Creating Individual DBs With State Support

Arun Muralidhar is the academic scholar adviser at the Center for Retirement Initiatives at Georgetown University, adjunct professor of finance at George Washington University, and founder of MCube Investment Technologies and AlphaEngine Global Investment Solutions.

Given his expertise in the areas of workplace retirement benefits coverage and investment markets, Muralidhar was asked to speak Friday, during a meeting of the Connecticut Retirement Security Board. Before the meeting, he took some time to explain to PLANSPONSOR the positions he would argue, most notably a proposal for forming state-supported individual defined benefit (DB)-like investing programs.

By way of background, Muralidhar noted he has been following retirement security issues for much of his career and has had the benefit of working with many skilled colleagues, including Nobel laureates and other celebrated researchers. He says he has little doubt—and there is little doubt among his esteemed peers—that a retirement security crisis is looming globally. Without concerted action from the private sector and local and national governments, he says it’s unlikely the crisis will be avoided.

“The pillars of retirement security are threatened because of insufficient funding, improper investment decisions and the transferring of risk to individuals who are least capable of bearing such risk,” he says.  

Retirement planning was never easy, even in the context of large, corporate-sponsored defined benefit plans, Muralidhar says, but in earlier times much of the challenging decisionmaking was left for trained financial experts, either working for investment providers, consulting firms or directly as pension fund administrators. Now, the defined contribution (DC) system is being called on to replace closing DBs, leaving wholly unprepared individuals responsible for everything from picking a salary deferral to choosing investments and, eventually, an appropriate withdrawal rate.

“Beyond this, there is a really apparent coverage problem for many private-sector workers,” Muralidhar adds, citing studies that show as many as half of all private-sector workers lack access to a workplace retirement plan. He also points to funding issues for Social Security and the ever-expanding cost of medical care for both workers and retirees, heaping still more pressure on individual decisionmakers.

 NEXT: So, what is the answer

At the White House Conference on Aging, President Barack Obama noted that, in every budget since taking office, he has put forth proposals to provide access for 30 million Americans to workplace-based retirement savings by requiring employers not currently offering a retirement plan to automatically enroll their workers in an individual retirement account (IRA).

He pointed out that, in the absence of Congressional action, states are leading the charge. Several have passed measures to create a state-run plan for private-sector employees. However, the president says states remain concerned about a lack of clarity regarding pre-emption by the Employee Retirement Income Security Act (ERISA), so he has urged the U.S. Department of Labor (DOL) to publish a proposed rule clarifying how states can move forward, including with respect to requirements to automatically enroll employees and for employers to offer coverage.

Taking all this together, Muralidhar says that encouraging momentum is building for the type of concerted government action that will likely be required to cut off a retirement security crisis in the U.S. Also important, he says, people are realizing simplicity will have to be a big part of any effective solution, given that untrained individuals will be called on to use them. Not to mention the fact that people are already inundated with choices and are generally intimated by complex financial products. 

“Continuing in this vein, I will be making the case that capital markets are missing a very simple and basic financial instrument, what we call a Forward Starting Bond or FSB, that can help institutional and retail investors achieve their retirement objectives at lower risk than portfolios created through a mix of traditional stocks and bonds,” he says.

Sounds a little too good to be true, perhaps, but Muralidhar hastens to add that his solution is in fact not all that revolutionary. Details will have to vary state by state, but in essence he is advocating for a bond that resembles a delayed annuity that will be issued by the states/federal government and will allow people “to create their own individual defined benefits.”

In a draft paper shared with PLANSPONSOR, Muralidhar lays out the inner workings of an FSB.

The instrument operates on the assumption that the “typical saver” sets aside resources at regular intervals today to receive a stream of income post-retirement, generally until death. No affordable or effectively portable instruments exist in the market today to match such a profile, he says, “and hence all attempts to recreate this profile through traditional stocks and bonds, or purchase such a profile through annuities, are suboptimal or expensive, thereby threatening retirement security.”

Muralidhar says the FSB will provide “a much needed bridge between the uses of funds and the asset markets.”

In terms of its basic design, he explains that the FSBs will be constructed as a series of real bonds issued at different forward starting dates (five years, 10 years, 15 years, etc.). “The term of the bond will be linked to the life expectancy in the economy post-retirement, and can be updated periodically.” There would be two possible versions of this instrument, Muralidhar says, including a coupon-only version and a coupon bond with principal repayment.

“Under the coupon-only version, essentially, for an upfront payment today to the issuer, the investor secures a guarantee of a fixed income from this instrument for a period of 20 years,” he says. “The benefit of the coupon-only version, by foregoing the principal payment, is that it can offer higher coupons … Based on the desired income of an investor who plans to retire in two years, five years, 10 years or 30 years, and based on the implied rate of return [and therefore price of the FSB], the investor’s problem of how much to save is greatly simplified. As long as there is sufficient liquidity in the instrument, the investor’s decisions is now just focused on how much to save in every year of his working life to achieve this target income [given the uncertainty of interest rates].”

Muralidhar says, in principle, as long as the investor is not income-constrained, his desired retirement income path can be hedged away under this model at low cost and without other issues currently associated with annuity investments.  

“As more and more of these instruments are issued, the entire yield curve will be filled out … thereby allowing individuals seeking to retire on a particular date to purchase the relevant FSB,” he says. “Assuming that these instruments have sufficient credit quality, they could be very liquid—much like current nominal bonds—and will have a very transparent price and could be traded at low cost.”

Again pointing to his background in the field, Muralidhar says he understands his proposal would have to jump a staggering number of hurdles before making a national impact, but he remains optimistic that the simplicity of the solution will carry it forward. He also points out that, given the strength and competitive nature of the investing and insurance industries, there are numerous potentially willing suppliers of such bonds already completing the market.

“I believe this is a simple instrument to create, and it achieves the goals of the average investor, thereby simplifying the investment decision, reducing the risk of achieving a target retirement income, and lowering the complexity and costs of investing assets—as it removes the need for intermediaries and complex investment approaches,” he concludes.