The challenges facing people saving for retirement are the same around the globe – trading flexibility for security, and balancing the benefits of personal choice with the convenience and cost of off-the-peg solutions. For Dr Michael Finke, professor of wealth management at the American College of Financial Services, the US DC sector may not be perfect, but its scale and the legal burdens placed upon it have created a lean machine for building funds. What is needed now is more product design to turn funds into income.
While those in the UK retirement system often shudder at reports of the level of litigation in the US over the investment strategy adopted by scheme sponsors, Finke thinks this pressure has made the American
system stronger.
“Probably the biggest success in the US system is how inexpensive it is. We’ve created this system where we give companies a fiduciary responsibility for managing defined contribution assets which means they can be sued if the assets are too expensive. That system has led to a very inexpensive retirement savings scheme. I think globally it is probably the most efficient in the world. That’s where we’ve really succeeded,” he says.
“Where we have not succeeded is how we’ve essentially put this bubble wrap around the workers during their accumulation stage to protect them from themselves. And at retirement we then give them full responsibility for doing everything, from managing their investments and rebalancing strategies to figuring out how much they can withdraw, which is even harder than the accumulation stage. And that’s frankly cruel. It’s not something that we should be doing to average workers.”
Partial annuitisation
One way to mitigate that cruelty is, in Finke’s view, to create products that include at least some level of annuity income as standard.
At a recent conference Finke published research, conducted with co-researcher Keegan Stewart, into consumer attitudes to security of income in retirement. That research, carried out with Pacific Life, asked investors what they want from a default retirement savings plan. More than half – 55 per cent of respondents – said they wanted a mix of investments and lifetime income, compared to 38.8 per cent who wanted to fund spending from their investments and 5.5 per cent who wanted a lifetime income. The research also found 76.7 per cent of respondents said they would worry less and have greater confidence about retirement if they knew their retirement plan included the option of a monthly income at retirement.
Asked whether they would stay in a default offering a mix of both traditional investment and monthly income, 64 per cent said they would stay put, while 19 per cent would stick with an investment-only default and 17 per cent would choose their own stocks.
Finke says: “Economists universally agree that annuitisation is the most efficient way to generate an income. I’ve never met an economist who didn’t think that there should be at least some allocation of your retirement savings to an annuity.”
It is worth noting that in the US the word ‘annuity’ generally covers a broader range of income-generating products than in the UK, some of which include exposure to stock market returns.
“If income is the only goal, then you just want to pull everything into some sort of a shared longevity risk structure so that you can spend more from all of your savings. The alternative is that you have some sort of guideline about how much you can safely spend.
“But that guideline either needs to be very conservative to avoid the risk of running out in old age, or it can be generous and create the possibility that if the market does not do well, you’re going to end up spending far less than you hoped for,” he says.
“You don’t have to have an insurance company managing this. You can have some sort of a pooled system where you estimate how long the pool is going to live and then you provide some sort of guarantee of base income, and then you have perhaps a little bit of floating income, but you can charge whatever expense ratio you want to charge for that type of a scheme,” he adds, describing a tontine structure that sounds quite like the UK’s proposed decumulation-only collective
DC arrangements.
Finke points to TIAA as a provider which offers a guaranteed income with some floating portion that depends on the experience that they have in terms of mortality and investment returns.
“You can operate that type of a scheme at a very low cost. You don’t necessarily have to rely on competition among insurance companies. You can develop a framework that allows retirement investment companies to give retirees the benefit of mortality risk pooling, but not necessarily through the use of an insurance company,” he adds.
Four for life?
Finke has an interesting perspective on the ‘four per cent’ rule, the rule of thumb aimed at those not opting for an annuity solution but who are instead drawing income directly from their investment pot.
“There’s two philosophies on the 4 per cent rule. One is that you want to draw a fixed amount of spending every year from your investment portfolio, but of course there’s always a risk that if the value of your investments falls early on in retirement, you may run out prematurely. So, the 4 per cent rule historically has been relatively conservative.
“A better approach is likely to start out with a higher percentage, maybe 5 per cent, but be willing to adjust spending downward if the market loses value. There are different approaches for algorithms that people can use to estimate how much they should adjust their spending every year based on how well the market does,” he says.
“Ideally, what you’ll do is live well in your late 60s, early 70s when you can enjoy the money the most, but be willing to be flexible, especially if you do get unlucky. We find people don’t spend as much as they could, but there is this barrier to spending money out of savings. With income people will spend every dollar, so tend to spend significantly more. They feel like they have a license to be able to spend that money. One of the benefits of the DB pension era was people received a flow of income through a pension, and didn’t feel any hesitancy to spend it. Now people have this investment account and, especially if it has lost money over the last year, it’s difficult to psychologically bring yourself to spend money out of that account.”
Private risks
So what does Finke make of the idea of incorporating private market assets into DC plans, something being pushed by the UK government through the Mansion House Accord, and starting to gain traction in the US too. For Finke, the threat of litigation is beneficial in the pressure it places on those running 401ks to get it right.
“I’m not worried about it in the United States because I feel the people who manage the assets on behalf of participants are held to a very high standard and they are the experts. They can choose when an investment works well for their portfolio and the plan sponsors have a strong fiduciary interest to ensure that the investments are being made in a manner that is consistent with the benefits of the participants and if they don’t they’re going to get sued.
“That threat of litigation actually serves as a bulwark against the potential abuses of less transparent types of investments,” he says.
“There’s not an employer who’s going to include private assets as an option that an individual participant can select, again, because of the litigation risk. The only place where it’s likely to enter into a retiree’s portfolio is through some sort of a target date fund where it’s managed by a professional and they’re including the asset class because it improves the quality of the performance of the portfolio.”
Litigation in the US does of course have its downside.
“Companies will get sued because they selected a target date fund that had a lower stock allocation because the market has done so well, and then five years later they could be sued for having a target date fund that has too much risk because the market maybe fell. That type of nuisance litigation is very costly.
“It costs participants in the United States. It’s not very efficient. But in the long run, that threat of litigation has been one of the major strengths of the US retirement system.”
Chooser losers
Finke has written about the impact of behavioural factors on retirement savings, and supports the default target date fund model for most workers.
He says: “I’ve done a lot of research on people who try to manage their own retirement savings versus those who save automatically in our target date funds which are automatically rebalanced.
“What I see is that consistently the ones that try to manage their own investments, and who tend to be more financially sophisticated, end up doing worse because they chase returns and don’t pay attention to how their portfolio becomes imbalanced.”
Finke recently completed a study looking at what happened during the Covid crash of March 2020. “I found that there was a good percentage of near retirees, people in their 50s and early 60s, who pulled a lot of money out of stocks because they didn’t recognise that their own portfolio had become very risky.
“People make mistakes and it shouldn’t be their job to manage their own pensions. So for them really there are two levers. One lever is how well do you want to live in retirement and the other is how much variability in that lifestyle you are willing to accept. And then the rest can be managed by a professional or
an organisation.”
Life trackers
In 2024 Finke also explored research showing that people who track their fitness also track their financial wellness, with resultant benefits in terms of higher savings rates. That work referenced a survey by the American College Granum Center for Financial Security, conducted with AGEIST.com, and noted that the real power of tracking can be that it forces us to make an investment in our ability to imagine the future, and take control of decisions today that will affect how we will live decades into the future.
He does note, however, that those who track performance in life are vulnerable to negative behavioural biases when markets fall, in some cases looking to get out of the market at the bottom, when holding steady would probably be a better strategy.
Performance
The dispersion of performance of DC returns in the US tends to be a lot narrower than in the UK. While in the UK the five-year annualised return of DC master trust and GPP providers ranges from 5.5 per cent to 14.3 per cent, 401k TDF providers’ returns tend to be a lot narrower, with about 2 per cent a year difference in 5-year annualised returns.
The UK is bringing in a performance test within the value for money framework, that incorporates elements of a similar test used by the Australian superannuation regulator.
But for Finke, such backward-looking benchmarking approaches contribute little.
“I get very uncomfortable looking at total returns. So much of who is in the lead is a function of their asset allocation. Was this a good period for risky assets? You could reasonably put together an optimal asset allocation that is, for example, less risky for workers, which I think is justifiable. And you could be at the lower end of the scale during this particular time period simply because the market did well.
“Now maybe over the next two years that type of low-risk fund may then do really well. What I focus on instead is does the asset allocation make sense for the participants and what are the expenses?
“And in the United States if expense ratios are 30 basis points on a target date default retirement investment plan sponsors start feeling like they’re vulnerable to getting sued. So the default choice for them is to choose a very low cost target date fund, something that’s closer to 5 to 10 basis points, which is incredibly inexpensive,” he says.
Default perspectives
Finke is talking from the perspective of a market where default funds are typically significantly more risk-on than many UK default funds, and says a 90 per cent-plus equity exposure for savers in their twenties is entirely defensible. That said, he does highlight concerns over equity valuations at this stage of the cycle.
He says: “How much benefit are you really getting these days from having a high equity allocation when everybody in the world is investing a higher percentage of their retirement savings and equities and perhaps the price of equities is higher than it should be and the expectation of that premium that you get over investing in less risky assets is going to be more modest?
“If you have a 30 per cent bond allocation for a 20-something year old, it doesn’t bother me that much.
“What does bother me is that the market has done so well over the last 15 years that people get comfortable with the idea of a 60 or 70 per cent stock allocation when they’re five years away from retirement, and a significant drop in the stock market can have a substantial impact on their lifestyle. That’s where I feel like there’s a greater potential for mistakes when it comes to asset allocation,” he says.