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.
This post comes from Anne Tergesen at partner site MarketWatch.
Since 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.
"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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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... :)
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.
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.
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.
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?
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!!!!
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.
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