PensionsMay 1 2018

How investment can help deal with the pension crisis

  • To understand what the current situation with pensions is globally.
  • To list the various changes in the pensions and investment industry.
  • To be able to discuss potential alternative arrangements for retirement.
  • To understand what the current situation with pensions is globally.
  • To list the various changes in the pensions and investment industry.
  • To be able to discuss potential alternative arrangements for retirement.
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Approx.30min
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How investment can help deal with the pension crisis

In the context of such a massive shift of retirement risk onto individuals, the investment management industry is facing an ever greater responsibility in terms of the need to provide suitable retirement solutions to be used within the context of defined-contribution corporate pension funds, and individual retirement accounts, which form the third and last pillar of pension systems.

Unfortunately, the current investment products distributed by asset managers or insurance companies hardly provide a solution to investors’ and households’ replacement income needs in retirement. 

The most natural way to frame an investor’s retirement goal is in terms of how much lifetime guaranteed replacement income they can afford at retirement.

Given that the biggest risk in retirement is the risk of outliving one’s retirement assets, securing replacement income in retirement can be achieved with annuities.

Annuities, as well as variable annuities (annuity products that offer participation to the upside of equity markets) suffer from a number of fatal flaws:

  • Their cost-inefficiency due to prohibitive cost of capital for insurers offering formal guarantees.
  • Their unavailability early on in accumulation phase.
  • A severe lack of transparency and lack of flexibility, which leaves investors with no exit strategy other than high cost surrender charges. 

Existing investment products such as life-cycle funds (also known as target-date funds), which are often used as the default option in retirement plans, may seem attractive alternatives to annuities.

This is due to the fact that these are inherently designed as long-horizon strategies that explicitly benefit from the well-documented presence of mean-reversion in risk premier in equity markets and beyond.

Target date funds, however, generally focus on reducing uncertainty over capital value near retirement date regardless of the beneficiaries' objectives in terms of replacement income in retirement.

As a result, they offer no protection to investors with respect to unexpected changes in retirement risk factors.

Making finance useful again

Goal-based investment principles grounded on solid academic foundations can actually be used to design retirement investment strategies that meet the needs of individual investors preparing for retirement.

It is time to launch a wake-up call before it is too late.

To address the looming pension crisis, investment managers must focus on the launch of meaningful mass-customized retirement solutions with a focus on generating replacement income in retirement, as opposed to keeping busy with launching financial products ill-suited to the problem at hand. 

A key ingredient of these retirement solutions can be provided by governments in the form of a novel form of fixed-income instrument that could be used to generate replacement income for a period roughly corresponding to the average life expectancy in retirement (say for 20 years after the retirement date).

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