Gambling with your Retirement Nest Egg

In April of 2013, PBS Frontline aired a documentary titled “The Retirement Gamble” (available online). It offers a sobering report on the problems with 401(k) type retirement plans in the U.S. and the obstacles facing working Americans in their quest to achieve a secure retirement. If you were already suspicious of the motives of some in the financial services industry, watching this documentary is unlikely to alter your opinion. There have been both vocal critics and defenders of the show. Here are my observations.

At the outset, the filmmakers highlighted the fact that too many Americans including the show’s producer, Martin Smith, have failed to save enough money to maintain even a modestly comfortable lifestyle after they stop working. They offered personal commentaries from those who simply failed to adequately plan for retirement and those who lost their jobs and savings as a result of the recent financial crisis.

In the second part of the show the producers transitioned to the role that financial institutions and their representatives have played in the retirement savings crisis. They unleashed a scathing exposé of the high and opaque retirement plan fees charged by the financial institutions and the conflicts of interest that exist between their salespeople and investors. Although “The Retirement Gamble” focused on workplace retirement plans, the problems of high fees and conflicts of interest which go hand in hand are rampant throughout the investment industry. So, even for those fortunate and diligent enough to be earning and saving sufficiently for a comfortable retirement, the program contains important lessons and has significant implications for their financial futures.

Not surprisingly, the shift in the show’s focus from the responsibility of the investor to save aggressively and invest wisely to that of the financial institutions and their representatives to act fairly and transparently sparked outrage from the financial services community. Their central argument is that: the accusations of unnecessarily high fees imbedded (i.e. buried) in many retirement plans and the conflicts of interest between them and the investors they serve are greatly exaggerated.

This argument is simply not credible. The evidence is overwhelming and the facts do not support their claim. Furthermore those making the claim clearly understand this. It was revealing to watch executives of the firms featured in the documentary looking visibly uncomfortable and struggling to formulate a plausible response when asked by Frontline to explain the obvious conflicts of interest inherent in a system they have fought vigorously to defend. This is the same system that allows their representatives to sell high commission, high margin and inappropriate investments to unsuspecting and trusting investors.

The unfortunate reality is that these firms which represent the overwhelming majority of those in the brokerage, banking, and insurance industries have no legal fiduciary obligation to their clients, which would require them to place the interests of those clients ahead of all others including their own. Instead, they operate on a much lower (so low as to be meaningless)”suitability” standard. Their representatives are commissioned salespeople who are incentivized to sell products, especially the ones that generate the highest earnings for themselves and their companies.

I’ll conclude with two points. First, don’t make retirement planning any more complicated than necessary. There is little doubt that saving more during your working years and controlling spending during your retirement years is the most important factor in achieving a successful retirement. This responsibility to forgo some spending today in order to save for the future falls squarely on the individual, not on the financial institutions. Furthermore tax-advantaged accounts like the 401(k) are powerful tools to build wealth because the investments inside them grow without the drag of taxes. Most working Americans would benefit from taking maximum advantage of these plans. In my opinion, Frontline could have done a better job communicating this in a simple, straightforward way.

Second, successful investing has more to do with avoiding inappropriate investments and building a diversified, low-cost portfolio than trying to identify the next” hot” investment. The program made clear the fact that all advisors do not operate under the same standard of care and the type of advisor you work with can have big implications for your finances primarily as a consequence of the types and costs of the investment recommendations made. The term “financial advisor” is broadly applied not only to Registered Investment Advisors who are fiduciaries and are mandated to place the client’s best interest ahead of all others, but also to salespeople who are not required to operate under such a fiduciary mandate. Under current laws it is again the responsibility of the investor to understand the distinction between the two and select the one who will better serve them. The principle of “buyer beware” is a smart one to follow when seeking financial advice.


Stages of the Financial Life Cycle

In my last blog I introduced the economic theory and field of study of life cycle finance, a principal goal of which is to construct a useable framework to help individuals improve their financial decision making to produce better monetary outcomes and maintain the smoothest and highest possible standard of living throughout their lives.

A central construct upon which life cycle finance is based is that most individuals experience important lifetransitions each with different social, family, career and financial characteristics. The quality of the financial decisions they make during these periods will have significant and long-lasting implications for their finances.

The life cycle concept has been widely accepted by sociologists and marketers for decades and adopted as a useful framework to study and predict human development and consumption behavior. In contrast the adoption of financial life cycle theory has until recently remained in the realm of academic research and is only now becoming an accepted tool of personal finance practitioners.

Economists generally agree that a person’s financial life consists of six sequential stages, three of which occur during their working years and three more during retirement. Let’s look at each one briefly.

Early career – This is the start of a person’s financial life. Typically the priorities include paying down student loans, establishing an emergency fund, borrowing for the purchase of a car and perhaps a first home and launching a retirement savings and investment plan.

Career development and raising a family – The focus may be on upgrading career skills, improving earnings prospects, moving to a larger home, building a college fund for children, increasing insurance protection for the family’s breadwinners and accelerating retirement savings.

Pre-retirement and peak earning years – During this phase the financial needs of the family typically decline, career prospects level off and the emphasis shifts decisively toward retirement planning and preparation.

Active retirement –This period is often characterized by a desire to enjoy a busy lifestyle filled with travel, entertainment and other leisure activities. While individual spending patterns vary widely, many new retirees experience an increase in discretionary spending in order to pay for these activities.

Passive retirement- This is the stage when energy levels may begin to decline and health issues surface. Devoting more time to family and friends and staying closer to home becomes the preferred way to enjoy leisure time. Discretionary expenditures will likely decline only to be replaced by rising health care costs.

Elderly care – This phase is often marked by a significant decline in physical and mental capacity, a further reduction in vigorous activity and increased health and age-related expenditures.

To better understand human development and spending behavior researchers and practitioners in the fields of psychology, sociology and marketing have studied changes that individuals, couples and families exhibit over their lives. Not surprisingly patterns emerge at various ages and stages in life as people experience major life cycle transitions such as launching a career, starting a family, preparing for a departure from the workforce and then retirement and old age. Personal finance researchers and more recently financial practitioners have begun to make extensive use of these same approaches in studying how people do and perhaps more importantly should make the kinds of financial decisions that have far-reaching consequences for themselves and their families.

What is Life Cycle Finance?

Life cycle theory is one of the more exciting and useful areas of research in personal finance. In broad terms, it represents the body of economic theory and knowledge that examines how individuals can make wiser and more beneficial decisions about spending, saving, investing and insuring over their lifetimes. There are several concepts underlying life cycle theory. We’ll discuss two of them in this article.

First is the premise that individuals will be making decisions about how to manage their wealth across a planning horizon that can span 60 years or more. This period begins at the start of a career at age 25 until the end of retirement at 85 or older and includes different life phases. The second assumption, derived from the field of classical economics, presumes that people are rational, have a firm grasp on self-control. Therefore, they will deploy their income and assets in a way that will enable them to maintain the smoothest and highest possible standard of living throughout their lives. This concept is known as “consumption smoothing”.

For example, following the consumption smoothing framework, a person might make a series of spending, saving, investing and insuring choices that allow them to maintain inflation-adjusted spending of $75,000 per year over their entire life. This is presumed to be preferable to a series of financial decisions that result in a $95,000 per year standard of living during their working years but only $55,000 during retirement or vice versa. The rationale behind this concept is intuitive. Given the option, most people would not choose to live an opulent lifestyle while they are working and then because they have failed to save enough, be forced to live frugally in retirement when they have more time to enjoy themselves. Conversely, they also wouldn’t want to live an unnecessarily frugal life throughout their careers in order to enjoy a lavish lifestyle that they may be unable to enjoy in retirement. In short, the main goal of life cycle finance is effectively to distribute a person’s income from the working and earning years over their entire life.

In theory, in order to accomplish this goal, individuals would borrow early in life when income and assets are low and needs are high. This would include paying for college, buying a car and purchasing a first home. Later in life when income is rising and basic individual and family needs have been satisfied, saving becomes important in order to fund the later years when they leave the workforce and rely on those assets to supplement Social Security, employer pensions and other income. That’s the theory. But as 20th-century philosopher and Yankee Hall of Famer, Yogi Berra has been attributed as saying, “In theory, there is no difference between theory and practice, but in practice there is.” In a computer model, applying consumption smoothing is relatively straightforward. In real life, however, many of the important financial choices we face are shrouded in uncertainty and fraught with risk. For instance, we can’t predict with accuracy the length or trajectory of our career earnings, the financial needs of our families, the returns we will earn on our investments or how long we will live in retirement.

In future posts, we’ll look at ways the average investor can use the life cycle model to make better financial decisions and improve the economic outcomes for themselves and their families.