Pension Plans: Fancy projections, Dangerous Outcomes

Pension Plans: Fancy projections, Dangerous Outcomes The problem with this methodology is that the whole analysis starts with theoretical assumptions. No doubt these assumptions seem reasonable and can be defended, but starting here in your planning or placing too much emphasis on these theoretical assumptions starts you off on very shaky ground and creates additional problems as you go along.

Very long term returns, say over 50 years or so have historically been relatively stable, and so arguably it makes some sense for an institution with a time horizon many decades into future to use a return assumption. Nevertheless, this approach proved disastrous for the theoretically long living defined benefit pension plans (DBPPs). However, for individuals these return assumptions make even less sense. The key time horizon is often a great deal shorter for individuals, and 5, 10, or 20 year investment returns have been very volatile. So guessing your investment return assumption over a shorter time period is even more hazardous. Remember, we don't know what the weather will be like next week. How on earth does it make any sense to assume we know what our investment returns are going to be over the next decade or so?

Nevertheless, thanks to the prevalence of return assumptions in many investors plans, individual investors often come to believe that their financial plan depends on achieving a particular return, say, a 10% investment return. This then somehow becomes their whole focus. They then start shopping for investments or an investment adviser that can provide what they believe they need.

This is the point at which their plan can become dangerous, because a highly theoretical outcome starts driving the process to achieve that outcome! In a rush to achieve a 10% return investors overlook the risk they are taking to achieve this target and the risk management that is necessary. With a sole focus on a 10% objective an investor could easily end up with a high risk portfolio. Government bonds yielding 4.5% clearly would be rejected, presumably as well as low growth, but great value equities. The only investments that may seem to match the return expectation would be high growth companies. This could mean that an investor ends up with a highly volatile portfolio. This may work out, but then again it may not. High growth companies tend to be highly volatile. What happens if the assets fall by 25% or even 50%? What would the investor do then? Take even greater risk because they now needed a 20% return to reach their target.

This is an extreme example of what can happen if a plan is too theoretically based and the investor does not understand the investment process. Despite the now acknowledged failure of DBPPs the actuarial investment projection approach is still alive and well. Investors will often, quite reasonably, ask where they stand in terms of their retirement needs. Usually what happens is that they are given some projections based on current asset levels, and inevitably the focus falls on investment returns, as the implicit assumption seems to be that everything depends on what your returns will be.

This is not a sensible or practical way to formulate a plan, as we have seen from the DBPP experience. It is also very over simplified and a highly theoretical approach that tends to detract from a healthy investment approach that will deliver good long term investment results without excessive risk.

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