Tuesday, March 20, 2012

Dimensional Retirement's Next-Generation Retirement Solution

I'm writing this from Chicago. The RIIA Spring Conference just finished up and I'm glad I came. Lots of interesting topics, and I could finally get to meet and have long chats with Bob Seawright, David Blanchett, Peng Chen, and lots of other great people. 

A lot of people asked me what I'm working on now.  It's a bit hard to answer. I've been taking a step back to try to look at a bunch of different systems that companies and researchers have developed to address how to build retirement income strategies: what asset allocation and how to incorporate annuities or other approaches. I'd like to find the best ideas from each of these approaches and see what other work I might still be able to do in this area.

One approach I've been meaning to learn about and hadn't had a chance to read much yet is Dimensional Retirement's Next Generation Retirement Solution for defined contribution plans. Their CEO David Deming gave a presentation about it, and it sounds pretty interesting. Just to be clear, this is not any sort of commercial. Actually, they only are making this available for corporate defined-contribution plans, they do not accept individual clients.  Also, I'm basing this write up on my own notes, so I hope I'm explaining the idea correctly. I haven't read much about it otherwise.

This is an example of goals-based investing connected to safety-first concepts very much in line with Zvi Bodie's work. The main inspiration for it is Robert Merton, a Nobel Prize winning economist.

It is meant for a typical person who is not interested in managing their own funds and is willing to turn everything over to the fund managers that will focus on building a guaranteed income for life.

Usually what a company highlights is the amount of wealth you've accumulated. But Dimensional Retirement (as well as a lot of other companies, it turns out, as I learned to today) emphasize the amount of lifetime guaranteed income you would be able to get from your savings, not the overall account value.

You can provide input about when you hope to retire, how much savings you wish to contribute each year, a minimal acceptable spending floor you have in mind for retirement, and a maximum spending level you have in mind (don't get greedy, but realize at some point your enjoyment of more spending won't increase much more once it is rather high).

They invest your money into 3 different funds: a broad stock fund, and long-term TIPS fund and a medium-term TIPS fund. The asset allocation they use depends where you are falling within the range for your potential lifetime income as it related to the minimum acceptable and maximum levels. The asset allocation is managed dynamically to manage risk in relation to meeting your retirement goals. I get the idea that you have the most stocks when you fall in the middle between the goals, and then you lock-in with TIPS when you are up to meeting the maximum goal. If you are falling toward the minimum goal, you could either save more, retire later, revise this goal downward, or go ahead and lock it in the best you can with TIPS. I'm guessing about this, it wasn't explained in the presentation, and I'm not sure if they let you know your current asset allocation or not.

What they are thinking in terms of is the amount of real annuity units you can buy. These are hypothetical deferred real annuities (which don't exist) that would begin payments at your targeted retirement date. The value of these real annuity units relate to interest rates, the inflation outlook, and mortality rates. Their prices are quite volatile, but the way that your asset allocation is managed with the TIPS funds is that they can match the duration of your assets pretty well to the duration of the annuity's liability payments so that the fluctuations in your guaranteed lifetime income stream are minimal.

They did an experiment with this in Holland and England, and just this month it is being rolled out in the United States. In Holland, everyone bought the real annuities at the retirement date. But that was a requirement in Holland's laws. I asked about this: will participants be required to buy these annuities in the US. It seems that the answer is no, but the whole point of this exercise is to buy the annuity to get the guaranteed lifetime income. That's what they recommend. In a survey, they found that 19% of Americans want to focus on wealth management without worrying about an income floor and 81% want protection with a guaranteed income floor even if it limits some potential upside. 

Their whole approach is designed to serve that 81%. The outcomes here are not about the pile of money you have at retirement, but about the lifetime sustainable income you can generate.

Guaranteed retirement income is expensive, which this approach helps people to realize and internalize.