Robert C. Merton

<article-ideainbrief class="article-ideainbrief">
 <h4 class="ideainbrief-title">Idea in Brief</h4>
 <div class="ideainbrief-contents">
  <h5>The Risk Problem</h5>
  <p>The move to saver-managed defined-contribution pension plans—most notably 401(k)s—has increased the likelihood of a pension crisis down the line as the baby boomers retire.</p>
  <h5>Why It’s Happening</h5>
  <p>Pension savings are invested so as to maximize capital value at the time of retirement, an objective imposed by regulation. But the goal of most savers is to achieve a reasonable level of retirement income. This mismatch almost guarantees that savings are badly managed, because an investment that is risk-free from an asset value standpoint may be very risky in income terms. At the same time, the defined-contribution process requires savers who often have little or no financial expertise to make complicated decisions about risk.</p>
  <h5>The Solution</h5>
  <p>Investment practice and regulation need to be changed to prioritize income security over capital gain, and communication needs to focus on variables the saver understands and give a clearer idea of the likelihood of reaching a given income target rather than emphasize investment returns.</p>
 </div>
</article-ideainbrief><p>Corporate America really started to take notice of pensions in the wake of the dot-com crash, in 2000. Interest rates and stock prices both plummeted, which meant that the value of pension liabilities rose while the value of the assets held to meet them fell. A number of major firms in weak industries, notably steel and airlines, went bankrupt in large measure because of their inability to meet their obligations under defined-benefit pension plans.</p>

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<p><span class="reprint">Reprint: R1407B</span> </p>
<p>Corporate America began to really take notice of the looming retirement crisis in the wake of the dot-com crash, when companies in major industries went bankrupt in large part because of their inability to meet their pension obligations. The result was an acceleration of America&#8217;s shift away from employer-sponsored pension plans toward defined-contribution plans&#8212;epitomized by the ubiquitous 401(k)&#8212;which transfer the investment risk from the company to the employee. </p>
<p>With that transfer has come a dangerous shift in investment focus, argues Nobel Laureate Robert C. Merton. Traditional pension plans were conceived and managed to provide members with a <em>guaranteed income.</em> And because that objective filtered right through the scheme, members thought of their benefits in those terms. Ask a member what her pension is worth and she&#8217;ll reply with an income figure: &#8220;two-thirds of my final salary,&#8221; for example. Most DC schemes, however, are designed and managed as investment accounts with the goal of accumulating the largest possible pot of savings. Communication with savers is framed entirely in terms of assets and returns. Ask a saver what his 401(k) is worth and you&#8217;ll hear a cash amount and perhaps a lament to the value lost in the financial crisis. </p>
<p>The trouble is that investment value and asset volatility are simply the wrong measures if your goal is to secure a particular future income. In this article, Merton explains a liability-driven investment strategy whose aim is to improve the probability of achieving a desired retirement income rather than to maximize the capital value of the savings.</p>

The Crisis in Retirement Planning

Reprint: R1407B Corporate America began to really take notice of the looming retirement crisis in the wake of the dot-com crash, when companies in major industries went bankrupt in large part because of their inability to meet their pension obligations. The result was an acceleration of America’s shift away from employer-sponsored pension plans toward defined-contribution plans—epitomized by the ubiquitous 401(k)—which transfer the investment risk from the company to the employee. With that transfer has come a dangerous shift in investment focus, argues Nobel Laureate Robert C. Merton. Traditional pension plans were conceived and managed to provide members with a guaranteed income. And because that objective filtered right through the scheme, members thought of their benefits in those terms. Ask a member what her pension is worth and she’ll reply with an income figure: “two-thirds of my final salary,” for example. Most DC schemes, however, are designed and managed as investment accounts with the goal of accumulating the largest possible pot of savings. Communication with savers is framed entirely in terms of assets and returns. Ask a saver what his 401(k) is worth and you’ll hear a cash amount and perhaps a lament to the value lost in the financial crisis. The trouble is that investment value and asset volatility are simply the wrong measures if your goal is to secure a particular future income. In this article, Merton explains a liability-driven investment strategy whose aim is to improve the probability of achieving a desired retirement income rather than to maximize the capital value of the savings.

The Crisis in Retirement Planning

Summary.

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