The Case for Safer Savings Defaults
This guest post by Zvi Bodie and Jonathan Treussard recommends concrete steps to improve consumer financial literacy, the subject of a hearing today by the House Financial Services Committee.
We think that the investment companies that now hold much of the retirement savings of the next generation of retirees have not done an adequate job of providing safe investment options for these customers. In the United States, investment advisers have a fiduciary duty to their clients to follow The Prudent Investor Rule (formerly known as the Prudent Man Rule).
That legal standard was established in 1830: "All that is required of a trustee to invest is that he shall conduct himself faithfully and exercise sound discretion. He is to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested."
The interpretation of the rule has changed over the decades in accordance with advances in the science of financial economics, the evolution of capital markets, and technological improvements in information processing and telecommunications. The current standard relies on diversification as the sole method for controlling the risk of an investor’s portfolio. That method has failed repeatedly in times of financial crisis because the prices of all assets tend to fall in unison.
Instead of focusing on the probability of “success” in meeting some assumed target level of assets by an assumed target date, fiduciaries should be required to address the potential severity of a failure to meet a minimum standard of living in old age. The old adage should be applied: “Hope for the best, but prepare for the worst.” If adopted, this new standard of prudence would rule out the Department of Labor's current regulations regarding QDIAs (Qualified Default Investment Alternatives) for auto-enrollment retirement plans.
An investment approach more aligned with consumer protection is to supplement Social Security benefits with a base layer of safe assets that guarantee principal adjusted for inflation — TIPS bonds issued by the U.S. Treasury. With this solid foundation, consumers can participate in more speculative assets like stocks, junk bonds, etc. A non-technical explanation of the method can be found in chapter 7 of Worry Free Investing: “Taking Calculated Risks in the Stock Market.”
After a safer default option is in place, new guidelines should be issued for educating the public about investing for retirement:
- First, do no harm! Do not advise consumers to rely heavily on portfolios of stocks and conventional bonds to protect their retirement income against inflation. Make them aware of the terrible experience of those who retired in 1973 with their assets invested mostly in stocks, bonds, or mutual funds composed primarily of these two asset classes. If they retired with variable payout annuities linked to stocks and bonds, many saw their income drop by up to 50 percent in the first two years.
- Safety first. Help consumers prepare for the most important risks they will face in retirement: longevity risk, market risk, health care costs, and inflation. Show consumers how to create a layer of secure lifetime retirement income with guaranteed inflation-protected income annuities. Help them to buy a diversified portfolio of such annuities at minimum cost. Warn them that stocks are especially risky for those who are approaching retirement or drawing down their assets in retirement.
- Long-term care insurance. Make consumers aware of what Medicare does and does not cover. Urge them to supplement Medicare with long-term care insurance.
- Keep working. If they are not saving enough, advise them (1) to continue working as long as they are still physically and mentally fit and (2) to accumulate adequate retirement assets and insurance for a potentially long life. Advise them to wait until age 70 to start drawing Social Security benefits so as to increase their level of benefits.
- Home equity conversion. Make consumers aware of the possible ways to convert their home equity into cash through a reverse mortgage.
June 25, 2009; 12:58 PM ET
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