Practical analysis for investment professionals
21 April 2014

Hard Choices: Where We Are

Posted In: Economics

At the center of every discussion or debate on US Social Security and retirement policy are questions of fairness and justice. As so often in debates over public policy, “where you stand is where you sit.” Each of us has a different personal story and thus a different personal situation and different assumptions, expectations, and understandings of promises made or promises heard or believed. And our specific vantage point is a powerful determinant of how we see every aspect of this complex problem and the resolution each of us considers fair.

Demographers know the future shape and scale of the problem by simply “aging” the present population. But because our personal experiences and perspectives differ, our beliefs about fairness differ — often greatly. That’s why the choices we need to make — before choices are made for us or are taken away from us — are so hard, particularly the choices that must be made through the political process of a large, pluricentric democracy.

As a society and nation, we need a “guided conversation” to explore the complex issues and questions and to clarify the main components in a wise and enduring resolution of our ballooning national retirement security problem. The longer we delay objective analysis, the more complex and entrenched our national problem will surely become — and the harder, more painful the resolution. It may already be too late.

To encourage the necessary — and necessarily constructive — “conversation” among the many policymakers who need to be engaged, I offer a sensible pathway to an overall resolution in this brief piece. Anyone who thinks a resolution now would be difficult must also believe that the longer we defer our decisions, the more difficult and painful a resolution will be for all of us.

So, it is about you — and about every other individual and our overall social contract. And there is no happy solution; there is no magic answer.

The Problem

Most Americans are in serious financial trouble and don’t even know it. Financially, we are like boys and girls proud of their dark suntans without realizing that in 40–50 years, they will be patients of dermatologists checking for melanomas and other skin cancers — or like teenage smokers who, years later, will have a seriously elevated risk of lung cancer. None of us want the United States to be plagued by large numbers of poverty-stricken elderly people who have outlived the retirement funds they once thought ample for a comfortable retirement. They can’t go back to work because they won’t know the people at their old company. They will have made their own investment and spending decisions, so nobody else will feel responsible for them. These former workers will be all alone, pleading to the gloom, “Why oh why didn’t somebody tell me?”

If we do not make hard choices now, what pension experts call the “predictable surprise” will be no surprise at all and it will be nasty. Other nations — Australia and Chile, in particular — have faced the same challenges and taken appropriate action. We can learn from their experiences. But will we?

One of our challenges is to find the appropriate balance between freedom of choice based on self-reliance and a social compact with regulations covering everything from licensing drivers at 16 if they pass written and practice tests to unemployment taxes to product safety.

We need to discover the central balance between work years and retirement years. When Social Security was introduced in 1935 and retirement was set at age 65, the rational “balance” — with the then actuarial life expectancy of 66½ — was 45 years of work and 1½ years of retirement, a ratio of 30 to 1. With the remarkable gains in health care, our actuarial life expectancy has been pushed all the way to 85 while our average age at retirement has declined to 63, with the overall ratio falling to less than 2 to 1.

Working longer — moving the fulcrum further out along the timeline — is the obvious answer. Although the case can easily be made that most of today’s workers are not engaged in heavy physical or dangerous work and so could easily work until age 70 (or even 75), changing the retirement norm to 70 would run up against strong social and political resistance because such a change would conflict with the embedded belief that workers have a “right” to retire at 65 (or earlier). Retiring at 65 has been seen for so long as central to our national social contract, but the view that it is a “right” is a myth.

A retirement age of 65 was set nearly 100 years ago in Germany, primarily for reasons of politics and public relations. To attract workers for the “newfangled” railroads that Chancellor Otto von Bismarck had made a symbol of the benefits of the German Empire — transporting fresh produce to cities and coal and iron across the empire — Bismarck guaranteed lifetime employment. The oldest workers, assigned to the easy job of minding switches that were used only a few times a day, were literally “falling asleep at the switch” and causing accidents that threatened to make a mockery of Bismarck’s symbol. So, he paid them not to work and chose age 70 (and later dropped it to 65) because so few lived that long that the cost was small.

Thinking clearly and objectively about the long term is hard for all of us, and in addition, most of us find thinking rationally about money very hard. Combining money and time and mixing in the political complexities of resolving questions about long-term financial fairness will be very, very hard. But the impact on millions of Americans and on our American way of life — our social compact — will be even worse if we do not agree on how to manage the major variables and do not have the national will to make the hard choices facing us.

State and municipal pension funds continue to be almost entirely defined benefit plans with three interested parties, only two of which negotiate the benefits: the government and the labor union. No genius is needed to predict the result — mayors and governors want to avoid “labor troubles” that would interrupt public services and do not want to increase taxes because either could bring defeat at the next election. Union leaders know this and agree to swap “labor peace” for long-term pension benefits. Both parties agree to defer recognition of pension benefit obligations by agreeing to use high “actuarial” assumptions about future rates of return so as not to accumulate explicit, realistic benefit commitments. The result is that required contributions to fund future pensions are seriously understated. Invisible or hidden, these obligations are contractual, and so the only “solution” is often the threat of bankruptcy. (Detroit, Rhode Island, Illinois, and Wisconsin are currently working on variations of the resulting long-term problem.)

For corporations that face hard choices as they set the terms and conditions of their retirement plans, one choice has been easy: switching from defined benefit plans to defined contribution 401(k) plans.

The United States has also had “difficulties” of its own making. For example, to protect the innocent from the unscrupulous, the US SEC has a history of regulating individuals and organizations that offer investment advice. When ERISA was passed in 1974, plan sponsors were made explicitly responsible for acting as fiduciaries under the jurisdiction of the US Department of Labor. One result: Lawyers advised clients that it was unclear which policy precedents of which part of the US government — the Department of Labor or the SEC — would govern if a plan sponsor advised its employees on how to invest 401(k) assets; so, lawyers advised their corporate clients to offer no advice. This outcome left each individual “free to choose” in an area where decisions are important and mistakes due to action or inaction can have serious adverse consequences, particularly over the long term. Examples include all the well-known mistakes made by individual investors — buying at or near market highs, selling at or near market lows, selecting or dropping specific funds on the basis of their past performance (which seldom works). In addition, many 401(k) participants begin their employment with tiny assets — too small for “investment” — and so they opt for a safe savings account and then, as the years go by, never change that decision.

However unintentionally, what we say collectively to the average worker is harsh: “You’re on your own now.” Will that average worker have enough funds for retirement? It’s up to the individual.

Each Individual’s Hard Choices

After you stop working, your financial security will depend on five factors:

  • How long you work
  • How much you save
  • How well you invest
  • How much you spend each year
  • How long you are retired

The first factor matters greatly. Most of us should work longer — to 70 — so that we can save more for retirement. The next two factors determine how much money you’ll have in retirement. If you worry that you’ll find these decisions — like the decision to lose weight — difficult to make and stick with, you are not alone. They are hard decisions that are very hard to stick with day after day, year after year. For many people, the secret is to recognize and embrace the “obvious”: You are saving and investing for you. So, it all begins with saving.Here’s something you can do for yourself within your employer’s retirement plan. If your employer offers to match all or part of your contributions to the plan, be sure to match the match 100%. Your employer is doing the right thing for you and your coworkers, so take advantage of this benefit and recognize that your employer’s matching contributions are really “found” money that goes into your account tax free. Even better, all contributions — yours and your employer’s — accumulate and compound tax free, year after year.

The last two factors determine how much money you’ll need. Although regular exercise, healthful eating, and not smoking can extend your life by a year or so, your gene pool will leave you little choice about the length of your life. The average life expectancy for all Americans is now 85. For Hispanics, African Americans, and poor people, life expectancy is less; for the affluent, life expectancy is somewhat more. And if 85 is the average, 20% will die before 82 and another 20% will live past 90.

Because most of us do not choose when we die, our real choice regarding how long we are retired centers on our decision about how long we work, either full- or part-time. Increasing numbers of people not only find their work interesting and fulfilling but also enjoy the social context of their work because that’s where most of their best friendships are. Where retirement is decided by each individual, many people continue working into their mid-70s. Those who do not have this option should consider working part-time.

To some extent, you can decide how much you’ll spend in the same way you decide how much to save during your work years. Examples of economizing include downsizing your home and reviewing your spending to see where you can cut back without feeling a real loss. (Although some of us spend somewhat less, some of us spend a lot more.) Be careful to avoid the mistake many people make of not anticipating a major increase in the cost of health care. The average person makes 60% of her total lifetime health care expenditures in the last six months of life.

The Rule of 72

The easiest way to understand the great power of compounding is to use the wonderful Rule of 72.

Simple and effective, the Rule of 72 goes like this: At X%, it takes Y years to double your money, and X times Y always equals 72. So, let’s try an example or “test run” and see how it works. If your investments are returning 8%, your money will double in nine years (8 × 9 = 72). If your investments grow at only 4%, they’ll double in 18 years (4 × 18 = 72). If your investments earn 6%, your money will double in 12 years (6 × 12 = 72), double again in another 12 years, and double yet again to eight times as much as the original amount after the next 12 years!

That’s why time is the Archimedes lever of investing. A dollar saved at age 25 and invested at 6% will be $2 at 37, $4 at 49, $8 at 61, and $16 at 73 (and $32 at 85). But getting that $16 or $32 depends on saving $1 at 25 and investing it sensibly over the long term. This, of course, takes self-discipline, but the necessary self-discipline is a lot easier to muster when we focus on the multiplied benefits that we all want to enjoy.

The Rule of 72 works just as easily and effectively with debts as it does with investments. That’s why banks want everyone to “take advantage” of credit card debt. Behold the Rule of 72 again! At 18%, the debt doubles in just 4 years, doubles again in another 4 years, and doubles yet again in another 4; so in only 12 years, $100 increases to $800.

When you spend today — instead of having multiples more to spend tomorrow — be careful to make your decisions as objectively as possible. The easiest (least hard) way to act rationally is to make your decisions long before the “moment of decision,” when you are calm and in the mood to set personal financial policies you believe you can stick with.

As we all know, the opposite of saving is borrowing. The laws governing 401(k) and other defined contribution plans allow individual plan participants to borrow from their accumulating savings for “hardship” reasons. These laws sound compassionate and that’s the intention, but the definition of hardship is so “generous” that it unintentionally encourages people to divert their much-needed retirement funds into nonretirement spending instead of working harder on their self-discipline.

One of the best ways to save on costs (i.e., fees) is usually ignored, which is a big mistake. Most investors somehow believe that fees for investment management are low. Fees are not low. Here’s why: By convention, fees are shown as a percentage of the assets, say, just 1%. But that’s seriously misleading. The investor already has the assets, so the manager’s fee should be stated as a percentage of the benefit (i.e., returns). If returns are 7%, then the same fee in dollars is 15% of returns. And because index funds deliver the full market return with no more than the market level of risk for a fee of 0.1%, the real cost of active management is the incremental cost as a percentage of the incremental benefit of active management. That’s why the true cost of active management is not 1% or even 15%. Because the average active manager falls short of his chosen benchmark, the average fee is more than 100% of the true net benefit. Increasingly, investors are learning that one way to reduce costs — and increase returns — is to save on costs by using low-cost index investments, particularly with their 401(k) or other retirement plans.

How your retirement funds are invested is important because many of those dollars are invested for a very long time — 20, 40, even 60 years. So, although the day-to-day and year-to-year market prices, economic inflation, profits, and politics will cause the stock and bond markets to fluctuate — sometimes greatly — around their long-term trends, a few realities are virtually certain over the long term. The stock market will outperform the bond market and will fluctuate more. Money market investments will — not always, but usually — earn about 1% more than inflation; quality bonds will earn about 3% more than inflation; and a diversified portfolio of stocks will earn about 5% more than inflation.

Most of the time and over most periods — particularly over long periods — stocks outperform bonds. So, how much should a 401(k) investor commit to bonds? For a long-term investor, the answer depends on how calm the investor will be when the stock market is behaving most horribly. Investors who are experienced with markets, highly rational, and unflappably able to maintain calm and take no action when the markets are causing others great distress — a remarkable and lucky few — will be able to focus on the very long term and sustain major commitments to stocks with an investment horizon of 20 years.

The conventional wisdom on asset mix (e.g., “invest your age in bonds”) ignores an important reality and so is misleading. If people would take a “big picture” look at their overall finances — investments and earned income — they would invest less than the conventional amounts at various ages. Most people with 401(k) plans are employed, and they can and should look at their salary as a “bond interest equivalent” in their total financial picture. If salary is capitalized at, say, 5%, then a $100,000 salary would have an estimated value of $2 million, which would be huge in a big-picture portfolio of a 30- or 40-year-old. (Yes, raises are somewhat uncertain in magnitude, but they are, realistically, quite predictably raises.)

Almost all investors with 401(k) plans would be wise to recall the famous Greyhound bus tagline, “and leave the driving to us.” Every 401(k) plan should have as an option — if not as a recommendation — a life-cycle or target-date fund that will adapt to short-term market fluctuations and follow an asset mix glide path to age 65.


Thinking clearly about money is hard for most people. Most of us are far from expert about investing. We “know” money is important, but we don’t talk about money objectively or regularly — even in our own families and even with ourselves.
Thinking clearly about the long term is also hard. Most of the time, most of us do not think more than a few years ahead. (And most of our “longer-term thinking” is really daydreaming.) How many of us have sat down and written a plan for the next 10 years that we would want to live by — or could sit down and write such a plan? Now combine the two — money and time — and most of us blush in recognition that we are “not ready for the question.”

But the question won’t wait. In fact, most of us are already facing serious trouble, trouble that we have still not recognized. We need to make hard choices on how much to save, how long to work, how to invest, and how much to draw from our savings for spending in retirement. Each of these important choices is hard; getting them all right is very hard. And waiting instead of making sensible choices soon will surely make every choice harder. Of course, not deciding will make our personal — and national — problem harder, much harder.

The following guest editorial was written by Charles D. Ellis, CFA, chairman of the Whitehead Institute in Cambridge, Massachusetts. It was published in the March/April 2014 issue of the Financial Analysts Journal.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

About the Author(s)
Charles Ellis, CFA

Charles D. Ellis, CFA, is chair of the Whitehead Institute, Cambridge, Massachusetts.

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