An Income-Focused Investment Strategy
So what should retirement planners be investing in? The particulars are, of course, somewhat technical, but in general, they should continue to follow portfolio theory: The investment manager invests in a mixture of risky assets (mainly equity) and risk-free assets, with the balance of risky and risk-free shifting over time so as to optimize the likelihood of achieving the investment goal. The difference is that risk should be defined from an income perspective, and the risk-free assets should be deferred inflation-indexed annuities.
It’s important to note that the fund manager need not actually commit the employee to purchasing a deferred annuity but should manage the risk-free part of the portfolio in such a way that, on retirement, the employee would be able to purchase an annuity that would support the target standard of living regardless of what happens to interest rates and inflation in the meantime.
This kind of liability-driven investment strategy is called “immunization.” It’s equivalent to how an insurer hedges an annuity contract that it has entered into and how pension funds hedge their liabilities for future retirement payments to plan members. What investment managers often fail to realize is that the same strategy can be employed at the individual investor level. (For a more detailed discussion see the sidebar “Portfolio Management: When Income Is the Goal.”)
Portfolio Management: When Income Is the Goal
Employees still get a pot of money upon retirement and thus retain the same freedom of choice over their retirement savings that they have under current defined-contribution arrangements. The difference is that the value of the pot would be obtained through an investment strategy meant to maximize the likelihood of achieving the desired income stream at retirement. Of course, that value might be much more or much less than the value of the pot obtained through a wealth-maximizing investment strategy.
Moving to an income-focused pension strategy will require changes not only to the way retirement plan providers actually invest the money but also to how they engage and communicate with savers. Let’s look at what’s wrong with current practice in this regard.