Yesterday we wrote a quick post talking about the very real challenge facing the financial services industry. In short, how we do we provide the average individual investor with a workable retirement solutions. Or as DFA CEO David Booth states it “cost-efficient integrated lifetime financial solutions to the average person.”
In a recent post Felix Salmon at Reuters talks about how individual investors, on average, were harmed as their savings shifted over time from defined benefit to defined contribution plans. The problem is that shift has occurred in a world where financial literacy, as we describe in our book, is “abysmal.” I am going to quote liberally from Salmon’s piece because it makes a number of important points.
The investment returns of people with defined-contribution pensions are woefully low — much lower than the returns seen by the managers of defined-benefit schemes. And the difference, to a first approximation, is rents being extracted by the financial-services industry. That’s the industry which does all of the educating: so it’s unrealistic to assume that it’s going to educate people and thereby reduce its own income.
It is unrealistic to rely on the financial services industry for literacy education. It is a bit like leaving the fox in charge of the hen house. It is unlikely to work.
Besides, as Appadurai says, the US population has never been more educated about matters financial than it is now. We can try to improve the level of education even further. But a little financial education can be a dangerous thing, if it instils overconfidence. And what’s more, there’s zero empirical evidence that educated investors have higher realized returns. Besides, you can’t hope to effectively educate everybody.
The other point is important as well. A little financial literacy can in an ironic fashion actually leave individuals with MORE overconfidence that before. Statistics show that individual investors are reliably poor at timing their investments. Salmon has a solution:
Much better, I think, to allow people to invest alongside the defined-benefit scheme of their employer, and accept the returns of that scheme. Most employers still have some kind of legacy defined-benefit scheme, and those schemes, as a rule, tend to be invested pretty sensibly. Those pension funds should accept defined-contribution money alongside their defined-benefit money: it would beef up their AUM and thereby their negotiating power, while at the same time delivering higher returns to the company’s employees.
Unfortunately I think Salmon overestimates the extent of companies that still have a legacy defined benefit plan in place. Employees in the public sector have much higher coverage rates. The other problem is that which we face with health care. A large percentage of Americans now get their health care insurance from their employer. This causes all manner of behaviors that don’t lend itself to better health outcomes. Do we really want to make ourselves dependent on our employer with another key financial relationship? I guess most Americans would be wary of this. Salmon continues:
Some employees, of course, will think that they are very clever and will be able to get large returns for themselves. But most of us aren’t that hubristic, and consider asset-allocation decisions and the like to be something of a chore. Give us the opportunity to outsource those decisions to somebody acting on our behalf, and we’ll jump at it. We might not get the same implied returns as the lucky people on defined-benefit plans. But at least we’ll have our money professionally managed, at little or no cost.
Salmon is right that there is a great, unmet need for low cost financial solutions. The vast majority of Americans don’t want to be mucking about with their own portfolios. Saving enough for retirement is according to a Gallup poll American’s biggest financial worry. A savings solution that Americans feel was fair, inexpensive and realistic would be a major step forward, but it is unlikely to be piggybacking on their employer’s pension plan. The question is what is the solution and where does it come from?