Retirement savings—in an IRA, a 401(k) plan, or a defined benefit plan—is, in the end, a project that involves turning present income, via savings and investment, into future income. As such, it inevitably involves the capital markets. And, indeed, it is often hard to sort out whether any particular innovation in this process is “about” retirement savings or “about” the capital markets.
Retirement Savings Have Transformed the Capital Markets
The capital markets (broadly, the stocks and bonds markets) are, speaking abstractly, where people with assets they do not need to use currently (a.k.a., savers and investors) trade those assets with the people (e.g., corporations and entrepreneurs) who do need assets currently. There is (at least) one other group of market participants: those for whom the capital markets themselves are a business, e.g., speculators and market makers.
Under our system, these market participants, through the “magic of the market,” allocate capital from persons who don’t need it now to those who do.
Not so long ago, say, at the beginning of the 20th Century, the capital markets were dominated, on the supply side, by (in one form or another, and disregarding government entities) people concerned primarily with preserving and increasing their private wealth. Think J.P. Morgan.
Over the course of the 20th Century, these markets were transformed by the entry of people—retirement plans and individual savers—whose primary concern is providing adequate income in retirement.
According to ICI, as of the first quarter of 2021, there were $35.4 trillion in U.S. retirement assets in the capital markets. And according to SIFMA, the U.S. equities and fixed income markets total around $88 trillion.
Doing the math, U.S. retirement savings are nearly half the size of the U.S. capital markets.
That is a new thing in the world. And many policymakers, regulators, retirement plan sponsors, individual savers and providers have not fully digested its consequences.
For instance…
Policymakers and DC Investors Need to Update Their Definition of ‘Risk’
Late in the 20th Century, ERISA and (I would argue) the investment community generally adopted as the normative retirement investment theory an understanding of (what they thought of as) Modern Portfolio Theory based on some basic principles that made nearly scientific good sense for persons investing with the objective of increasing/preserving their wealth. Very broadly, this consisted of two axiomatic propositions:
- The efficient frontier: That there is an efficient risk/return “frontier” defining “fair market” compensation for the riskiness (defined more or less as volatility) of the investment asset, with the expected return increasing as risk increases.
- Diversification moves the efficient frontier “up”: That, up to a certain point, diversification reduces risk without decreasing return (as “single-stock” risk is diversified away).
These two principles were, in effect, encoded into ERISA’s fiduciary prudence and diversification standards.
The problem with this approach emerged in the defined benefit plan community as interest rate declines became a persistent feature of our economy in the late 1990s and early 2000s. Private DB plan sponsors, required by the Financial Accounting Standards Board to value liabilities currently based on current interest rates, found that these rate declines generated net pension “losses,” even in some years when the value of plan assets increased.
The point here is deep and not very well understood. (See, e.g., my last column, The Assets-to-Income Challenge.) Generic, “wealth preserving” investors may generally get by investing against a generic version of risk—volatility. But retirement investors face the challenge, ultimately, of turning their assets into income, and therefore must, ultimately, reckon with interest rates and interest rate risk.
The liability driven investment (LDI) movement in the DB community represents, more or less, a recognition of this difference in investment theory for a retirement investor. That movement resulted in a number of DB sponsors creating fixed income portfolios that matched the duration of pension their liabilities.
That insight, however, has not penetrated the DC community—or, for that matter, the policymaker/regulator community. Thus, the complaints at a recent Senate hearing on target date funds were about the generic riskiness (defined as volatility) of TDF investments, not about the failure of TDFs to adequately hedge the interest rate risk faced by (especially) older DC participants, in an era of significant interest rate declines.
That, IMHO, has to change.
Retirement Policy and Capital Markets Policy Are Inextricably Entangled
The other consequence of the massive increase in retirement savings assets that we must reckon with is that decisions about retirement policy are, inevitably, decisions about capital markets policy.
Here’s a simple version of what I mean: You could probably talk me, as a retirement saver, into a single-payer retirement savings system, in which we all pay into one big pot and get a generic rate of return.
But remember, we’re talking about somewhere between a third to nearly half of the capital markets. Who’s going to invest all that money, and how are they going to figure out where (to invest it)?
Whenever I hear someone (typically a lawyer) comparing “overpriced” investment funds to what can be had—nearly for free (as in, “beta is free”)—in an S&P 500 fund, I think: What’s your theory here? That we all invest in just 500 companies? And these 500 companies can issue whatever kind of paper they want, and we’ll just take it?
Our current system—in which a widely distributed and diverse group of investors/investment consultants make more-or-less individual choices about where to allocate this $35.4 trillion in capital—creates a lot of problems. A lot of money is wasted on non-generic advice. One recalls Warren Buffett’s (hypothetical) advice to his widow, should he die intestate—just put it all in the S&P 500.
But the diversity of the investor community is also an asset to our economy, allowing more resilient portfolios and supplying capital to a more diverse community of entrepreneurs and corporations than just the top 500 companies. We’re not going to put (as some have suggested) all our retirement savings assets into the Federal Thrift Savings Plan. And within certain limits, we should be prepared to live with the losses in efficiency this diversity entails.
Capital Markets Innovations Are Good Retirement Policy
I’ll conclude by observing that, in this context, it’s conceivable (even likely) that the most significant improvement in retirement outcomes may result from innovations in the capital markets.
Consider how the mutual fund has revolutionized investing. Or for that matter, the “invention” of the index fund.
With the takeaway that—for those who want to make the retirement world “a better place”—perhaps we should focus our energies on capital markets innovation, not the latest tweak to the 401(k) rules.
Michael P. Barry is a senior consultant at October Three and President of O3 Plan Advisory Services LLC, which provides retirement plan regulatory analysis targeted at plan sponsors and those who provide services to them.
Opinions expressed are those of the author, and do not necessarily reflect the views of NAPA or its members.
