PIMCO DC Dialogue - It's Your Living Standard

PIMCODC Practice

DC DialogueDC DialoguePIMCO ™

September 2011 In this PIMCO DC Dialogue, we talk with Larry Kotlikoff

about the changes in retirement, focusing first on

generational transfer payments and the reality that we’re

all on our own to save for the future. He shares his concerns

about our current Social Security system and proposes a

revamped system, including private, fully funded accounts.

Larry emphasizes the importance of saving in DC accounts,

yet suggests that this saving be balanced over one’s lifetime

to allow a more stable living standard, or what he calls

“consumption smoothing.” He offers the suggestion that

plan sponsors provide a higher contribution to accounts of

younger workers, who are less able to save, given other pulls

on their resources. Finally, Larry discusses the market risk

and uncertainty we face in the future. He underscores

that participants should not be exposed to risk,

which may endanger their living standard

or may trigger fear.

It’s Your Living Standard.

This issue features an interview with Laurence Kotlikoff,

prolific author, entrepreneur, and Boston University professor

w w w.esplanner.com

Moderated by

Stacy L. Schaus, CFP®

PIMCO Senior Vice President and Defined Contribution Practice Leader

Volume 6, Issue 8

DC Dialogue

DC Dialogue: How has retirement changed?

Larry Kotlikoff: As we know, for many centuries, retirement really didn’t exist. People

died before they reached their forties. If they did make it beyond that

age, people used their children as an insurance market; the deal being,

if I make it to old age, the kids will take care of me. If I die before then,

I leave them my money. As modern life evolved, kids left home

and these kinds of family arrangements broke down. Fertility rates

also declined.

Today, there’s pretty strong evidence that parents and adult kids are

acting like independent households, not sharing risk. The kids are not

going to provide annuities for their parents’ retirement. So now we

have the problem of people having to save for their own retirement. As

longevity increases, for some people, retirement’s going to be longer

than their working lives. We all have to take care of ourselves. And

we’re not doing a great job of it.

DCD: Do you think this breakdown in generational support is happening

just in the U.S.?

Kotlikoff: Each country has its own culture and behaviors. For instance, in Asia,

the culture continues to be oriented toward the extended family, and

financial flows between family members are significant.

But in the U.S., for the vast majority of the population, we don’t see

significant flows of income and support between adult children and

their parents or vice versa, regardless of whether one side is much

better off than the other. There is some support for the kids while

they’re getting their higher education. Yet the fact that so many young

people today leave college with massive amounts of student debt

suggests that too many parents have left the financial problem of their

children’s education to their children.

So, the behavior of typical households is that the generations are on

their own. They’re almost, in some ways, at war with each other.

Or at least there is a clash between the generations.

DCD: Why do you think there is a clash between generations?

Kotlikoff: I think part of it is the heterogeneity in our society. Broadly speaking,

I don’t think the older people in our country see the children of our

“Today, there’s pretty

strong evidence

that parents and

adult kids are acting

like independent

households, not

sharing risk.”

PIMCODC Practice

country as their own. In countries like Sweden where the

population is very homogeneous, you don’t see this kind of problem.

But when you have great heterogeneity, you say, “Well, if I’m going to

do anything, I’m going to do it for my kids. I’m not going to vote for

raising taxes in my local community to provide better schooling

for my neighbors’ kids because they’re not mine.”

And if I’m a 60- or 70-year-old, am I going to support a higher property

tax in order to educate somebody else’s kids? You see communities in

Florida where the older people are voting against those propositions.

Of course, it’s selfish behavior. But we are so diverse that we don’t

actually see our common interests anymore.

DCD: You’re suggesting the older generations won’t spend to provide

for the younger generations, yet the young are taxed to support

the elderly.

Kotlikoff: Well, yes. The vast majority of the obligations facing today’s

18-year-old who just became eligible to vote have been piling up for

decades before that person was even born. While that person was a

child, during all those years when we expanded Social Security, made

promises to the current elderly, and expanded Medicare and Medicaid,

these young people who are now left with the bill were given no say.

They were not franchised to vote because they were under 18.

So, this is definitely taxation without representation, which we fought

the Revolutionary War to prevent. We’ve piled up these obligations in

a way that is particularly despicable because we’ve used in my opinion

fraudulent deficit accounting to hide what we’re doing. We’ve run this

massive transfer payments scheme for six decades as a pay-as-you-go

system where we’ve taken ever larger sums from young people and

called it taxes and given it to older people as benefits. And we’ve told

each set of young people, “Don’t worry. Yes, you’re going to have to

pay these very high taxes now. But when you’re old, you’re going to get

all these taxes back in benefits plus a whole lot more.”

But now the baby boomers are reaching retirement age and expecting

the huge transfers they’ve been promised. And, of course, we haven’t

had enough children and they’re not earning enough for this all to work

“Baby boomers are

reaching retirement

age and expecting the

huge transfers they’ve

been promised.“

DC Dialogue

out. This pay-as-you-go accounting meant that all these obligations

to pay the baby boomers, which will total over $3 trillion a year, in

today’s dollars, year after year when they’re fully retired, never showed

up on the books as official debt because we never used the words

“borrowing” and “repayment of principal plus interest.”

So it’s all implicit debt. And our fiscal gap at this point, which really

records the sum of all our explicit and implicit debt, is $211 trillion,

which is about 14 times GDP. There is only so much money you can

extract from young people. And, at some point, if you start taking too

much, they start leaving the country. We saw that in Uruguay where

they have super-high tax rates and young people headed off in droves

to Spain and other countries. That could happen here because there’s a

limit to our generational expropriation, and we’re reaching that limit.

DCD: How may the current deficits and funding of Social Security affect

baby boomers and younger generations as they seek to retire?

Kotlikoff: I think older people know that current fiscal problems could lead to a

financial collapse of an even bigger magnitude than we saw in 2008.

They know that we’re coming to the end of this transfer payment

scheme and that their Social Security benefits are in danger—maybe

not directly through Social Security benefit cuts, but indirectly through

higher taxes on their benefits. A total of 85% of Medicare expenditures

and 70% of Medicaid expenditures goes to the elderly in the form of

old-age nursing home support. And they know that their Medicare and

Medicaid benefits are in danger.

These three big programs—Medicare, Medicaid, and Social

Security—are now spending $30,000 per old person, if you add up

the expenditures of these three programs and divide by the number of

old people. That’s about two-thirds of the per capita GDP. When the

baby boomers fully retire, the projection is that they’ll receive at least

$40,000 per head in today’s dollars. This will represent close to 85% of

per capita GDP. The bill is just going to be too big.

The older people who realize this are saying, “Gee, this won’t work

out for the country. My benefits will be cut. We’re going to have to pay

more out of pocket for health care and retirement. How am I going

“There’s a limit to

our generational

expropriation, and

we’re reaching

that limit.”

PIMCODC Practice

to make it through? I’m going to keep working.” But, of course, not

everybody can keep working, physically, nor is every employer willing

to keep the elderly on the job. So, this is a very anxious country.

There are ways to dig ourselves out of this hole, but it’s not going

to be easy.

DCD: How do we dig out of this hole, especially related to retirement

funding? With the concern you’ve raised about Social Security, does

that leave defined contribution plans to meet the retirement income

needs for workers?

Kotlikoff: DC plans are part of the answer. We need workers to save in these

programs. Workers need to realize that no one is going to bail them

out. Unfortunately, there are a lot of workers who say, “Well, the

employer is putting in some basic money for me, so I don’t really need

to put in that much myself. Uncle Sam’s providing Social Security

and Medicare and Medicaid. I’m going to be taken care of. So I don’t

need to save on my own.” The percentage of people who contribute

has been too low and the amount they put in is also often too low.

Plus, the returns clearly haven’t been that great for some generations,

depending on what they invested in and when they did it.

But we cannot rely on defined contribution alone. We also need to fix

Social Security. We need a modern version of Social Security, which I

would call the Personal Security System—a system that would provide

a basic level of support via fully funded private accounts that are

sustainable and transparent. Social Security now has 2,728 rules in its

handbook that make the system almost entirely indecipherable.

DCD: How much would people need to save in the private account system,

and how might it work?

Kotlikoff: To replace the Social Security coverage in place today (including to

cover survivor insurance, life insurance, and disability insurance), the

government would need to mandate that everybody contribute 10% of

their salary into this system. Right now the OASDI tax rate for Social

Security is 12.4%. So the private system would require a somewhat

lower contribution overall. But you’d know for sure what was being

done with the contributions.

“We need a modern

version of Social

Security, which

I would call the

Personal Security

System—a system

that would provide a

basic level of support

via fully funded

private accounts that

are sustainable and

transparent.”

DC Dialogue

I suggest that the contribution be divided 50-50 between legal

partners and spouses so that they each have an equal size account

if one’s not working. In addition, the government would need to

make matching contributions on behalf of the poor and the disabled

and the unemployed. So everybody would have an account. Then,

I would invest this money in a globally diversified, market-weighted

index portfolio and have the government annuitize each cohort

gradually starting at age 60. Although these are personal accounts, the

government, actually a government computer, would do the investing

at zero cost to participants. Investment companies and insurance

companies would play no role in the system.

Plus, I suggest that the accounts attach a government guarantee of

the inflation-adjusted principal invested—a zero real rate of return.

So you know you’re never going to lose your contribution. You’re

not going to have the leeway to invest it on your own. You’ll be fully

globally diversified.

That’s my vision for a fully funded system that leaves no future

generation on the hook for any current generation. You’d be able to

check your individual account balance and understand how it’s being

invested. It would be a very simple, transparent system. Of course, we

also need to address health care. While there are no simple solutions,

we need to realize that there’s no other option—we’re in a very deep

hole. Changes must be made.

DCD: If people contribute 10% of pay to your revised Social Security

system, how much more would they need to save to meet their

income-replacement goal in retirement?

Kotlikoff: First, let’s talk about the “rule of thumb” for income replacement.

The industry has told us that we need to replace 75% to 85% of our

pre-retirement earnings to maintain our living standard in retirement.

For a lot of people, I believe that replacement goal is too high. This

is particularly true for pre-retirees who have expenses that won’t

carry into retirement, such as college funding, mortgage payments,

supporting a parent, and so on. I fear that if you set a target that’s too

high for people, they start turning pale because it means they’d have

to save every penny and starve. Many retirees may be able to maintain

“A fully funded system

leaves no future

generation on

the hook for any

current generation.”

PIMCODC Practice

their living standard on 45% to 55% of pre-retirement pay.

Unfortunately, many financial experts and models suggest a savings

goal that is inflated, and then they often say, “Don’t worry. You can

save less if you take on more risk.” And it’s true that the probability

of reaching the target may be much higher. But so may the

probability of losing most of what you’ve invested.

So, I think the industry has put people into riskier securities than is

necessarily appropriate and has not fully explained the downside

risk in terms of the way they’ve done their Monte Carlo analysis.

Over the years, they’ve had lots of Monte Carlo tools that show the

probability of making your target. They typically don’t show the

probability of losing everything. If we’re going to invest in something

that involves risk, we need to understand the downside as well as the

upside risk to our living standard.

DCD: How would you determine how much a person must save to meet

their expenses in retirement or to maintain their living standard?

Kotlikoff: The appropriate target should be based on figuring out how much

you need to save in order to have a smooth living standard. So the

appropriate target comes from thinking about trying to have the same

living standard in the future that you’re having now. That’s what

economics says. This calculation should be run for each individual.

Unfortunately, calculating the savings amount correctly is extremely

complicated, as it requires assumptions about taxes every year for the

rest of your life. I’ve tackled these complexities by creating financial

planning software with my colleagues that embeds a mathematical

technique called dynamic programming. This type of modeling does

what economists call “consumption smoothing”—it is designed to help

people maintain the same living standard during both working and

retirement years.

If you ask households to save too much, they may sacrifice their youth.

Yet, if they save too little, they may be unable to retire or they may

be required to reduce their living standard during retirement. I believe

we have about 20% of our population that is saving too much, while

at least 40% is saving far too little. To economists, the whole story of

“The industry has

put people into riskier

securities than is

necessarily appropriate

and has not fully

explained the

downside risk.”

DC Dialogue

personal financial planning is about your living standard. It’s not about

some arbitrary number that you’re supposed to hit at retirement.

DCD: Consumption smoothing, or maintaining your living standard,

pre- and post-retirement is a reasonable goal. Yet, to calculate

what’s needed to accomplish this is a challenge. We need default

assumptions for DC savings. What do you suggest?

Kotlikoff: To answer this question, I would need to know more about what other

funding sources the population has. If we assume they only have a DC

plan in addition to Social Security and that they have typical expenses

at certain ages, I would suggest a lower saving rate initially.

My sense is that for young people who have children, are paying

a mortgage, and may be helping out their parents financially, an

appropriate contribution may be only 3% and the employer ideally

would contribute, say 6%. As the worker’s income increases and

expenses decrease, they can contribute a higher percentage of pay and

perhaps the employer wouldn’t need to contribute as much. To smooth

consumption, younger workers simply need more help. DC plan rules

may not allow different contribution levels based on age, yet from a

lifestyle management standpoint, I believe that would be better.

DCD: What do you believe is the appropriate default investment for a

DC plan?

Kotlikoff: The default investment has to be relatively low risk. I would start with

inflation-indexed bonds such as Treasury Inflation-Protected Securities

(TIPS), and then add risk cautiously. Participant assets shouldn’t be

defaulted into the riskiest securities. Yet, we can push people into a set

of investments with risk-adjusted return potential that may be too low.

We’ve got to get the right balance here. So, in terms of investment risk,

economists think about living standard risk. What does it mean if you

invest in high-risk securities? What is the downside risk to your living

standard? What’s the upside? Because, as you stay in the stock market,

if there’s a chance for a fantastic upside, there is also a chance for a

fantastic downside. So this is like a random walk to heaven or hell.

Plan sponsors need to consider living standard risk as they select the

default. Whatever the risk level, participants need to be shown what

“If you ask households

to save too much,

they may sacrifice

their youth.”

PIMCODC Practice

they may face in both a possible downside and a possible upside to

their lifestyle or living standard. Of course, through time, that risk to

your living standard will depend not just on how you intend to invest,

but also on how you intend to spend.

If you’re going to spend more aggressively each year, thinking that

you’re going to do well on these risky investments, and they don’t turn

out, then you’re likely to have a more substantial downside in your

future. For example, let’s just say that you spent a certain amount when

you were younger, because you were pretty sure that you were going

to do well in the market. If that turns out not to be the case, you’re

likely going to suffer a bigger downside than if you had not

consumed so aggressively earlier on.

We also need to recognize that people may adjust their spending based

on how their investments perform. If they lose a lot of money, they’ll

reduce spending. If they make a lot of money, they’ll likely increase

spending. They’re going to respond to their circumstances. They’re

probably not going to spend the same amount each year independent

of whether their asset values decline or rise dramatically. No one

typically acts the way conventional financial planning recommends

they act, which says volumes about conventional financial planning.

We need to have them think carefully and make sure that the tools plan

sponsors are using and providing their employees are the best possible

planning tools.

If you were retired in 2008 with $1 million in assets and it went down

to half a million, you probably aren’t going to spend the same amount

you did before. In fact, you may have sold out at the bottom, and

now you’re investing much more conservatively and, unfortunately,

experiencing a lower living standard.

The bottom line is that we need to show people the potential

consequences to their living standard of not contributing sufficiently to

their retirement plan, as well as what may happen if they take on too

much risk. We also need to understand that younger participants may

need more help in saving. Maybe the employer offers a contribution

percentage that’s the same for all workers, but with a minimum dollar

amount that would give younger workers a greater contribution.

That’s just one idea.

“Whatever the risk

level, participants

need to be shown

what they may face

in both a possible

downside and a

possible upside to

their lifestyle or

living standard. “

DC Dialogue

DCD: As people grow older, they do tend to save more in DC plans as a

percentage of pay.

Kotlikoff: That’s right. If you look at the typical pattern of life cycle savings,

people save relatively small amounts when they’re young. When

they’re between 45 and 55—or even 50 and 60—that’s when most of

the life cycle savings for retirement occurs.

If you look at longitudinal pictures of actual wealth accumulation

with age, you see this picture. And it makes perfect sense because

it’s exactly what the theory predicts. When you have more mouths to

feed, when the kids are young, you’re going to have to spend more on

consumption just to keep everybody’s living standard relatively smooth

compared to where it’s going to be in the future.

DCD: When you look at what’s happened with the financial crisis and the

markets recently, how does that affect thinking about managing

retirement savings and income?

Kotlikoff: I think the investment environment is riskier—we’re dealing with far

greater uncertainty. It’s not just the financial system that’s riskier. The

fiscal policies of the different countries also are producing a lot more

risk. So the employer, if they’re making the call about how to default

people or they’re talking to their employees about their investing

strategies, has to be aware of these increased risks. Unfortunately, when

anxious investors are frightened out of the market, they tend to stay

there rather than commit to taking risk again. Once bitten, twice shy.

We’re emotional creatures. When there’s uncertainty in the markets,

this can literally and uncontrollably transmit fear in human brains.

Emotions often drive economic decision making.

Our weakened economy has to enter into an employer’s thinking and

also into an employee’s thinking. It’s made life much more difficult.

It’s not like we’re in an era where we can count on the stock market

delivering consistently positive returns so that we don’t have to worry

about changing economic realities.

“When there’s

uncertainty in

the markets, this

can literally and

uncontrollably

transmit fear in

human brains.

Emotions often

drive economic

decision making.”

PIMCODC Practice

“We need to manage

retirement assets

with the reality

of generally higher

risk and likely

future inflation.”

We’ve always had risks in the economy. But this environment seems

to be much more uncertain. We need to manage retirement assets

with the reality of generally higher risk and likely future inflation. That

may mean adding more conservative investments, as well as inflation-

hedging securities such as TIPS, as well as commodities, real estate,

and natural resources. Inflation risk tends to be significant for retirees,

yet fortunately can be managed.

DCD: What else might you suggest to plan sponsors?

Kotlikoff: As fiduciaries, plan sponsors have an obligation to think about their

investment choices very carefully. They can’t just leave it to the

company that’s selling them or the employees financial products or DC

services to make these decisions for them. They have to ask questions

and they have to adjust what they’re doing through time in light of how

they see the economy and markets progressing.

We have put employers in a difficult place. I don’t think they should

have been put in this position, but they are because we’ve created an

environment in which the employer can influence their employees’

ability to save as well as pay taxes. Employers often have to play this

role because if they choose to sponsor a retirement plan for their

employees, it becomes part of their responsibility at this point, as well

as running their companies. We need to have them think carefully and

make sure that the tools they’re using and providing their employees

are the best possible tools. They also need to think carefully about risk,

particularly in the default investment. Even if risky assets perform well

over the long run, they may entail a bumpy living-standard ride…which

some may find intolerable.

Unfortunately, we only go around once. Our lifetime happiness

depends on our lifestyle or living standard at all ages, not just

retirement. How plan sponsors structure DC plans, both from a

saving and investment standpoint, can make a huge difference in their

workers’ current as well as retirement living standards. That’s a lot of

responsibility resting with the employer!

DCD: Thank you, Larry.

Kotlikoff: My pleasure.

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DC Dialogue

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Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. PIMCO does not offer insurance guaranteed prod-ucts or products that offer investments containing both securities and insurance features. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. Government. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. Diversification does not ensure against loss.

There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax questions and concerns.

This material contains the current opinions of the author, but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, ©2011, PIMCO.

About PIMCO and Our DC Practice

Based in Newport Beach, California, PIMCO is a global investment

management firm with over 1,400 dedicated professionals focusing

on a single mission: to manage risks and deliver returns for our clients.

For four decades, we have managed the retirement and investment

assets for a wide range of investors, including corporations, governments,

not-for-profits, and other organizations, as well as for individuals around

the globe.

As of June 30, 2011 our:

n Clients include more than two-thirds the Fortune 100

n Investment professionals on staff exceed 500

n Global presence includes offices in 11 locations

n Total assets under management are $1.3 trillion

n DC assets under management nearly $170 billion

Our PIMCO DC Practice is dedicated to promoting effective DC plan

design and innovative retirement solutions. We are among the largest

managers of assets in defined contribution plans, offering investment

management for stable value, fixed-income, inflation protection, equity

and asset allocation strategies such as target-date solutions. We also

provide analytic modeling, plus can help plan sponsors identify DC

consultant resources. Our team is pleased to support our clients and the

broader retirement community by sharing ideas and developments for DC

plans in the hopes of fostering a more secure financial future for workers.

If you have any questions about the PIMCO DC Practice, please contact

your PIMCO representative or email us at [email protected].

Laurence J. Kotlikoff

Professor of Economics, Boston University and President, Economic Security Planning, Inc.

617 353-4002

w w w . kotlikoff.net

[email protected]

PIMCO DC Dialogue - It's Your Living Standard

Economy & Finance

Transcript of PIMCO DC Dialogue - It's Your Living Standard