Think of the major financial firms that have been destroyed with devastating swiftness at various times over the past decade:
- Barings Bank
- Lehman Brothers
- Long-Term Capital Management
- Washington Mutual
What did they have in common? They had put themselves in a position where the value movements of their assets did not match the value movements of their liabilities. Because of that, they were taking risk, and even though these companies were run by sophisticated financial specialists, the risk bit them.
Deep within every major financial institution is a group of people performing a crucially important financial engineering function called asset/liability management. As a Fellow of the Society of Actuaries, I once helped perform this role at a major insurance company. It was my job to frequently analyze our assets and liabilities to make sure they were properly matched, because if they were not properly matched, the company could be at risk of financial ruin.
What does this have to do with you and your retirement savings? Everything.
You see, you have a major financial liability ahead of you -- funding your retirement. Whether you are already retired or have many years until that time, there is a time in your life when you will likely not be earning a wage and will be relying on your savings.
What can we say about the characteristics of this liability?
1. You need a steady income, increasing with inflation, to bridge the gap between your expenses and what you will receive from Social Security and any pensions.
2. You need that income to continue for the rest of your life, no matter how long you live.
3. You need that income to increase substantially if you enter a long term care situation, since in that situation, your expenses will increase substantially.
Now, let's look for an asset, or a bundle of assets, that can perform those functions and exactly offset the liability.
What would the perfect product look like? It would provide periodic payments for the rest of your life, with the payments indexed to inflation, and also increasing in the event of a long term care situation.
Does such a product exist? As far as I know, not as a stand-alone product, but you can achieve it with a combination of two products. There are immediate lifetime annuities that provide payments that continue for life and increase with the Consumer Price Index. And there is long term care insurance that provides a pool of additional money should you enter a long term care situation. Buying this combination of products in a sufficient amount matches the assets to the liability and virtually eliminates your chance of financial ruin.
Notice that this analysis is very simple and compelling, yet the conclusion is very different from the recommendations you hear from most investment-oriented publications. Consumers hear again and again that they should be invested in stocks and bonds. But the fact is that stocks and bonds do not match the liabilities very well. Thus, consumers who follow that strategy are running a huge risk of running out of money.
Let's look at the risks that they, by relying on stocks and bonds, are running. Each of the items below is a substantial asset/liability mismatch:
1. If inflation rises, interest rates will spike upward. Their bonds will fall in value, and their stocks likely will do so as well. Yet their liability -- the income they need to generate to maintain purchasing power -- will increase.
2. If they enter a long term care situation, their expenses will increase substantially, so their liability will increase, yet their assets will not change in value.
3. Their liability is related to how long they live. If they live longer, their liability increases. Yet their assets do not have any value trigger tied to their personal longevity.
4. Stocks and bonds add additional risks, such as market-related value fluctuations, that are completely unrelated to the liability.
The bottom line: When an investment firm recommends to consumers to invest their retirement savings in stocks and bonds, they are making a recommendation that they themselves would not follow if they needed to fund a retirement liability for a single person.
When pension fund managers manage pools of money for thousands of pension recipients, they tend to invest the vast majority of that money in bonds and very little in stocks. They can use bonds because, with thousands of recipients, the average length of the recipients' lifetimes is fairly predictable. But if there was only one recipient, the length of the recipient's lifetime is very unpredictable. Thus, a pension fund manager managing a pension liability related to one person (instead of thousands of people) would buy an annuity.
Keep that in mind the next time you read that you should have most of your retirement money invested in stocks. Whenever you run a big asset/liability mismatch, you might win, but if so you would be fortunate, because you might lose.
The Wall Street Journal
itself made this statement on February 12, 2000: "Retirement is the great financial riddle. Think of the uncertainties. You don't know how long you will live. You don't know what investment returns you will earn. You have only a limited sum of money. And there are no second chances. One possible solution: immediate fixed annuities."
*NOTE: Chris Conklin is a Fellow of the Society of Actuaries but not a Registered Investment Advisor or Investment Advisor Representative. Neither he nor Insurance Insight Group provide investment advice, and the statements above should not be relied upon as investment advice.
*For further information, or to contact this author, please leave a comment and your e-mail address in the forum below.