“Meeting the global challenge of funding retirement” –Highlights of Robert Merton’s CFA Institute seminar

In a nutshell-

In this 90 minute CFA Institute seminar, Nobel prize winning Professor Robert Merton tackles some of DC pension plans’ well known but unresolved deficiencies in a holistic approach to the mass/working class pension. He sets the stage by pointing out that, in the shift from DB to DC average workers were by default left with the impossible task to manage their investments themselves to retirement success. Then, recognizing the reality of an unengaged participant, he proposes a new pension solution which has a goal of maximizing the chance of maintaining inflation protected retirement income close to spending levels in working years while assuring some specified minimum income level. The proposal is a total solution because it takes a goal-based mass customization approach to the retirement income problem using individual accounts; the solution is individually customized as it factors in the individual’s goal, age, and gender and it is a solution to the mass/working class pension as it incorporates all assets/incomes (Social Security, DB pension, DC pension and human capital or future earning potential). The asset allocation is done dynamically. The annual feedback to the participant, in the form of the probability of achieving the goal, also comes with three knobs that a little more engaged participant can optionally adjust to increase probability of success: save more, retire later and/or increase risk. No individual financial plan is required, as long as the participants meet the specified profile. While the proposed solution comes without guarantees, one can quickly grasp its superiority over current approaches to DC plans.

The approach

Professor Merton notes that the goal is expressed in terms of real income not assets, and spends considerable time to explain that correspondingly the only meaningful measure of risk can only be in terms of income (not assets).

The individually customized portfolio is dynamically optimized to maximize chances of achieving a goal; a goal for example might be a desired $40,000/year income (from all sources) but a minimum of no less than $20,000/year. The optimization makes no effort to exceed the $40,000 income; instead the approach is to focus on maximizing the chance of achieving the goal of $40,000/year as well as protecting the minimum of $20,000/year.

He points out that that the target-date funds (which increase fixed income allocation purely on the basis of age) currently used as DC plan defaults are suboptimal as age is an insufficient determinant of asset allocation.

The annual feedback to each individual comes in very simple form: a number which represents the probability of achieving the goal. Most of his proposed approach is based on no “help” from the individual, except to initially set the goal and provide some minimal personal context like age and other sources of wealth/income (Social Security, DB plans, DC plans, and human capital).

However with the annual feedback also come three knobs that a little more engaged participant can optionally adjust: save more, retire later and/or increase risk (by reducing the minimum in the goal statement). Note that these knobs have nothing to do with return, standard deviation, interest rates, asset allocation, and other such things which he argues that most participants do not understand nor can control.

The dynamic asset allocation is done with an objective function used for the optimization. The minimum specified annual income pretty much has to be implemented by assets which are risk-free in terms of income (e.g. TIPS with duration matched to the minimum income stream desired- i.e. asset liability matched); the risky part of the portfolio is implemented with some optimal composition of the risky assets selected by the provider (e.g. equities, REITs, etc). Then the risk-free and risky assets are mixed dynamically to achieve goal.

In response to a question on whether providers will be willing to take responsibility of some sort for such an offering, Professor Merton opined that fiduciary level of care, whether required or not today, will be a requirement in the future. So while such a product does not offer explicit guarantees, the provider will likely have some implicit responsibility.

Bottom line

Professor Merton emphasized that this is not an academic proposal, but it is already a commercial product. This product, though not universally applicable, is designed to deliver a mass customized solution to the unengaged mass/working class pension problem in the form of a retirement income (total) solution which can be fine tuned to meet different (cultural and other) contexts across the globe. There is no individual financial plan required, as long as the participants meet the specified profile.

Ii is highly recommended to all those interested in the definition/delivery of retirement income solutions to watch the video not just for the specific proposal, but for the clarity of the explanations of: risk and its management, the mechanism of setting appropriate and understandable goals, recognizing and accounting for the reality that the vast majority are unengaged and few are capable/interested in dedicating the necessary effort/attention to achieve their retirement goal, and how to define meaningful/motivating feedback and a set of drivers for those who would care to engage enough to try to increase probability of achieving the desired goal. I hope to have done justice to his solution presented in the seminar (I was unable to read all of the slides); if you watch it and think otherwise I would appreciate hearing from you.

You’ll note that in the limit where the desired and minimum annual incomes are the same, either because  the individual has no discretionary expenses or because the individual has insufficient assets/income to service the anything beyond the required expenses, the implementation essentially appears to default to asset-liability matching with TIPS which was Professor Bodie’s recommendation through a narrower lens in “The long-run risk of stock market investing: Is equity investing hazardous to your client’s wealth?”. For comparison another mass market approach to retirement income generation used by millions of American whose employers hired Financial Engines to manage their DC plan is described in WSJ’s “How to cash out in retirement” . It also approaches the problem from an asset-liability management (ALM) perspective; retirement starts with 80% bonds and 20% stock which is deployed as follows- “65% bonds to create a payout from 65 to 84…a further 15% also goes into bonds, but it’s considered a “longevity reserve”” to be transformed into an annuity at age 85, and 20% stock allocation is gradually reduced to zero with age.

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2 comments

  1. Some questions remain after reading (only) the CFA presentation-slides and after a quick read through the papers and the presentation here:

    http://www.dfaus.com/mdc-presentation.html

    – How should an employee handle moving to a new occupation / hiring at a new employer?
    – What happens once someone looses his job too early?
    – Are the three (main?) offered alternatives to steer the plan outcome enough real-options?

    Best regards

  2. For some reason I am having some problem with the link you provided, but if I understand your questions correctly the Merton proposal:
    -is intended to be (or could be) implemented as a 3rd party proposal, so if employee changes employers there should/could be no reason why contributions could not continue seamlessly with the new employer
    -if job is lost, contributions stop and clearly would be a setback, but again as in the above point once new employment is found contributions could continue and remember this is still a DC plan, what this offers among other things is “optimal (in some sense)” asset alocation toward the desired goal…but no guarantees
    -makes the point that most participants don’t know how and/or are uninterested to work on the problem, so to maximize the chance of participant involvement he suggests the three simple but meaningful adjustments to the average paticipant

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