A new Harvard Business Review piece, written by Robert C. Meron, the 1997 Nobel Prize winner in Economic Studies and Harvard University Professor Emeritus, is so important that I wanted to share parts of it with you. Here I will share excerpts in italics with my comments added in Bold.
The Crisis in Retirement Planning – Robert C. Merton
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.
As I have mentioned before, fewer retirees can depend on company-sponsored pension plans for their retirement income and those who still have them are seeing those plans promise lower payouts.
The result was an acceleration of America’s shift away from defined-benefit (DB) pensions toward defined-contribution (DC) retirement plans, which transfer the investment risk from the company to the employee. Once an add-on to traditional retirement planning, DC plans – epitomized by the ubiquitous 401(k) – have now become the main vehicles for private retirement saving.
But although the move to defined-contribution plans arguably reduces the liability of business, it has, if anything, increased the likelihood of a major crisi down the line as the baby boomers retire. To begin with, 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 shoft in focus 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 has always 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.
Professor Merton is making clear that the thought process, mechanics, and decisions made during the accumulation/saving phase of life need to be very different than during retirement. Not making that critical transition is leading scores of people toward a retirement planning crisis.
Traditional defined-benefit pension plans were conceived and managed to provide members with a guaranteed income. And because this objective filtered right through the scheme, members though of their benefits in those terms. Ask someone what her pension is worth and she will reply with an income figure: “two-thirds of my final salary.” For example. Similarly, we define Social Security benefits in terms of income.
The language of [401(k)] plans is very different. Most plans are designed and operated as investment accounts, and communication with savers is framed entirely in terms of assets and returns. Plans’ annual statements highlight investment returns and account value. Ask someone what his 401(k) is worth and you’ll hear a cash amount.
The trouble is that investment value is simply the wrong measure if your goal is to obtain a particular future income. Communicating with savers in those terms, therefore, is unhelpful – even misleading. To see why, imagine that you are a 45 year-old individual looking to ensure a specific level of retirement income to kick in at age 65. Let’s assume for simplicity’s sake that we know for certain you will live to age 85. The safe, risk-free asset today that guarantees your objective is an inflation-protected annuity that makes no payouts for 20 years and then pays the same amount (adjusted for inflation) each year for 20 years. If you had enough money in your retirement account and wanted to lock in that income, the obvious choice decision is to buy the annuity.
Interestingly, when the lens is shifted from “How much do we have?” to “How much income do we need?” the Nobel Prize winning Harvard professor says the guaranteed income annuity is the obvious choice. He goes on…
The seeds of the coming pension crisis lie in the fact that investment decisions are being made with a misguided view of risk. The only way to avoid a catastrophe is for [retirement] plan participants, professionals, and regulators to shift the mind-set and metrics from asset value to income…risk should be defined from an income perspective, and the risk-free assets should be deferred inflation-indexed annuities.
It’s important to note that the [financial professional] need not actually commit the employee to purchasing a deferred annuity but should manage the risk-free part of the portfolio in such a way that, on retirement, the employee would be able to purchase an annuity that would support the target standard of living regardless of what happens to interest rates and inflation in the meantime.
Professor Merton is speaking to that critical period of time before retirement when rik of a large loss in the stock market is not simply a loss of account value, it is a loss of guaranteed lifetime income. It is in this phase when the mindset shift must begin for the person nearing retirement. Finally…
Consumer education is often proposed as a remedy [to the coming retirement crisis], but to my mind it’s a real stretch to ask people to acquire sufficient financial expertise to manage all the investment steps needed to get to their pension goals. That’s a challenge even for professionals. You’d no more require employees to make those kinds of decisions than an automaker would dump a pile of car parts and a technical manual in the buyer’s driveway with a note that says, “Here’s what you need to put the car together. If it doesn’t work, that’s your problem.”
Here at Fourth Dimension, we have been doing everything in our power to communicate to you the critical shift in thinking and strategy required to successfully transition from earning a paycheck to creating your own paycheck. If this article helped the idea finally hit home with you, please contact us to discuss this and you planning. Also remember that your friends, family, and co-workers very likely don’t know what you now know so please pass this along to them and encourage them to contact us to help them avoid their coming crisis in retirement planning.
You can also email us and we’ll send you a copy.