Christine Benz: So, one other issue I want to discuss with you is when people exit the 401(k) setting, they are in retirement, and they are trying to figure out how to draw down their assets. Do you have any thoughts on how that process might be handled better? Are there any guardrails that could be put in place to help people in that position?
Robert Merton: That's a very good question, and it's quite important. One because of course the end result of all of this is to take care of people in retirement, and if you get all the way through the accumulation phase and then don't use the funds you have accumulated in a way it's best, you have sort of lost out in the last leg of the race. And also because people are living longer in retirement, their lifestyles change.
Benz: Cognitive functioning also declines pretty significantly after a certain age and so people are managing these assets when they are maybe not in a position to do it well.
Merton: I think it's a process that begins during the accumulation period. I don't believe in formal education for people; it's not reliable in the sense that people are going to go and read books. Some will, some won't. Some will understand it. What I think is that, for example, in the Dimensional Managed defined-contribution plan that we do, the targets and everything that are expressed to people are always expressed in terms of income in retirement, not a set amount of wealth, or we'd never mention a rate of return. So, there is a certain amount of income.
Now, if people have gone through that system through many, many years in the accumulation period, it is more likely, not assured, but more likely when they get to retirement that their mindset is going to be about getting that amount of income or some amount of income. They'll be income-oriented. If instead, as is done typically now, the focus is on the amount of money…
Benz: Getting that kitty to be as large as you want it to be.
Merton: Yeah, and you get there, then to say by now you need to switch to thinking about income, it's like anything else--that's not going to be, I think, as effective. So, part of it really begins in the right mindset. Now, when you get there, we target in our solution a stream of income for life, which is like a annuity--that may you live to 120 we'll cover you--that's protected for inflation, so that it can preserve the standard of living at that level.
When they get there, if we've done our job they'll have enough to purchase that annuity, once they retire, from a highly rated insurer or several of them. But they don't have to, and it may not be the best to answer for everyone. So, you can still take any or all of that money and use it for other things. You can invest it in different things; there are all kinds of plans. There are notions of buying tail insurance should you live so long. So, sometimes what people do is they've suggested if they retire at 65 that they buy annuity that starts at 85.
Benz: Longevity insurance?
Merton: It's longevity insurance, and then they live off that. That's a certain possibility and will fit some people's needs, and it's clear that people will have probably a need for some amount of cash that they can have access to, that they might need for an emergency and so forth. That said, I still think that for the vast majority of people working in the middle class who are not poor, they are doing fine. But they don't have a lot of extra money--as if anyone does, but you know what I am saying--they are going to find that the so called mortality credit of an annuity is going to be very difficult not to use at least to some large extent.
And what I mean by that is the following: If you have a certain amount of money at your retirement, again let's just say $1 million so I can talk about it, and if the interest rates protected for inflation--what we call real rates--were 2%, then just holding that money and locking and buying this and holding onto it, they can earn 2% or $20,000 a year.
Benz: In a certificate of deposit or something like that?
Merton: Well in an inflation-protected, long-term bond. But so it would pay $20,000 a year. By the way this points out just how much you need to accumulate if you take account of inflation. We think that $1 million is a lot of money and it is, but if you wanted to just live off the interest and keep the principal, it's $20,000 a year.
If, and again don't hold me precise to the number, you had a well-functioning group with life insurance and so forth and it was well-designed, for a single life--meaning that as soon as the person passes away, they gets nothing more, no more benefits that are beneficiaries--the number might be something around 6% or $60,000 a year.
Benz: Due to that mortality risk pooling.
Merton: Right, you have a choice. You could take your $1 million, earn 2% a year, $20,000 a year and when you pass away, the $1 million goes to whomever you want. Alternatively at the other extreme, you could buy a $1 million of an annuity, and you would get about $60,000 a year for the rest of your life. No matter how long you live, it never stops. But, when you stop living and don't need the money anymore--because I hope you are going to a better place--you give up whatever value might there.
So, those are the real choices and for most people. They don't have the luxury; they won't have the accumulation that allows them to live off the 2% versus the 6%. So, I think that what we will see, as this is core retirement, that it's going to look like again the kind of benefits in the past that you had from a defined-benefit plan--which in United States sadly was not protected for inflation, so they are different--but where you receive income for life, but only for as long as you live, with no residual value.
So, it will be some mix of those two, and it's important to say that it will be different. For example, if I have nobody that I want to leave any money to, I surely want to annuitize because any money I leave behind will be wasted.
Even if I had people I want to leave money to, I might be better off to take a portion of my money. Say in the example I gave, where you can get 2% versus the 6%, if I had $1 million, I could buy a 33 1/3% of it or $333,000 in the annuity at 6%, which gives me $20,000 a year. That's the same as if I had just held on to the bond, in that $20,000 a year, but now I have $667,000 left over that I could give to you if you were my beneficiary right now.
So, the point is that the decision of how much you might want to leave to someone else, or bequest, should be done separately from what you need for your own retirement--and in most cases, people who have a spouse conduct a joint retirement together; they see themselves as a unit. It's those things that need to be done. So there are wide variety of choices, and there are going to be more of them. I just think as a practical matter, we're going to find that most people, who come to assist based on principally the defined-contribution plan, are going to need to do the annuity just because the mortality credit allows them to live when they need the money. They give up the money when they don't need it when they are no longer here, in return for having more money when they are here.