Meet 2 thought leaders who aim to revamp retirement planning

Retirement allocations encompass four concepts:

• Risk retention, addressed by diversification among risky assets;

• Risk management, which entails forgoing future potential returns to limit downside losses;

• Risk pooling, which involves the purchase of insurance policies and product guarantees; and

• Risk avoidance, which is achieved using risk-free assets like cash and cash-equivalents.

Hersch: The development of the RMA program strikes me as an implicit criticism of existing educational programs for advisors, including those leading to the CFP and ChFC designations. Are you and Dirk suggesting there are big holes in these programs?

Cotton: Yes. I have on my shelf textbooks from Boston University's CFP program. Though they have chapters on risk and insurance, none of them address spending in retirement.

There are lots of models for retirement financing, but none are very good in my opinion. Probably the worst is SWR, which assumes you'll live a certain number of years and that market returns in the future will be the same as market returns in the past. The model assumes that you will spend the same amount — a flat and not declining amount — throughout retirement, even in the face of obvious financial ruin.

Hersch: So…most retirees and pre-retirees who meet with financial planners are being ill-served by poor advice?

Gadenne: They're being incompletely served. When I review my financial planning textbooks, I'm oftentimes reminded that it's like looking at countries. As with countries, there are hundreds of books. And like the United Nations, RIIA brings the collective knowledge of those books together; we think of the association as the U.N. of the financial services industry.

As such, RIIA synthesizes different schools of retirement research. They include the traditional school, which uses certain quantitative techniques, including linear regressions and Monte Carlo simulations, to draw conclusions about investments. This school of research is extremely investment management myopic.

What we did in collaboration with PwC [PriceWaterhouseCoopers] over the last few years is to develop a new school of retirement research. The PwC paper published in February, "Leveraging Behavioral Simulation to Enhance the Four Percent Rule," is the first public statement on this research; there will be many more.

The focus of the research analysis is not the market, but the client. Our school of retirement research, which we call agent-based simulation, operates along the same principles of a video game I once played, Sim City. In this game, you play the mayor of a city. The collective behavior of the city's citizens — the aggregate impact of their little sims — emerges as they interact with one another. That's what an agent-based simulation does. Similarly, using RIIA's retirement research tools, we can simulate the actions of the U.S. population or employees in a retirement plan.

Every agent in our model is represented by its own balance sheet, income statement, life history, risk aversion, risk profile, and so on. And we can run simulations both forward and backwards. This capability — akin to scrambling and then unscrambling eggs — is not possible in a traditional model. Thus, we now have a financial laboratory where we can test the effect of, among other things, legislation, regulation, and new product features and launches. That's the power of agent-based simulation.

Hersch: Can you speak in practical terms as to how RIAA's research and tools will translate into the work that life insurance and financial service professionals do in the field and how they can more successfully serve their clients?

Gadenne: Very simply, it means they need to work with a complete household balance sheet: all of the assets and all of the liabilities. And they need to be able to deduce from this comprehensive data set the appropriate product and plan recommendations for clients.

To that end, we urge them to get the RMA designation. This is part of our mission at RIIA: to identify, develop, validate and avail advisors of the tools they need to work with a comprehensive household balance sheet.

Hersch: In respect to life insurance and annuities, will we have to see new products or techniques to better leverage RIAA's research findings and tools?

Gadenne: The existing products are fine. What's needed is a framework for broadening the traditional retirement asset allocation of stocks, bonds and cash to incorporate retirement allocations: risk-retention, risk management, risk-pooling and risk avoidance. And it's within these retirement allocations that guaranteed protection products — solutions that can ensure that a client's fixed expenses in retirement are met — have a place.