Stop worrying about asset value

March 7, 2017

4 minute read

Volatility and valuations are the wrong measures for retirement saving, says Robert Merton. Income stream is what the industry and regulators should look to as a benchmark

Although aged 72, Nobel laureate Robert Merton is far from retiring. The professor of finance (MIT Sloan School) provides a personal example when he argues people should retire when ready, not at a pre-set age.

“Some people can’t wait to reach retirement but I’m not one of them,” says Merton in a recent interview with PROJECT M, brushing aside the notion he should slow down. “When one reaches retirement age one needs greater opportunities to make intelligent choices.”

Meanwhile, in the years leading up to retirement, people need savings solutions that are smarter than what is currently on offer. Retirement plans suffer from a preference for assets over income, Merton criticizes.

“Investment value and asset volatility are simply the wrong measures if your goal is to obtain a particular future income,” he writes in a contribution to the Harvard Business Review (HBR). Yet these are the benchmarks cemented into the regulation of DC plans. In the US, disclosures highlight net asset value and its changes while “regulators in the European Union have even considered requiring minimum rates of return. But if the goal is income for life after age 65, the relevant risk is retirement income uncertainty, not portfolio value,” Merton writes in HBR.

In fact, such requirements would prohibit investments into vehicles that provide a reliable income stream. “Under regulations that set a minimum floor, retirement plan managers would not be allowed to invest savers’ funds in deferred annuities or long-maturity US Treasury bonds – the very assets that are the safest from a retirement income perspective.” In short: for retirees, risk should be defined from an income perspective and the risk-free assets should be deferred inflation-indexed annuities.

MAKE IT PLAIN

Managers do not necessarily need to buy annuities. “They should match the risk-free part of the portfolio in such a way that, on retirement, the employee would be able to purchase an annuity.” This kind of liability-driven investment already exists for institutional investors; it simply needs to be applied on the individual level.

If savers accept that retirement plans are inherently opaque then the only option is trust Robert C. Merton

Despite – or because of – his deep understanding of finance’s mechanics, Merton is no stranger to plain talk. In saving for retirement, individuals are too often asked complex question such as, “How much debt versus equity do you want?” This resembles salespeople asking car buyers what engine compression ratio they prefer when what matters to them are mileage, acceleration and reliability.

Merton bought his first stock at the age of ten in General Motors, allowing him to combine finance with his other great passion: cars. Throughout college and graduate school, young Bob Merton, as his late mentor Paul Samuelson used to call him, would rush to the brokerage houses by 6.30a.m., where he would trade stock, convertible bonds, warrants and over-the-counter options for hours before classes. What followed is an impressive career in finance.

JOGGING OR WALKING?

What irks Merton most is that, following the shift from defined benefit (DB) to defined contribution (DC) pension schemes, workers with little financial expertise are expected to understand complex retirement investments. “With DC plans, the responsibility falls on the member. They are asked to make decisions for which they are largely unprepared,” Merton explains.

In his opinion, the idea that people are able to manage their retirement funds isn’t realistic. “If I’m having a knee operation, should the doctors ask me whether I want titanium pins or stainless steel ones inserted in my leg? It doesn’t make sense.”

Robert C. Merton

Born in 1944, Robert Cox Merton’s achievements include the first continuous-time option pricing model, the Black-Scholes formula, which secured him a Nobel Prize in 1997. He is a School of Management distinguished professor at the MIT Sloan School in Cambridge, resident scientist at Dimensional Holdings Inc. and university professor emeritus at Harvard University

Instead, savers should be presented only with decisions that are meaningful to them. Namely, the financial equivalent of asking whether a patient wants a standard knee operation or a more complicated, expensive one that would allow him to go jogging in the future.

Secondly, retirement providers should help set sensible goals, so that a saver is left with no more than three concerns: his retirement income goals, how much he is able to contribute from his salary and how many more years he plans to work. And the only feedback he needs from his plan provider is how likely he is to achieve these goals.

The next step is to strengthen trust in the financial industry. “Before surgery, the surgeon could show me a history of the surgeries he performed, a list of all the tools he is going to use and the surgical procedures he is going to take,” says Merton. He then adds, “But that wouldn’t mean anything to me. If savers accept that retirement plans are inherently opaque to them then the only option is trust.”