What went wrong with retirement planning?
If you participate in a “Defined Contribution” retirement plan, you should know how it came about and what it really means, especially the risks.
How it began.
Back in the heyday of the Industrial Age about 70% of workers in the West were employees. And many government and corporate employees were on a “Defined Benefits”, employer-sponsored pension plan; the old pension-for-life.
“Defined Benefits” meant that the employee never had to worry about planning for their old age; if they worked long enough for the same company, the company would ‘look after’ them for life.
A long service award and gold watch meant much more than recognition; it meant a comfortable old age for the recipient and the ceremony served as a useful reminder to other employees to appreciate their employment.
For employees who were fortunate enough to work for a stable company with a generous pension plan, life could hardly have been better. The future was taken care of.
A pension for life was viewed as the norm but it wasn’t really the norm as only about 45% of employees in the USA participated in a Defined Benefits plan. Millions of small to medium business owners and their employees did not have company-sponsored pension plans. While many business owners regarded their businesses as their pension plan, most of their employees had a meager state-sponsored pension or Social Security to look forward to. More about this in a future article.
Then it changed.
In 1978 in the United States, where corporate interests dictate government policy, a clever slight-of-hand shifted responsibility for, and risk of, retirement planning from the employer to the employee. Enter “Defined Contributions”.
Under the new Defined Contributions schemes, the employer continued deducting “retirement contributions” from their employees’ pay checks, the “defined contribution”, but were absolved of all responsibility after their employees retired; the days of the “pension for life” plan were numbered.
Why it happened.
Why it happened is quite simple; people started living longer after retirement. As a result, pension-related risks for the employer increased to unacceptable levels and corporate America needed to eliminate the risks.
Defined Contributions was a simple solution for companies. Pass the buck from the employer to the employee; from the strong to the weak. Let the employee take care of their own retirement planning. The alternatives would have been far too complicated and contentious for the companies.
The Cost of Risk.
In a Defined Benefits scheme, the risks were spread across all the retired employees as well as current employees. As such, the risks were fairly easy to quantify and manage.
Let’s go back to the 1950’s and say that a company had a hundred employees drawing retirement benefits and that the average life expectancy for the predominantly male workforce was around 67. Of the 100 retirees drawing pensions, most would die during the decade after retirement while a few might live into their eighties or nineties. The cost of the few who lived longer was offset by the many who died earlier. Think of an elongated S-curve on its side; quite a few retirees dying shortly after retiring then a lull for a few years as the rest settled into retirement and then the attrition rate beginning to rise as most retirees died a few years either side of the average expected lifespan.
In a Defined Benefits scheme, the company could bet on some of their retirees living longer but it didn’t matter to the company which retirees lived longer.
The problem for the companies only arose when life expectancy increased and too many retired employees started living longer. The companies could have increased the retirement contributions to accommodate the increasing life expectancy but that would have led to ongoing conflict with employees and labour unions. It was much simpler to change the law and switch to Defined Contributions.
Risk is completely the opposite in a Defined Contribution scheme.
In the era of Defined Contributions, the risk has shifted squarely onto the shoulders of the individual.
Without the “offsets” available to the corporate retirement fund manager, average life expectancy becomes completely irrelevant when planning for one’s own retirement. The individual has become their own fund manager although most don’t know it.
- How does one plan when one could die today or live to a hundred or more?
- How does one plan in a world that is increasingly volatile and uncertain?
- How does one plan for the single biggest risk in old age, medical costs?
In the light of these questions, planning to have “enough to retire” seems utterly ludicrous.
Since all the risks associated with retirement are on our shoulders, we have to plan for every eventuality; like an engineer designing a bridge to withstand a 500-year flood. If the bridge can withstand a 500-year mega flood it should be able to handle the 100-year floods with relative ease. But a 500-year flood could happen next year, even tomorrow. The bridge must be ready.
For me to enjoy a comfortable, stress-free old age, I am making three key assumptions;
- I will live past a hundred.
- My investment portfolio will lose 50% at least once during my retirement.
- My medical costs will double every five years plus at least one major medical event.
Trying to build a retirement portfolio to accommodate these assumptions as an Ignorant Passive Saver (“I don’t know anything about investments”), reliant on ‘professionals’ to grow one’s wealth, is virtually impossible because the Saver lacks the only solid foundation needed for financial independence; “a reserve of knowledge, experience and ability” (Henry Ford).
These are very real scenarios.
In 2009 my retirement plan lost over 60% of its value and my income was virtually wiped out. Ten years later and I am now 20% of the way to 100 and still alive and healthy. In 2018 the South African government announced its plans to expropriate property without compensation; that announcement derailed a property sale and could result in a 100% loss if my properties are expropriated without compensation.
But here’s the difference. In 2009 losing 60% of my retirement plan was a nasty shock to the system while in 2019, the threat of losing 100% of my property portfolio is just a fact of life that needs to be accommodated in future planning.
The risks haven’t changed but my attitude and skill are changing.
As I see it, the only way to plan for financial independence in old age is to become an Intelligent Active Investor who exercises maximum intelligence and skill managing their own money.
The minimum return goes to the passive investor who wants both safety and freedom from concern. The maximum return would be realised by the alert and enterprising investor who exercises maximum intelligence and skill. (Benjamin Graham, The Intelligent Investor)
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