Pension planning
A new approach to an old-age problem
IT IS a brave new world of personal responsibility. Private-sector companies have been abandoning their commitment to defined-benefit (DB) pension schemes, in which employees receive an income based on their final salary. The cost of the promise has been too great. But the replacement of DB schemes with defined-contribution (DC) plans hurts employees. Under a DB scheme, it was up to the employer to fill any hole in the fund caused by a market shortfall; in a DC plan, the employee bears all the market risk. If returns are disappointing then pensions will be, too. And employers often use the switch from DB to DC to cut their contributions. If less goes into the pot, less will come out.
Employees in DC schemes can be at a loss when deciding how much to invest, where to put their money and what kind of pension to expect. To avoid this problem, many turn to “target date” funds, which invest in equities in the early years for growth and switch to safer government bonds as retirement approaches. Almost one-third of Americans with personal pensions have assets in such funds, according to the Investment Company Institute.
But this may still put too much emphasis on asset allocation. Robert Merton, a Nobel prize-winning economist, has an alternative approach. He says the main concern for employees is to ensure that switching from work to retirement does not involve a sharp drop in their standard of living. For them the key decisions are: when do they want to retire, how much do they want to save, and what minimum proportion of their final salary, or “replacement rate”, do they wish to target?
Under Mr Merton’s system—marketed via a company called SmartNest, which is being acquired by Dimensional Fund Advisors, a big fund manager—the employee answers those questions explicitly. The asset allocation of the pension pot is then driven by those decisions—a very high minimum requires a more conservative investment approach. As the market moves, the system keeps employees informed about the probability of meeting their target. If necessary the savings rate or the retirement date may have to change. This approach acts like the satellite-navigation system of a car, automatically replotting the route when the plan goes off course. If it works, the system will help employees avoid a penny-pinching retirement. At the very least it should ensure that they ask the right questions.
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Full article: http://www.economist.com/businessfinance/displayStory.cfm?story_id=14973155&source=hptextfeature
