Nobel laureate says seeds of a 401k crisis are sown

MIT finance professor Robert C. Merton warns that recent moves to upgrade the retirement plans have missed the point.

By Money Staff Jun 25, 2014 11:50AM

This post comes from Anne Tergesen at partner site MarketWatch.


MarketWatch on MSN MoneySince the dark days of 2008, employers have taken some steps to fix the 401k, the backbone of the nation's private retirement savings system. But Nobel laureate Robert C. Merton says that in the rush to upgrade these plans, sponsors and administrators have overlooked one big problem: They are managing the plans with the wrong goal in mind.


Robert Merton, Nobel laureate and finance professor © John Hanna/AP

"The seeds of an investment crisis have been sown," the MIT professor of finance writes in an article in the July-August issue of Harvard Business Review, which was published Tuesday. "The only way to avoid a catastrophe is for plan participants, professionals, and regulators to shift the mind-set and metrics from asset value to income," writes Merton, who won the Nobel Prize in Economics in 1997.


In recent years, employers have tried to improve 401k's by introducing features such as automatic enrollment and products including target-date funds. But in his article and in a recent interview with Encore, Merton said these moves are not likely to be sufficient.  To fix the 401k, he argues, employers and the financial services companies that manage the plans must get past the ongoing obsession with two things: account balances and annual returns. These metrics, Merton says, are far less important than the amount of sustainable income an employee can expect to receive in retirement.


By disclosing annual income, instead of (or in addition to) an account balance, Merton says, employers would help employees quickly and easily calculate how much of their annual salary they can expect to replace in retirement, together with Social Security. As a result, employees would be better able to take action to ensure they are on track to retire as planned.


But that’s only half of it. In order to accurately calculate how much retirement income a participant's 401k balance will purchase, the plan sponsor must assume the money will be invested in an inflation-adjusted deferred annuity or in long-term U.S. Treasury bonds. These investments, Merton writes, ensure "spendable income" that's "secure for the life" of the bond or annuity and are "the very assets that are the safest from a retirement income perspective."


That's not to say that 401k money shouldn't be invested in stocks. In fact, Merton says, 401k investment managers should invest participants' savings in a mixture of "risky assets," including equities, and "risk-free assets," such as long-term U.S. Treasurys and deferred annuities. Moreover, investment managers should shift the investment mixes over time to optimize the likelihood of success.


Employers, he says, should begin by asking employees not about their tolerance for investment risk but about their expectations for income needs in retirement.


If the investments are managed well, employees upon retirement should have enough money to buy a deferred, inflation-indexed annuity that (together with Social Security) will replace a salary in retirement. Retirees who don't want to buy an annuity don't have to have one. But once they achieve their retirement income goals, he says, they'd be foolish to leave their money at risk in the stock market.


"Think of risk as a tool," he writes. "When you don't need it, get rid of as much of it as you can, because it's costly. When we take a risk, it's generally for a good reason. You wouldn't normally put yourself in harm's way for no reason."


Merton has also been working with mutual fund manager Dimensional Fund Advisors to turn his ideas about 401k reform into a commercially viable strategy. For more on those efforts see this recent Forbes article by Matt Schifrin.


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82Comments
Jun 25, 2014 12:34PM
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Well, Robert C Merton may have a PhD and a dusty Noble prize in economics, but he too has missed some key points if the article fairly represents his position and statements:
1.  It is impossible to know how much retirement income one will need (compared to the cost of goods and services in retirement) without factoring in projections for real inflation, which no one can predict, and
2.  It is laughable that he cites long-term US Treasuries as being a "risk-free asset", when in the last 6 years the US Federal debt has ballooned from $10 trillion to $17.6 trillion, a debt load equivalent to $55,000 for every citizen of the United States. 
Jun 25, 2014 1:13PM
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I have read some of Merton's articles; he is in general a decent economist.

I find it supremely ironic, though, that a guy who presided over one of the biggest financial services meltdowns in history is carping about risk today.

Merton was one of the masterminds behind Long Term Capital Management.

He won his Nobel in 1997; LTRM blew up in 1998.

Funny thing about LTRM strategies is that they were all considered nearly risk free.

And they were...until liquiduty totally dried up for them...wait... :)

Jun 25, 2014 2:38PM
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He's pushing annuities.  He must work for an insurance company.
Jun 25, 2014 12:48PM
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My plan already provides that information. So does my wife's. I really don't think it would encourage anyone to invest more. I also do not like any kind of treasury bonds. With the debt we have they are not long term secure and we should be cutting government debt and spending, not giving them an easier way to borrow more.
Jun 25, 2014 2:55PM
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The risk, of course, has to do with the so-called "free market". Companies used to offer a pension that was guaranteed based on years of service . The 401 k plans were originally planned as a companion to the pension.
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Dont worry about annual returns or account balances..... [Yeah right]

Worry about annual returns and account balances until you are ready to retire..... Then all you have to worry about is moving it to an income producing vehicle.

Jun 25, 2014 1:43PM
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Obama is surrounded by these  M I T financial Professors  that are THEORETICIANS.
 
 We are witnessing Their lack of REAL WORLD EXPERIENCE which is effecting ALL OF US ! 
Jun 25, 2014 3:53PM
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No one knows what inflation, the value of the dollar, what the stock market will do or what our inept government will do in the future so it makes it impossible to calculate how much money one will need in retirement.

 

 All you can do is what you can control, which is to put as much money in a 401k as you possibly can. Diversify the investments to minimize risk and adjust your portfolio as you get closer to retirement. Then pray that what you have will won't be eaten up by inflation or screwed up by some government policy.

Jun 25, 2014 5:06PM
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For what it is worth: Barack Obama has also won a Nobel Prize.
Jun 25, 2014 3:18PM
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Wait until the first devaluation of the U.S. dollar takes place (some say as early as this year), and the value of everybody's money drops by 30-percent. If you thought having the value of your 401K fall by as much as 50-percent during the great Crash of 2008, just wait until you take a 30-percent hit on top of the 50-percent in less than ten years, and it costs $300.00 bucks for the weekly trip to the grocery store, and gasoline is $8.00 per gallon. All this coming to your life a lot sooner than you thought. Nobody is going to get out of this mess alive, much less retire. Oh, and the working world still hates old people. "Ageism" was coined to describe their behavior.
Jun 25, 2014 1:20PM
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I figured this out decades ago.  Does that mean I should get a Nobel prize?   Thankfully, he did not expose what pays the best monthly income.   He would have ruined the party for the rest of us.
Jun 25, 2014 2:30PM
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A good start into a bad problem. Hoarding trillions in anticipation of retirements is what we get with degrees but not commonsense. The more plausible approach involves cash flow and that can only be generated from enterprise. Wiping out 100% of these ridiculous "business platforms" and going headlong into small businesses puts everyone to work, makes everyone a buying consumer and creates the needful competition that isn't the complacent destruction of us all. 
Bolstering Generation X & Y 401K accounts was NOT a good plan, Obama. Neither was turning the whole nation destitute so administrative types could reign supreme in office suites pushing paper and pressing buttons. Hiring back career competence while cutting off Fed funds completely and absolutely would actually help us. 
Jun 25, 2014 7:00PM
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Half the problem -even with the solutions offered here- is that the average American doesn't know how to best invest money, but reads a 4-page brochure and thinks he's a know-it-all.  Then he "knows" emerging markets must be good and they sound good. Etc. Also, he is not allowed to shift money around very often to react to new opportunities.

The other half of the problem is that Wall St. unethically skims off 60% of the lifetime gains in a typical 401k with, as Vanguard founder John Bogle noted and others who set out to prove him wrong surprisingly confirmed.

To those know-it-alls who say that much is required to administer the 401k's, check out a Roth IRA set up directly with Vanguard, T. Rowe Price, etc.  The annual fee is 0.1%!

There's a lot of propaganda saying Defined Benefit Pensions are unsustainable, yet typically DBP's require just HALF the contributions a 401k requires to reach the same payout.
Source: http://www.nirsonline.org/index.php?option=com_content&task=view&id=122&Itemid=61

So if DBP's are twice as good as 401k's and allegedly unsustainable, how do you expect to retire on the typical no-employer match 401k?


Jun 25, 2014 3:14PM
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401k.  Contribute the amount matched by your employer.  Example:  Walmart matches 6%, dollar for dollar of your pay.  That is a 100% return on your money, plus the return on your money dependent on what type of fund you place your money in.

Any additional funds available for retirement should go into a Roth IRA Account.. the long term benefit of this is simple.  You open the account, after 5 years you can pull out whatever you put in.  No penalties, no tax.  (you've already paid taxes on this, unlike a 401k which is deferred). 

Bonus.  When you keep this account past age 59 1/2, you can now pull this money out completely without any tax consequences whatsoever.  Zero. Zilch.  So if you earned 6, 7, 8% on this money for say 40+ years, it's all free and clear!!!!  Can't get any better than that.  So Simple!!!!

Jun 25, 2014 5:08PM
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The "shift" from defined contribution  to 401k plans was necessitated by the "fedrl gubmnt" decreeing that Companies had to have total retirement funds set aside for their employees many years before actual retirement.  90% of companies couldn't (and the other 10% wouldn't) lock up that much cash.  We are seeing the results of 'publik' entities (Detroit's bankrupt retirement system ... 'fedrl gubmn't soon to follow) failure to go to a FULL contributory plan.  THE LAW OF UNINTENDED CONSEQUENCES.  The "gubmnt" f**ks up everything it touches. 
Jun 25, 2014 4:02PM
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This is a veiled attempt to get the idea in people's minds that the government taking over their 401ks is a good idea.  The scheme is that the government gets the cash now and "promises" a ~3% return no matter what, which may attract some older folks closer to retirement.  Personally, I don't think it will go anywhere and it may have been an ultra-conservative talking point the last couple elections.  Some have looked into the source(s) of the idea and found it to be politics.  However, the Clintons floated quite a few ideas like this to get more cash into the government, such as reducing the inheritance tax to 250k and wealth taxes; so this had to have been an idea with someone.  Bottomline: Some 401ks do this already and people are rightly concerned after the Republican and now mainly democratic failure to get the economy going.

 

Jun 28, 2014 11:33PM
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DID NOT READ THE POST BUT LOGICALLY WITH THE FED ARTIFICIALLY  PUMPED UP THE MARKETS AS IT HAS FOR THE LAT 6 YEARS--AT 85 BILLION A MONTH--THAT JUST DEVALUES YOU IN POCKET DOLLARS---AND ALL YOUR INVESTMENT THAT SHOW BIG GAINS THAT AREN'T REALLY THERE--AND THAT THEIR IS A BUBBLE TO BURST IN THE MARKETS DUE TO THIS --THEN YES WHAT IS SAID ENDANGERS ALL 401K ACCOUNTS---YOU'D BEST GET READY FOR IT---AT BEST YOUR EXISTING VALUES OF M-FISCAL THING WILL JUST BE WORTH WHAT IS IT NOW --A DOLLAR BUYS ONLY 70% OF WHAT IT DID JUST 7 YEARS AGO-----
Jun 26, 2014 11:24AM
Jul 4, 2014 12:05AM
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Let's be poetic about it.  When the baby boomers cash, the market will crash.  End of story.
Jun 27, 2014 6:22AM
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Not at all true, the way the liberals are steering this Country to socialism you need not worry, the government will take care of you regardless of your personal achievements in life, so gamble with your 401k vigorously, and treat it like a lump sum of extra income. Because at the end of the day you will be taken care of......Unless your a veteran and relie on the V.A. for longevity.
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