Managed DC® Solution
May 22, 2012
Pension plans are like cars, according to Nobel laureate Robert Merton. People want a car they can drive and a pension that will maintain their standard of living in retirement; they do not care about what goes on under the hood.
Advisors, however, must care. So when a new pension-like option hits the market, as Dimensional Retirement’s Dimensional Managed DC® recently did, it’s important to go beyond simply kicking the tires and carefully examine how it works as a retirement- saving vehicle.
In March, I heard the CEO of Dimensional Retirement (an affiliate of DFA), present the concept of the Dimensional Managed DC® at the RIIA Spring Conference in Chicago. DFA’s objective is to provide retirement income solutions based on life-cycle finance theory, as developed by Merton (and fellow Nobel Prize winner Paul Samuelson).
I’ll review life-cycle finance and how it differs from traditional modern portfolio theory, then explain Dimensional Retirement’s new offering and how I believe it will help investors.
Life-cycle finance
The Dimensional Managed DC® defined-contribution managed account solution is essentially an implementation of life-cycle finance theory, and understanding their approach must begin with a grasp of the theory’s key concepts.
Milwaukee-based financial planner Paula Hogan is among those who have documented the emergence of life-cycle thinking. In a May 2007 Journal of Financial Planning article, Life-Cycle Investing is Rolling Our Way, Hogan urged planners to get up to speed on life-cycle finance – or risk being left behind. She described how developments in life-cycle investing theory in the 1970s, coupled with innovations in derivative markets, set the stage for the emergence of a new “dominant paradigm” in 1990s institutional finance. Those changes, she argued, had begun shifting to the personal finance retail market.
For those interested in a more extended discussion of the theory than I provide below, Hogan’s article and a similar introductory article by Boston University professor Zvi Bodie in the January/February 2003 issue of Financial Analysts Journal both articulate the nuts and bolts of life-cycle finance theory very well.
Life-cycle finance developed as a more general case of modern portfolio theory (MPT) which can be applied to households. With MPT, investors aim to maximize wealth by seeking the highest possible returns given their capacity and tolerance for risk. They find a satisfactory point on the efficient frontier of suitable investments based on single-period asset class expected returns and standard deviations, which are generally estimated from historical data. For retirement planning, spending and asset allocation recommendations are based on historical or Monte Carlo simulations of failure rates, to mitigate the risk of wealth depletion that is inherent in drawing down a portfolio of volatile assets.
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