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Optimizing your retirement savings
Increasing uncertainties in market returns, government benefits and the rise in the cost of living is a growing concern for many who fear they may outlive their retirement savings. Professor Ken Vetzal of the School of Accounting and Finance explains how pension holders can manage their investments to improve the odds that their retirement savings will last.
Why is there a growing concern that retirement savings may not last the life of a retiree?
There are several reasons:
• Improved longevity: The longer savings are needed to fund retirement, the greater the chance of running out of money.
• Low interest rates: Investors must rely on riskier investments such as stocks compared to safer investments in bonds to obtain sufficient returns.
• The shift from defined benefit (DB) to defined contribution (DC) pension plans: Investments in DC plans are managed by plan members who may lack the necessary skills. Inappropriate investments can increase the chance of exhausting savings.
How do defined contribution and defined benefit pension plans differ?
DB plans promise a lifetime retirement income according to a given formula, typically designed to pay around 50 per cent of the employee's salary before retirement. Assuming the employer remains solvent, the risks of the plan fall mainly on the employer who manages the plan's investments and makes the promised payments. In a DC plan, employees make specified contributions into retirement savings accounts and manage the investments of those accounts themselves. The amounts available in retirement depend on the contributions and investment returns. Essentially, employees bear most of the risk in DC plans, employers for DB plans.
Is one better than the other?
There are pros and cons for each. DB plans are generally safer and simpler for long-term employees, with investments managed by the employer and promised payments known in advance. Employees who expect to switch employers or who are confident about managing their own investments may prefer DC plans. Given a successful investment strategy, they could get higher retirement income.
How can investments be optimized and managed for people with defined contribution pension plans?
Nothing is guaranteed. The best scenario is to improve the odds of success. In a recent study, Peter Forsyth (UW Computer Science), Graham Westmacott (PWL Capital), and I tried to design investment strategies for DC plan members that would give about the same retirement income as that promised for DB plan members. Strategies recommended by the finance industry resulted in too much chance of running out of money.
We tried more sophisticated methods, specifying an objective (such as minimizing the probability of running out of money) and computing the strategy that would best achieve that objective. Such strategies often worked well in the idealized conditions of the model but failed more often when tested with historical data. Our best approach aimed for a healthy remaining balance after 30 years in retirement but still had a small chance of failure. Compared to standard approaches, our strategy sacrifices upside gains in exchange for downside protection. Investors following standard approaches might do much better, but they could also do much worse.
How do you suggest that investors respond to market crashes, such as during the onset of the COVID-19 pandemic?
Our model allows for occasional market crashes. Every few years, we expect significant declines in stock prices, such as the financial crisis in 2008, the dot-com crash in 2000, and other cases as well as COVID. In narrow financial terms, COVID was nothing new. How an investor following our strategy should respond to any market crash depends on circumstances. Investors trying to accumulate more savings to fund retirement should invest more in stocks, anticipating a recovery. In the case of COVID, investors who bought stocks in late March 2020 would have done very well to date. Alternatively, investors who have already accumulated sufficient funds for retirement may be relatively unaffected by a crash due to low remaining investments in stocks. Such investors should not do anything.
Our strategy is fundamentally contrarian, which can be difficult to implement. An investor may be required to buy more stocks when most other investors are selling. Conversely, after a lengthy bull market, the strategy could call for investors to sell stocks while others are still enjoying further good returns. It can be hard to be independent and not follow the crowd, but our study suggests that is the best thing to do.