Retirement saving and the principal-agent problem

retirement

Source: Flikr Creative Commons

‘Customers First’ to Become the Law in Retirement Investing read the headline in the New York Times. You’re first reaction might be, “it wasn’t already?” No, retirement planning grew out of the financial intermediaries that already existed in the 1980s, when retirement saving started to change radically.

Before the 1980s, the 3-legged stool was the metaphor for retirement saving. The legs were personal saving, Social Security, and company-provided defined benefit pensions.

The first two legs are still with us but the third has disappeared in private industry and is disappearing in the public sector. The 1980s saw defined-benefit pensions replaced by 401(k) and 403(b) plans. These are defined-contribution policies, i.e. a person puts aside a given amount each pay period, the money grows, and the retiree can draw on whatever the balance in the fund is at retirement.

Policy makers assumed that the financial services industry would respond to this change by creating a variety of vehicles in which families could put aside resources for the future. This happened, but these new services (e.g. money market mutual funds, brokerage firms geared towards individual investors) grew out of the existing universe of financial intermediaries.

Financial intermediaries such as commercial banks, investment banks, and brokerages, were set up to match up savers and borrowers and, most importantly, to make a profit for the intermediary. Take a look at this clip from Trading Places:

Just like the commodities brokers in the clip, financial advisers’ first duty was to their company’s shareholders or, if it was a partnership, to themselves.

The new rules are an attempt to deal with a classic economic issue: the principal-agent problem.  In this case, the retiree is the principal and his/her goal is to maximize their resources available at retirement.  The agent, here the financial advisor, is supposed to carry out the principal’s plans but if the incentives are not set correctly this won’t happen.

The new rules won’t solve the problem of lousy retirement planning, but it’s a step in the right direction given that we’ve set up a new retirement system over the past 30 years called YO-YO: you’re on you’re own.