In the wake of the spectacular failure of Enron Corp., the House of Representatives has passed a pension reform bill, stressing new diversification rights, more disclosure and tax credits for "retirement education." The Senate is working on a version of its own. Even without the legislative oversight, plenty of people are thinking hard about their retirement income.

Boston University finance professor Zvi Bodie has a couple of concrete suggestions. Even if the lawmakers don't heed them, perhaps you should.

First, think hard about whether stocks as a class of assets really possess the property that is most often claimed for them -- that they inevitably are the best retirement bet in the long run.

Then, consider a set of alternative retirement investments that rarely are discussed -- inflation-protected bonds and real annuities.

The effect of these products is to insure a certain minimum standard of living, no matter how long you live -- by hedging your bets, meaning sacrificing some (but not necessarily all) of the potential for further gain in exchange for certainty.

Bodie has been working for years on clear explanations of what has changed in investment management (and what has not) as a result of the torrent of technological innovations in recent years -- the first framing of modern portfolio theory in 1952, say, or the discovery of an options pricing formula in 1973.

He is among the new generation of economists who are in training to take over the watchdog role that for the past thirty years has been played by Paul Samuelson, Franco Modigliani and Merton Miller. These market-knowledgeable but independent critics have tracked the wiles and pretensions of professional money managers, of which (and whom) there are many.

Bodie, for instance, is a close student of corporate America's shift during the last 20 years from defined-benefit pension plans to cash-balance plans and defined-contribution plans. By putting individuals in charge of their own portfolios, he says, these self-directed plans quietly have transferred risk to those who are least prepared to manage it.

Markets must now find some way of restoring expert management to private pensions. No doubt eventually they will. Safer products, with fewer choices will be required, he says.

But it will take more than one scandal to make manifest the need for greater safety. Myriad hearts remain to be broken by the retirement system. If Congress is going to use Enron to pass new pension legislation, Bodie says, it ought to give the industry a push in the right direction.

That means taking a close look at the self-serving and seriously flawed advice now being provided by nearly all professional retirement planners in the financial services industry.

What the retirement planning firms don't tell you, he says, is that stocks can go sideways as well as up and down -- sometimes for periods quite long enough to be considered forever, in terms of the rest of your life.

Hedges are available. But they don't tell you about those either.

Bodie brought "An Analysis of Investment Advice to Retirement Plan Participants" to the annual Pension Research Council Symposium in Philadelphia last month. In it, he carefully tracked the advice being given to the general public by well-regarded Web sites that offer free investment education and advice to people planning retirement.

Quicken, Smart Money, mPower (Money Central) and Financial Engines were identical in three crucial respects. All four recommended that the fraction of stocks increase with investors' time horizons. None mentioned the availability of risk-free alternatives to stocks -- inflation-protected government bonds, for example.

And none mentioned the wide differences of opinion among experts about what to expect from the stock market in the next several years.

Conventional wisdom is that stocks are not all that risky, provided you hold them long enough. Hence the popular rule of thumb that holds that the fraction of your portfolio that should be invested in equities is 100 minus your age. If you are 30 years old, 70 percent of your investments should be in stocks. If you are 70, only 30 percent.

But such advice rests on a statistical illusion, according to Bodie. Studies that show returns on common stocks narrowing to a range between 8.5 percent and 13.5 percent over a thirty-year period stock commit an elementary mistake, he says. They confuse the dispersion of an average compound rate of return with the dispersion of the value of the portfolio itself.

Markets don't always move in a straight line. And it can make a big difference whether deviations from the average you are projecting occur sooner or later in a certain span of years.

A real-world example makes it clear. Suppose you retired in 1973 with a $1 million nest egg. During the previous 20 years New York Stock Exchange shares had averaged annual gains of 12.78 percent. You mark that down to a conservative 10 percent assumption about future growth and decide to spend $117,460 annually for the next 20 years -- what you expect to be the rest of your life.

Immediately you run headlong into the long bear market of the 1970s. The market drops nearly 15 percent in 1973. When you take out your $117,460, you have $735,040 left. The next year the market drops another 26 percent. After you withdraw your $117,460, you have $423,530 -- less than half your original poke. For a time the roller coaster turns up, then down again. By 1981 your savings are gone. So much for the long run. Welcome to Social Security -- and the rest of your life.

Could it happen again? Bodie notes the ongoing disagreement between two prominent students of the stock market, Yale's Robert Shiller and the University of Pennsylvania's Jeremy Siegel. "Although both have PhDs in economics from the same university (MIT) and have been close friends since their graduate student days, Shiller is a 'bear' and Siegel is a 'bull.'" Each represents a large group of similarly inclined investors vastly different expectations of the next ten years

If experts can't agree even on the mean rate of return on stocks over the next decade, Bodie says, then even a well-diversified portfolio of stocks should be considered a risky investment.

What's the alternative? In the old days, protection against market decline came in the form of defined benefit plans. These were, in effect, guaranteed life annuities, replacing 60 percent or 70 percent of salary. Employees earned these benefits by working a certain number of years. Now companies have for the most part skated out of these obligations.

But new technologies have made it possible for financial firms to offer similar retirement vehicles to individuals, with a significant improvement. The appearance of inflation-protected government bonds in the United States and Europe make it possible to hedge such annuities against inflation, partially or completely.

Combined with upside participation in various stock market indexes, such new products based on advances in hedging techniques are known as "escalating annuities." They can provide -- for a price -- complete protection against both market declines and outliving one's resources

Yet financial service firms almost never mention them in the materials that they distribute to retirement plan participants, Bodie found. Instead they push their highly profitable mutual funds, on the grounds that everybody knows that stocks are the best long-term investment option.

In an editorial last week in the widely-read trade newspaper Pensions and Investments (http://www.savingsbonds.gov/sav/sbiinvst.htm), Bodie noted that the House of Representatives already had ducked the issue. He urged the Senate to require companies to offer inflation-proof government bonds among investment choices in their 401(k) plans, in its version of the pension reform bill. Not a single plan makes the offer now, he wrote.

Alas, only an abstract of Bodie's Pension Research Council paper is available (http://prc.wharton.upenn.edu/prc/2002conf-bodie.html) But for an overview of his ideas, consult his Retirement Investing: A New Approach -- or wait for The Enlightened Investor, his book (with Michael Clowes), scheduled for publication next year.

Expect that the language in the House bill, requiring that plan administrators explain in plain English "generally accepted investment principles" to participants, will bring investment advisors into line -- some day.

previous | contents | next