This week my thoughts have turned to retirement for others, including my children and grandchildren as well as many others that I know. The concept of a voluntary cessation of producing an economic income and relaxing comfortably at leisure is shaping up to be one of the great myths. They simply won’t have the money to be only mild spenders and not earners at hard work. If we think the current debt structures and deficits are troublesome, we only need to look at the future. Unless we dramatically change the savings, investing, and living practices, the size of the population that will need help to retire with any sort of comfort will be huge. In my view the only long-term answer to the crushing problem is practical education. Of the three parts to the solution: saving, investing and life style, my only expertise is in investing. Nevertheless, I recognize the other learned skills of budgeting (controlled spending) and leading a healthy life are equally important.
Investment is an art that begins with reading
While almost all could benefit from reading Wealth of Nations by Adam Smith, Securities Analysis by Benjamin Graham and David Dodd or even to a much smaller degree my book MoneyWise, these are not what I am talking about. The kind of reading that I am alluding to is reading the situations around the world by observing every single day. Particularly now in these stressed times we watch conspicuous consumption with some awe. We do not pay enough attention to those who are not currently spending because they can’t and those who choose to spend less. Both groups are important to observe. Those with little resources and living moment to moment didn’t follow (or found it too difficult to follow) their few successful classmates, teammates, fellow workers, neighbors, etc. There are always some that took advantage of the opportunities to move up and out. Luck was not the source of their ascendency, but rather they recognized opportunity and the willingness to do the difficult. The second group of curtailed spenders may well be future-oriented as distinct from living moment to moment. The second group has internalized the fact that limiting current spending is transferring resources (no matter how small) to a future period. This transfer can earn additional awards through investing. Other places to read the economy are the gas stations (gas prices and level of maintenance and repair work), supermarkets (changing prices, excess inventories, the shifting to store brands from nationally advertised brands, quality of produce, etc), and shopping malls with high turnover stores (promotional and everyday prices, inventory of your size, stock liquidations, imports vs. locally produced merchandise).
There are too many financial illiterates
At the last board meeting for the Museum of American Finance where I sit as a Trustee, there was mention of a study by Annamaria Lusardi (George Washington School of Business) and Olivia S. Mitchell (Wharton School, University of Pennsylvania) entitled “Financial Literacy and Retirement Planning in the United States.” In a survey of 1200 responding Americans, the study asked three very simple questions; (1) understanding that interest rates can add to the value of savings, (2) understanding that inflation can reduce spending power in the future, and (3) whether some form of diversification lowers the risk of loss. Only 35% of the respondents got all three answers correct. What is even more discouraging is when the respondents were divided between those that are planning for retirement and those who were not, 47% of the planners got all three correct and the non-planners 23.9% got all three correct.
Salary savings plans: 401(k), 457, 403b come to the rescue
These savings plans increasingly require all the new, and in many cases present, employees to participate in defined contribution plans which are replacing defined benefit plans where and when possible. These plans are usually funded by employer and employee contributions. These contributions are invested at the discretion of the employee into various options including default options if they fail to make a choice. Open end mutual funds are the single most popular choice for managing this money according to the funds' trade association, the Investment Company Institute (ICI). Last week I contributed a brief column to Reuters on how I select the various options to be offered within a plan. In addition to the nine alternatives, I suggested that a managed account offered through the 401(k) could adjust the investments to changing market conditions and outlooks.
There are two dangers lurking in these plans
Both of the dangers lurking in these plans stem from some of the participants (beneficiaries) of the plan and an occasional sponsor of the plan not grasping that these are fiduciary accounts whose sole purpose is to build retirement capital. Another survey by Transamerica Center for Retirement Studies found that 63% of those who had participated in a 401(k) plan drew cash out when they became unemployed, and 34% of the underemployed did as well. Not only is there a tax penalty for a premature withdrawal, they are in effect robbing their own retirement money and/or benefits that could go to their family or heirs. I suspect that many who withdrew would have been part of the 65% who did not correctly answer the three basic questions in the other survey. Also they did not read (or see) the poor and struggling retirees around them. In the long run they and the rest of society who will give them some support will have suffered from their financial illiteracy and their inability to observe others around them. The contribution to our future deficits will be caused by this failure to educate our people.
The second risk, which is much smaller, but still a risk in some relatively small plans of privately held employers, is an attempt to replicate the senior executive's personal investment account. Even in the smallest of plans with just one owner and one employee, the sponsor has a fiduciary responsibility to the sole non-owner employee that the money is being invested in a prudent fashion. Also the executive who presumably has a significant personal account would be better off investing in potential capital gain earners in their personal account where, under current US tax regulations, they will pay fewer taxes when they liquidate.
What has me worried is when I see sector-oriented indexed exchange traded funds (ETFs) in retirement plans. These are narrowly focused portfolios designed to replicate a fixed list of stocks in one sector or industry. My concern is that these are good trading vehicles particularly when combined with short sales of some stocks within the industry. But the flows in and out of these ETFs are much more volatile than the underlying stocks. According to the ICI, the gross redemptions for all sector/industry funds through August, 2012 was $146 billion and the total assets in these funds was $246 billion. To be fair, the gross redemptions were somewhat offset by some inflows. Nevertheless, the gross redemption total indicates to me the speculation that is going on within these kinds of vehicles. This is just one of the types of investments that may be wonderfully appropriate in a personal account, but should not be found in a fiduciary account for all employees in a plan. Luckily, instances of these hyper-aggressive strategies in retirement plans are rare.
I speak with bias, in that I manage a small, private financial services fund that has positions in a number of investment management stocks. Despite the problem with financial literacy, I believe that defined contribution plans will continue to grow at rates faster than employment and the economy in general. Investment management company stocks should benefit from this perceived trend.
Are you reviewing your retirement planning?
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