Saving for retirement: investing beyond our life expectancy

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Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.

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A report published by the French equivalent of the UK’s Central Advisory Committee on Pensions and Compensation notes that in retirement, “most French households aged 70 and older save and they save about as much as the rest of the population in proportion to their income,” as shown in the graph below (extracted from the report).

Exhibit 1: Savings rate in 2003 according to the age of the specific person, before and after financial aid (in cash) has been taken into account

alain jaques exhibit 1

Sources: INSEE, National Accounts 2003, Survey SRCV 2004, Fiscal revenues 2003, Family budget 2006, Housing 2002, Health 2003 and author’s calculations, from Accardo et al. (2009).

This observation contradicts conventional economic theory, which holds that during retirement, households will dip into their savings to offset the drop in income and maintain their standard of living.

How do we explain this paradox? 

Life-cycle theory assumes that the average household has constant needs. It would appear, however, that this is not the case:

1. The transition to retirement involves a decline in consumption that goes beyond the decline in income, notably for spending on food and clothing, even if new needs, such as health insurance, become apparent.

2. Provision of financial support for children ends (although this generally takes place before retirement).

3. A fall-off in discretionary spending on outings, holidays, leisure, but an increase in consumption of new goods and services for the home such as domestic help.

The decline in needs toward the end of the life cycle gives way to residual saving in the most elderly households, at least as long as they can remain autonomous and stay in their homes. This is driven by two motives: precautionary savings (in the face of possible increases in health-related costs and above all the loss of autonomy) and the desire to transmit family wealth to one’s heirs.

What lessons can we draw from this with regard to the constitution of retirement savings? 

In the article published on this blog and entitled “The retirement savings paradox in France” we noted that there was a strong misalignment between the performance objective for retirement savings and the products in which the French invest for retirement. It was apparent, that French savers invest in short-term products although they have a long-term investment horizon. In doing so, they forego significant additional performance potential.

In reality this misalignment is even more apparent if we take the findings from the report by the Conseil d’Orientation des Retraites (COR – Council for Retirement Guidance), which shows that retirees continue to save during their retirement. The investment horizon for at least part of the pension savings, namely that part intended for transmission as an inheritance should by nature be much longer than the retirement age, knowing that in France the life expectancy at retirement is 27 years for women and 23 years for men (according to a study by the OECD published on 1 December 2015). We are therefore talking about a very long term investment horizon which can reach approximately 40-50 years.

Under these conditions it seems more than reasonable to take risk on a significant portion of the savings. Consider the emblematic example of US equities which offer sufficiently long historical data. We can see in the chart below, which shows the average performance of US shares based on the length of time they are held, that the stocks can behave erratically over the short-term with strongly negative or positive performance. However beyond a holding period of 10 years one sees that the average annualised performance was significantly positive with low variability. Beyond 16 years, the observations show a minimum performance of above 1%, so there is never a loss of capital.

Exhibit 2: Annualised total return, US equities (%) 1900-2014

alain jaques exhibit 2

Source: BNP Paribas Investment Partners

Once we have accepted that it was rational to be exposed to equities within the framework of the constitution of a pension savings plan, the question remains: to what extent and in what form? Obviously each case is different and must be analysed as such. Nevertheless a simple and efficient response would be to use target date funds, usually starting at 100% exposure to equities until about 20 years from the age of retirement, and gradually reducing the equity exposure as one approaches retirement age, to finish with an allocation between a zero and 5% . If we consider that retirees retain some of their savings for transmission to the next generation, it would mean that a part of their pension savings be invested in funds with a horizon equal to the number of years up to the date of theoretical retirement PLUS life expectancy at retirement (27 years for women and 23 years for men). A higher risk alternative would be to invest that portion intended for transmission to heirs in equity funds, knowing that the heirs themselves are likely to need a long investment horizon for part of their savings …

Alain Jaques

Product Strategy Manager, Retirement Specialist

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