U.S. patent application number 13/970520 was filed with the patent office on 2014-03-06 for method for defined contribution default benchmark.
The applicant listed for this patent is Allianz Global Investors US LLC. Invention is credited to Daniel Philip Cassidy, Michael Walter Peskin, Stephen Charles Sexauer.
Application Number | 20140067715 13/970520 |
Document ID | / |
Family ID | 46235551 |
Filed Date | 2014-03-06 |
United States Patent
Application |
20140067715 |
Kind Code |
A1 |
Sexauer; Stephen Charles ;
et al. |
March 6, 2014 |
METHOD FOR DEFINED CONTRIBUTION DEFAULT BENCHMARK
Abstract
A method for generating an integrated family of benchmarks
representing portfolio allocations for a participant is described.
At least two assets for a portfolio are identified. A current
market rate for at least one of the assets and a break-even
inflation rate for a predetermined time period are determined via a
computing device. The computing device determines a portfolio
allocation to each asset based on the current market rate and the
break-even inflation for obtaining inflation-protected income for a
predetermined number of years and then non-inflation protected
income for subsequent years. The identified assets and the
portfolio allocations are published via a network.
Inventors: |
Sexauer; Stephen Charles;
(La Jolla, CA) ; Cassidy; Daniel Philip; (Concord,
MA) ; Peskin; Michael Walter; (New York, NY) |
|
Applicant: |
Name |
City |
State |
Country |
Type |
Allianz Global Investors US LLC |
New York |
NY |
US |
|
|
Family ID: |
46235551 |
Appl. No.: |
13/970520 |
Filed: |
August 19, 2013 |
Related U.S. Patent Documents
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Application
Number |
Filing Date |
Patent Number |
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13413614 |
Mar 6, 2012 |
8515852 |
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13970520 |
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13282356 |
Oct 26, 2011 |
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13413614 |
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61406980 |
Oct 26, 2010 |
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Current U.S.
Class: |
705/36R |
Current CPC
Class: |
G06Q 40/08 20130101;
G06Q 40/06 20130101 |
Class at
Publication: |
705/36.R |
International
Class: |
G06Q 40/06 20120101
G06Q040/06 |
Claims
1. A method of generating a benchmark representing portfolio
allocations of portfolio assets for a participant, the method
comprising: obtaining, via a computing device, at least one of
stated payout ratios periodically for at least one treasury
inflation protected securities (TIPS) portfolio or fund offered by
an asset management company, or payouts of a predetermined number
of years laddered TIPS portfolio; identifying, via the computing
device, at least an annuity sponsored by an insurance company;
selecting, via the computing device, a particular TIPS portfolio or
fund based on the payout ratios and a particular annuity based on a
current market price; determining, via the computing device, a
portfolio allocation for the selected TIPS portfolio or fund and
the selected annuity so as to define a process for obtaining
inflation-protected income for the predetermined number of years
and then non-inflation protected income for subsequent years; and
publishing, via a network connected to the computing device, the
portfolio assets and corresponding allocations.
2. The method of claim 1, additionally comprising publishing, for a
given participant, one or more of a break-even inflation rate,
income at year zero, the cost of a deferred annuity that provides
$1 for life beginning in a predetermined number (D) of years, and
income at the predetermined number (D) of years.
3. The method of claim 1, wherein a source of the funding of the
portfolio assets includes one or more of defined contribution plan
payouts, defined benefit plan payouts, 401(k) plan payouts, or any
other retirement savings of any nature.
4. The method of claim 1, wherein the treasury inflation protected
securities portfolio or fund define an asset for obtaining income
for the predetermined number of years and at the end of the
predetermined number of years, the treasury inflation protected
securities fund or portfolio has a balance of zero.
5. The method of claim 1, wherein the particular annuity begins at
a selected maturity of the treasury inflation protected securities
portfolio or fund.
6. A method of generating a benchmark representing portfolio
allocations of portfolio assets for a participant, the method
comprising: obtaining, via a computing device, at least one of
stated payout ratios periodically for at least one inflation
protected securities portfolio or fund offered by an asset
management company, or payouts of a predetermined number of years
laddered inflation protected securities portfolio; identifying, via
the computing device, a deferred annuity; selecting, via the
computing device, a particular inflation protected securities
portfolio or fund based on the payout ratios and a particular
deferred annuity based on a current market price; determining, via
the computing device, a portfolio allocation for the selected
inflation protected securities portfolio or fund and the selected
deferred annuity, based on at least a current break-even inflation
rate, for obtaining inflation-protected income for the
predetermined number of years and then non-inflation protected
income for subsequent years; and publishing, via a network
connected to the computing device, the portfolio assets and
corresponding allocations.
7. The method of claim 6, additionally comprising publishing, for a
given participant, two or more of the break-even inflation rate,
income at year zero, the cost of the selected deferred annuity that
provides a certain payout amount for life beginning in the
predetermined number of years, and income at the predetermined
number of years.
8. The method of claim 7, wherein the certain payout amount is
$1.
9. The method of claim 6, wherein a source of the funding of the
portfolio assets includes one or more of defined contribution plan
payouts, defined benefit plan payouts, 401(k) plan payouts, or any
other retirement savings of any nature.
10. The method of claim 6, wherein the inflation protected
securities portfolio or fund define an asset for obtaining income
for the predetermined number of years and at the end of the
predetermined number of years, the inflation protected securities
fund or portfolio has a balance of zero.
11. The method of claim 6, wherein the particular deferred annuity
begins at a selected maturity of the inflation protected securities
portfolio or fund.
12. The method of claim 6, wherein the benchmark is generated at a
predetermined frequency.
13. The method of claim 6, wherein the benchmark is generated
daily.
14. The method of claim 6, additionally comprising publishing, via
the network, a payout vector for a predetermined investment amount,
the payout vector including an initial payout for year one, the
break-even inflation rate, and the predetermined number of
years.
15. The method of claim 14, wherein the payout vector additionally
includes a portfolio allocation percentage for the deferred
annuity.
16. The method of claim 6, wherein a portfolio allocation
percentage for the deferred annuity and a portfolio allocation
percentage for the inflation protected securities fund are
separately calculated for male participants and for female
participants at each participant age in a range of ages from age 60
to age 70.
17. The method of claim 16, additionally comprising publishing, via
the network, a payout vector for a predetermined investment amount
for each combination of age and sex, the payout vector including an
initial payout for year one, the break-even inflation rate, and the
predetermined number of years.
18. A method of generating a benchmark representing portfolio
allocations of portfolio assets for a participant, the method
comprising: obtaining, via a computing device, at least one of
stated payout ratios periodically for at least one inflation
protected securities portfolio or fund, or payouts of a
predetermined number of years laddered inflation protected
securities portfolio; identifying, via the computing device, a
deferred annuity; selecting, via the computing device, a particular
inflation protected securities portfolio or fund based on the
payout ratios and a particular deferred annuity based on a current
market price; determining, via the computing device, a portfolio
allocation for the selected inflation protected securities
portfolio or fund and the selected deferred annuity based on at
least an inflation protected securities distribution rate at the
predetermined number of years for obtaining inflation-protected
income for the predetermined number of years and then non-inflation
protected income for subsequent years; and publishing, via a
network connected to the computing device, the portfolio assets and
corresponding allocations.
19. The method of claim 18, additionally comprising determining the
inflation protected securities distribution rate at the
predetermined number of years at a current break-even inflation
rate.
20. The method of claim 19, additionally comprising publishing, for
a given participant, one or more of the break-even inflation rate,
income at year zero, the cost of the selected deferred annuity that
provides a certain payout amount for life beginning at the
predetermined number of years, and income at the predetermined
number of years.
21. The method of claim 20, wherein the certain payout amount is
$1.
22. The method of claim 18, wherein the benchmark is generated at a
predetermined frequency.
23. The method of claim 19, additionally comprising publishing, via
the network, a payout vector for a predetermined investment amount,
the payout vector including an initial payout for year one, the
break-even inflation rate, and the predetermined number of
years.
24. The method of claim 23, wherein the payout vector additionally
includes a portfolio allocation percentage for the particular
deferred annuity.
25. The method of claim 19, wherein a portfolio allocation
percentage for the deferred annuity and a portfolio allocation
percentage for the inflation protected securities fund are
separately calculated for male participants and for female
participants at each participant age in a range of ages from age 60
to age 70.
26. The method of claim 25, additionally comprising publishing, via
the network, a payout vector for a predetermined investment amount
for each combination of age and sex, the payout vector including an
initial payout for year one, the break-even inflation rate, and the
predetermined number of years.
Description
CROSS-REFERENCE TO RELATED APPLICATIONS
[0001] This application is a divisional application of U.S. patent
application Ser. No. 13/413,614, filed Mar. 6, 2012, which is a
continuation application of U.S. patent application Ser. No.
13/282,356, filed Oct. 26, 2011, which claims the benefit of U.S.
Provisional Application No. 61/406,980, filed Oct. 26, 2010, and
entitled System and Method for Defined Contribution Default
Benchmark, each of which are incorporated by reference in their
entirety.
BACKGROUND
[0002] 1. Field
[0003] The field is retirement income generally, and specifically,
a system and method for benchmarking for a sustainable and real
(after-inflation) retirement income for a participant's remaining
lifetime.
[0004] 2. Description of the Related Art
[0005] A large and looming issue is the need to convert over $7
trillion of defined contribution (DC) and IRA-type assets in the
United States into lifetime retirement income: income that
maintains its purchasing power throughout a retirement that can
last only a few years or as long as thirty or more years. This
assets-to-income process is the subject of this description.
[0006] To accomplish this, however, there must first be an initial
and broader discussion of retirement income, especially the reality
that there is no risk-free retirement income scheme. All
retirement-income schemes, from Social Security to a bank savings
account, contain risks and these risks are material and they vary
only in degree. The reality of a no-risk-free pension scheme is
very important and often underappreciated.
[0007] Sustainable and real (after-inflation) retirement income is
a major goal of work. This work produces a wide range of income
sources and individual income levels, reflecting the overall wealth
and the economic diversity in America.
[0008] From this work, almost all Americans will draw retirement
income from three financial sources. First there is Social
Security. Next there are defined-benefit (DB) pension schemes, and
personal savings that are mostly held in defined-contribution plans
and IRAs. There is also retirement income derived from working
during "retirement." Workers who are not in Social Security are
covered by the Railroad Retirement Board or Teachers Retirement
Systems in thirteen states and most government employees who do not
participate in Social Security. For the purposes of this
description, one can group view all non-DB, DC, and IRA retirement
plans as "Social Security-like" in that they are promises of a
government entity.
SUMMARY
[0009] In one embodiment, there is a method of generating an
integrated family of benchmarks representing portfolio allocations
for a participant, the method comprising identifying at least two
assets for a portfolio; determining, via a computing device, a
current market rate for at least one of the assets; determining,
via the computing device, expected inflation for a predetermined
time period; generating, via the computing device, a portfolio
allocation to each asset based on the current market rate and the
expected inflation so as to define a process for obtaining
inflation-protected income for a predetermined number of years and
then non-inflation protected income for subsequent years; and
publishing, via a network connected to the computing device, the
identified assets and the portfolio allocations.
[0010] In another embodiment, there is a method of generating a
benchmark representing portfolio allocations of portfolio assets
for a participant, the method comprising obtaining, via a computing
device, at least one of stated payout ratios periodically for at
least one treasury inflation protected securities (TIPS) portfolio
or fund offered by an asset management company, or payouts of a
predetermined number of years laddered TIPS portfolio; identifying,
via the computing device, at least an annuity sponsored by an
insurance company; selecting, via the computing device, a
particular TIPS portfolio or fund based on the payout ratios and a
particular annuity based on a current market price; determining,
via the computing device, a portfolio allocation for the selected
TIPS portfolio or fund and the selected annuity so as to define a
process for obtaining inflation-protected income for the
predetermined number of years and then non-inflation protected
income for subsequent years; and publishing, via a network
connected to the computing device, the portfolio assets and
corresponding allocations.
[0011] In another embodiment, there is a method of periodically
generating a benchmark representing portfolio allocations of
portfolio assets for a participant, the method comprising
recording, via a computing device into a storage, at least one of
the payout of predetermined (D) year self-liquidating treasury
inflation protected securities (TIPS) funds, or the payouts of a
predetermined number of years laddered TIPS portfolio; recording,
via the computing device into the storage, the D year TIPS
break-even inflation rate; for a D year deferral, calculating, via
the computing device, the TIPS distribution rate at year D at the
current break-even inflation rate as (1+D year TIPS break even
inflation rate) D*payout of D=zero year TIPS fund or laddered
portfolio=TDR_YD; recording, via the computing device into the
storage, the cost of a deferred annuity that provides $1 for life
beginning in D years (CO$1) using a preselected list of insurance
companies offering a deferred annuity at D years; calculating, via
the computing device, the cost of an annuity that provides a payout
equal to the TIPS payout at D years as (CO$1*TDR_YD), wherein
(CO$1*TDR_YD)/(1+CO$1*TDR_YD) is a portfolio allocation percentage
for the deferred annuity; calculating, via the computing device,
the cost to acquire the TIPS fund as 1/(1+CO$1*TDR_YD), which is a
portfolio allocation percentage for the TIPS funds; and publishing,
via a network connected to the computing device, the portfolio
assets and corresponding allocation results.
[0012] In another embodiment, there is a method of generating a
benchmark representing portfolio allocations of portfolio assets
for a participant at a predetermined time interval, the method
comprising recording, via a computing device into a storage, at
least one of the payout of 20 year self-liquidating treasury
inflation protected securities (TIPS) funds, or the payouts of a 20
year laddered TIPS portfolio; recording, via the computing device
into the storage, the 20 year TIPS break-even inflation rate; for a
20 year deferral (D), calculating, via the computing device, the 20
year TIPS distribution rate at year 20 at the current break-even
inflation rate as (1+20 year TIPS break-even inflation rate)
D*payout of D=year zero TIPS fund or laddered portfolio=TDR_year20;
recording, via the computing device into the storage, the cost of a
deferred annuity that provides $1 for life beginning in 20 years
(CO$1) using a preselected list of insurance companies offering a
20 year deferred annuity; calculating, via the computing device,
the cost of an annuity that provides a payout equal to the year 20
TIPS payout as (CO$1*TDR_year20), wherein
(CO$1*TDR_year20)/(1+CO$1*TDR_year20) is a portfolio allocation
percentage for the deferred annuity; calculating, via the computing
device, the cost to acquire the TIPS fund as 1/(1+CO$1*TDR_year20),
which is a portfolio allocation percentage for the TIPS funds; and
publishing, via a network connected to the computing device, the
portfolio assets and corresponding allocation results.
[0013] In another embodiment, there is a computer readable medium
having instructions that when executed by a processor perform a
method comprising obtaining at least one of stated payout ratios
periodically for at least one treasury inflation protected
securities (TIPS) portfolio or fund offered by an asset management
company, or payouts of a predetermined number of years laddered
TIPS portfolio; identifying at least an annuity sponsored by an
insurance company; selecting a particular TIPS portfolio or fund
based on the payout ratios and a particular annuity based on a
current market price; determining a portfolio allocation for the
selected TIPS portfolio or fund and the selected annuity so as to
define a process for obtaining inflation-protected income for the
predetermined number of years and then non-inflation protected
income for subsequent years; and publishing, via a network, the
portfolio assets and corresponding allocations.
[0014] In yet another embodiment, there is a system for generating
an integrated family of benchmarks representing portfolio
allocations for a participant, the system comprising means for
identifying at least two assets for a portfolio; means for
determining a current market rate for at least one of the assets;
means for determining expected inflation for a predetermined time
period; means for generating a portfolio allocation to each asset
based on the current market rate and the expected inflation so as
to define a process for obtaining inflation-protected income for a
predetermined number of years and then non-inflation protected
income for subsequent years; and means for publishing the
identified assets and the portfolio allocations.
BRIEF DESCRIPTION OF THE DRAWINGS
[0015] FIG. 1A is a diagram of an example of one embodiment of a
configuration for operating a system and method to obtain a defined
contribution default benchmark.
[0016] FIG. 1B is a diagram of an example of another embodiment of
a configuration for operating a system and method to obtain a
defined contribution default benchmark.
[0017] FIG. 2 is a flow diagram of an example of one embodiment of
a process operating on the system shown in FIG. 1A or 1B.
[0018] FIG. 3 is a flow diagram of an example of another embodiment
of a process operating on the system shown in FIG. 1A or 1B.
[0019] FIG. 4 is a flow diagram of an example of another embodiment
of a process operating on the system shown in FIG. 1A or 1B.
[0020] FIG. 5 is a flow diagram of an example of yet another
embodiment of a process operating on the system shown in FIG. 1A or
1B.
[0021] FIG. 6 is a chart illustrating U.S. retirement assets in the
year 2009.
[0022] FIG. 7 is a chart illustrating U.S. workers with pension
coverage in the years 1983 and 2007.
[0023] FIG. 8 is a chart illustrating U.S. workers with pensions
and without pensions in the years 1992 and 2007.
[0024] FIG. 9 is a flow diagram of an example wealth transfer.
[0025] FIG. 10 is an example graph illustrating projected cash
surpluses/deficits in the U.S. combined social security trust
fund.
[0026] FIG. 11 is an example graph illustrating 401(k)/IRA actual
and simulated accumulation of individuals with 401(k) plans, by age
group in the years 2004 and 2007.
DETAILED DESCRIPTION OF CERTAIN EMBODIMENTS
Introduction
[0027] The system and method described herein can be implemented on
various configurations of hardware and software. The system can be
comprised of various modules, tools, and applications as discussed
below. As can be appreciated by one of ordinary skill in the art,
each of the modules may comprise various sub-routines, procedures,
definitional statements and macros. Each of the modules are
typically separately compiled and linked into a single executable
program. Therefore, the following description of each of the
modules is used for convenience to describe the functionality of
the preferred system. Thus, the processes that are undergone by
each of the modules may be arbitrarily redistributed to one of the
other modules, combined together in a single module, or made
available in, for example, a shareable dynamic link library.
[0028] The system modules, tools, and applications may be written
in any programming language such as, for example, C, C++, C#,
BASIC, Visual Basic, Pascal, Ada, Java, HTML, XML, or FORTRAN, and
executed on an operating system, such as variants of Windows,
Macintosh, UNIX, Linux, VxWorks, or other operating system. C, C++,
C#, BASIC, Visual Basic, Pascal, Ada, Java, HTML, XML and FORTRAN
are industry standard programming languages for which many
commercial compilers can be used to create executable code.
DEFINITIONS
[0029] The following provides a number of useful possible
definitions of terms used in describing certain embodiments of the
disclosed development.
[0030] A network may refer to a network or combination of networks
spanning any geographical area, such as a local area network (LAN),
wide area network (WAN), regional network, national network, and/or
global network. The Internet is an example of a current global
computer network. Those terms may refer to hardwire networks,
wireless networks, or a combination of hardwire and wireless
networks. Hardwire networks may include, for example, fiber optic
lines, cable lines, ISDN lines, copper lines, etc. Wireless
networks may include, for example, cellular systems, personal
communications service (PCS) systems, satellite communication
systems, packet radio systems, and mobile broadband systems. A
cellular system may use, for example, code division multiple access
(CDMA), time division multiple access (TDMA), personal digital
phone (PDC), Global System Mobile (GSM), or frequency division
multiple access (FDMA), among others.
[0031] A website may refer to one or more interrelated web page
files and other files and programs on one or more web servers. The
files and programs are accessible over a computer network, such as
the Internet, by sending a hypertext transfer protocol (HTTP or
HTTPS [S-HTTP]) request specifying a uniform resource locator (URL)
that identifies the location of one of said web page files, where
the files and programs are owned, managed or authorized by a single
business entity. Such files and programs can include, for example,
hypertext markup language (HTML) files, common gateway interface
(CGI) files, and Java applications. The web page files preferably
include a home page file that corresponds to a home page of the
website. The home page can serve as a gateway or access point to
the remaining files and programs contained within the web site. In
one embodiment, all of the files and programs are located under,
and accessible within, the same network domain as the home page
file. Alternatively, the files and programs can be located and
accessible through several different network domains.
[0032] A web page or electronic page may include that which is
presented by a standard web browser in response to an HTTP request
specifying the URL by which the web page file is identified. A web
page can include, for example, text, images, sound, video, and
animation.
[0033] A computer or computing device may be any processor
controlled device that permits access to the Internet, including
terminal devices, such as personal computers, workstations,
servers, clients, mini-computers, main-frame computers, laptop
computers, a network of individual computers, mobile computers,
palm-top computers, hand-held computers, set top boxes for a
television, other types of web-enabled televisions, interactive
kiosks, personal digital assistants (PDAs), interactive or
web-enabled wireless communications devices, mobile web browsers
such as operating on a smartphone, or a combination thereof. The
computers may further possess one or more input devices such as a
keyboard, mouse, touch pad, joystick, pen-input-pad, and the like.
The computers may also possess an output device, such as a visual
display and an audio output. One or more of these computing devices
may form a computing environment.
[0034] These computers may be uni-processor or multi-processor
machines. Additionally, these computers may include an addressable
storage medium or computer accessible medium, such as random access
memory (RAM), an electronically erasable programmable read-only
memory (EEPROM), programmable read-only memory (PROM), erasable
programmable read-only memory (EPROM), hard disks, floppy disks,
laser disk players, digital video devices, compact disks, video
tapes, audio tapes, magnetic recording tracks, electronic networks,
and other techniques to transmit or store electronic content such
as, by way of example, programs and data. In one embodiment, the
computers are equipped with a network communication device such as
a network interface card, a modem, or other network connection
device suitable for connecting to the communication network.
Furthermore, the computers execute an appropriate operating system
such as Linux, UNIX, any of the versions of Microsoft Windows,
Apple MacOS, IBM OS/2 or other operating system. The appropriate
operating system may include a communications protocol
implementation that handles all incoming and outgoing message
traffic passed over the network. In other embodiments, while the
operating system may differ depending on the type of computer, the
operating system will continue to provide the appropriate
communications protocols to establish communication links with the
network.
[0035] The computers may contain program logic, or other substrate
configuration representing data and instructions, which cause the
computer to operate in a specific and predefined manner, as
described herein. In one embodiment, the program logic may be
implemented as one or more object frameworks or modules. These
modules may be configured to reside on the addressable storage
medium and configured to execute on one or more processors. The
modules include, but are not limited to, software or hardware
components that perform certain tasks. Thus, a module may include,
by way of example, components, such as, software components,
object-oriented software components, class components and task
components, processes, functions, attributes, procedures,
subroutines, segments of program code, drivers, firmware,
microcode, circuitry, data, databases, data structures, tables,
arrays, and variables.
[0036] The various components of the system may communicate with
each other and other components comprising the respective computers
through mechanisms such as, by way of example, interprocess
communication, remote procedure call, distributed object
interfaces, and other various program interfaces. Furthermore, the
functionality provided for in the components, modules, and
databases may be combined into fewer components, modules, or
databases or further separated into additional components, modules,
or databases. Additionally, the components, modules, and databases
may be implemented to execute on one or more computers. In another
embodiment, some of the components, modules, and databases may be
implemented to execute on one or more computers external to the
website. In one instance, the website includes program logic, which
enables the web site to communicate with the externally implemented
components, modules, and databases to perform the functions such as
disclosed herein.
DESCRIPTION
[0037] Embodiments will now be described with reference to the
accompanying figures, wherein like numerals refer to like elements
throughout. The terminology used in the description presented
herein is not intended to be interpreted in any limited or
restrictive manner, simply because it is being utilized in
conjunction with a detailed description of certain specific
embodiments. Furthermore, embodiments may include several novel
features, no single one of which is solely responsible for its
desirable attributes or which is essential to practicing the
inventions herein described.
Example System Configuration
[0038] Certain embodiments of a system utilize a network as
described in conjunction with FIG. 1A hereinbelow, or utilize a
cloud, as described in conjunction with FIG. 1B hereinbelow.
Certain embodiments are based on an example open system integrated
architecture shown in FIG. 1A and FIG. 1B. In FIGS. 1A and 1B, the
example open system integrated architecture may be based on, for
example, a user interface interacting with a local or remote data
repository and a local or remote application running on a local or
remote application server, such as an application server 150. FIGS.
1A and 1B are block diagrams of an example system 100 that may be
used to implement certain systems and methods described herein. The
functionality provided for in the components and modules of
computing system 100 may be combined into fewer components and
modules or further separated into additional components and
modules. Various other types of electronic devices communicating in
a networked environment may also be used.
[0039] Referring to FIG. 1A, an example configuration of components
of an embodiment of the system 100 will now be described. A mobile
or fixed computing device 110 is operated by a user 130. There may
be other mobile or fixed computing devices such as a device 170
operated by other users. The computing device 110 can be a handheld
computing device or other portable computing device such as a Palm,
Pocket personal computer (PC), Linux based handheld, PDA,
smartphone such as an iPhone.RTM., Tablet computer such as an
iPad.RTM., or PC having a display. In other embodiments, the
computing device can be any form of Internet connected device,
including but not limited to PCs, mobile devices, PDA, laptops,
tablets, chips, keyboards, voice audio and video software, mouse,
keypads, touch pads, track ball, microphones, videos, storage
devices, network devices, databases, scanners, copiers, digital
pens, image recognition software and device, screens and other
forms of displays, netbooks and other forms of computer hardware.
The computing device 110 in certain embodiments operates in a
stand-alone (independent) manner. In other embodiments, the
computing device 110 is in communication with one or more servers
150 via a network 140, such as a wide area network or the Internet.
The server(s) include one or processors 152, memory 158, data
storage 154 and system software 156 executed by the processor(s),
and input or output devices 160. In certain embodiments, the data
storage 154 stores one or more databases used by the system. The
processor(s) 152 are in communication with the database(s) via a
database interface, such as structured query language (SQL) or open
database connectivity (ODBC). In certain embodiments, the data
storage 154 is not included in server(s) 150, but is in data
communication with the server(s) via the database interface. The
connection from the computing device 110 to the network 140 can be
a wireless or a satellite connection 144 or a wired or direct
connection 142. In certain embodiments, the server(s) are part of a
web site, such as on an intranet or the Internet.
[0040] When the computing device 110 is connected with the
server(s) 150, the web site may optionally provide updates on new
features. In another embodiment, the computing device runs software
for the system and method described herein only when connected to
the server(s) 150.
[0041] The computing device 110 includes a processor 112, memory
122, a display 114, and one or more input devices 116. The
processor 112 is in data communication with a data storage 118. In
certain embodiments, the data storage 118 may store prior records
of the user and/or other data or software. System software 120 is
executed by the processor 112. The system software 120 may include
an application graphical user interface (GUI). The application GUI
can include a database interface to the data storage 118 of the
computing device. In certain embodiments, the software is loaded
from the data storage 118. In embodiments where the computing
device 110 communicates with a web site, the processor utilizes
browser software in place of or in addition to the software 120.
The network browser may be, for example, Microsoft Internet
Explorer.RTM., Apple Safari.RTM., Mozilla Firefox.RTM., Google
Chrome.TM., browsers from Opera Software.TM., and so forth. An
optional output device 129, such as a printer is connected to the
computing device 110.
[0042] Referring to FIG. 1B, an example configuration of components
of an embodiment of the system 100 using a cloud computing
architecture will now be described. The configuration of components
in FIG. 1B is similar to that of FIG. 1A except that the network
140 and servers 150 of FIG. 1A are replace by the cloud 180 of FIG.
1B. An optional private cloud 190 can also be utilized. Cloud
computing can include web-based tools or applications that users
can access and use through a web browser as if it were a program
installed locally on their own computer. In certain embodiments,
the cloud 180 comprises various computers, servers and data storage
devices that function to provide a cloud platform (e.g., a web
front end), cloud service (e.g., a queue), cloud infrastructure,
and cloud storage (e.g., a database). A public/external cloud can
be used with a private cloud in a hybrid cloud or a combined cloud
environment in certain embodiments
Overview
[0043] Successful retirement-income schemes require a savings plan
to transfer work today to income in the future and then an
assets-to-income scheme to convert accumulated savings into
retirement income that will last a lifetime--a lifetime that is
increasingly lengthening and for an individual, is quite
unpredictable in its length. The core of all retirement-income
plans will have two key components: an asset transfer vehicle and
an assets-to-retirement income scheme.
[0044] A major change over the last twenty-five years is the large
and rapidly growing role of defined-contribution plans and IRAs to
provide retirement income, with the dominant characteristic that
the management of the two core components of a retirement-income
scheme have been transferred from the pension plan sponsor to the
worker (and future retiree). It is the dramatically increased role
of DC plans and a specific focus on improving the assets-to-income
scheme in retirement that sets the framework for the two formal
purposes of this description: [0045] Show that the structure of a
sustainable retirement-income program does not depend on the
pension scheme (DB or DC), but on the benefits promises pursued,
the asset vehicles used, and the choice of the asset-to-income
options available to the retiree. In other words, the core
components of a good DC plan will look and feel like the core
components of a good DB plan. [0046] For the retirement-income
distribution phase, a key, but so far missing component for solving
the assets-to-income problem embedded in the current structure of
all defined-contribution plans is offered: A Defined Contribution
Default Benchmark (DCDB). [0047] This benchmark is the basis from
which retirees can make their retirement asset allocation
decisions. It is this benchmark, and its use with existing market
structures, that provides a key step in solving the
defined-contribution distribution problem.
[0048] The description is organized as follows. Section I reviews
where we are today, and defines the common core elements of all
retirement schemes. Section II explores the risks of pension-income
shortfalls and failure. In Section III, the economic structures and
challenges of both DB plans and DC plans are analyzed in more
detail. An analysis is presented showing that a sound DC plan
should not be unlike a sound DB plan. In Section IV, the DC
distribution problem is analyzed and a sound and executable Defined
Contribution Default Benchmark (DCDB) for retirement income is
introduced. Section V develops and shows the structure and
calculations for the Defined Contribution Default Benchmark (DCDB).
Section VI is the conclusion.
[0049] The Appendix is a history of pension failures. This is
important given that many believe that a "risk-free" pension system
exists, or can be created.
I. RETIREMENT SCHEMES
Background and Economics
[0050] There are three sources of retirement income for American
workers: Social Security (and other promises of a government
entity, as previously discussed), Pension Schemes (DB plans), and
personal assets held in DC plans, IRAs and taxable accounts. These
plans cover 52 million retired Americans and 130 million working
Americans.
[0051] The combined assets in these plans were just under $16
trillion at year-end 2009. See chart 600 of U.S. retirement assets
in FIG. 6 where plan assets at December 2009 ($ billions) were
15,987 (source: Flow of Fund Accounts of the United States, Federal
Reserve Statistical Release, Mar. 11, 2010, Overview of the Social
Security Administration, SSA 2009 Performance and Accountability
Report). These assets are the pillars of retirement income for
American workers.
[0052] Over the past quarter century, a striking change has taken
place in the retirement income profile for workers covered by a
pension plan. Defined-contribution (DC) plans have expanded to
become the dominant employer-sponsored retirement plan for
Americans, with work-based coverage expanding from 12% to 63%. At
the same time, workers covered by defined-benefit plans (DB) have
dropped from 62% to 17%. At the beginning and at the end of this
period, 52% of US workers were covered by an employer-sponsored DC
or DB pension plan.
[0053] Defined-benefit plans are often held out as the gold
standard for retirement income. But, as chart 700 of U.S. workers
with pension coverage in FIG. 7 (source: Munnell, Alicia H.,
Richard W. Kopcke, Francesca Golub-Sass and Dan Muldoon, 2009, "An
Update on 401 (K) Plans: Insights from the 2007 Survey of Consumer
Finance", Center for Retirement Research at Boston College, WP
2009-6, November 2009) and chart 800 of US workers with pensions
and without pensions in FIG. 8 (source: "Frequently Requested
Data", Center for Retirement Research at Boston College) show, they
were never the broad-based longstanding solution to retirement
income.
[0054] While DB plans have many powerfully positive attributes,
including longevity pooling and the institutional scaling of costs
and skills, they also have real and material economic limitations.
The dominant limitations are (1) counter-party risk, when companies
fail and then the pension promise fails and (2) the underlying
structure of a retirement-income promise based on future wages.
Since future wages are both unknown and cannot be hedged, the
worker is left with an uncertain retirement income.
[0055] In 2009, American workers held approximately $7.3 trillion
in DC plans and IRAs. The IRA balances include both DC roll-over
balances (and possibly DB lump sum roll-overs) and self-funded
pension assets not part of an employer-sponsored plan.
[0056] DC and IRA plans have attributes not found in DB plans that
have been highly valued by participants--namely portability and
individual ownership and control of the assets.
[0057] At the same time, these individual ownership plans have
economic limitations that can and do create real hurdles in their
use to provide real sustainable retirement income. These
limitations include not saving enough, no pooling of longevity
risk, limited institutional scaling for asset management, and no
good solution to the DC distribution problem of converting assets
to income in retirement. (For a thoughtful and thorough comparison
of DB and DC plans, see "Don't Kill the Golden Goose, Saving
Pension Plans" by Barton Waring and Lawrence Siegel, Financial
Analysts Journal, Volume 63, No. 1, 2007.)
Economic Goals and Common Components
[0058] Each of the three core sources of retirement
income--Government-based Social Security (widely defined),
defined-benefit plans, and DC/IRA assets--has two common core
components: a wealth transfer mechanism from the present (work) to
the future (retirement income), and an assets-to-income capability
that provides lifetime retirement income.
[0059] Retirement income must exhibit two dominant characteristics:
[0060] 1. Sustainable real (after inflation) retirement income and
[0061] 2. Longevity protection such that individuals do not outlive
their income-generating assets.
[0062] Common elements to Social Security and DB pension schemes
are retirement income based on pooling arrangements where the
promises are made by, and the assets are held by, a counter-party.
This counter-party is relied upon to measure, value, and fulfill
the retirement-income promise. The retiree's claim is the promise
of retirement income, not ownership of the underlying assets.
[0063] For Social Security, the counter-party is the United States
Government. The pooling population is all past, present, and future
United States taxpayers. This pooling provides both longevity
pooling and asset protection pooling. The savings rates and
retirement income benefits are set by the political process.
[0064] For state and local pension schemes, the counter-party is
the local government entity, for example, the California State
Teachers Employees Retirement System (CALSTERS). The pooling for
longevity and asset protection is the past, present, and future
workers in the scheme as well as the taxpayers within the state and
local jurisdiction. The savings rates, retirement income benefits,
and taxes are set in labor and political-election negotiations.
[0065] For private pension schemes and multi-employer pension
schemes, the counter-party is the company or the pension entity.
For example, the General Motors Salaried Retirement pension fund or
the Service Employees International Union fund (SEIU). The pooling
for longevity and asset protection is the past, present, and future
workers in the scheme as well as current and future stock holders
of the sponsoring corporations. Pooling and asset protection are
dependent on the continued existence of the company and
multi-employer pension scheme. The savings rates and retirement
income benefits are set in labor negotiations. For private and
multi-employer pension schemes, taxpayers may play a role as a
limited funder-of-last-resort. For example, for private employers,
this role is carried out by the Pension Benefit Guarantee
Corporation (PBGC).
[0066] For DC-IRA plans, there is no counter-party. These plans are
based on individual ownership of assets, the amount determined by a
lifetime of savings and investment decisions. The savings and
investment decisions are made by the individual. The resulting
retirement income will be dependent on both individual savings and
investment decisions and the realized investment and inflation
results that the saver/retiree will live through and realize.
[0067] For DC-IRA plans, there is no counter-party to provide
retirement income via the pooling of longevity and asset risk. In
retirement, some or all of the DC-IRA assets will need to be
converted into income. The decisions will be made by the retiree.
There is no automatic institutional asset management to execute
this conversion. There is no longevity or asset protection pooling.
Any longevity and asset protection pooling must be separately
researched and contracted for by the retiree.
Common Purpose and Problems
[0068] Social Security, defined benefit, and defined contribution
pension schemes share a common purpose: transferring wealth and
labor from today to future consumption. This future consumption is
commonly called retirement income.
[0069] To do this, Social Security, defined benefit, and defined
contribution retirement-income schemes have common components: a
saving accumulation program, an investment program, and a
distribution/de-accumulation programs.
[0070] Social Security, defined benefit, and defined contribution
retirement-income schemes also have a common set of problems and
risks, and these risks vary only in degree and who bears them.
[0071] The common set of risks (the relative importance of these
risks will vary over time, and it will vary across plans) are as
follows: [0072] Counter-party risk [0073] Savings risk--not saving
enough for long enough [0074] Investment return risk, including
inflation risk [0075] Longevity risk--living longer than the
assets
[0076] These problems have led to pension failures for all three
types of pension schemes, and some have been catastrophic failures.
In Section II and in the Appendix, these failures are reviewed. It
is shown that there is no perfect pension scheme. This makes a
critical and overarching point: there is no risk-free
retirement-income scheme.
II. RISK
[0077] The common view sees defined-benefit pensions as the gold
standard against which to compare other retirement-income plans.
Another common view is that Social Security is the risk-free option
that covers all American workers. But these common views are not
the case. As Section I laid out, all retirement-income schemes have
material risks, even the highly regarded defined-benefit pension
and Social Security.
[0078] From a retiree's point of view, all pensions can and do
fail. When they fail, the failure comes from three basic causes:
[0079] 1. The counter-party fails, even when the counter-party is a
government. [0080] 2. The counter-party can change the rules, and
it does so. [0081] 3. The structure is deficient and subject to
large-scale failure.
[0082] The Appendix contains a detailed review of these causes of
failure. This section provides an overview of pension failures. It
ends with a general framework as to why pensions fail.
[0083] While governments have sovereign taxing powers to fund
pension promises, they still fail to provide reliable pension
income. The failure can be the total collapse of a government, but
it is more typically hyper-inflating away the value of nominal
pension promises. The most extreme and notable example was Germany
in 1923, when hyperinflation consumed both the economy and the
nominal pensions of German workers.
[0084] This inflation-failure is not limited to Germany. Since
1900, inflation episodes in excess of 400% occurred in many
countries including Italy, Austria, Hungary, Russia, Brazil and
Argentina. In all these cases, nominal pensions were destroyed by
government policies that did not protect the pension promises made.
The core point is even federal government as counter-party can fail
to honor pension promises.
[0085] In the U.S., Social Security provides a lifetime benefit
indexed to general wages and inflation for the lifetime of
beneficiaries and their spouses. How could this pension promise
fail? The benefits are financed on a pay-as-you-go system through
taxes on working Americans. The burden of Social Security thus
depends on the size of liabilities (number of retirees, level of
benefits, and the longevity of retirees) relative to the size of
the tax base (gross domestic product (GDP)). Thus a combination of
falling birth rates, improving longevity, and the large debt burden
on GDP can all stress the system. At some point the burden, along
with other burdens on GDP, can become too large and the system
fails.
[0086] What is more common is the counter-party failure of private
companies and multi-employer plans. It was the 1974 failure of
Studebaker that led to the Employment Retirement Income Security
Act (ERISA). Company failures should be no surprise in a dynamic
economy; failure should be part of the expected normal state of
events. Examinations of America's top twenty companies since 1917
shows this state of events (see the Appendix, Table 10). These
expected failures have led to the creation of the Pension Benefit
Guarantee Corporation (PBGC) to take over, at a reduced income
payout, failed pension plans. Once failure is expected to occur, it
is important to organize the pension scheme to account for some
level of hard-to-forecast failure of individual companies. The PBGC
is one such step. As will be shown in Section III, there are more
steps to take to improve the reliability of pension promises.
[0087] A second pension failure is when the counter-party can and
does change the pension promise. Again, this is from the retiree's
position. For example, the 2007-2009 recession created enormous
stresses on the fiscal condition of many state governments. In
addition, the fall in equity markets, combined with extraordinarily
low interest rates, exposed massively underfunded state and local
pension plans.
[0088] State and local governments, faced with these budget
deficits and large unfunded pension promises, acted to change their
public employee pension plans. For the states, 22 of 50 materially
changed their pension plans in 2009 alone. These changes included
raising retirement dates, increasing employee contribution rates,
and in some cases, tying future cost-of-living increases to the
funding status of the plan. A "political earthquake" is how the
governor of the State of Illinois described the vote in 2009 to
change Illinois public pension funding and payout rules.
[0089] State and local defined benefits pensions have underpriced
their liabilities by using the expected rate of return on the
assets rather than the appropriate bond rates to discount future
benefits. As a result, to "pay" for these public pension promises,
pension funds have taken significant risk to meet the high returns
needed to finance their pension promises. For many funds, the risk
has not paid off. Local taxpayers are then left with the resulting
heavy pension burden. But, the wealthier taxpayers are able to
migrate and leave the state. There is a considerable migration from
high tax-paying states to low tax-paying states. This leaves the
large unfunded liability to be shouldered by an even smaller tax
base. The situation has and will result in some systems
failing.
[0090] A third failure happens when the pension structure itself is
deficient. For private companies and pubic employees, the
defined-benefit promise is typically some form of retirement income
based on a final salary payout percentage. The problem is that the
value of this promise is very difficult to forecast and then hedge.
Plus, many companies do not prefund the estimated promise with
risk-free assets. Instead, they rely on risk-asset returns
(typically equities) to combine with company and employee
contributions to fund the pension promise. This leads to failure
twenty-to-thirty years later when the value of the promise can be
so far above the available pension assets and company cash flows
that the company adjusts by freezing or terminating its pension
plan.
[0091] For defined-contribution pension schemes, the primary
failure comes from not saving enough for long enough. Failure also
comes from investing retirement assets in companies or industries
highly correlated with the workers' income, with Enron being the
most well-known case where workers lost both their jobs and their
retirement savings.
[0092] There are other material challenges to a successful
defined-contribution plan, especially pooling for longevity and
efficiently converting assets-to-income. But these are not so much
deficiencies as they are economic conditions that need to be
managed well; the deficiency can be the knowledge and skill
required of the individual retiree to successfully undertake these
tasks.
[0093] There is a basic framework for pension failure: [0094] 1.
Promising pension benefits not based on existing capital market
asset legal vehicles will lead to potential failure. For example,
promising to pay an unknown salary level thirty years in the future
when there is no way to invest in an asset that returns an unknown
future wage rate. [0095] 2. Promising pension benefits, but not
fully funding them, and thus relying on future funding from
contributions or gains from higher risk, higher expected return
assets. [0096] 3. A funded pension plan that relies in part, or in
full, on the assumed long-term average returns to risk assets to
fulfill the pension promises. Here if the returns are below
expectation, the pension promise is at risk. [0097] 4. An
assets-to-income scheme in retirement that does not efficiently
provide lifetime inflation-protected income.
[0098] In Section III, the core purpose and requirements of a
successful retirement-income scheme are analyzed. The case is built
that by focusing on the objective of providing lifetime
inflation-protected income, and by explicitly recognizing the risk
trade-offs inherent in alternative pension schemes, individuals are
best served when they can make fully informed decisions where the
goal is to maximize the retirement-income benefit (utility) to the
individual retiree.
III. ASSETS-TO-INCOME
[0099] Referring to FIG. 9, a flow 900 of wealth transfer will be
described. All retirement plans seek to transfer wealth from today
910 to some future date. Transfer vehicles are specific legal
structures to hold wealth 920 during this period, and in return for
postponed consumption, earn a return on the wealth. At some future
date the wealth will be converted into retirement income for
consumption 930 as depicted in flow chart 900.
[0100] There are several key components in this transfer process:
[0101] Who owns the liability? [0102] Who owns the assets--the
government, the company/plan, the individual? [0103] How much
investment risk is taken? [0104] How and by whom are the assets
converted into lifetime income?
[0105] Today, two types of transfer vehicles are used to secure
retirement income--private employers can only utilize the first,
while government entities can utilize the second.
[0106] The first is the traditional asset vehicle. Dollars saved
today are invested in assets--US Treasury securities, equities,
annuities, corporate bonds, etc.--that are held to some future
date. The performance of the assets then defines the wealth that
can be transferred. In the case of a defined benefit plan, the
deferred wages are partly invested in market securities (the plan
assets) and partly in the sponsoring corporation (the promise to
pay the unfunded liabilities). If the combined investment
underperforms the price of the benefits then the benefits (or
direct compensation to workers) will be curtailed. The underlying
engine of this vehicle is the investment performance.
[0107] The second is the future tax collecting ability of a
government entity. A primary example of this is U.S. Social
Security. This system relies on the future GDP of the U.S. economy
being sufficiently strong to support payments to the growing
population of retirees from future tax collections. The underlying
engine of this vehicle is the economy of the country. The nature
and size of the "risk" attached to a future retirement income
stream will depend on the strength of the linkage between the
inflation adjusted retirement income promised or expected (the
liabilities) and the performance of the underlying engine of the
transfer vehicle (the direct or indirect assets).
[0108] There is no riskless way of transferring wealth into the
future that will meet all the needs of all the participants for
retirement income. This forces participants--individuals,
companies, pooled industry schemes, and governments--to make
trade-offs. These trade-offs are best measured and judged in a
framework of risk and utility. For our purposes, the following
definitions are used: [0109] Risk--How certain is the payment of a
future real, after inflation, dollar from a particular transfer
vehicle over the joint lifetime of the investor and dependent
spouse. [0110] Utility--Ability of a transfer vehicle to satisfy
investor-specific needs for retirement income for the life of the
participant, including dimensions such as flexibility to access
emergency funding, opportunistic investing, and other unexpected
changes in preferences.
[0111] To set a baseline for a successful retirement-income scheme,
the following objective is used as a starting point: a transfer
vehicle and assets-to-income plan that has the lowest risk possible
using existing legal structures and assets vehicles.
[0112] A risk lens is used that has four dimensions: [0113] 1.
Savings risk--not saving enough for long enough [0114] 2.
Investment return risk, including inflation [0115] 3. Counter-party
risk [0116] 4. Longevity risk--living longer than the assets
[0117] A dominant benefit design rule is defined as follows:
benefits promised must be tied to existing capital markets
vehicles. For example, promising inflation-protected income twenty
years into the future would meet this rule since the TIPS market
goes out for twenty years. Promising lifetime income that is based
on the average of the final three years of salary would not meet
the rule. Final salary in as much as thirty-five years cannot be
forecasted; and even if it could be forecasted, there are no deep
and close-to-risk-free asset vehicles that can be invested in today
that go out to up to seventy years, thirty-five working years and
thirty-five years of retirement.
[0118] A lowest-risk solution would be a scheme where the promises
are only in nominal terms. The savings are invested in nominal
government bonds that match the expected retirement-income cash
flows to age 100. For young people, where retirement cash flows are
more than thirty years away, the present value of those cash flows
past thirty years would be invested in the then thirty-year bond.
As time goes by, the present value held in the thirty-year bond is
reinvested in the then longest maturity government security. The
assets-to-income scheme is the bond coupons and the maturing bonds.
The savings rate is based on the desired retirement income that is
discounted back by current bond yields. This is the best that can
be done with today's asset vehicles. We can call this the Low-Risk
Cash Flow Matched Solution (LRCFMS).
[0119] This solution will minimize savings risk, assuming the
savings actually happens. Investment return risk is minimized by
investing in the lowest risk asset, government bonds. Counter-party
risk is not zero, but it is as low as practically possible.
Longevity risk is not zero as life expectancy is expanding, but it
is extraordinarily low at 100. The assets-to-income (distribution)
is determined by the laddered bond portfolio.
[0120] The solution could be adopted by 401(k) participants (using
standard tools to estimate the key savings decisions). It could be
used by private companies and multi-employer plans. Private
companies and multi-employer funds would estimate final salary and
then fund that income stream the same way a 401(k) participant
would fund. It could be used by governments.
[0121] There are significant problems with this solution; and the
utility for both plan sponsors and participants would be low, maybe
very low. There are four key drawbacks, or to use a term from
economics, costs: [0122] First, there is no pooling for longevity.
There is also no pooling for investment return risk across time.
This means that every person must save for and provide an
asset-to-income for the possibility of living to 100 when their
expected life is 85. The cost of this, in terms of assets required,
is 30%. [0123] Second, all investments and cash flows are nominal.
Retirement income should be real, after inflation, income. But, the
TIPS market goes only twenty years, and the liquidity across is not
uniformly deep. Hence, there is material inflation risk, not unlike
the risk associated with today's DB and DC plans. [0124] Third,
there is a very large institutional-class management burden placed
on DC investors; they must individually do all the calculations and
rebalancing. This is also a sophisticated burden. It extends from
evaluating "risk" in government bonds to rebalancing and
recalculating the portfolio based on new information: a new job; a
job loss; an inheritance; a divorce; children; any unexpected major
change to individual circumstance or global markets. The rich body
of research around decision making under uncertainty, from
Kahnemann and Tversky's Prospect Theory to the growing field of
Behavioral Finance, clearly shows that individuals are not well
suited to make these decisions. And this skill mismatch widens as
people grow older. [0125] Fourth, there is limited-to-no
flexibility. For example, one utility increasing choice for many
individuals would be to invest some percent of their portfolio in
equities, or similar higher-risk assets. The expectation is that
over a long period of saving and returns there could be increased
wealth, possibly as high as three times the wealth (and hence
income) as could be realized from investing in risk-free government
bills and bonds. The increased expected wealth and income is judged
against the possible shortfall of wealth and income if investment
returns do not match expectations, and even fall well below the
risk-free return.
[0126] Another flexibility choice would be to underfund in the
early years when incomes are low but expenses are high, and
overfund in later years when income is higher. The behavioral
finance-based "Save More Tomorrow" strategy is a version of
this.
[0127] Other more sophisticated schemes would be diversifying the
bond portfolio by adding TIPS, international government bonds, and
some high quality corporate bonds. This is very much what insurance
companies do to fund the promises made in their fixed annuity
products.
[0128] The lowest-risk low-utility pension scheme can now be
contrasted with today's existing pension schemes. Since inflation
is such a dominant factor in retirement income, investment return
risk and inflation risk have been formally split. Table 1.A
organizes the trade-off between risk and utility. The estimates are
relative and for framing. They are not absolute or empirically
derived. Table 1.A summarizes this.
[0129] What is clear from Table 1.A, or any similarly arranged
table, is that there is no perfect retirement-income scheme today
and trade-offs must be made.
[0130] While there is no perfect scheme today, the following
questions can be asked and answered: [0131] 1. In retirement, is
there a default structure for retirement-income that would provide
the highest utility to the uninformed investor, and would allow an
informed investor to make utility-enhancing additions/changes based
on that investor's circumstance and preferences? [0132] 2. Can a
public benchmark, much like the S&P 500 or Barclays Aggregate
Bond Index, be defined and computed for this structure?
[0133] Such a structure and index does not exist today, but if it
did it could look like the following: a self-liquidating TIPS fund
for twenty years (the current maximum maturity for liquid TIPS)
matched with a lifetime nominal annuity that starts in twenty years
when the TIPS portfolio is depleted. The income from the annuity,
beginning in year twenty-one, would be set to match the final
expected payment from the TIPS portfolio. This structure would
provide lifetime income with minimal counter-party risk, and the
first twenty years of the income would be inflation protected. At
retirement, control of the majority of the assets is maintained by
the retiree.
[0134] For example, using rates of the Fall 2010 timeframe, a
$100,000 portfolio would be split $86,000 invested in the TIPS
portfolio and $14,000 would purchase a deferred annuity. The
portfolio would provide twenty years of inflation-protected income
with an initial coupon of 5.7% and cash flow of $4,880. By year
twenty, at the current break-even inflation rate (2%), the final
annual cash flow would be $7,000. The annuity would be purchased to
provide annual lifetime nominal income after twenty years of
$7,000.
[0135] Note that it takes $100,000 of assets to convert into $4,800
of lifetime income that is partially inflation protected. The
average 401(k) balance of $56,000, referenced in the Appendix,
points out the high risk of undersaving in DC plans.
[0136] This TIPS plus deferred annuity is the closest that a
retiree can come to lifetime real income with limited counter-party
risk while maintaining control over some of the assets for some
period of time, and using existing legal structures to transfer
work today into future retirement income.
[0137] The two parts of this structure--TIPS and the deferred
annuity--as well as the combination can be viewed through the risk
and utility paradigm. For the second question, could a public index
of this Default Retirement Income Scheme be created? The answer is
yes, and Section IV is dedicated to this index, which is called the
DCDB Index, where DCDB is an acronym for Defined Contribution
Default Benchmark.
[0138] Before further discussing the index, Table 1.B is built on
to show how higher risk-return and higher-flexibility assets can be
added to this default scheme. Again, the focus is on retirement
income. The goal is a structure that lets individual circumstance
drive a higher risk/higher utility asset allocation; but that asset
allocation can be measured against an executable low risk/lower
utility choice. This is shown in Table 1.C.
[0139] The structure of Table 1.0 allows trade-offs to be measured
and judged. The default option is executable with today's asset
vehicles. It is measurable with an index (see Section IV). It is
doable in that an individual is capable of executing this option
with a minimal burden--including the calculation to split the
assets between TIPS and an annuity--and yet gain the baseline
utility. Individuals can also choose to add to, or change from, the
default scheme if they judge that to be desirable.
[0140] Many combinations could be added to Table 1.C, but the
structure of the table would not change. The table is built on the
TIPS plus deferred annuity structure that comprises the DCDB index,
which is now developed in Section IV.
TABLE-US-00001 TABLE 1.A Risks*: Investment Counter Schemes:
Savings returns party Longevity Inflation Utility*: LRCFMS 1 1 1 1
5 3 (Nominal Saving must In present Legal claims 100 years
Everything is Limited promises and occur; value terns, on a nominal
flexibility; annual calculation most cash government: high
accruals) risk flows are T-Bills and opportunity matched Bonds
costs Social 2 1 2 1 2 4 Security Underfunded, Returns help;
Governments The rules can High (Implicit in but multi- taxing power
fail; change; for coverage: this is generation dominates
governments example, the Pooling for Medicare as it taxing power
change the current move longevity and is both a rules by the
investment dominant Colorado returns; retirement Public Inflation
income need Employees protected; and a claim on trust to Limited
the government) decrease the flexibility; COLA Counter party
formula risk is low, but not zero. Corporate 3 2 2 2 5 3 DB:
Defined- Most are Ability to take Companies Risk is low as
Retirement Lifetime Benefit Plan underfunded; risk; multi- fail,
more long as the income is income, but it Most rely on generation
often than company nominal is nominal, risky assets for investment
appreciated exists to pool and it can fail. funding pooling;
longevity Currently Stock, bond unavailable to holders, and the
majority of employees all workers. at risk Defined- 5 5 1 5 3 2
Contribution Overwhelming No returns The investor There is no Most
savers Asset control, Plan evidence of pooling; controls the
default assets- and retirees flexibility and undersaving
Substantial assets to-income think and wide coverage; evidence that
scheme; invest in offset by no individuals annuities are nominal
terms; pooling and buy high and not widely Inflation- large sell
low used protected institutional annuities and burdens TIPS are
carried by available individuals For risk, (1) is low (good) and
(5) is high (bad). For utility, (1) is low (bad) and (5) is high
(good)
TABLE-US-00002 TABLE 1.B Retirement Scheme: Risk, Utility,
Trade-offs Risks*: Investment Schemes: Savings return: Counter
party Longevity Inflation Utility: #1. TIPS N/A 1 1 4 1 4 portfolio
Distribution Certainty is A claim on the (20 years; (Inflation Low
risk and only high; the government, TIPS, is at 65, protected
inflation protected for goal is the counter party expected bonds)
20 years, access to income with life is 20 principal; Principal low
risk years) depletes to zero in year 20, some longevity risk;
Potential higher income from higher risk-return assets foregone #2.
N/A N/A 2 1 5 4 Deferred Distribution Insurance company, No There
is Deferred lifetime annuity only therefore: must stay longevity no
inflation- income is nominal; under the state risk protected Must
rebalance if insurance caps; asset to material changes in Offset is
that risk is invest in inflation arise; Some 20 years after past 20
counter party risk retirement and years therefore a small
percentage of total assets Lifetime N/A 1 2 1 3 4 Income Certainty
is A claim on Lifetime Inflation Lifetime income, Default high; the
government is the income protection mostly inflation Benchmark goal
is main counter party; for 20 protected, Control of income with
limited insurance years only some percent of low risk company risk
due to assets; Some counter time and state party risk pooling
schemes
TABLE-US-00003 TABLE 1.C Risks*: Investment Schemes: Savings
returns Counter party Longevity Inflation Utility: DCDB .TM. N/A 1
2 1 3 5 Certainty is A claim on Lifetime Inflation Lifetime income,
mostly high; the goal government, TIPS, income protection for
inflation protected, is income with is the counter party 20 years
only Control of some percent low risk of assets; Some counter-
party risk N/A 2 1 3 3 ? Add equities, Lower savings Higher returns
The assets are held It is possible to Equities Determined by
individual in some needed if a come with by the individual outlive
your assets help offset preference percentage given higher higher
risk if a minimum inflation expected income is required, risk, but
return is and you put there is realized some of these risk of low
assets at risk realized returns and high inflation *For risk, (1)
is low (good) and (5) is high (bad). For utility, (1) is low (bad)
and (5) is high (good).
IV. DEFAULT BENCHMARK FOR RETIREMENT INCOME PORTFOLIO
[0141] Fifty-two million Americans will need to convert $7.3
trillion in assets they hold in IRAs and DC plans into retirement
income. These numbers are highly likely to increase as the number
of retirees and their assets will grow. In addition, the increasing
retirement-income role played by DC plans amplifies the importance
of this asset-to-income decision.
[0142] Currently, DC plan participants are faced with an incredibly
complex task of figuring out for themselves how they would like to
distribute the value of their DC account. Participants want to know
how to convert DC account balances to real, inflation-protected
income. Exacerbating this difficult task is the abrupt stop in
accumulation phase of DC plans--due both to the stoppage of work as
well as plan provisions forcing distributions. According to the
PSCA's 51st Annual Survey of Profit Sharing and 401(k) Plans,
almost 100% of the plans offer a lump sum option while some plans
(25%) require participants to exit the plan completely.
[0143] At retirement, a person is on his/her own, and while
significant educational resources are available for plan
participants, it is the belief of most experts that current advice
and modeling tools are insufficient to truly help participants make
the best decision for their particular situation.
[0144] Current options include both in-plan and out-of-plan
solutions. For example, one option is direct from insurers such as
MetLife, Prudential, Genworth, and others. Another option is
partnerships with investment/platform providers such as Fidelity,
Vanguard, BlackRock, and Hueler. A major limitation is that capital
markets are incomplete. One cannot transfer retirement income in a
riskless manner, due to inflation, longevity and counter-party
issues. This forces a trade-off between risk and utility. A plan
sponsor question is how best to help participants weigh these
tradeoffs.
[0145] In the risk/utility tradeoff there are current shortcomings.
For example, participants have little or no context to evaluate
alternatives. Additionally, current platform providers' modeling
tools are over-reliant on mean/variance optimization ("4%
withdrawal rule").
[0146] Therefore participants need a benchmark--something that will
provide a standard from which to make utility-increasing
retirement-income decisions based on the circumstances and
preferences of each investor. Other factors that have not been
addressed here include taxes, health and medical insurance, such as
Medicare coverage status. The key to the DCDB is that this is a
starting point from which to make better informed individual
decisions.
[0147] These investor-specific decisions can range from a 100%
nominal lifetime annuity, to a 60/40 equity/bond portfolio, to a
laddered TIPS portfolio. The benchmark provides a measured frame of
reference to make these retirement-income decisions.
[0148] What core economic structures would a default
retirement-income benchmark need to meet? There are three: [0149]
1. The lowest practical possible counter-party risk achievable
[0150] 2. Inflation protection for as long as the TIPS market
provides [0151] 3. Gains from longevity pooling
[0152] In addition, the default retirement-income benchmark must
meet these functional criteria: [0153] 1. Doable--using transfer
vehicles that exist today--e.g., 20-year TIPS (as the markets
change, the index will change.) [0154] 2. Executable--any and all
participants in 401(k)/IRA plans can individually execute the
strategy; it is not constrained by marketplace capacity or a
specific set of market conditions or a complexity that only the
experts can master. [0155] 3. Measurable/Indexable--it is possible
to create an index that tracks benchmark components. These
components of index income and return of the index are available to
the public.
[0156] Combining these six criteria defines an embodiment of a
Defined Contribution Default Benchmark (DCDB). In one embodiment,
this DCDB is made up of two assets and one market-based calculation
for asset allocation:
[0157] Assets: [0158] A TIPS portfolio structured to pay out income
and principal over twenty years [0159] A deferred annuity that
begins at the maximum maturity of the effective TIPS market,
currently twenty years (insurance company counter-party risk
mitigation). A comment on counter-party risk and using nominal
deferred annuities that are not backed by US Treasuries in the
benchmark is as follows. There is the gain of approximately 30%
from longevity pooling. This pooling is offered by insurance
companies. It is standard longevity pooling insurance--not capital
markets insurance. There is still some counter-party risk as
insurance companies cannot perfectly forecast and hedge increases
in longevity. This risk is mitigated, and can by managed, by taking
advantage of state insurance pools and owning multiple annuities
below the level of state guarantees. In the limiting case where
everyone's utility drives them to buy a deferred annuity, the
ability of the state's insurance pools to truly "insure" a deferred
annuity will default to the general taxing power of the state, not
a "true" insurance pool. Also, as more and more people seek
longevity protection, the pooling improves due to reduction in
"anti-selection" issues, e.g., only healthy individuals selecting
annuities.
[0160] Calculation: [0161] The portfolio allocation to the TIPS
portfolio and the deferred annuity is determined by existing market
rates for TIPS, deferred annuities, and expected inflation.
[0162] In one embodiment, the index is to be published monthly.
Section V shows the calculation for the index for one month in the
year 2010. The index is computed each month for retirees at age 60
and 65, in certain embodiments. In another embodiment, the index
will be computed each month for retirees at age 70 and/or other
ages.
[0163] The TIPS and deferred annuity combination is the best
default option available today that meets the six criteria for a
retirement income benchmark. Therefore, the DCDB can be a default
option for DC plan participants in distribution.
[0164] It is recognized that it is possible today to purchase an
inflation-protected lifetime annuity. The annuity does provide the
utility of pooling and lifetime inflation-protected income. This is
offset by the following risks and costs: [0165] 1. Counter-party
risk. [0166] 2. The requirement that the retiree's portfolio must
be irrevocably committed to the annuity and this is typically a
large percentage, sometimes 100%, of the retiree's portfolio.
[0167] 3. Since the active TIPS market currently only goes for
twenty years, the counter-party, typically an insurance company,
has no way to directly hedge the promise, and this results in both
the insurance company and the retiree taking on this risk.
[0168] Hence, the best option today is an optimal combination of a
deferred annuity and a TIPS portfolio that pays out for twenty
years.
[0169] Over time, the marketplace is expected to evolve and so too,
the retirement income benchmark. For example, insurance companies
are the only place where longevity risks can be pooled and managed
today. In the future, the capital markets are expected to provide
additional pooling solutions to manage this specific risk. Also,
the benefits of pooling with annuity products is not a "perfect"
solution since some counter-party risk remains as well as
additional costs present in insurance company capitalization needs,
i.e., the cost of renting the balance sheet of the insurance
carrier. While nothing in the real world is "perfect", this
combination of TIPS plus a deferred annuity does the best job at
meeting the criteria for lifetime income today, and, just as
importantly, the benchmark uses market pricing and that can be
measured.
Methodology
[0170] To determine how much the participant should allocate to
TIPS and how much to the deferred annuity, the system applies the
expected inflation currently priced into the TIPS marketplace and
the current market price of a 20-year deferred annuity. The market
price of a deferred annuity is obtained for ages 60 to 70, and for
males and females, in certain embodiments. In other embodiments,
the market price of a deferred annuity is obtained for ages 55 to
70, and for males and females. Using these inputs, the system
simultaneously solves for the income stream that tracks inflation
expectations for twenty years, then held is steady for the
remainder of the person's lifetime at the level of the inflation
adjusted payment in year 20. This is the lifetime income
stream--twenty years of inflation-protected income, then a nominal
annuity--that is the DCDB.
[0171] The calculation can be repeated for ages 60 through 70 by
obtaining the market price of the deferred annuity and the expected
inflation currently priced into the TIPS marketplace and
simultaneously solving for the income stream that tracks inflation
expectations for twenty years, then is held steady for the
remainder of the person's lifetime at the level of the inflation
adjusted payment in year 20.
[0172] In an example, for a 65-year-old male, the market pricing of
the benchmark in September 2010 would split the portfolio as 88%
TIPS and 12% for the annuity. Assuming a $100,000 account balance,
the DCDB would show beginning yearly income of $5,220. This is
computed by taking the current TIPS payout times the 88%
allocation.
[0173] The overall TIPS market has a break-even inflation rate of
1.91% over twenty years. So, the best forecast for the final year
twenty payment is $7,332. See Section V for this calculation. Note
that over the twenty years the principal and income payments are
adjusted for inflation. And, at the end of twenty years, the entire
balance of the portfolio will have been paid, leaving a balance of
zero.
[0174] In year twenty one, the deferred annuity begins. In this
example, the annuity will pay $7,332 each year for life after the
age of 85. This annuity is not inflation protected.
[0175] Actual inflation will be different than the expected
inflation in the TIPS market at the point of calculation. This
method is the best estimate today to use for determining a
default-deferred income in twenty years, but the retiree has
flexibility to adjust his or her portfolio based on actual
inflation.
[0176] This methodology can be applied to shorter time periods than
20 years. It can also be applied to an age younger than 65;
however, until a liquid TIPS market develops that is longer than
the current twenty years, the TIPS portfolio has a maximum life of
twenty years. The calculation is also gender specific since the
cost of the deferred annuity is different for men and women.
[0177] This benchmark solution is doable, executable, and it can be
measured with a public index. The benchmark can be used to create
an individual portfolio of lifetime retirement that is as inflation
protected as possible, realizes the gains from longevity pooling,
and allows the retiree to retain control of a substantial portion
of his/her portfolio (the TIPS allocation) when retirement
begins.
[0178] And, just as importantly, the DCDB can be used to measure
asset-allocation decisions to take on more risk to gain higher
expected returns and income or more decision flexibility. For
example, after the TIPS annuity allocation is set and the deferred
annuity is purchased (12% at year 2010 rates for a 65-year-old),
the retiree may choose to split the remaining 88% into two pieces:
TIPS and a global balanced portfolio.
[0179] Table 2 shows aspects of the DCDB Index:
TABLE-US-00004 TABLE 2 The DCDB Index Time Age: 65 to 85 Age: 85
(20 years post Allocation 88% retirement) 12% Components 20-year
self-liquidating TIPS Deferred annuity starting in portfolio.
Income is coupons year 21. The income level plus return of
principal. purchased is matched to the Principal value decreases
expected final coupon of the overtime as principal is TIPS
portfolio at time of returned. The value is zero in purchase. year
20. Current Yield; Distribution 5.69% (distribution rate) * $6,472
based on current 88% Rate 88% allocation of 5.69% distribution rate
and 1.91% annual inflation Annual income $ based $100,000
portfolio, years 1-20 Annual income, year 21+ $5,022 In year 21:
$7,332 Inflation protected? Yes No Control of assets? Yes No
How Participants can Use the DCDB
[0180] Individuals and advisers may use the index any time
decisions are made about how to construct a portfolio to generate
lifetime retirement income. These decisions can be in the context
of how to convert an account balance, e.g., 401(k) or IRA balance,
to retirement income, or when a participant in a traditional
pension plan needs to make a decision between an annuity within the
plan or a lump sum payment.
[0181] The DCDB provides the lowest risk alternative for a secure
retirement that is currently achievable in the marketplace today.
Asset allocation different for the DCDB can be made when the
participants believe they can achieve higher utility based on their
own needs and risk tolerances.
Below are Three Example Applications of an Embodiment:
[0182] 1. The participant chooses full annuitization with an
insurance company. [0183] a. Participants have the option of
annuitizing their 401(k) balance. Should participants do this?
[0184] b. Current annuity quotes for age 65--fully indexed
annuity--are $5,800 [0185] c. Participant trade-off
Retiree Choice:
[0186] Does the utility of guaranteed inflation income for life
combined with the loss of flexibility of the portfolio and
counter-party risk offset loss of inflation-protected income after
age 85?
TABLE-US-00005 TABLE 3 Time Age: 65 to 85 Age: 85 (20 years post
Default: DCDB .TM. 88% retirement) Benchmark Allocation 12%
Components 20-year self-liquidating TIPS Deferred annuity starting
in year portfolio. Income is coupons 21. The income level purchased
is plus return of principal. matched to the expected final
Principal value decreases coupon of the TIPS portfolio at over time
as principal is time of purchase returned. The value is zero in
year 20. Current Yield; 5.69% (distribution rate) * $6,472 based on
current 88% of Distribution Rate 88% allocation 5.69% distribution
rate and 191% annual inflation Annual income $ based $5,022 $7,332
$100,000 portfolio Inflation protection Yes No Control of assets
Yes, until liquidation is No complete Portfolio choice Lifetime
Inflation- Protected Annuity Allocation 100% 100% Current Yield;
Distribution Rate Annual income $ based $4,856 $ 7,090 (if
inflation is 1.91% p.a.) $100,000 portfolio, years 1-20 Inflation
Protection Yes Yes Control of assets No No
[0187] 2. Participant chooses to invest in risky assets, e.g.,
target date funds [0188] a. Participants can choose to stay
invested in the target date funds that will manage the "glide path"
and asset allocation [0189] b. Current retirement modeling calls
for 3.1% portfolio yield [0190] c. Participant trade-off
[0191] Is the utility from target date funds combined with complete
ownership of assets that are expected to grow in value (not
deplete) but with the risk of loss sufficient to overcome the DCDB
that provides higher income per year over the target-date portfolio
yield and has almost no inflation risk, close-to-no asset risk, and
protects against longevity risk?
TABLE-US-00006 TABLE 4 Time Age: 65 to 85 Age: 85 (20 years post
Default: DCDB .TM. 88% retirement) Benchmark Allocation 12%
Components 20-year self-liquidating TIPS Deferred annuity starting
in portfolio. Income is coupons year 21. The income level plus
return of principal. purchased is matched to the Principal value
decreases expected final coupon of the over time as principal is
TIPS portfolio at time of returned. The value is zero in purchase
year 20. Current Yield; Distribution 5.69% (distribution rate) *
$6,320 based on current 88% Rate 88% allocation of 5.6%
distribution rate and 1.8% annual inflation Annual income $ based
$5,022 $7,332 $100,000 portfolio Inflation protected Yes Control of
assets Yes, until liquidation is No complete Portfolio Allocation
Target-date fund Allocation 100% 100% Current Yield; Distribution
3.1% Rate Annual income $ based $3,100 Uncertain $100,000
portfolio, years 1-20 Inflation protected? No No Control of assets?
Yes No
[0192] 3. Participant has to choose between lump sum payment from a
DB plan or an annuity within the plans [0193] a. Many DB plans
(especially cash balance plans) include a lump sum option. [0194]
How can participants evaluate whether or not to take a lump sum?
[0195] b. Participant can choose the following: [0196] i. $100,000
lump sum (lump sum factor/annuity conversion based on sample DB
plan client using year 2010 factors--author's calculation) [0197]
ii. $6,811 annuity (fixed, no COLA) from DB plan [0198] c.
Participant Tradeoff [0199] i. Participant can evaluate tradeoff
between the two options when compared to the DCDB [0200] ii. Some
counter--party risk remains if select the DB annuity--although PBGC
provides certain guarantees for most DB plans [0201] iii. While
longevity risk is managed in DB annuity, typically no inflation
protection is provided
TABLE-US-00007 [0201] TABLE 5 Time Age: 65 to 85 Age: 85 (20 years
post Default: DCDB .TM. 88% retirement) Benchmark Allocation 12%
Components 20-year self-liquidating TIPS Deferred annuity starting
in portfolio. Income is coupons year 21. The income level plus
return of principal. purchased is matched to the Principal value
decreases expected final coupon of the over time as principal is
TIPS portfolio at time of returned. The value is zero in purchase
year 20. Current Yield; Distribution 5.69% (distribution rate) *
$6,472 based on current 88% Rate 88% allocation of 5.6%
distribution rate and 1.91% annual inflation Annual income $ based
$5,022 $7,332 $100,000 portfolio Inflation protected Yes No Control
of assets Yes, until liquidation is No complete Portfolio
Allocation Nominal Lifetime Annuity Allocation 100% 100% Annual
income $ based $6,811 $6,811 $100,000 portfolio, years 1-20
Inflation protected? No No Control of assets? No No
[0202] The DCDB provides a market-based income curve providing the
lowest possible risk income stream to a retiree. Just as the swap
curve provides a market-based measure of trading cash flows, the
index provides a market-based reference point for better decision
making by the retiree. A retiree can better evaluate alternatives
based on the real risks (inflation, longevity and counter-party)
faced during the de-accumulation phase rather than the risks used
in traditional mean/variance models on standard deviation of
return. This is a large and positive step forward in helping all
401(k)/IRA plan participants.
Process States
[0203] Referring to FIG. 2, the following states of a process 200
are described for one embodiment of determining the DCDB benchmark
using 20 year self-liquidating TIPS funds or a 20 year laddered
TIPS portfolio and a 20 year deferred annuity. In FIG. 2, the
number of years of annuity deferral is 20 years. In other
embodiments, other time periods, such as 10 year or 30 year TIPS
and annuities, for example, could be used.
[0204] Beginning at a start state 205, process 200 moves to state
210 to periodically (e.g., monthly), record the payout of 20 year
self-liquidating TIPS funds or determine and record payouts of a 20
year laddered TIPS portfolio. Proceeding to state 220, process 200
periodically (e.g., monthly), records the 20 year TIPS break-even
inflation rate. In some embodiments, this is based on information
such as from a publicly available source, e.g., Bloomberg. The
break-even inflation rate is further discussed below. Continuing at
state 230, for a 20 year deferral (D), process 200 calculates the
20 year TIPS distribution rate at year 20 at the current break-even
inflation rate as (1+20 year TIPS break-even inflation rate)
D*payout of D=year zero TIPS fund or laddered TIPS
portfolio=TDR_Y20. Proceeding to state 240, process 200
periodically, using a preselected list of insurance companies
offering a 20 year deferred annuity, records the cost of a deferred
annuity that provides $1 for life beginning in 20 years, which is
referred to as CO$1, for each year of ages 55 through 70, and for
males and for females.
[0205] Advancing to state 250, process 200 calculates the cost of
an annuity that provides a payment equal to the TIPS payout at 20
years as (CO$1*TDR_Y20). (CO$1*TDR_Y20)/(1+CO$1*TDR_Y20) is the
portfolio allocation percentage for the deferred annuity. Moving to
state 260, to determine the cost to acquire the TIPS fund, process
200 calculates the value of 1/(1+CO$1*TDR_Y20), which is the
portfolio allocation percentage for the TIPS funds. Continuing at
state 270, process 200 publishes the portfolio allocation results
via the network and a vector for payments for years one through
year 20. In certain embodiments the payout is an annual amount for
each $100,000 invested. In this description $1 is used in the
discussion of the process, so the equivalent numbers for the
example vector shown in Table 6 below is $0.05022 or 5.022% for
year one.
[0206] Optionally at state 280, process 200 also publishes one or
more of: income in year 20 (given the break-even inflation rate and
portfolio allocation), income at year zero resulting from the
portfolio allocation, the break-even inflation rate of the relevant
TIPS portfolio, and the cost of a deferred annuity that provides $1
for life beginning in 20 years. Proceeding to optional state 285,
process 200 provides an option to the participant to select or
change at least one portfolio asset and/or allocation. Process 200
completes at an end state 290.
[0207] In certain embodiments, the above states are repeated for
different maximum maturities of liquid TIPS and the availability of
matching deferred annuities and/or different retirement ages of the
participants and/or for males and females. Therefore, the DCDB
index can be an index series based on these identified
calculations.
[0208] In certain embodiments, a vector of payments is computed. An
example vector of payments for a 65 year-old male as of Sep. 30,
2010 is shown in Table 6 below.
TABLE-US-00008 TABLE 6 The DCDB for a 65-Year-Old Male as of Sep.
30, 2010* Year 1 2 3 4 5 6 7 8 9 10 11 12 Payout ($) 5022 5118 5216
5315 5417 5520 5626 5733 5843 5954 6068 6184 Year 13 14 15 16 17 18
19 20 21 22 23 24 . . . Payout ($) 6301 6421 6544 6669 6796 6926
7058 7193 7193 7193 7193 7193 . . . *Payout is annual amount per
$100,000 invested. Note that the vector in Table 6 can be
characterized by only 3 numbers: the initial payout, the inflation
rate during the laddered-TIPS or inflating period, and the length
in years of the inflating period. The DCDB vector for a 65-year old
man as of Sep. 30, 2010 can thus be written (5022, 1.91%, 20).
Adding in the portfolio weight of the annuity, x, fills in the
picture: (5022, 1.91%, 20, 11.716%); only one weight is needed
since the other, that of TIPS, is (1-x). These short-form
expressions are useful in reporting the benchmark, which would
otherwise become quite space-intensive.
[0209] Referring to FIG. 3, the states for a process 300 in
determining the DCDB benchmark for a predetermined number of years
are described. In FIG. 3, the number of years of annuity deferral
is represented by D years. Beginning at a start state 305, process
300 moves to a state 310 and periodically (e.g., monthly), records
the payout of predetermined (D) year self-liquidating TIPS funds or
determines and records payouts of a D year laddered TIPS portfolio.
Proceeding to a state 320, process 300 periodically (e.g.,
monthly), records the D year TIPS break-even inflation rate. In
some embodiments, this is based on information such as from a
publicly available source, e.g., Bloomberg. The break-even
inflation rate is further discussed below. Advancing to a state
330, process 300 for a D year deferral, calculates the TIPS
distribution rate at year D at the current break-even inflation
rate as: (1+D year TIPS break-even inflation rate) D*payout of
D=zero year TIPS fund or laddered portfolio=TDR_YD. Continuing at
state 340, periodically, using a preselected list of insurance
companies offering a D year deferred annuity, process 300 records
the cost of a deferred annuity that provides $1 for life beginning
in D years, which is referred to as CO$1, for each year of ages 55
through 70, and for males and for females.
[0210] Moving to a state 350, process 300 calculates the cost of an
annuity that provides a payout equal to the tips payout at d years
as (CO$1*TDR_YD). Then (CO$1*TDR_YD)/(1+CO$1*TDR_YD) is the
portfolio allocation percentage for the deferred annuity. Moving to
state 360, to determine the cost to acquire the TIPS fund, process
200 calculates the value of 1/(1+CO$1*TDR_YD), which is the
portfolio allocation percentage for the TIPS funds. Continuing at
state 370, process 300 publishes the portfolio allocation results
via the network and a vector for payments for years one through
year 20. Optionally at state 380, process 200 also publishes one or
more of: income in year D (given the break-even inflation rate and
portfolio allocation), income at year zero resulting from the
portfolio allocations, the break-even inflation rate of the
relevant TIPS portfolio, and the cost of a deferred annuity that
provides $1 for life beginning in D years. Advancing to an optional
state 385, process 300 provides an option to the participant to
select or change at least one portfolio asset and/or allocation.
Process 300 completes at an end state 390.
[0211] Other ages can be used in further embodiments. In certain
embodiments, the above states are repeated for different maximum
maturities of liquid TIPS and the availability of matching deferred
annuities and/or different retirement ages of the participants
and/or for males and females. Therefore, the DCDB index can be an
index series based on these identified calculations.
[0212] In other embodiments, other financial vehicles could be used
in addition to the TIPS and annuities.
[0213] In certain embodiments the benchmark is generated on a
monthly basis as described below. In other embodiments, the
benchmark is generated more frequently, such as daily, weekly or
bi-weekly, for example. In yet other embodiments, the benchmark is
generated less frequently than monthly, such as quarterly or
bi-monthly, for example. In certain embodiments, the benchmark
steps may be performed at the same time. In other embodiments, the
steps may be performed at different times. In other embodiments,
the steps may be performed in a different order.
[0214] In certain embodiments, the break-even inflation rate is
(TIPS yield at D years)--(Fixed yield at D years). This provides
the inflation rate at which the instruments "break-even." For the
acts below, see the cells in the spreadsheet of Table 7 (with
formulas) and Table 8 (with results). [0215] 1. Each month record
the payout of 20 year self-liquidating TIPS funds or determine and
record the payout of a 20 year laddered TIPS portfolio. Enter in
cell D14 [0216] 2. Each month record the 20 year TIPS break-even
inflation rate (based on information such as from a publicly
available source, e.g., Bloomberg). Enter in cell D15 [0217] 3.
Each month survey the approved list of Insurance companies offering
a 20 year deferred annuity. Record the cost of $1 for life
beginning in 20 years in cell D21 [0218] 4. Enter the date in cell
D10 [0219] 5. Enter the number of deferral years (20) in cell D11
[0220] 6. Index Results: [0221] a. Index allocations to TIPS and
the deferred annuity are in cells D6 and D7 [0222] b. The
calculation is in cells D25 to D27 [0223] c. Column F is an example
for a $100,000 portfolio
[0224] The mathematics rule for setting the allocation is as
follows: This is embedded in column D of the spreadsheet. Income in
year 20, Y(20)=[(1-X)*TIPS coupon Y(1)*(1+inflation) 20], where X
is the Annuity allocation. The cost to buy Y(20) income for life
beginning in year 21 is 1.5975. For every Y(20) dollar, there is a
1.5975*annuity allocation=>[(1-X)*TIPS coupon Y(1)*(1+break even
inflation) 20]=[1.5975 X]; solve for X. The calculation can be seen
in the spreadsheet calculations of Table 7 (with formulas) and
Table 8 (with results).
TABLE-US-00009 TABLE 7 ##STR00001##
TABLE-US-00010 TABLE 8 ##STR00002##
Publication of Benchmark and Family of Benchmarks
[0225] In certain embodiments, the percentage of the portfolio
allocation for the deferred annuity and the percentage of the
portfolio allocation for the TIPS funds are published, such as via
the network. In one embodiment, the publication occurs after the
allocations are determined on a periodic schedule as described
above. In addition to the percentage allocations for the deferred
annuity and the TIPS funds, other data can be optionally published.
For example, one or more of a) the income in year D, given a stated
break-even inflation rate and the portfolio allocation, b) income
at year zero resulting from the portfolio allocation, c) the
break-even inflation rate of the relevant TIPS portfolio, and d)
the cost of a deferred annuity that provides $1 for life beginning
in D years are published. In certain embodiments, the income in
year D, given the stated break even inflation rate and portfolio
allocation, and the income at year zero resulting from the
allocation are calculated. In certain embodiments, the break-even
inflation rate of the relevant TIPS portfolio, and the cost of a
deferred annuity that provides $1 for life beginning in D years are
discovered using other published resources, for example. The
publication of the percentage allocations for the deferred annuity
and the TIPS funds, the payout vector, and the one or more items a)
to d) can be, for example, on one or more websites or documents
(such as a newsletter), where the user is a member or client of a
particular company, or the publication can be on websites and/or
publications open to anyone of the public.
[0226] In other embodiments, a family of benchmarks is developed
and published periodically. For example, one or more of the items
identified in the previous paragraph is generated and published for
both males and females, and/or different ages of the participant
(e.g., 55, 56, 57, 58, 59, 60, 61, 62, 63, 64, 65, 66, 67, 68, 69
and 70 years old), and/or different numbers of years for the
deferment of the annuity (e.g., 10, 20 and 30 year deferred
annuities) and/or different number of years for the TIPS fund or
portfolio. In one embodiment, the percentage allocations for the
deferred annuity and the TIPS funds, the income in year D (given a
stated break-even inflation rate and the portfolio allocation), the
income at year zero resulting from the portfolio allocation, the
break-even inflation rate of the relevant TIPS portfolio, and the
cost of a deferred annuity that provides $1 for life beginning in D
years are generated or determined and then published for every
permutation of gender, a set of selected ages for the participant,
and a selected set of years of deferment for the annuity.
Additional Embodiments
[0227] Referring to FIG. 4, the following states of a process 400
illustrate another embodiment of determining the DCDB benchmark.
Beginning at a start state 405, process 400 moves to a state 410
and identifies at least two assets for a portfolio. Suitable assets
for the portfolio have been previously discussed above. Proceeding
to a state 420, process 400 determines a current market rate for at
least one of the assets. Advancing to a state 430, process 400
determines an expected inflation for a predetermined time period.
Moving to a state 440, process 400 generates a portfolio allocation
to each asset based on the current market rate and the expected
inflation to provide inflation-protected income for a predetermined
number of years and then non-inflation-protected income for
subsequent years. Proceeding to a state 450, process 400 publishes
information about the identified assets and the corresponding
portfolio allocations. Optionally, other information such as
described above in conjunction with the descriptions for FIGS. 2
and 3 can also be published. Advancing to an optional state 455,
process 400 provides an option to the participant to select or
change at least one portfolio asset and/or allocation. Process 400
completes at an end state 460.
[0228] Referring to FIG. 5, the following states of a process 500
illustrate yet another embodiment of determining the DCDB
benchmark. Beginning at a start state 505, process 500 moves to a
state 510 and obtains stated payout ratios periodically for a
treasury inflation protected securities (TIPS) portfolio or asset
management company fund or determines the payouts of a
predetermined number of years laddered TIPS portfolio. Continuing
at a state 520, process identifies an annuity sponsored by an
insurance company, in one embodiment. Proceeding to a state 525,
where a loop of several states is performed for one or more
starting ages of a participant, e.g., age 60 through 70 and/or the
gender of the participant. In other embodiments, other ages can be
used. For a first pass through the loop, a female at age 65 can be
used, for example. Moving to a state 530, process 500 selects a
particular TIPS portfolio or fund based on the payout ratios and a
particular annuity based on a current market price. Advancing to
state 540, process 500 determines a portfolio allocation for the
selected TIPS portfolio or fund and the selected annuity to provide
inflation-protected income for a predetermined number of years and
then non-inflation-protected income for subsequent years. Moving to
a decision state 545, process 500 determines if additional ages
and/or gender are to be processed at states 525, 530 and 540. If
so, process moves to state 525 where another age and/or gender is
used for the subsequent states. However, if decision state 545
determines that no further ages and/or gender are to be processed,
process 500 advances to a state 550 and publishes information about
the selected assets and the corresponding portfolio allocations for
each age and/or gender that was processed. Optionally, other
information such as described above in conjunction with the
descriptions for FIGS. 2 and 3 can also be published. Advancing to
an optional state 555, process 500 provides an option to the
participant to select or change at least one portfolio asset and/or
allocation. Process 500 completes at an end state 560.
V. DEFAULT BENCHMARK EXAMPLE
The DCDB
[0229] Participants exposed to the DCDB can make utility-enhancing
decisions based on their own particular situations. [0230] How much
to annuitize--faced with the question of annuitizing a 401(k)
balance, the benchmark highlights the tradeoff between increased
counter-party risk with possible higher income [0231] Continue to
invest in 401(k) plan's target date fund for retirees--does the
increased utility of possible higher income outweigh the increased
risk of inflation/asset risk and increased longevity risk. [0232]
Build a customized higher expected return, higher risk portfolio--a
portfolio tailored to their preferences.
DEFINITION AND PROCESS
[0233] This description focuses on a retiree at age 65. Note that
benchmarks for other ages will vary. However, since the vast
majority of the assets are deployed during the first twenty years
in an age-independent manner, e.g., a self-depleting TIPS
portfolio--the differences are less than might be expected. For
example, for a retiree at age 70, the benchmark may be 92% TIPS and
8% deferred annuity, and for a retiree at age 60, the benchmark may
be 82% TIPS and 18% deferred annuity. This discussion will start
with the three risks participants face, namely: [0234] Inflation,
[0235] Longevity, [0236] Counter-party.
[0237] The first issue is how to prioritize these risks given
today's marketplace. Since we are not going to be able to
simultaneously solve for the lowest risk and meet all three, one
needs to work through what is available in the marketplace today in
a riskless way, and then only take on risk where a riskless
transfer vehicle is not available. Based on this methodology and
today's marketplace, inflation risk can be reduced for the first
twenty years using TIPS. The U.S. Treasury has issued longer-dated
TIPS--up to thirty years--however; the issuance was small in total
dollars. For the purposes of this description, the effective TIPS
availability has been limited to twenty years.
[0238] Using TIPS for the first twenty years also significantly
helps with longevity risk. According to current mortality tables, a
man aged 65 is expected to live for another nineteen years and
females, another 21 years (2010 IRS Generational Mortality--author
calculation).
[0239] To manage the longevity risk further, the insurance
marketplace is available; however, this introduces counter-party
risk. While not optimal, this counter-party risk is reduced from
the participant perspective since it covers only after twenty
years. It can further be reduced by observing any state guarantee
limits. For the DCDB, quotes are received from annuity providers in
the U.S. for a twenty-year deferred annuity. This annuity would
provide lifetime, nominal coverage for a participant--starting at
age 85.
[0240] The DCDB combines the two products into one income
stream--producing an inflation-protected income stream for the
first twenty years, plus a lifetime guaranteed payment starting
after twenty years.
[0241] Solving the mathematics at August 2010 market prices
produces the following results in Table 9:
TABLE-US-00011 TABLE 9 DCDB Example Example Retirement Income
Benchmark Portfolio: Portfolio Allocation at Retirement: $100,000
TIPS Fund 88% $88,273 Deferred Annuity 12% $11,727 Age 65 65
Calculation Date Aug. 01, 2010 Aug. 01, 2010 TIPS payments, number
years 20 20 1st nominal annuity payment year 21 year 21 20 year
TIPS distribution rate, year 1 5.69% 5,027 20 year TIPS break-even
inflation rate 1.91% 1.91% 20 year TIPS distribution rate, year 20
8.32% 7,031 (at current break-even inflation rate) Payment is TIPS
88% of TIPS dist.rate 20 year Deferred Annuity Price 1.60 1.60
(current cost of $1 per year for life, beginning in year 21)
Annuity cost to earn year 21 TIPS 0.12 0.12 payout Cost to acquire
TIPS fund 0.88 0.88 Total Portfolio 1.00 1.00 note: portfolio is
scaled to $1 in year zero, age 65
[0242] This methodology can be applied to shorter time periods than
20 years. It can also be applied to an age younger than 65;
however, until a liquid TIPS market develops that is longer than
the current twenty years, the TIPS portfolio has a maximum life of
twenty years.
[0243] The calculation is gender specific since the cost of the
deferred annuity is different for men and women.
[0244] The index is an index series: The DCDB index series for men
and women, for combinations of retirement at ages and the maximum
maturity of liquid TIPS and the availability of matching deferred
annuities.
VI. CONCLUSION
[0245] Many past retirement systems difficulties and failures, at
their core, are attributable to ignoring the connection between the
benefits promised and the legal/investment transfer vehicles. All
retirement systems stakeholders--participants, employers,
taxpayers, regulators and financial services firms--are encouraged
to directly tie promises made with existing legal/investment
transfer vehicles and market prices.
[0246] When labor and pay negotiations, and investment product
offerings, are moved off this strict requirement of a direct
promise/transfer vehicle paradigm, all participants can be, and
should be, aware of where the risks lie. Doing so will enable
market participants to understand the true cost of risk--and
encourage the capital markets to develop products and markets to
find the most cost-efficient manner to hedge these risks.
[0247] The goal with the Defined Contribution Default Benchmark
(DCDB) is for it to become a publicly available, investable option
for the DC marketplace. Participants would be able to see how
alternative distribution options compare to the DCDB--and make
utility maximization decisions around it.
[0248] Retirees can choose a low-risk lifetime income with
longevity pooling and a high degree of inflation protection, or
they can choose options that better suit their individual needs and
circumstances. And they can do so in an informed and measured
manner.
[0249] Various illustrative logics, logical blocks, modules,
circuits and algorithm steps described in connection with the
implementations disclosed herein may be implemented as electronic
hardware, computer software, or combinations of both. The
interchangeability of hardware and software has been described
generally, in terms of functionality, and illustrated in the
various illustrative components, blocks, modules, circuits and
steps described above. Whether such functionality is implemented in
hardware or software depends upon the particular application and
design constraints imposed on the overall system.
[0250] In one or more aspects, the functions described may be
implemented in hardware, digital electronic circuitry, computer
software, firmware, including the structures disclosed in this
specification and their structural equivalents thereof, or in any
combination thereof. Implementations of the subject matter
described in this specification also can be implemented as one or
more computer programs, e.g., one or more modules of computer
program instructions, encoded on a computer storage media for
execution by, or to control the operation of, data processing
apparatus.
[0251] If implemented in software, the functions may be stored on
or transmitted over as one or more instructions or code on a
computer-readable medium. The steps of a method or algorithm
disclosed herein may be implemented in a processor-executable
software module which may reside on a computer-readable medium.
Computer-readable media includes both computer storage media and
communication media including any medium that can be enabled to
transfer a computer program from one place to another. A storage
media may be any available media that may be accessed by a
computer. By way of example, and not limitation, such
computer-readable media may include RAM, ROM, EEPROM, CD-ROM or
other optical disk storage, magnetic disk storage or other magnetic
storage devices, or any other medium that may be used to store
desired program code in the form of instructions or data structures
and that may be accessed by a computer. Also, any connection can be
properly termed a computer-readable medium. Disk and disc, as used
herein, includes compact disc (CD), laser disc, optical disc,
digital versatile disc (DVD), floppy disk, and blu-ray disc where
disks usually reproduce data magnetically, while discs reproduce
data optically with lasers. Combinations of the above should also
be included within the scope of computer-readable media.
Additionally, the operations of a method or algorithm may reside as
one or any combination or set of codes and instructions on a
machine readable medium and computer-readable medium, which may be
incorporated into a computer program product.
[0252] Certain features that are described in this specification in
the context of separate implementations also can be implemented in
combination in a single implementation. Conversely, various
features that are described in the context of a single
implementation also can be implemented in multiple implementations
separately or in any suitable subcombination. Moreover, although
features may be described above as acting in certain combinations
and even initially claimed as such, one or more features from a
claimed combination can in some cases be excised from the
combination, and the claimed combination may be directed to a
subcombination or variation of a subcombination.
[0253] Similarly, while operations are depicted in the drawings in
a particular order, this should not be understood as requiring that
such operations be performed in the particular order shown or in
sequential order, or that all illustrated operations be performed,
to achieve desirable results. In certain circumstances,
multitasking and parallel processing may be advantageous. Moreover,
the separation of various system components in the implementations
described above should not be understood as requiring such
separation in all implementations, and it should be understood that
the described program components and systems can generally be
integrated together in a single software product or packaged into
multiple software products.
[0254] The foregoing description details certain embodiments of the
invention. It will be appreciated, however, that no matter how
detailed the foregoing appears in text, the invention can be
practiced in many ways. As is also stated above, it should be noted
that the use of particular terminology when describing certain
features or aspects of the invention should not be taken to imply
that the terminology is being re-defined herein to be restricted to
including any specific characteristics of the features or aspects
of the invention with which that terminology is associated. The
scope of the invention should therefore be construed in accordance
with the appended claims and any equivalents thereof.
APPENDIX
Failures
[0255] Pensions fail in three ways. In the first, the counter-party
fails. In the second, the counter-party has the right to change the
rules, and it does so. In the third, the structure itself is
deficient. In this section, we will review some examples of each of
these types of failure.
Counter-Party Failures--Governments Fail, and then so do
Pensions
[0256] In 1914, it took four German marks to purchase a US dollar.
By November 1923, it took 630 billion marks to purchase a US
dollar. The German hyperinflation, requiring thirty paper mills
just to print money, consumed the German economy and with it all
the savings and pensions of civil servants, doctors, teachers, and
professors--the "backbone of Germany" (Ahamed, Liaquat, Lords of
Finance (New York: The Penguin Press, 1987, 120-121) and (Chernow,
Ron, The House of Morgan, (New York, The Atlantic Monthly Press,
1990, page 249). A catastrophic failure occurred for any pensioner
relying on a fixed nominal pension.
[0257] The inflation-induced losses are not restricted to 1923
Germany. Since 1900, inflation episodes of 400% and more occurred
in Austria, Greece, Hungary, Italy, Poland, Russia, Argentina,
Bolivia, Brazil, and Chile (Reinhart, Carmen M. and Kenneth S.
Rogoff, This Time is Different, New Jersey: Princeton University
Press, 2009, page 186). The point here is that even pension schemes
with a close-to-unconditional promise of a government have
counter-party risk because governments can and do fail--and, they
typically fail in a conflagration of inflation that decimates the
economy, savings, and pensions.
Counter-Party Failures--Companies Fail
[0258] On Friday, Mar. 28, 1980, after seventy-five years of making
steel for International Harvester tractors and equipment, Wisconsin
Steel closed its doors and 3,400 steelworkers lost their jobs
(Brown, Terry, "The Closing of Wisconsin Steel", The Chicago
Tribune, Mar. 28, 1980). On May 31, 1980, the Wisconsin
Steelworkers' pension plan ended in "termination". On Dec. 31,
1981, the Pension Benefit Guarantee Corporation (PBGC) assumed
responsibility for the plan, with a maximum monthly pension payment
of $1,261 for those age 65, well below the pension promises of the
now-defunct Wisconsin Steel (PBGC:
http://www.pbgc.gov/workers-retirees/find-your-pension-plan/PlanPage/plan-
3122200.html and
http://www.pbgc.gov/workers-retirees/benefits-information/content/page789-
.html).
[0259] Much like the failure of Studebaker, which led to the
Employment Retirement Income Security Act (ERISA) in 1974, the
failure of Wisconsin Steel shows the counter-party risk of almost
all DB pension schemes.
[0260] It is an observable economic fact that even in a dynamic,
growing economy companies do not last forever. In fact, as Table 10
shows, the correct expectation is that over a long period of time
companies will fail, will merge, and will markedly change as they
adapt to a growing economy. This economic fact of life has a direct
implication for DB pensions: If the pension promises are not
properly funded, the employee has material counter-party risk.
TABLE-US-00012 TABLE 10 (Cox, Michael, Richard Allen, "The Churn
Among Firms", Federal Reserve Bank of Dallas, January/February
1999): America's Top Twenty Rank 1917 1945 1967 1987 1998 (August)
1 U.S. Steel AT&T IBM IBM General Electric 2 AT&T General
AT&T Exxon Microsoft Motors 3 Standard Oil DuPont Kodak General
Coca-Cola of New Jersey Electric 4 Bethlehem Standard Oil General
AT&T Exxon Steel of New Jersey Motors 5 Armour & Co.
General Standard Oil General Merck Electric of New Jersey Motors 6
Swift & Co. Union Carbide Texaco DuPont Wal-Mart 7
International Humble Oil & Sears, Ford Pfizer Harvester
Refining Roebuck 8 DuPont Sears, General Merck Intel Roebuck
Electric 9 Midvale Steel U.S. Steel Polaroid Amoco IBM &
Ordinance 10 U.S. Rubber Texas Co. Gulf Oil Digital Procter &
Equipment Gamble 11 General Coca-Cola DuPont Philip Morris Phillip
Morris Electric 12 International Standard Oil Xerox Chevron
Bristol-Myers Mercantile of Indiana Squibb Marine 13 American
Standard Oil Minnesota Sears, Lucent Smelting & of California
Mining & Roebuck Technologies Refining Manufacturing 14
Anaconda Chrysler Standard Oil Mobil Johnson & Copper of
California Johnson Mining 15 Standard Oil Kodak Mobil BellSouth
Cisco Systems of New York 16 Phelps Dodge Gulf Oil GTE Kodak
AT&T 17 Singer International Avon Standard Oil American Nickel
International Group 18 Jones & Socony- Hewlett- Hewlett-
Berkshire Laughlin Steel Vacuum Oil Packard Packard Hathaway 19
Westinghouse Kennecott Procter & Coca-Cola Eli Lilly Electric
Copper Gamble 20 American Pennsylvania Standard Oil Wal-Mart SBC
Tobacco Railroad of Indiana Communications Note: Rankings are based
on market value. Sources: Forbes, Jul. 13, 1987 (1917, 1945, 1967,
1987); Standard & Poor's Compustat database (1998)
[0261] To understand the power of a properly funded DB plan, a
steel company pension plan from the same location and the same time
as the Wisconsin Steel failure is examined, but here, the outcome
is vastly different.
[0262] In 1980, located a just a few miles to the northeast of
Wisconsin Steel, was Indiana Harbor Works of Inland Steel (now part
of Mittal Steel). Wisconsin Steel and Inland were part of a
thirty-five mile industrial arc that combined to be the most
concentrated steel-making center in the world. Both Wisconsin Steel
and Inland Steel suffered the devastating impact from the Midwest
industrial closures of the 1980s and 1990s (Fallows, James,
"America's Changing Economic Landscape", The Atlantic Monthly,
March 1985).
[0263] But the outcome for Inland workers was far different from
that of the Wisconsin Steel workers. While Inland's employment
shrunk and the company was sold, first to Ispat and then Mittal,
all Inland pensioners received full pension checks from the Inland
Steel pension fund. The reason: Inland fully funded its pension
plan. In 1998, when Inland Steel was purchased by Ispat
International N.V., the fair value of its pension assets was $2
billion and its projected benefits obligation (PBO) was $2 billion
(Ispat SEC filing, 1998).
[0264] Equally important, Inland made the decision to immunize its
liabilities by buying U.S. Treasuries that matched its expected
future pension payments. Hence, Inland made the funding of its
pension promise to its workers independent of Inland's future
economic prospects or the prospects of the returns from higher
risk-return assets. So, while many Inland Steel workers lost their
jobs in the economic change that swept their industry, they did not
simultaneously lose their vested pension income: the security of
their pension income was uncorrelated to the security of their
jobs.
Failures--when the Pension Promise is Chan
[0265] In April 2010, near the end of the "Great Recession" of
2008-2010, the Illinois State Legislature voted to reform pensions
for state employees. The vote was described by Illinois Governor
Pat Quinn as a "political earthquake."
[0266] The changes put a cap on the amount of earnings that can be
used as the basis for calculating benefits. Some of the change was
in response to employees gaming the system by "spiking" their last
year's earnings by accumulating large overtime pay to be included
in the pension calculation. But most of the change is to deal with
unfunded retirement-income promises to state employees. For
example, most new Illinois government employees must now work until
age 67 to be eligible for full retirement benefits. (Those already
on the state payroll can still retire at 55 with full benefits).
This "earthquake" in Illinois demonstrates that governments can and
do change pension promises.
[0267] The economic stresses from the 2008-2009 recession have led
to 22 of 50 US states changing their pension plans. The changes
include increasing retirement dates, decreasing future pension
increases, and increasing employee contributions.
[0268] A second retirement-income earthquake occurred in April
2010: the U.S. Social Security Trust Fund experienced a net
outflow--a full six years before the forecasted date of 2016.
[0269] This brings forward the question for U.S. retirees as they
assess their confidence in their retirement-income counter-party:
what happens to a pension promise when (1) retirees are promised
benefits that exceed their accumulated contributions, (2) retirees
live materially longer than expected when the promises were made,
and (3) working Americans refuse to pay higher taxes to support
this combination of unfunded benefits and longer-than-planned-for
lives?
[0270] A clear option is to change the rules. This is what U.S.
Representative Paul Ryan of Wisconsin calls for in his proposal, A
Road Map For America's Future. To "secure" Social Security's
solvency, Representative Ryan calls for indexing retirement income
benefits to personal total income levels, and for all retirees, to
increase their retirement date. The alternative to such changes, as
the forecast graph 1000 from the Social Security Trustee Reports
shows in FIG. 10 (source: 2009 Social Security Trustees Report),
could be a catastrophic failure (Ryan, Paul, "A Road Map For
America's Future", US House of Representatives,
http://www.roadmap.republicans.budgethouse.gov/UploadedFiles/Roadmap2Fina-
l2.pdf, January 2010).
[0271] It is unclear if Representative Ryan's plan, or a similar
plan, will be adopted. What is clear is that the rules will change,
or that benefits will be decreased (for a deeper discussion, see
the Academy of Actuaries: www.actuary.org.).
[0272] What has been viewed as an "unconditional" Social Security
pension promise, should be assessed as a conditional promise; a
promise subject to change when the conditions change.
Failures--when the Basic Structure is Deficient
[0273] Defined contribution plans (DC), deferred salary plans, and
similar tax-protected savings plans, were originally conceived and
designed as supplemental plans to Social Security and DB plans.
They were not designed to be the primary source of retirement
income.
[0274] DC plans have no longevity pooling and no investment return
pooling. In addition, they are subject to the deficiency from
undervaluing the implicit promise, the future retirement-income
needs, and then not saving enough for long enough.
[0275] The Center for Retirement Research at Boston College has
computed what would be the expected 401(k)/IRA defined-contribution
balance for diligent savers for individuals age 55 to 64 in the
year 2007--before the market crash of 2008. The expected balance:
$320,000. See example graph 1100 of 401(k)/IRA Actual and Simulated
Accumulation of Individuals with 401(k) Plans, by Age Group, 2004
and 2007 of FIG. 11. Please note that sample excludes individuals
who only have IRA wealth. 401(k) holdings alone would have been
$25,000 for 35-44 year olds, $45,000 for 45-54 year olds, and
$60,000 for 55-64 year olds--source is Munnell and Sunden (2004 and
2006) and authors' calculations from the 2007 SCF. The expected
balance of $320,000 could have been converted into a lifetime real
annuity for a retiree aged 65 of $18,000 per year.
[0276] Here is the problem. The average balance in 2007 was only
$78,000. And by 2008, it was $56,000. The $56,000 would convert
into $3,100 of inflation-protected retirement income for a retiree
aged 65 (Munnell, Alicia H., Richard W. Kopcke, Francesca
Golub-Sass, and Dan Muldoon, "An Update on 401(K) Plans: Insights
from the 2007 Survey of Consumer Finance", Center for Retirement
Research at Boston College, WP 2009-6, November 2009, FIG. 1.1,
page 36).
[0277] Here the basic structure failed. People did not save enough
for long enough. And, the 60 to 64 year old cohort saw the ending
years of their working lives experience one of the worst economic
and investment epochs since the 1930s--for them, investment pooling
failed.
Failures--the DC Investment Choices are Deficient
[0278] A DC plan can offer investment options highly correlated
with the employee's job; for example, a biotech fund for a biotech
or pharmaceutical company employee. Worse yet, the DC plan can
offer an investment option perfectly correlated with the employee's
job: company stock.
[0279] When a same-industry stock fund or company stock comprises a
large part of a DC plan, participants have two risks: the company
fails and their retirement savings vanish with their current
income, or the whole industry is at risk, much like steel in the
U.S. in the 1980s.
[0280] Enron is the iconic example of deficient investment choices.
Enron collapsed in 2001. As of Dec. 31, 2000, Enron's
company-sponsored defined-contribution programs held 62% of the
assets in Enron stock (CRS Report for Congress, The Enron
Bankruptcy and Employer Stock in Retirement Plans, Patrick Purcell,
Mar. 11, 2002). This came about through two major decisions by
Enron. [0281] 1. Actively encouraging employees to invest in the
company [0282] 2. Restricting employees from trading out of Enron
stock until age 50
[0283] Combined with unfortunate timing of changing plan
administrators when the employees were "locked-out" of trading
their accounts during the meltdown of the company, Enron employees
lost billions of dollars in retirement savings.
[0284] Enron, while an extreme case of fraud, failure, and loss,
was not alone in its DC structure. At the time of the failure of
Enron's 401(k) plan, the 401(k) plans of many prominent and
respected companies had a substantial component of company
stock.
TABLE-US-00013 TABLE 11 Congressional Research Service Report,
March 2002 Employer Stock in Selected Retirement Plans Company
stock as a percentage of defined Does company have contribution
plan's a defined benefit Company Name assets: plan? Procter &
Gamble 91.5% No Anheuser-Busch 81.6% Yes Coca-Cola 81.0% Yes Abbott
Laboratories 80.0% Yes General Electric 77.4% Yes William Wrigley,
Jr. 75.0% Yes Pfizer 74.8% Yes Home Depot 72.0% No BB&T (Branch
Banking & 69.6% Yes Trust) Texas Instruments 69.0% Yes Duke
Energy 67.9% Yes Target 66.0% Yes Textron 65.0% Yes Reliant Energy
64.5% Yes Kroger 63.6% Yes Southern Company 62.8% Yes Exxon Mobil
62.0% Yes Household International 61.4% Yes Sherwin-Williams 59.1%
Yes BellSouth 57.9% Yes Merck 57.5% Yes Williams 57.0% Yes
McDonald's 56.8% No TXU (Texas Utilities) 56.3% Yes Dell Computer
53.4% No Ford Motor Company 50.2% Yes Source: S.E.C Forms 10-K and
11-K and company spokespersons. Source: Purcell, Patrick, "CSR
Report for Congress", Congressional Research Service. March 2002.
Washington DC.
[0285] Congress took action and passed new laws specifically
targeting the problems exposed by the Enron bankruptcy. Many
defined contribution plans, however, still have significant
investment in company stock. While this concentrated investment may
achieve corporate and personal investment objectives, it runs
counter to prudent retirement planning to provide a secure
retirement income source.
[0286] For the vast majority of employees, human capital (the
ability to work today and in the future) is their largest asset and
this asset is tightly tied to the company employing them. An
optimal asset mix during the accumulation of retirement savings
would explicitly account for the correlation between an employee's
income stream from work (human capital) and the risk-return profile
of their retirement assets (financial capital). A complete
plan/solution would also include insurance assets. To invest
retirement assets in the employer or the employer's industry, the
worker "doubles down" on the bet that the company will do well.
This goes against both the basic rules of diversification and the
economic history captured in Table 10. Workers could and should
diversify away this risk.
* * * * *
References