Zvi Bodie: Well, it’s an axiom of modern finance that if you hold stocks long enough, they are bound to outperform all other asset classes. This is a fallacy. Paul Samuelson exposed it back in the mid-’60s. You should not believe the risk of equities goes away in the long run even though this is often promoted in so-called investor education material. This is voodoo finance. It is junk science. Stocks are as risky in the long run as in the short run. In some ways, they are even riskier.

Does this have something to do with the “Bodie paradox”?

One of my concerns is that people mistake the probability of a shortfall as the right measure of risk. However, the probability of a shortfall is a poor measure as it does not take into account the severity of the shortfall. In my work, I have offered an alternative measure that takes into account both severity and probability. This is based on the market price of insuring against a shortfall using put options. If you graph this, you get what friends call “Bodie’s Paradox.” What happens is that the probability of a shortfall relative to safe assets does seem to decline as the time horizon extends. This seems to imply less risk the further out you go. But if you look at the price of a put option to protect against the shortfall, it is exactly the opposite. It becomes higher the longer you go. This reflects the fact that the potential severity of the shortfall is becoming progressively worse. And this is not taken into account when you just look at the probability of a shortfall.

What factors should drive an investor’s asset allocation over time?

One has to take the trade-off between risk and return seriously. You start off by deciding what is essential for your needs in retirement and – if part of plan is to have a solid base that you can rely on for retirement income and to have it protected against inflation – then you ought to match that with investments that will deliver that type of income. In the US context that means inflation-protected bonds and annuities.

How should individuals invest and spend in retirement so they don’t outlive their assets?

I am a fan of life annuities. In the last couple of years a few have emerged offering inflation protection. I recommend them to my older relatives because they’re guaranteed not to outlive their income stream and not to have it eroded by inflation. But annuities have heavy load fees.  

The 4% rule, the amount recommended for a retiree to annually spend of their nest egg, is one piece of industry wisdom. Is this also flawed?

My main criticism of the 4% rule is that it is one-size-fits-all. We need an efficient and relatively inexpensive way of customizing solutions for different people. The industry needs standard configurations that can be tailored to individuals in different situations.

What is wrong with target date funds? How would such a fund be constructed to match your ideal?

Target-date funds are misleading. The name implies retirement is made secure by matching the date of the fund to a planned retirement date. But TDFs offer no guarantees. At the target date the customer gets whatever the current value is. The customer assumes all the risk. That is exactly the kind of incentive structure customers don’t need or want! I think our new, sobering financial reality provides convincing proof that you cannot rely on equities to provide a safe target date for a portfolio. Surely, guaranteeing a minimum level of inflation-protected retirement income should be a prerequisite for certification as a qualified default investment under the Pension Protection Act.

 Are “absolute return” funds a suitable recommendation for retirement savings (intending to provide protection and upside participation), and should they be preferred over life-cycle products?

What is needed is guaranteed lifetime income that is protected against inflation. As they approach retirement, employees should convert part of their retirement assets into inflation-linked life annuities. Such annuities should be a “qualified default payout alternative” at retirement. I believe that in the next decade we will see a transition to more end-user- oriented investment products. There will be a whole new generation of retail life-cycle products. One current emerging example is inflation-indexed life annuities. The next stage will be various types of guaranteed products that have equity kickers that let an investor participate in the upside in a very controlled way – a way the investor and the investor’s advisor can easily understand.

What minimum features should a “default option investment strategy” of a DC pension plan have?

The default choices offered in self-directed retirement plans should have principal protection. In the US, corporate plans never offered inflation protection, and were never really safe or portable. Yet, for people who lack investment knowledge, these are exactly the features you want. It is something resembling a DB plan without the limitations, an insurance-like benefit, only better because it is portable. With an individual account you’ll be able to take it with you even as you change employers.

You’ve used the analogy of surgery to explain the dangers inherent in laypeople making complex asset decisions. Are we expecting too much from the average investor?

One of the fallacies of our current system is that we pretend that ordinary people can make sophisticated financial decisions. Most people work, raise families, spend time with friends, volunteer in the local community and so on. Yet, on top of all that, they’re supposed to know how to allocate investment assets for when they retire up to 30 years from now. I don’t think that is realistic, even for people who may be brilliant in their own fields of endeavor. If defined-contribution investing was medicine, we’d effectively be saying, “Insurance no longer covers surgery, so you’ll have to do it yourself after reading this brochure.”

What is the alternative? Do you think employers should take a stronger fiduciary role for employees when it comes to the design and organization of retirement products?

We need plans with DB features that provide guaranteed income for people, but I don’t think private-sector employers should offer them again. I think we need financial intermediaries to do that. The 401(k) plans are moving in that direction with target date accounts where people are not in charge of their own asset allocation. This recognizes that people want the process automated. They don’t want to or are not able to plan on their own.

Does this imply that the role of financial advisors and firms will change?

I think competition will develop during the next decade as baby boomers reach retirement, receive all this money from 401(k) or other plans and search for greater security so they don’t outlive their assets. Financial innovation is on the way because of the technology revolution and major advances in the theory and practice of financial risk management. Inflation-proof personal pensions will become widely available to all. The challenge will be to produce and distribute them efficiently. Financial advisors will need to explain these products to people, to keep abreast of the latest developments in the field and guide clients towards the products that make sense for them – not spend their time explaining asset allocation mixes.

Published by PROJECT M in September 2009