Two Great Minds
Don Ezra and Zvi Bodie are two great minds when it comes to thinking about pension investing. They largely agree on the theoretical approach for addressing the “nastiest, hardest problem in finance,” as Bill Sharpe once wrote. But in their personal investment approach and practical recommendations, they reach different conclusions. Does that mean one of them are wrong? The short answer is both are right, since it boils down to the framing of the pension problem and their personal way of dealing with uncertainty. This shows that economic theories give us guidance, but those theories do not provide us with clear-cut, ready-to-use answers.
The human capital
Both Don and Zvi agree that stocks gets riskier as the investment horizon increases and that the size of the risk premium is unknown. Historically, there have been long periods with poor investment returns. So having a long investment horizon is no guarantee, but there is a risk premium to be earned by investing in return-seeking assets.
Both think that for young people it is beneficial to invest all their financial savings in risky assets, since most of their wealth is in their human capital. This is a simple rule of thumb that applies to most of us, unless you were born with a silver spoon in your mouth and large trust fund.
Needs and wants at retirement
Another recommendation that Zvi and Don share is that we need think about our consumption in retirement and separate our ‘needs’ from our ‘wants’. Knowing both, I think Zvi probably has a higher proportion allocated to ‘needs’ than Don. Their joint advice is to secure our ‘needs’ with a combination of state pension and inflation-linked annuities. For our ‘wants’, we can then take investment risk to earn a premium. This way you might not get want you want, but you will get what you need, to paraphrase a song by the Rolling Stones.
This is where it gets interesting, since Don and Zvi have different ways of approaching uncertainty when it comes to investing. In other words, how to deal with low-likelihood, high-impact events that may or may not occur. I am not talking about a temporary fall in stocks, followed by a quick recovery. Rather, a systemic shock where we end up in a long period of economic headwinds and face a stock market that initially falls and then remains low for a long period.
To deal with uncertainty, Zvi prefers buying protection. Don advocates adapting as the main approach for dealing with uncertainty. It is a traditional trade-off between earning risk premium and tail-risk protection.
A simple example
The reality is many who face retirement in the UK do not have enough workplace pension savings to make a meaningful allocation between their needs and wants. In many cases, the state pension represents needs. Buying an inflation-linked annuity paying £9,339 per year – the same as the UK state pension – would cost £350k in the market (December 2021). Unfortunately, many will not have a workplace pension savings pot matching the implicit value of the state pension. If you have a savings pot of £350k, it means that 50% of your pension savings are already invested in a safe asset, before considering how to allocate your workplace savings. Looking at the current price for inflation-linked annuities, it is not surprising that most people who retire in the UK chose to take a drawdown. So let’s look at the investment implications, based on our great minds.
Zvi would cover ‘needs’ with an inflation-linked annuity, or a strategy of managing a portfolio of inflation-linked bonds that approximate such an annuity. If there are some savings left, he would invest those in risky assets. For the risky assets, he prefers strategies with some downside protection and argues for an investment approach that is not dissimilar to a traditional with-profits fund, but with proper regulation to protect the saver.
Don would argue that unless one has enough money saved, we should be prepared to take some investment risk throughout retirement. To do that, he mentally separates his investment portfolio into two buckets. One provides a stable income for the next five years and is invested to target inflation with low risk. The other bucket is invested in risky assets, targeting a real return with equity-like risk. The logic here is simple; if there are short term shocks to the stock market, Don can wait it out. If there is systemic shock, he has time to adjust his consumption to the new situation.
Are you a Don or a Zvi?
The conclusion is that each of us must think about how to manage the trade-off between earning risk premium and dealing with tail risks. Personally, I am more of a Don than a Zvi when it comes to dealing with uncertainty, so for me the trade-off is relatively straightforward. But this is based on my personal preferences. So while it is right for me, you might come to another conclusion based on your own situation.
Among members in a pension scheme there are many Dons and Zvis, so we need to think about what the right approach is when making this trade-off on their behalf. What complicates this is that among trustees, there are also several Dons and Zvis. Therefore it is important not to let our own personal risk-preference and trade-off influence the decisions we make.
The Dutch pension regulator tries to address this trade-off in the new pension contract that will be implemented over the next five years, by introducing a requirement that pension fund trustees need to measure the average risk appetite of different member cohorts. A brilliant idea from a textbook perspective, but not a great idea from a real-world perspective. I think both Don and Zvi would agree on that.