Pensions and the Stockdale Paradox

Squadron Commander James Bond Stockdale (later Vice Admiral of the United States Navy) was shot down over North Vietnam in September 1965. He was held as a prisoner of war for seven years. During that time he was horrifically beaten and tortured, had his back and leg broken, shoulders pulled from their sockets, but he survived and was ultimately released in September 1973.

In the book Good to Great, the author James Collins discussed the Vietnam experience with James Stockdale and he asked Stockdale about his coping strategies. Stockdale replied: "I never lost faith in the end of the story, I never doubted not only that I would get out, but also that I would prevail in the end and turn the experience into the defining event of my life, which, in retrospect, I would not trade."

Then Collins asked who didn't make it out of Vietnam, and Stockdale replied: "Oh, that’s easy, the optimists. Oh, they were the ones who said, 'We're going to be out by Christmas.' And Christmas would come, and Christmas would go. Then they'd say, 'We're going to be out by Easter.' And Easter would come, and Easter would go. And then Thanksgiving, and then it would be Christmas again. And they died of a broken heart."

Stockdale then added: "This is a very important lesson. You must never confuse faith that you will prevail in the end—which you can never afford to lose—with the discipline to confront the most brutal facts of your current reality, whatever they might be.”

So Collins coined the term the Stockdale Paradox. It is fundamental to survival and success to face the facts, and not depend on blind optimism.

What has this got to do with pensions? We as a nation and an economy are going through a very tough time at the moment. The impact on pension schemes generally of the investment market falls in 2007 and 2008 has been considerable. The vast majority of pension schemes have their assets invested on behalf of the scheme members in managed investments such as stocks and shares, Government bonds, commercial property and cash. Most pension investments fell in value during 2007 and 2008. Although there was a strong recovery in 2009 and into the early part of 2010 it is fair to say that many funds are still below their pre-fall level. Trustees of defined benefit schemes must look very carefully at the investments behind their schemes, and must take a very realistic view of the action that they need to take to ensure that their schemes cover their pension liabilities.

Members of defined contribution schemes and personal pension plans must review their current fund values and contribution levels and take a very realistic view of the likely pension benefits they could realistically expect at retirement. I would urge such reviews to include a pessimistic rather than an optimistic assumption regarding future investment returns and inflation. Too often in the past high projected returns lulled pension scheme members into a false sense of security regarding the amount of pension contribution they should make. If you are targeting a specific size of fund at a specific target retirement age, the main variables affecting your target fund are the size of the annual pension contribution, the investment returns generated by that contribution, and the inflation rate assumed. So if you are too optimistic about the assumed investment return the amount of pension contribution required would be smaller.

My advice is to assume low rates of return and take a more realistic view of the amount you should contribute towards your pension. There is no doubt in my mind that in Ireland we substantially under-provide for pension – our average contribution rates are just too low. Tax reliefs are generous, so the State encourages pension contributions. Contributions are generally fully deductible against tax, the investment funds themselves grow free of tax, and you can draw out a portion of your fund at retirement as a tax-free lump sum, so there are plenty of tax breaks to encourage pension provision. Unfortunately a too-optimistic view of investment returns will lead to contribution levels being lower than they should be, and will also lead to disappointment when investment markets fall (as they do from time to time).

By the way, you can generally also decide on the level of investment risk being taken by your pension, and I would encourage everyone to look carefully at the funds behind their pension. Does the investment risk profile of the fund match your own attitude to investment risk? What funds are available to your pension plan for fund switches?

How diversified is your pension fund? There are many excellent diversification options available now. For example, French leaseback properties can now be part of a diversified pension portfolio. Many investors are drawn to French leasebacks because of good, stable rental returns, and the leaseback model has been operating successfully in France for many years now.

You can select an investment fund with little or no investment risk if you wish. This is particularly important if you are coming close to retirement.

You can select an investment with lots of exposure to investment risk; you can even directly select particular stocks and shares via self-directed and self-administered pension schemes, if that is what you want.

So there are lots of investment options available – my message is to take a realistic view. Look carefully at your own pension fund and the investments behind it. Then look at your contribution level. Take a look at the projected pension at retirement (but based upon lower rather than higher growth assumptions). If your projected pension is lower that you would like it to be then the gap must be corrected by higher contribution levels between now and retirement, rather than a vague hope that the investment markets will correct it for you. Take control, and use the tax breaks to help you bridge the gap!

Pensions and the Stockdale Paradox

By: Tony Gleeson B.Comm., AIIPM,

Executive Benefits Limited