Black Swan Free World (9)

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement. Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require. Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control).

The treatment of retirement in many countries has been drastically marred by a fundamental lack of understanding of risk and of risk pooling.  Taleb’s suggestion here seems drastically radical, especially here in the US where we came very close just a few years ago to shifting all retirement programs over to market based.

Whether or not you believe in the “socialization” of social security, no one seems to be thinking of the risk management aspect of retirement.  One of the fundamental concepts of risk management is to take specific risk and to use diversification to minimize the relative impact of any specific adverse event.  What the planned market based alternatives to Social Security did was to maximize two specific risks.  Those are the risk of the level of the market at point of retirement and the risk of outliving the funds.  An individual can avoid one of the two, but never both as savings plans are currently run.

This would have been one more step in the direction away from any recognition that there is any risk whatsoever in the idea of providing pensions.  In 1974, the US Congress, in effect, drove the insurance industry out of the business of providing guarantees of pensions in any form.  They did that by telling businesses that they were fully funded if they put up an amount that was sufficient to pre-fund their promices and made sure that the amount was determined without any risk margin whatsoever.  You see, when insurers were in the business of guaranteeing pension benefits, they included a risk margin.  So if you compare an actuarial projection of costs WITHOUT a risk margin to an actuarial projection of costs WITH a risk margin, the projection WITHOUT a risk margin will always seem more economical.

So looking at an individual retirement savings plan without regard to risk is just one more step in this same wrong direction.

So I believe that Taleb has a point, but I would not agree that it is necessarily the best solution to remove the retirement issue entirely from the markets.  That is because I firmly believe that with the entirely unrealistic way that government approaches financial issues that extend into the far future (meaning after lunch), some relationship to the market provides discipline and transparency around the adequacy of the funding.

I would suggest two simple adjustments to the normal features of the personal retirement savings programs.  These can be additional options that are required for all qualified retirement vehicles (US term for plans that meet regulatory standards – there must be similar terms for any other countries where there are personal retirement accounts), or they can be required for all plans – if you are the type that prefers making people do things for their own good.  For investing, the single date dependency of the current system can be repaired with a fund that bases its earnings on an average of 5 prior years and that can only be cashed out over 5 years.

For the longevity risk, my suggestion is to offer an annuity payout option that can be purchased piecemeal at any time prior to retirement.  This option should appear very competitive to younger workers since their cost for an annuity unit deferred until their retirement will appear very inexpensive.  The annuity option can be provided through purchasing additional units of Social Security benefits or through private insurers.  Since the lack of income for elderly people in the countries like the US where lack of lifetime annuity ownership by retired individuals (like the US) will become an extremely serious issue within 20 years when most of the baby boomers who had retirement savings will have spent that savings long before half of us expire, some amount of annuity purchase should be required.  I would favor the gradual elimination of tax advantage to any funds withdrawn as a lump sum or as any form that has no lifetime guarantee.

In the end, to do this right with individual accounts may just be too much trouble for all.  Perhaps what would be better would be to require all employers to provide defined benefit plans and to fund them with risk adjusted premiums.  Now that would make sense.

Black Swan Free World (8)

Black Swan Free World (7)

Black Swan Free World (6)

Black Swan Free World (5)

Black Swan Free World (4)

Black Swan Free World (3)

Black Swan Free World (2)

Black Swan Free World (1)

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2 Comments on “Black Swan Free World (9)”

  1. Karim Jetha Says:

    This post is especially timely, given that the United States Supreme Court is deciding whether, as a matter of law, unreasonably high mutual fund management fees violate a fiduciary duty owed by fund advisers.

    Two very prominent judges in the 7th Circuit–the appellate court level before the Supreme Court–disagreed over the role of the market as a “storehouse of value.”

    The Conglomerate recently did a good writeup on the case: http://www.theconglomerate.org/2009/10/masters-forum-jones-v-harris.html

  2. Dave Ingram Says:

    By the way, the first ever Global Pensions Study, performed by Mercer, suggests that one of the ways that the US system (rated 6th out of 11th) could improve would be to require that some fraction of retirement savings plans be converted to lifetime annuities. See http://www.mercer.com/referencecontent.htm?idContent=1359420


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