In this book, respected finance academic Milevsky turns his hand to the task of giving the person in the street the benefits of academic research into individual financial planning from the last few decades. Motivated by the rapid demise of private sector defined benefit pension funds, he aims to answer the concerns of people who now find themselves having to bear the risks previously borne by such financial vehicles: the investment risk, the mortality risk, the inflation risk and the longevity risk. These individuals need to have the tools to manage both the accumulation phase (pre-retirement) and the decumulation phase (post-retirement) of their investments. The real gem of Milevsky's book is its treatment of the latter. I can't think of another book with such an intelligent treatment of the decumulation phase.
The book starts out by nailing down the concept of human capital as central to financial planning. In particular, if we think of the capitalised value of your future income stream as an asset, it can be characterised as a stock or bond depending on the risk profile of your job. Hence the title.
Mortality risk is then treated. For an individual with a bequest motive, the natural insurable amount at any age will be the difference (if positive) between her desired bequest at that age and her financial capital at that age. And her desired bequest should be closely related to her human capital.
Having laid down the concept of human capital and its risk profile, we can then turn to investment risk. Here, Milevsky has much more to say, and notes that retirement planning success depends a lot on your strategy and products. One key element is the nature of your human capital – that it is important to recognise the bond-like nature (or stock-like nature) of your human capital and adapt your investment strategy to complement it.
Individuals need to diversify their investments over the universe of available choices. Diversification doesn't stop there – one should diversify over time as well. For an investor whose human capital is bond-like, this means investment in risky assets when young, gradually progressing to safe with age.
One should also be prepared to embrace leverage. Accepting the importance of human capital to our finances means realising the large stock of total wealth we hold when young. Investing a small fraction of that total wealth can well entail borrowing – that small fraction of total wealth will likely exceed our current financial capital. This means the young should be prepared to borrow and invest in risky assets (more so if you're like a bond, less so if you're like a stock).
The latter part of the book deals with the decumulation phase of one's wealth. This is the focus of much of Milevsky's recent research, and he has many interesting things to say.
In the decumulation phase of our lives, investment risk and inflation risk are still important, but concern over mortality risk will fade – more relevant now is longevity risk. Chapter Seven discusses the elements of longevity risk. The author points out that the idea of life expectancy isn't that relevant – we need to focus on conditional life expectancy; how long will I expect to live given I've survived to 67? These figures generate much longer lifetimes, and impress on one the importance of longevity risk.
Of course, when we hit retirement, we have to have some idea of whether our decumulation strategy is sustainable. Chapter Eight provides a formula – a function of age, portfolio return, portfolio volatility and your spending – to do exactly that.
Equipped with the knowledge that one's strategy is sustainable, we can turn to the issue of tailoring one's portfolio to deliver a successful decumulation phase. Milevsky suggests diversification again – diversification over products. The first product is simple – systematically withdrawing from our investments over our lifetime. However, as pointed out in Chapter Six, when we start withdrawing from our savings, then the sequence of returns we earn on our investment really matters – poor returns can devastate our portfolio. This means we need protection against investment, inflation and longevity risks. A portfolio of stocks and bonds alone isn't going to deliver this. To achieve this protection we have to turn to two products, one ancient, one thoroughly modern – the lifetime annuity and the variable annuity (with some form of guarantee).
A lifetime annuity can protect us against investment, inflation and longevity risk – but only once we've purchased it. In the years before we've done so, and in particular in that vulnerable phase in the run-up to our desired retirement date, we need to protect ourselves against the risk of our portfolio being wiped out, and necessitating us working well into what we thought would be our ‘golden years’. For this, we need a variable annuity with some sort of guarantee.
The utility and timing of this book is impeccable. Americans need help to plan their retirement – studies show that the level of financial literacy and sophistication in the US is alarmingly low among both the young and the elderly. Plus, given recent concerns over the cost of US public sector pensions, these public sector workers may well be joining their private sector colleagues in lamenting the demise of defined benefit pensions.
