Designing retirement solutions isn’t easy. A practical barrier for innovation is that retirement solutions doesn’t seem fit within a traditional investment fund. Bill Sharpe famously said that decumulation is the “nastiest, hardest problem in finance”, and he is right.
What’s less well-known is Bill Sharpe’s proposed solution to this problem, which he called the “lock-box approach”. His solution is straight forward and not particularly complicated from an investment perspective. And with some tweaks inspired by Don Ezra, this solution becomes quite useful for many people who retire on a DC pension.
An important lesson
In experimental physics, the goal is to contradict a theory by falsifying it. The quality of an experiment is determined by the measurement errors of its parameters. The key to improving the quality of the experiment is to reduce the largest measurement error, as it dominates all other measurement errors. In other words, we need to focus on the main driver of uncertainty.
Applying this to finance, we know that there’s huge uncertainty around future investment returns and will dominate the quality of our projected outcomes. We also know that our financial models are simplified approximations which don’t capture the dynamics of the real world. This explains why a simple rule of thumb tends to outperform the most complicated and detailed models used by professional investment teams. This also explains why taxi drivers talk about investments rather than constructional engineering.
This got me thinking. In addressing the decumulation problem, perhaps we should look for a simple solution based on rules of thumb, rather that some complicated financial engineering solution that works well… until it doesn’t! But first, we need to clearly define the decumulation problem.
The ‘squeezed middle’
Those with little savings are covered by social security. Those who have lots of money are well served by advisors, and most financial products in the market, which are designed for them. The real challenge lands on the growing number of people who are in the “squeezed middle” – those who have some savings, but not enough to buy a meaningful inflation-linked life-long income. Not surprisingly, this is the situation for most people who are retiring with a DC savings pot alone.
For the “squeezed middle”, the retirement problem boils down to deciding how to spread their available savings during retirement, while using the State Pension as protection against living to very old age. It is about getting the most mileage out of what you’ve got, while maximising your happiness during retirement.
At retirement, people have experienced different walks of life and have different wants and needs. Geriatricians often say, “if you have met one old person, you have met one old person”. There is no optimal retirement income profile that will work well for everyone. Instead, a saver has to address two questions: “How do I want to spend my savings?” and “How do I invest my savings to archive that?”. The latter question is quite daunting for most.
A simple solution: A ladder of target date funds
The simple way to address the second question is to create the preferred income profile through buying a ladder of inflation-linked zero-coupon bonds. In terms of preserving the purchasing power of one’s savings, this would be a risk-free investment. Bill Sharpe introduced what he called “the lock-box approach” which in today’s terminology could be seen as a ladder of target date funds.
To get more mileage out of retirement savings, many are willing to take some investment risk. The question then, is how to manage risk during retirement´´. Don Ezra has given this question some thought. He suggests splitting savings into two mental accounts: The short-term safe account in which savings are earmarked for income stability, and a long-term return seeking account where money is invested with the goal to earn the risk premium.
Combining these two ideas, one can think of a ladder of target date funds, where time to maturity of each target date fund determines its asset mix. Target date funds that mature far into the future can be invested in equity-like assets, and those maturing in the near future invested in safe assets. From an investment perspective this has two main advantages – take risk when time is on your side, and provide income stability for the next few years. There are no guarantees, but it helps savers plan their future.
As simple as possible, but not simpler
The investment strategy for the target date funds could be based on simple rules of thumb. For the upcoming three years money is invested in safe assets. For five years and beyond it is invested in stocks and in year 4, it is a 50/50 mix.
Thinking of it as a ladder of target date funds makes it easy to implement a customised income profile. It is just about allocating the right amount to each of the target date funds. This could be made very transparent – standard index trackers would do the job. Hopefully, savers won’t think of this as black box investing.
Of course, this could be further complicated but before getting carried away with financial engineering, we should think about the uncertainty of the financial markets. We should ask ourselves, does a more advanced approach add value or are we just ending up modelling noise? And if we pass that test, we need to think about how to explain a more complicated approach to savers.
What does it deliver?
This simple approach helps members to think about the income profile base that they want to have, without having to think about how to invest the money. It can be used in a planning tool for members, or as a way for financial advisors to help their clients. It is easily explained to most people, and it can be implemented using low-cost index trackers.
Knowing what you will receive for the next few years gives you some peace of mind. Taking investment risk in retirement with money that has a longer investment horizon could make the savings last longer. Again, the real risk for savers is not the short-term volatility, but that the assumptions about the long-term trends are wrong. In the latter case, having stability for the next few years provides time for adapting…
