Investing for Retirement: The Defined Contribution Challenge by Ben Inker and Martin Tarlie of GMO
The retirement landscape has changed. Defined benefit plans, the historical workhorse of the retirement system, had the advantage of access to corporate profitability. In the event that financial asset returns fell short of design expectations, this access mitigated the impact on workers’ retirement. But, as defined benefit plans have given way to defined contribution (DC) plans, the burden being placed on financial returns in satisfying retirement needs has increased.
Target date funds are rapidly becoming the workhorse for DC plans. These funds have grown substantially in recent years, partly as a result of automatic enrollment made possible by the Pension Protection Act of 2006. By and large, current target date funds resemble the old investment advisor adage that stock weight should be about 110 minus a person’s age. While this satisfies the common-sense intuition that, all things being equal, weight in stocks should go down as a person ages, there are a number of problems with this approach. In this paper we focus on two in particular.
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First, the standard solution is inflexible: all things are rarely equal. To address this shortcoming, we introduce a framework based on a common-sense definition of risk: not having enough wealth in retirement. The goal is not to put investors into yachts, but rather to increase the odds that they have the appropriate level of resources in retirement. Viewing risk this way leads to highly customizable solutions that under certain equilibrium assumptions are consistent with current solutions but offer far more flexibility and insight. Second, the standard solutions do not recognize that expected returns vary over time. We show that dynamic asset allocation – moving your assets – is an essential part of achieving retirement goals.
This paper is divided into two parts. In Part I we frame the question and explain how our framework leads to flexible, customizable solutions. In Part II we demonstrate the importance of dynamic allocation.
Asking the Right Question
The most common method for building multi-asset portfolios is based on Modern Portfolio Theory: maximize return for a given level of risk, where risk is return volatility. From the perspective of the retirement problem, and perhaps more generally, this approach is inadequate. The main problem is that it is asking the wrong question: given a level of risk, i.e., return volatility, which is the portfolio that maximizes the expected return?
This is the wrong question because it focuses on returns, not wealth. But returns are only the means to an end, the end being the wealth that is to be consumed throughout retirement. Not only is it the wrong question, but it presupposes the investor has a good reason for choosing a particular level of return volatility. So two investors faced with similar circumstances in terms of current wealth, future income and savings, and future consumption needs may have very different portfolios simply because their attitude toward return volatility differs.
A better approach is to focus on what really matters: wealth. An investor saving for retirement has fairly well-defined needs, both in terms of how much wealth he needs to accumulate and his pattern of consumption in retirement. An investor’s portfolio should be driven primarily by his needs and circumstances – what does he need and when does he need it? It should not be a function of his personality. The financial risk to an investor saving for retirement is very simple: it is not having enough wealth. So the more appropriate question is: which is the portfolio that minimizes the expected shortfall of wealth relative to what’s needed?
This definition of risk is central to our framework. All other things being equal, a person who is more risk averse should save more or consume less. In contrast, the standard approach gives bad advice. Putting the more risk-averse individual in a less volatile portfolio, one that from a Modern Portfolio Theory (MPT) perspective is considered less risky, without making any compensating savings or consumption adjustments, actually increases the wealth risk to that individual in that he is less likely to achieve his wealth needs. A virtue of optimizing based on minimizing shortfall of wealth is that it is highly customizable and easily able to handle the question of how to invest for a more risk-averse person who expresses his increased risk aversion through, for example, a higher savings rate. This flexibility is a consequence of asking the right question.
Returns vs. Wealth
To better understand the difference between MPT – a return-focused approach – and the wealth-focused approach that we advocate, it is helpful to compare the distribution of returns with the distribution of wealth. To a fairly good approximation, returns are normally distributed, as illustrated in Chart 1. While there is plenty of empirical evidence that, at least over shorter horizons, this is not quite true for many asset classes, our problem with the assumption for portfolio construction purposes here is not particularly that returns are “fat-tailed” or may be slightly skewed in one direction or another. It is rather that, even if returns are normally distributed, the wealth those returns lead to is not.
Chart 1 shows a normal distribution of annual returns for an asset with a 5% return per annum and a 14% annualized volatility. In a normal distribution, the average is the same as both the median and the mode, the most likely return. Whether you are actually concerned with the average of all of the potential returns, the most likely return, or the return that is in the middle of the distribution is irrelevant, because they are all the same.