ASSETS VERSUS INCOME- PART ONE
Traditional defined-benefit pension plans were conceived and managed to provide members with a guaranteed income. And because this objective filtered right through the scheme, members thought of their benefits in those terms. Ask someone what her pension is worth and she will reply with an income figure: “two-thirds of my final salary,” for example. Similarly, we define Social Security benefits in terms of income.
The language of defined-contribution investment is very different. Most DC schemes are designed and operated as investment accounts, and communication with savers is framed entirely in terms of assets and returns. Asset value is the metric, growth is the priority, and risk is measured by the volatility of asset values. DC plans’ annual statements highlight investment returns and account value.
The trouble is that investment value and asset volatility are simply the wrong measures if your goal is to obtain a particular future income. Communicating with savers in those terms, therefore, is unhelpful—even misleading. To see why, imagine that you are a 45-year-old individual looking to ensure a specific level of retirement income to kick in at age 65. Let’s assume for simplicity’s sake that we know for certain you will live to age 85. The safe, risk-free asset today that guarantees your objective is an inflation-protected annuity that makes no payouts for 20 years and then pays the same amount (adjusted for inflation) each year for 20 years. If you had enough money in your retirement account and wanted to lock in that income, the obvious decision is to buy the annuity.
But under conventional investment metrics, your annuity would almost certainly look too risky. As interest rates move up and down, the market value of annuities, and other long-maturity fixed-income securities such as U.S. Treasury bonds, fluctuates enormously. In 2012, for instance, there was a 30% range between the highest and lowest market value of the annuity for the 45-year-old over the 12 months. However, the income that the annuity will provide in retirement does not change at all. Clearly, there is a big disconnect about what is and is not risky when it comes to the way we express the value of pension savings.
SOURCE: HARVARD BUSINESS REVIEW