I’ve been blogging recently about defined benefit plans providing a more secure retirement than defined contribution plans, such as 401(k) plans. With Congress again discussing how to amend the tax code to provide a portable individual retirement plan for employees whose employer does not offer a plan, the relevant question is whether that plan should be a defined benefit or a defined contribution plan, and how defined benefit plans can be deregulated to make administration affordable for small plans.
A friend of mine sent me this article by Moshe A. Milevsky. I obtained permission to post the entire article because, not only does he agree with me, but he makes some really good points – especially the reminder that a 401(k) plan was never meant to be a pension plan. Here is the article:
Your 401(k) is a Number, Not a Pension
by Moshe A. Milevsky, author of Are You a Stock or a Bond? Create Your Own Pension Plan for a Secure Financial Future (FT Press; ISBN: 0137127375)
As global markets remain frustratingly volatile — and highs of a few years ago remain a distant memory — now is a good time to remember that your 401(k) plan was never meant to be a pension plan. Retirement is more than just a number, it’s what you do with that number that counts.
A traditional pension, often called a Defined Benefit (DB) plan promised a guaranteed paycheck during your golden years. The size of your pension check depended on the number of years you worked for the company as well as your salary near retirement. A typical DB plan replaced 60% to 80% of your final salary, guaranteed. But, in recent years an increasing number of companies have frozen or eliminated their traditional pensions and replaced them with 401(k) plans. In other words, most companies are shifting the responsibility of retirement income directly to their employees. The risk and possible reward sits squarely on the shoulders of individuals. If markets don’t live up to their expectations — and especially if stocks decline around the time people are supposed to retire — the nest egg will be woefully inadequate.
So, what can you do about this turmoil? Unfortunately, in the short-run the answer is nothing. Selling all your investments now and moving to cash is futile. On any given market day, it’s virtually impossible to predict how markets will perform. Moreover, market timers have to get two things right: exiting prior to further declines, and entering again prior to the inevitable rebound. Some might get the first one right, but the odds of hitting both nails on the head are exponentially smaller.
Yet, for your long-run financial health and sanity I do have some economic aspirin. Now is the time to take a very close look at your job, profession and career and ask yourself an odd-sounding question: Are You a Stock or a Bond?
Let me explain. From an economic perspective your personal balance sheet – which is a concise statement of your total net worth – consists of two distinct categories of capital or assets. They are (i) financial capital and (ii) human capital. Your financial capital is relatively easy to visualize. You don’t need special glasses or measuring cups. It is the market the value of anything you can auction on eBay or sell for cash. That includes your investment portfolio, your retirement plan, your house, your car and perhaps even the family pet. The other type of capital on your economic balance sheet is your human capital. That is invisible to the naked eye, but is also an asset. It can be quantified as the present value of future wages, salary and income you will earn during your working life. Human capital is the oil in the well or gold in the mine called You Inc.
We now reach my main point. Make sure you manage your human capital and financial capital, jointly and together. The old maxim that counsels to keep your eggs in different baskets is just as relevant on the macro (jobs and portfolio) level as on the micro (stocks and bonds) level. Make sure your retirement plan’s financial capital and your job’s human capital are in completely different buckets. Indeed, the majority of hard working folks at Bear Stearns, Sprint, General Motors and Dell Computers, not to mention Enron, learned this lesson only after it was too late.
So, for example, if you work in the financial services industry, your retirement plan investments should be tilted towards consumer staples, healthcare or information technology. And, if you work in the airline industry, your portfolio should overweight energy and natural resources, etc. If you manage a hedge fund, I suggest your financial capital be entirely in treasury bills and bonds. If you are a teacher, fireman or policeman with a steady and reliable income that will convert to a lifetime DB pension when you retire, then your financial capital can be entirely invested in broadly diversified stocks.
The bottom line again is as follows. Make sure your human capital (i.e. your job) and your financial capital (i.e. your money) are in completely different sectors. This way, when one zigs the other zags and the true value of all the assets on your balance sheet won’t fluctuate as much.
At the very least, next time you check the value of your investment portfolio and feel the urge to jump from the highest window, remember that your human capital is still the most valuable asset class on your personal balance sheet for most of your working life. Jumping will exhaust that one too.
About the Author
Moshe A. Milevsky is one of the most sought-after speakers in North America on issues related to investment management, retirement planning and longevity annuities. Dr. Milevsky is the Executive Director of the Individual Finance and Insurance Decision (IFID) Centre and is an Associate Professor of Finance at York University in Toronto , Canada . He is also the CEO and President of The QWeMA Group, which is a software company that develops proprietary retirement income analytics. In addition to being an award-winning teacher and author he has served as a consultant and advisor for a variety of financial services companies and pension funds. He has published six books and over 50 peer-reviewed articles and has been interviewed and quoted in Business Week, the Wall Street Journal and Money Magazine amongst others.
Thank you for sharing the article, which I agree with and more by accident than design I followed.
I would like to pose a question for the future:
My Dad was a stockbroker many years before 401K’s and Hedge Funds were created. In those days a broker had to rely upon their research into corporate performance or the soundness of a municipal bond. In the final analysis there was no certainty in the market – you placed your bet and waited for your horse to give a good performance.
My Question: 401K’s funds have grown enormously over the past 15 years and represent a huge amount of predetermined new cash into the stock market. Due to the predictable pay cycles of monthly or hourly paid employees one could assume that there are a few days in each month where this cash would hit the market – that is a predictable occurrence. Has this been a vehicle for institutional investors to make predictable profits?