Where the purpose may have once been to alleviate old-age poverty or reward long and loyal service, broad social contracts mean people now expect a pension so they can cease work in later life and enjoy their remaining years in relative peace and comfort.

Yet, the fundamental tenet of retirement – income security – is being undermined. In the past, retirees could depend on a reasonable pension income from essentially one of two formal sources: social security systems and/or occupational pension plans. But the retirement landscape is radically changing.

Increasing longevity combined with plunging birth rates has created a “demographic time-bomb.” This describes the potential crisis countries face as a shrinking labor force is required to support a growing segment of older, nonworking dependents.

While this will hit all regions, it has implications for individuals expecting a comfortable retirement based on social security. With a significant portion of the population in developed nations now living up to 30 years or longer than the global life expectancy of 67.2 years (UN World Population Prospects 2006), social security schemes are becoming unsustainable.

Demographic changes will also affect recently industrialized countries in the process of building up pension scheme assets, such as South Korea (A country for old men), and developing countries, like China, seeking to establish a broad-based social security system. Both countries will gray dramatically in the next few decades.

On the occupational side, employers have moved away from defined benefit (DB) plans. Previously, employer-sponsored pension benefits played an important role in supplementing modest state social security. Under DB plans, companies commit to pay retired workers a defined amount for as long as they live. Yet, with retirees living longer, such generous promises have proved costly, particularly when combined with unrealistic return expectations.

To reduce costs, companies offering such schemes are moving toward defined contribution (DC) plans. With DC plans, employers no longer promise a payment. Instead, the employee shoulders the investment risks with the payout dependent on the value of the fund at retirement. The trend has been evident in the United States, where DC plans have grown from 67% of all plans in 1975 (some 26% of all participants) to 93% in 2005 (64% of all participants). In Europe, governments are also introducing tax-sponsored DC-type schemes, such as the PERCO-plans in France.

As a result of these trends, increasing pressure is placed on the third source of retirement income: personal savings. Assets such as savings, bonds, equities or the family home have traditionally provided a source of complementary retirement income. With the burden of financing retirement now placed on individuals, income from personal savings is becoming an integral part of the old-age income to support or partially replace social security benefits.

In addition, the change in occupational schemes will see increasing millions of people arriving at a pivotal point in their lives to find a substantial pension savings pot waiting.

As Professor Raimond Maurer and Barbara Somova from the Goethe University in Frankfurt (Live long and prosper) describe it, for individuals entering retirement, “this pension savings pot may well be their most significant financial asset, and deciding on how to convert it into retirement income is one of the most important financial decisions they will ever make.” How individuals invest and spend this “pension savings pot” will increasingly determine their retirement lifestyle – or even if they can afford to retire at all.

Olivia S. Mitchell, professor of insurance and risk management at the Wharton School of the University of Pennsylvania and director of the school’s Pension Research Council, believes the consequences of these trends are clear. “Past generations were fortunate in having reliable old-age security. The story is quite different for baby boomers. I think retirement is becoming a more fraught and riskier period of life.”

To fund up to 30 years or more of retirement in a sustainable manner without outliving their assets, individuals will need to spend their money wisely. Yet, this is no easy task. Professor Mitchell argues that the unprecedented shocks of recent events have thrown into question many of the old rules associated with retirement, such as historic assumptions of stock market returns and the value of property. “In the new markets, individuals planning for retirement will need to become more self-reliant and seek out additional financial advice and protection. This process will be a dynamic one, continuing throughout retirement.”

How will individuals fund retirement spending? The accumulation phase of the life cycle will continue to be a key. Concepts such as “sustainable spending” (Hope is not a retirement strategy) assist people in accumulating assets and ensure assets retain purchasing power in the face of inflation. However, increasing attention will also be paid to the consumption phase.

Known as decumulation, this is the period when the retiree draws down assets. Decumulation has been a neglected field precisely because in the past a stream of income from a formal source was largely assured. With tens of millions of baby boomers set to retire in the next decades, decumulation is gaining greater attention, as it becomes clear that the investment and spending decisions these individuals each make will be critical in determining the sustainability of their lifestyles in retirement.

Boomers will have to protect against a range of risks including inflation, falling interest rates, and also poor health and the resulting medical bills that can rapidly consume assets. As recently seen, capital market volatility can also savage household assets and pension savings (see Repairing the household assets and Asset trouble for baby boomers). And all of these contribute to longevity risk, the risk of individuals outliving their assets and being reduced to a lower standard of living or even old-age poverty.

Such complex factors make decisions daunting even for individuals with a solid grasp of economics and finance. And if the decisions are wrong – there is no second try. Zvi Bodie, professor of finance and economics at the Boston University School of Management, has observed: “No one would imagine that you or I could perform surgery to remove our own appendix after reading an explanation in a brochure published by a surgical equipment company. Yet, we seem to expect people to choose an appropriate mix of stocks, bonds and cash after reading a brochure published by an investment company. Some people are likely to make serious mistakes.”*

As the financial implications of living longer in retirement are significant, individuals will increasingly turn, as Professor Mitchell suggests, to intermediaries to assist them. Yet, the question must be asked, does the financial services sector offer solutions that really meet their needs?

Professor David Blake of the Cass Business School in London has doubts. In an article titled “One day pensions will be properly planned” (with Cairns and Dowd in Financial Times, May 2008), he wrote that there is little connection between the accumulation stage and the decumulation stage of pension plan design. This, he argues, is because plan members have a poor understanding of both stages and of the resources and risks involved in ensuring an adequate pension in retirement.

As Professor Blake points out, “As a consequence, plan providers have little incentive to give much thought to pension plan design, let alone take an integrated approach to it. The fund manager during the accumulation stage has no target retirement lump sum to reach. And the annuity provider just annuitizes the lump sum handed over by the fund manager, but has no concern about the standard of living this might provide to the plan member.”

In the article, Professor Blake suggests the optimal strategy may be a type of “stochastic lifestyling.” The sector is moving in this direction with attempts made to construct multi-asset-class strategies and insurance delivered by asset managers and insurance companies combining. Target-date funds (TDFs), which take into consideration the size and behavior of liabilities in portfolio construction rather than solely focusing on the growth of the assets, are a nascent step in this direction.

However, among the criticisms of TDFs (Boding tough on voodoo finance) is that they still fail to provide efficient solutions for the decumulation phase. But in this, the financial services sector is not alone. Regulators too have overlooked decumulation. Since 1990 nearly all 30 member countries of the OECD have made changes to their pensions systems. While about half of these reforms have altered retirement benefit payouts, the wider issues of decumulation have been overlooked. When decumulation is addressed, it is in terms of annuitization without consideration for wider implications that may leave people stranded in retirement without sufficient income.

The emerging retirement landscape demands recognition from all parties – regulators, the financial services sector and individuals – that investing for retirement is not quite the same as investing for growth. Part of this is the realization that the start of retirement is not the investment time horizon. Rather, the end of retirement is.

In the end, decisions relating to retirement investment and spending will be in the hands of individuals. They need the support of viable, affordable solutions. If the financial services industry can provide solutions that allow individuals to invest and spend wisely in their retirement years, the industry will maintain its importance for millions of investors and go a long way to repairing the reputational damage suffered during the current crisis.

* Cited in Rational Decumulation by David F. Babbel and Craig B. Merrill (May 2007)

Published by PROJECT M in September 2009

(Artwork/Generative Design: Projekttriangle Design Studio; Photos: Alex Telfer/gallerystock, Matthew Farrant/gallerystock, Jouk Oosterhof/gallerystock, PR)