of risk aversion and the bequest motive will affect the resulting mix.