Merton on retirement incomes


Jason Collins


June 4, 2015

There is a neat article by Robert Merton (from July last year) in the Harvard Business Review on the shift to defined contribution plans when saving for retirement.

There are two major types of retirement savings arrangements. The first is defined benefit pension plans. Under these plans, a set income is paid to retirees based on factors such as years of service and final salary, with the income paid until death. These were once common, but they are now rare.

Today most of us are in a second type of arrangement, defined contribution plans. Under these, we contribute a proportion of our income to a retirement fund. Our retirement income is dependent upon our contributions and the performance of that fund. In Australia, we are required to contribute 9.5 per cent of our income to a superannuation account.

When I get a statement from my defined contribution fund, it tells me about my contributions, the asset value and the fund returns. There is no mention of the retirement income I might be able to obtain. I also have a choice of asset allocations, which are defined in terms of risk to the asset value. But as Merton points out, this is where things start to go wrong.

The trouble is that investment value and asset volatility are simply the wrong measures if your goal is to obtain a particular future income. Communicating with savers in those terms, therefore, is unhelpful—even misleading. To see why, imagine that you are a 45-year-old individual looking to ensure a specific level of retirement income to kick in at age 65. Let’s assume for simplicity’s sake that we know for certain you will live to age 85. The safe, risk-free asset today that guarantees your objective is an inflation-protected annuity that makes no payouts for 20 years and then pays the same amount (adjusted for inflation) each year for 20 years. If you had enough money in your retirement account and wanted to lock in that income, the obvious decision is to buy the annuity.

But under conventional investment metrics, your annuity would almost certainly look too risky. As interest rates move up and down, the market value of annuities, and other long-maturity fixed-income securities such as U.S. Treasury bonds, fluctuates enormously. In 2012, for instance, there was a 30% range between the highest and lowest market value of the annuity for the 45-year-old over the 12 months. However, the income that the annuity will provide in retirement does not change at all. Clearly, there is a big disconnect about what is and is not risky when it comes to the way we express the value of pension savings.

So what does that mean for fund managers ?

The particulars are, of course, somewhat technical, but in general, they should continue to follow portfolio theory: The investment manager invests in a mixture of risky assets (mainly equity) and risk-free assets, with the balance of risky and risk-free shifting over time so as to optimize the likelihood of achieving the investment goal. The difference is that risk should be defined from an income perspective, and the risk-free assets should be deferred inflation-indexed annuities.

Then there is the consumer side of the equation. As a start, financial advisers should be asking what are the consumer’s retirement_ income_ goals and what action would need to be taken to meet them.

But rather than suggesting the adviser try to educate the consumer about the technicalities of this decision, Merton suggests more consumer engagement may not be a good thing.

Consumer education is often proposed as a remedy, but to my mind it’s a real stretch to ask people to acquire sufficient financial expertise to manage all the investment steps needed to get to their pension goals. That’s a challenge even for professionals. You’d no more require employees to make those kinds of decisions than an automaker would dump a pile of car parts and a technical manual in the buyer’s driveway with a note that says, “Here’s what you need to put the car together. If it doesn’t work, that’s your problem.”

It might even backfire.

Experience also suggests that customer engagement in investment management is not necessarily a good thing. People who are induced to open a brokerage account in their IRAs often become very active in investing for their pension, trading stocks around the world on their computers after work. This is far from a good idea; such short-term trading will not improve the savers’ chances of successfully achieving retirement goals—in fact, it will diminish them.

This is, after all, why we have financial professionals - there is a need for (and benefit to) specialisation and trade.

It is fair enough to expect people to provide for their retirement. But expecting them to acquire the expertise necessary to invest that provision wisely is not. We wouldn’t want them to. We don’t want a busy surgeon to spend time learning about dynamic immunization trading instead of figuring out how to save lives, any more than we would want skilled finance professionals to spend time learning how to do their own surgery.

It is interesting that Merton uses automotive and medical examples. People are often wary of trusting mechanics. In medicine, it is hard to asses surgeon quality before an operation, and we receive almost no reliable feedback on whether they did a good job (unless they accidentally leave an instrument in you). If anything, the trend in medicine is for people to become more educated (hello Google) about what services they are about to receive rather than completely letting go and trusting the medical professional.