Collective DC, and other whole of life solutions, look great on paper but they are also a perpetual source of debate. When it comes to pension design, I have identified two common practices which, in my opinion, could be labelled as ‘designers folly’. The first folly is combining the savings and spending problem into one. The second folly is to separate product design and investment strategy. From a common sense perspective it actually makes perfect sense to do it the other way around.
Two problems, two solutions
The same drivers that make it straight forward to deal with the savings problem create challenges when addressing the consumption problem. No surprise Nobel Laureate Bill Sharpe called decumulation “the nastiest, hardest problem in finance”.
The investment problem for the savings phase is basically a buy and hold strategy. The key is to take financial market risk to earn the risk premium. Over several decades, we will experience our fair share of good times and bad times and with all savings fully invested, the sequence of ups and downs doesn’t matter. If our investments are not turning out as planned, we can always increase our future contributions.
At retirement our pension pot is what it is and we need an investment strategy supporting how we want to withdraw our savings. While some of our withdrawals take place in the near future, there are also withdrawals further away allowing for taking investment risk. The size of our withdrawals depends on how we expect our investments to grow; too optimistic expectations lead to overconsumption in early retirement years and too restrictive lead to under consumption. The sequencing of investment returns also matters. When faced with bad times early on in our retirement, it’s difficult to compensate for that during good times because we can’t earn investment returns on what we have already withdrawn. And to make it more difficult, we don’t know how long we are going to live.
The common sense approach is to have two separate solutions; one for the savings problem and one for the spending problem. Trying to combine the two problems into one, is definitely a designers folly. Surly it must be more likely to hit one bird using two stones, compared to hitting two birds with one stone.
We can’t just assume the problems away
Theorists have an excellent way to deal with the complexity of the real world, they just assume the problem away. As practitioners living in the real world, we unfortunately don’t have that luxury. Whether we like it or not, we must deal with complexity and uncertainty. Another common folly is to think that we can mitigate risk, or more precisely uncertainty, through a complicated product design. If that folly would be true, the investment problem could be reduced to providing financial market exposure.
This folly is motivated by seemingly plausible theories about future investment returns, such as mean-reversion, which basically assumes the main problem away. In other words, we can solve a much simpler investment problem in which financial assets are well behaved, delivering a steady return albeit with some shorter term volatility, which means that in the longer term stocks are not that risky. This effectively separates the product design from the investment strategy and, as a consequence, it is sufficient to use a static investment portfolio tracking a combination of market benchmarks for stocks and bonds. This makes it straight forward to implement the portfolio and to evaluate the skill of the investment team against a market benchmark.
Problem solved according to the theorists, what could possibly go wrong? From a practitioner perspective, the short answer is a lot. This is clearly a designers folly since the real world doesn’t care about what theorists have assumed anyway. As Richard Feynman, an American theoretical physicist and Nobel Laureate, once said: “It doesn’t matter how beautiful your theory is, it doesn’t matter how smart you are. If it doesn’t agree with experiment, it’s wrong.”
A robust pension design reinforced by a robust investment portfolio
To avoid the designers folly, what should we aim for in designing a new pensions product or contract? The first step is to acknowledge that the world is uncertain and that we can’t calculate the odds for different outcomes based on a simple mean-variance simulation. As a consequence, we need to approach product design with a mindset focusing on robustness.
The purpose with pension design is to help members achieve their goals; expressed as the target in the savings problems and as a withdrawal profile in the spending problem. When our assumptions about the future do not hold, a robust design should have the ability to self-adjust in order to give members time to adapt, by adjusting their spending, to their new situation in a controlled way.
For the spending phase, this puts a lot of pressure on the investment portfolio as the first line of defence against the uncertainty in the financial markets. Traditional portfolio optimisation will not do the job. Instead, we need to pursue a satisficing strategy which has acceptable outcomes across the different phases of the business cycle and bearable consequences under potential future stress scenarios.
Common practice or common sense?
To avoid the designers folly, we need to have different designs when approaching the savings and the spending problem. For the latter it is particularly important that both the product design and the investment portfolio are robust against what we don’t know. This raises the question, are you a theorist assuming the problems away or are you a practitioner that sees the world for what it is? For any Matrix fans – it reminds me of the choice that Neo was given by Morpheus in the first Matrix movie. The pension analogy would be; do you choose the blue pill and follow common practice or do you choose the red pill and follow common sense?