Allison's ode to the second moment


Welcome to the eighteenth issue of Allison’s Ode to the Second Moment, a newsletter that scares away bogies and keeps your brain from turning to mush.

Your brain won’t go bad after all

Sometimes I suspect we haven’t thought this whole modern retirement thing through. As you know, I worry that people don’t know how much to spend and how to invest after they retire. It is the hardest part of personal finance. You don’t know how long you will need to make the money last; there will probably be large, unpredictable health expenses; and there is no room for error. If you run out of money, you can’t just go back to work. Yet the saving part gets way more attention, maybe because it’s easier to understand.

There isn’t much guidance to help people solve one of the most difficult financial problems I can think of. It doesn’t help that the problem gets harder to solve as you age, health worsens, and assets dwindle. And to make matter worse, that’s just when your brain goes soft. For most people (but not all) fluid intelligence, the ability to learn, problem-solve, and respond quickly to new information, declines with age.

But there is some good news. Fluid intelligence may decline, but crystalized intelligence—wisdom, knowledge, and experience, increases with age. And wisdom can more than make up for declines in cognitive function. Turns out it is better to be wise than fast. Studies show people who go into retirement financially literate can still make good financial decisions.

I reckon this means people need to build up financial knowledge the same way they do savings when they are young. The riskiest thing you can do is leave financial matters to your spouse until it’s too late.

Freedom for financial advisors

It is a new regime and a new world. No one knows what that will mean; we are left to speculate. And for some reason, there is hot speculation that a Trump presidency will mean financial advisors won’t be subject to the fiduciary standard. I suspect the fiduciary rule is not Trump’s top concern right now. Yet, the financial planning community is anxious about its future and wondering about the regulation. They have reason be unsure. Some Trump loyalists have been very vocal that they think it’s a terrible idea. They’ve even likened the fiduciary standard to slavery! Imagine forcing advisors to act in their client’s best interest—crazy, right?

To be honest, I am not a fan of the fiduciary standard for financial advisors either—but for very different reasons than the wannabe abolitionists. I agree advisors should act in their client’s best interest and would love to see that happen all the time. I just don’t think the fiduciary standard achieves that. In fact I think it creates incentives for worse advice.

The fact is, regulators wagging their finger at people and saying, “You better do right by people,” doesn’t magically align incentives. It certainly doesn’t if no one has defined what ‘best interest’ really means. The regulation seems like an invitation for lawsuits if you don’t like your investment performance. I think good advice, which is worth paying for, is customized and takes a holistic risk perspective. I worry the regulation will discourage this, because why try something new, when you can get sued for straying from the pack?

Now you’d think that, before we implement a sweeping regulation, we’d study how it works in practice. Normally that’s hard to do, because new regulations are, well, new and risk unintended consequences. But with the fiduciary standard, we have almost 40 years of experience; it is already applied to 401(k) sponsors. And it has hardly been a great success. Most 401(k) assets are invested in high cost mutual funds (the market the fiduciary standard is supposed to shrink), and there’s little innovation.

Rather than another rule, why not just make all advisors fee-only—it aligns incentives, and it is much simpler.

A sad victory for financial economists

I went to a conference last week and sat in silent horror as I watched a panel containing representatives of three municipal pension plans. They openly swapped strategies on how to meet their “bogie.” The bogie (and I can’t believe they actually call it that! The irony!) is the assumed rate of return on pension assets. The higher the return, the better funded the pension appears, and the lower contributions made by workers and tax-payers.

You can imagine how the conversation went, but I’ll give you the annotated (slightly editorialized) version. It went something like, “Let’s invest in super risky assets that are impossible to value, like private equity. If you think low rates are a problem, you’re investing all wrong.”

I am not sure what disturbed me more, the fact the conversation was happening, the fact there was no shame, or the fact I was the only one in the audience disturbed by it.

Or the fact this conversation was happening as news broke about the dire state of the Dallas pension fund. They took on lots of risk to hide (or to make-up for) serious underfunding. Now the fund is nearly bankrupt.

And what do you expect? Actuaries have told me it is fine to discount liabilities at the assumed rate of return as it doesn’t encourage risk-taking. That always struck me as absurd, but it was hard to prove. Well, no more. I am calling this one for financial economists, but wish we weren’t proved right

Financial economist 12
Actuaries -4

And even more bad accounting

Speaking of fantastical accounting, I am noticing a trend of reporting (not even commentary) that an entity is broke only when can't pay any of its liabilities. By this definition, if a pension, Social Security, or Medicare can only pay 70% of its obligations, it is not such a big problem, because… well 70% is closer to 100% than 0%. I don’t get it. If you can only pay 70% of your debt, it’s considered a default. Why hold entitlements to a different standard?

I normally don’t think it’s worth pointing out sloppy reporting, but I worry it reflects a mindset that underfunding obligations isn’t a big deal. At least not until all the money runs out, interest rates are high, and harder choices must be made.

A dose of reason

On a more positive note, I am delighted that it is now officially politically correct to argue that infrastructure spending only boosts growth if it is well targeted. Next, people will say that infrastructure is stymied by what’s going wrong at the state and municipal level.

Right now we can still project our greatest fears or hopes on the new regime. So I am going to hope they will care deeply about municipal finance and will vanquish bogies from their balance sheets forever.

Until next time, Pension Geeks!