by Zvi Bodie and David Macchia
LIFE&Health Advisor, June 2008
Is there any topic more on the radar screens of financial advisors than retirement income? Financial processionals continually hear about and read about the enormity of the business opportunity represented by Boomer retirement income distribution. When an amount of money on the scale of $30 trillion starts to move it’s big enough news to garner everybody’s attention.
But it’s also true that awareness of an opportunity and successfully executing on that same opportunity are two very different things. In spite of all the hype around retirement income, one issue that isn’t sufficiently focused on is what good execution really means. What will insurance agents and financial advisors actually do in order to maximize retirees’ financial results? What investing strategies will they employ that provide the best management of the real world risks retirees face?
For any agent or advisor wishing to target retirement income as a business priority, there are at least two critical questions to ask one’s self:
- “How will the retirement dollars of my present and future clients actually be invested?”
- “What strategies, risk management techniques and products will I be using to prudently place my clients’ assets into a distribution mode?”
It’s a good time to ponder these questions because the answers may not be the ones that you expect.
The Engine of Past Growth Is Running Out of Gas
Over the past four decades the growth of the financial services industry has been fueled by an investment – and public relations – paradigm which, to some extent, has arguably outlived its usefulness. The Markowitz model, which highlights mean variance optimization (investment diversification conquers all ills) model has collided with a new investment realities reality matrix that renders it, if not at least incomplete, possibly if not obsolete. In either case, the outome is the The incompleteness, or obsolesce, is a result of the investment diversification old model’s inability to fully address the tangible multiple risks retirees actually face.
You’ve heard about longevity risk and inflation risk. However, these are but two in a set of risks facing retirees that include human capital risk (the uncertainty over one’s ability to earn money), public policy risk (the elimination or reduction in relied-upon post-retirement benefits), issuer risk (unanticipated failure, downgrades or performance impairments of financial companies) and household shock risk (unforeseen events such as pre-mature death, divorce or job loss).
To formulate a more sensible and complete approach to postretirement investing, an entirely new investment model is called for. This new model continues to embrace investment diversification as a vital component, but it also adds elements of longevity protection, risk hedging and essential advice.
What we are describing are the elements in a new retirement investing model that is built upon a framework that recognizes the complexity, unpredictability and variety of retirement-related risks. Why is this new model needed?
A number of reasons argue for the introduction of an advanced retirement income investing framework. Relevance is one. To the extent that the investing framework accurately recognizes the genuine needs and risks that retirees confront, it points to the likelihood of producing superior overall results. Another significant issue has to do with the financial liabilities retirees face. It’s an issue agents and advisors need to focus on because a retiree’s liabilities may turn into your own financial liabilities.
While it’s impossible to predict the full dimensions of financial liability that could attach to agents and advisors during the income distribution phase, not to mention broker dealers and product manufactures, one can safely assume that the totality of the financial liability potential will exceed anything we’ve experience over the accumulation phase. This increased liability potential arises out of the fact that investing mistakes made during the distribution phase create a far more severe set of consequences for consumers. These consequences include a substantial risk of lowered living standards due to poor overall investment performance and the potential for portfolio ruinrunning out of money, entirely.
How will the courts, government regulators or self-regulatory organizations view this issue in the future? How significant may the financial sanctions become if unfortunate investors relyied upon poor investment advice, under-performing products or inferior strategies? We can’t know. What we can safely assume is that the retirement industry needs to define a “prudent man” framework for retirement investing that as fully as possible takes into account the real-world risks retirees confront.
Introducing EVF- The Empirical Validation Framework
Currently, vital work is being carried out on the development of a new framework for retirement investing. Called the Empirical Validation Framework (EVF), its development is being led by the non-profit Retirement Income Industry Association (RIIA). The effort around EVF has established the goal to define and introduce a prudent investing framework for income generation that will offer maximum relevance to retirees’ financial needs. The objective is to create a practical retirement investing approach that financial advisors can implement with their clients, preserving the flexibility to fine tune to the individual investor’s suitability and risk tolerance profile.
Fact-Based, Neutral and Unbiased
What’s described above does not mean that the EVF takes sides in terms of products or strategies. No, the EVF is industry and business silo neutral. What ist does mean is that there will emerge an index case, a “prudent man” framework within which various products, strategies and techniques can co-exist. RIIA’s effort around the development of fact-based and objective EVF is a collaborative one. It has brought together leading academics in the fields of economics and finance. This effort builds upon a core science – The Theory of Lifecycle Saving and Investing – and will result in the investing framework needed to propel financial services forward over the next several decades.
What Does This Mean for You?
Let’s take a peek into the future. Imagine yourself on the front lines in guiding the planning for your clients’ retirement income needs. To prudently carry out your work you may have shifted away from reliance upon single products to create income in favor of strategically combining products in order to achieve superior overall results. Your orientation and outlook will be transformed, having moved away from hopeful investing objectives in favor of strategies that prioritize predicable outcomes such as guaranteed lifetime income adjusted to future inflation. You’ll focus on managing multiple complex retirement-relatyed risks, and you will monitor the plans you implement on an ongoing basis. You’ll work with products you don’t work with today, and your guidance will become ever more important to your clients as they grow older.
Are You Ready?
Are you prepared to assume these diverse responsibilities? It’s probably true that many if not most agents and advisors are unprepared to effectively participate in the new retirement investing framework. That will change, and quickly. And it’s for this reason that RIIA is defining the “job description” for tomorrow’s retirement- focused financial advisor. Moreover, RIIA’s Education Committee is developing the next-generation of retirement income educational programs for advisors designed to impart the skills, insights and knowledge that will be necessary to successfully implement the new retirement investing framework.
Prepare yourself to participate in the largest financial transformation in history. For financial professionals who commit to acquiring the professional education, practical skills and investing expertise necessary to shepherd millions of investors through their retirements, the future is unambiguously bright.
Note: Financial advisors wishing to learn more about the EVF and RIIA’s advisor education programs should attend the organization’s Annual Meeting to be held in Boston in September. Visit www.riiausa. org for details.
Zvi Bodie is the Norman and Adele Professor of Management at Boston University.
David Macchia is President & CEO of Wealth2k, Inc.
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