A Nobel Laureate's Retirement Proposal

The Retirement Crisis? 
A physicist, a chemist, and an economist are stranded on an island, with nothing to eat. A can of soup washes ashore. The physicist says, "Let's smash the can open with a rock." The chemist says, "Let's build a fire and heat the can first." The economist says, "Assume a can opener."

Nobel Prize winner Robert Merton is an economist. He has published a paper in the current issue of Harvard Business Review titled, "The Crisis in Retirement Planning." Merton's proof of the existence of the crisis is that "putting relatively complex investment decisions in the hands of individuals with little or no financial expertise is problematic." As a result, "the seeds of an investment crisis have been sown." Without intervention, "catastrophe" will occur.

Thus, Merton has assumed a can opener.
I doubt the existence of that can opener. As I have written elsewhere, I have read many such claims of an impending retirement crisis but have yet to see convincing evidence that things are truly worse than in 1995, or 1980, or any other time in the American past. What's more, when I hear from retirees after I express such sentiments, they inevitably state that I am on the right track--that with a bit of planning, the retirement reality can be quite bright.  

For example, Linda Logan writes, "I have been amazed at how little it takes to live on if everything is already paid for. We're no longer saving for retirement, and we don't owe income tax. Our $46,288 income is way more than enough to cover necessities and more discretionary spending than we've ever done in our lives. Our nest egg just sits there, growing unmolested. The survivor may need to tap the nest egg when one Social Security income stream is gone, but for now we are more than fine."

Admittedly, Logan retired debt-free, which is uncommon. Most future American retirements will not begin with that advantage. Nor, I grant, will $46,288 in annual income--even debt-free--satisfy every reader's needs. (Yes, I've read the comments on previous columns.) But acknowledging that many retirements will not be as comfortable as Logan's, and that some may have higher goals yet, is not acknowledging an impending retirement crisis. When have things ever been otherwise?

Talking Income
On to the proposal.

Merton recommends that 401(k) plans be redefined, so that they save for a target income, rather than save for a target wealth amount.

He writes, "The [current] dialogue between the provider and the saver consists of regular reports on the value of the pooled fund, the amounts contributed, the annual returns achieved, and the size of the employee's share of the fund. The employee feels happy if the value and returns look positive, but he typically has little or no idea what the implications of this performance might be on the chances of maintaining his standard of living in retirement as measured by income – an outcome which, as I demonstrated earlier, may not at all be related to returns on investment."

"When employees try to become engaged and make decisions about their retirement, they are often confronted with very technical decisions, such as 'How much debt versus equity do you want?' or "How much exposure to large-cap European stocks do you want?' It's a bit like having salespeople ask car buyers what engine compression ratio they want … Fuel efficiency, speed, and reliability are the factors that car buyers care about."

Merton proposes to eliminate standard mutual funds from 401(k) plans, and thus the need for investors to choose funds. Instead, their contributions would automatically be funneled into a single investment option that is run to maximize the available income at the time of retirement. Merton describes this option as a flavor of deferred annuity, such that the employee who makes contributions at age 45 should be thinking in terms of buying a future income stream, but the 401(k) fund need not be annuitized. At the time of retirement, the employee could opt for a lump sum instead.

With this approach, writes Merton, "The customer need worry about three things only: her retirement goals, how much she is prepared to contribute from her current income, and how long she plans to work. The only feedback she needs from her plan provider is her probability of achieving her income goals. She should not receive quarterly updates about the returns on her investment (historical, current, or projected) or about the current allocation of her assets. Those are important factors in achieving success, but they are not meaningful input for the choices about income that the customer has to make."

In Response
I like the core idea of reframing the 401(k) plan as being about retirement income, not accumulated wealth. Wealth is something that can be used for any purchase, for example, buying a car with assets from a discontinued 401(k) plan. Projected retirement income, on the other hand, is dedicated to a purpose. Investors would likely be more reluctant to squander 401(k) proceeds on nonretirement items if it meant setting the needle back to zero for their projected retirement income.

That said, probability of success doesn't seem to be the right primary signal. You are 53 years old and hope to retire in 12 years. Inspired by Logan's tale, your income goal is $44,000 in today's money. You are told by your 401(k) provider that you have a 43% chance of achieving that target. If you contribute another 1% of salary, your chance increases to 48%. 

Helpful? Not so much for me. I'd prefer to see the income forecast. Show me that my current plan projects an annual income of $42,000 via the median percentile, with that figure rising to $43,000 if I boost my contribution. As supplementary information, provide some favorable and unfavorable cases, so I have a sense of the size of the uncertainty band.

The display, of course, is easy enough to adjust, so that is only a modest quibble. 

The larger quarrel is that much of Merton's proposal can be accomplished without taking the giant step of scrapping existing funds. Merton discusses using "financial technology" to construct a better investment option for maximizing retiree income than the existing default option of target-date funds, but he concedes that there are no guarantees that such technology will produce better results. "That value might be much more or much less than the value of the pot obtained through a wealth-maximizing investment strategy [i.e. conventional target-date funds]." 

In contrast, while Merton hedges his promise of improved investment results by the creation of a new fund type, he is certain about his proposal's communications benefits. As am I. But those can largely be grafted onto the current system. There's nothing preventing 401(k) plan providers, with the permission of plan sponsors, from emphasizing income projections in their presentations to 401(k) owners. Yes, changes in asset prices must be published. There's no escaping at least some discussion of wealth. But there is much that can be done to spread the gospel on retirement income.

Finally, it's worth noting that some of Merton's communication battle has already been won. Few of today's 401(k) investors worry about how much European large-cap stocks to own. The masses are now firmly entrenched into target-date funds, which simplify their investment decisions and which also help to prevent untimely redemptions. Merton is correct that switching from wealth statements to income projections would encourage better investment behavior. However, target-date investors are already among the very best behaved of fund owners, holding relatively fast during the 2008 bear market and then buying shares throughout the ensuing rebound. 

In summary, Merton neither demonstrates the existence of a retirement crisis, nor offers a proposal that would fix a crisis should it exist. His proposal does not restore defined-benefit plans, expand 401(k) plans to the tens of millions who now lack them, increase contributions into such plans, or reduce consumer debt. Those are the biggest concerns with retirement planning, as opposed to the performance of existing 401(k) funds or poor investment behavior by 401(k) participants. It is, in short, a modest proposal.

It's quite sound as far as it goes, however. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.