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By Christine Benz | 08-10-2011 08:48 AM

Target an Inflation-Proof Stream of Income for Retirement

Investors should worry about income, not total wealth, when assessing their retirement needs, says Nobel laureate Robert Merton.

Christine Benz: So, Professor Merton, you've talked about some shortcomings that you see in traditional defined-contribution plans. Let's discuss some of those?

Robert Merton: Sure. One has to look back a little bit of the history in connection of DC plans. They were traditionally for most people a supplemental addition for retirement, usually for people who were somewhat higher-income, who needed to save more than they would have in their company plans, which were typically defined-benefit plans.

And as supplements, we look at them in a different day than we do if they were at the core of retirement, which is where they are now looking like are going to be employed. And I would say that the limitations of them are that for the vast majority of people, vast majority, the challenges, the questions, or the decisions they have to make are very complex decisions. They are decisions they've never had to make in the past; they are decisions they can't make in the present or are not equipped to.

Benz: So, decisions like how much to save, how to asset allocate?

Merton: Yes.

Benz: Things that most people don't have experience with?

Merton: Absolutely, because if you think of that most people came from some kind of a retirement plan, a corporate retirement plan like a defined-benefit plan, where they never had to make any decisions, they never even knew anything about rate of returns and never even thought about it.

Benz: All being done behind the scenes?

Merton: All being done behind the scenes by their employer or the agents of their employer. Now we're saying to them, "OK, now it's your responsibility, and here is the problem you need to solve." The problem you need to solve is that you're going to have contributions made as a function of your income over the years you work, and those contributions have to be invested in such a fashion, so that when you reach retirement you will have sufficient resources to provide for a good standard of living for the rest of your life. That's a very complex set of decisions.

We who are professionals who do this for a living every day find this a very daunting challenge. The idea that millions of individuals are going to solve this problem or will be required to solve that problem is a bit daunting. And yes, as you said, they can get advice, and they should. But then they are in the role of whose advice do they take, where, and what do they do. If the advice given to them is that of "Well, what do you want to do?" frankly most people don't know, particularly when they are much younger, someone like yourself, you have so many years before you will retire, it's an abstract concept.

So, to say what do you want for retirement? The typical answer that I have seen is,  "Tell me what I probably going to need or want in retirement." They throw it back to you because they really don't know. So, that responsibility for this complex decision is pushed around.

I mean this is as if you're a brain surgeon or professor or auto assembly line worker, it doesn't matter. And indeed on top of that not only it is something that we are not equipped to do, but it's also something that most people don't like to do. There are plenty of people in the finance profession, when it comes to their personal savings for retirement, they turn it over to someone else rather than do it themselves. So that's the first thought.

The second is that the goal in retirement is to achieve enough to live on, not to get partial pieces. So, to do a good job of managing that money to try to achieve the proper goals, you need as much information as possible about all the assets of the individual. Historically, there are sort of three, as we'd say in the United States, legs of a stool through the retirement. (In the United Kingdom and Europe it's a little more sophisticated. They call the three pillars, but it's a same thing.)

These are the three sources of retirement funding. We have government. In our case in United States Social Security, employer plans which is the second, and then personal savings. And it's a mix of all of those to get to us our goal. Ideally, we would want to know all three. The third one is difficult, at least at this time because we just don't have the information.

Benz: On individuals' personal savings?

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