Advisors with clients in defined benefit retirement plans will want to take note of the latest missive from Robert Merton. According to the controversial economist most defined contribution pension plans have misplaced risk and left many retirees unprepared for coming retirement.
If Merton's name sounds familiar he was, of course, along fellow Nobel laureate Myron Scholes, co-founder and board member of Long-Term Capital Management. The infamous hedge fund made risky bets on the direction of the rouble, melted-down, was thought to have almost brought down the global economy before the U.S. Federal Reserve stepped in and took over the fund. So it is interesting then to see Merton back in the news
with a new warning about risks to current retirement investment practices.
According to Merton the general trend away from defined benefit pension plans toward defined contribution (DC) plans, has left many investors in trouble because these plans take a far-too-risky approach to retirement investments.
According to Merton, investors in DC plans become concerned only with return on their investments, or the size of the portfolio, and take on too much risk to as a way of chasing gains. The people in these plans have not been asking the right question--"How much will the investor need in retirement?"--the answer to which would lead investors to a different investment strategy.
To Merton the smartest thing a self-directed investor in a DC plan could do is not invest in government bonds, but rather in an inflation-pegged annuity. Merton suggests DC plan investors invest in a mix of stocks as well as bonds and deferred annuities. But over time the asset allocation should shift based on how much income they will need. At retirement the worker would have enough money to buy an annuity that would provide the target salary replacement amount. The retiree would not have to worry about running out of money as risk is shifted to the insurance company. A retirement is guaranteed like it was in a DB plan.
Merton lays out this thinking in a new Harvard Business Review article, found here
. The article is generating interest. As Merton says, "putting relatively complex investment decisions in the hands of individuals with little or no financial expertise is problematic. Research demonstrates that decision making is pervaded with behavioral biases...More dangerous yet is the shift in focus away from retirement income to return on investment that has come with the introduction of saver-managed DC plans: Investment decisions are now focused on the value of the funds, the returns on investment they deliver, and how volatile those returns are. Yet the primary concern of the saver remains what it always has been: Will I have sufficient income in retirement to live comfortably? Clearly, the risk and return variables that now drive investment decisions are not being measured in units that correspond to savers' retirement goals and their likelihood of meeting them. Thus, it cannot be said that savers' funds are being well managed."
One of Merton's criticisms: Current 401(k) regulations do not allow deferred annuities as an investment option, but should.