“Individuals Must Create Their Own Pensions” – But How?

Many advisors are still taking their cues from pensions funds and endowments, even as losses in the recent financial crisis prompt these institutions to reshape their strategies. But that follow-the-leaders approach may not be right for all clients.

So starts a Dow Jones newswire article appearing in Financial Advisor Magazine online this morning. The point being made is that pensions and endowments are using more risk-managed strategies and reducing stock market exposure. Therefore, as the article continues, clients may be “underexposed” to equities (stocks) in their retirement planning portfolios.  it even quotes a couple of financial advisors who mention that they think “inflation risk” is a bigger threat than stock market risk. Of course inflation should be addressed – however, increasing stock market exposure does increase other kinds of risk – especially risk to lifestyle in retirement.

What increasing stock market exposure exposes YOU to is the risk of uneven market returns and “black swan” risk. As noted author Nassim Taleb notes in his best selling book, surprising “black swan’ events, such as market crashes, happen more often than we think. If for example, 2008 was 3 years before your retirement date, and you were invested in a target date fund or such, chances are, you took a big hit. Generally accepted investing strategies, such as Modern Portfolio Theory (MPT – which is used in many target date funds), work ok when the goal timeline is infinite – such as is the case of a University Endowment or maybe a charitable fund. In these cases there is no “retirement date.” But for those who need to make sure there will be income in place at a SPECIFIC time in the future, these risks – i.e. overexposure to stocks – may be unacceptable.

What is the alternative? It may make better sense to ensure a base lifetime income stream before risking capital. How? using some kind of guaranteed vehicles that can create an income stream that matches estimated basic living expenses. Guaranteed vehicles could be government guaranteed vehicles liked bonds, or insurance company guaranteed vehicles like annuities (Of course additional risk management analysis will have to be done if annuities are chosen). Also, obviously, the amount of assets and income sources one has is the largest determinant of how a retirement income plan should be structured.

The bottom line – most retirement INCOME plans focus on strategies using statistics and models, but still expose the whole portfolio (and hence the investor’s lifestyle) to too much risk. Risk management can take many forms – but whatever methods are used, one should consider lifestyle risk management first before thinking about anything else.