Allison's ode to the second moment: Sixth issue

Hello,

Welcome to the sixth edition of Allison’s Ode to the Second Moment, a newsletter that worries about risk so you, and the government, don’t have to. Lots to talk about this week…

Can annuities be redeemed?

The U.S., and many other countries, jumped head first into defined contribution world, but never bothered to think through what people are supposed to do with the money they saved when they retire.

Like any good life-cyclist, I think annuities are a fantastic solution. They ensure a steady income stream, efficiently manage risk, and give consumers good bang for their risk-adjusted buck (assuming they live a long time). But for some reason almost everyone else hates them. I spoke to CEO of TIAA, Roger Fergusson, on why that might be.

Annuities can make a lot of financial sense, but people are reluctant to part with their life savings when they enter a life phase featuring large, unpredictable healthcare expenses. Besides, many people haven’t saved enough to make buying an annuity worth it.

Nonetheless, it is a conversation we need to have. Annuities are a great option, but people don't want them and forcing retirees to buy them is unrealistic. Just look at what happened in the UK where savers were required to buy annuities. To put it mildly, it was unpopular. Enough so, the UK government eliminated the requirement last year (people can even return annuities they don't want) and left Brits without a better solution.

We need better alternatives and the spend-4%-of-your-balance-each-year rule just doesn’t cut it. I am working on something I think is better, but we need lots more discussion (among policy makers and with savers) on this issue. It’s a discussion we should have had thirty years ago. More baby boomers retire each day without any clue how to spend and invest their savings.

Is the answer more government intervention?

Several developments in the last few weeks suggest a desire to push more risk on the government.

First, the Consumer Financial Protection Bureau released a proposal to reform the payday loan industry. Payday loans are how many low earners, who have no savings, smooth out income shocks and unexpected events. But they pay for it, annual interest rates are nearly 400% and many borrowers roll over debts and rack up fees. It all sounds terrible, right?

Well it is less terrible than the alternative, debt default, bounced check fees, and other products that target the financially vulnerable and often unbanked. The New York Fed urged us to take a more careful look at the industry before rushing to judgment. We don’t know if the people who take payday loans are naïve rubes needing protection, or are just rational people without better options. It seems the CFPB already decided. But cracking down on payday lenders does not erase the demand for emergency credit. Unless there are better alternatives, their plan to make payday lending harder and more expensive may have some nasty unintended consequences.

And what is going on with Social Security? I thought we all agreed we need to sore up its finances. But, what—everyone running for President (and the current President) would like to make it more generous instead. The thinking goes "this whole 401(k) experiment isn’t going so well, lets enlarge what is ‘working’--Social Security."

Sigh. I plan to write more on this later. But us pension geeks see what’s wrong with this plan. It’s expensive and inefficient. Raising taxes on high earners won’t be enough to pay for it. And even if some political math claimed it did, you can’t deny it puts loads of risk on future generations. The risk that we have low productivity growth or that people die later than expected all factor into how expensive benefits are. Future taxpayers will have to make up the difference if expectations fall short. But hey, if there’s one group less sympathetic than high earners, it’s future high earners.

Here’s a better idea: fix 401(k)s. Have better default options, expand coverage, and figure out a good post-retirement plan. The conversation we should be having is about risk sharing. How much risk should the government take on (some—that’s why we’ve got Social Security) and how much should fall individuals take on (some too—how much comes down to preferences and income)? But putting all the risk on the government is awfully expensive, and I fear that may come back to haunt us (or our descendants).

The grit behind risk

I also spoke with Kat Cole, the dynamo behind Cinnabon, those delicious calorie bombs they sell at malls and airports. We normally think about risk in financial terms, I spoke to Kat about how she uses the same principles in pastry, business, and life. There are also some fun videos on the future of the fast food industry. Everyone else is going healthy, but Kat took a risk and doubled down on decadence. All risk enthusiasts can learn from her.

Are things really that bad?

It may be the election. Or, that every day we hear about how income inequality is fraying the social fabric. But it is hard not to feel like things have never been worse. Pshaw say some, the economy has never been better. According to a new survey minority groups, with the highest rates of poverty, still believe in the American dream and good times are ahead. Optimism may be back in fashion.

I hope so, humans have never lived so well in terms of life-expectancy, material comfort, and leisure time (yup, when you include retirement, we’ve never worked so little.).

But some caution: while we are living better—high household debt levels means we are more vulnerable to bad shocks to health, wealth, or income. A new paper from the St. Louis Fed estimates many American households have more debt than ever before—especially old and middle-age people. And even after controlling for income, minority households have much higher delinquency rates, a bad mark that can destroy your financial life.

Perhaps all the negativity we feel is the lasting scar from the Great Recession. We may be more aware the cost of better living standards (that we don’t pay for in cash) is more risk.

I hate to end on such a sad thought. Let’s be happy a plan to help Puerto Rico out of its debt crisis passed the House of Representatives.

Until next time, Pension Geeks!

Allison