This Post covers an article by Nobel Laureate Professor Robert Merton: Funding Retirement: Next Generation Design, which was written in 2012.
It is a relatively long but easy article to read, very entertaining, he is a wonderful conversationalist with some great analogies.
It should be read by all, particularly those interested in developing a robust Retirement System.
The concepts underlie a move globally to the development of more innovative investment solutions to meet a growing need from those in retirement.
I have tried to summarise his concepts below, probably without full justice.
Before we begin, it is important to emphasis, what Professor Merton has in mind is a retirement system that supports a mass produced and truly customised investment solution.
This is not a hypothetical investment strategy/approach he is advancing, cooked up in a laboratory, investment strategies are already in place in Europe and the United States based on the concepts outlined in his article.
These concepts are consistent with the work by the EDHEC Risk Institute in building more robust retirement income solutions. The performance of these solutions and those provided by the likes of BlackRock can be tracked by the indices they produce.
The behavioural finance aspects of these approaches are outlined in a previous Post.
Due to excessive complexity in investment choices and a focus on the wrong goals, hundreds of millions of low- to middle-income earners face a precipitous decline in their living standards upon their departure from the workforce.
But it doesn’t have to be that way. Technology, innovation and our understanding of what are meaningful choices about retirement funding mean we are now in a position to design a better system that serves all people, not just the wealthiest ones.
And he concludes:
In designing a new retirement system, Merton argues first we need to define the goal. He defines the goal as helping participants achieve income throughout retirement, adjusted to keep pace with inflation.
Merton notes, the current system is no longer sustainable and requires individuals to make overly complex investment decisions and the industry bombards them with jargon that is meaningless to them.
Therefore, he argues strongly we should move away from the goal of amassing a lump sum at the time of retirement to one of achieving a retirement income for life.
This requires customisation of the investment strategy. Asset allocation strategies should be personalised. And, each individual is given regular updates on how “they” are travelling in ways that make sense to them.
However, unlike simple target-date funds that mechanically set the asset allocation using a crude calculation based on a single variable — the participant’s age — Merton proposes a customised, dynamically managed solution based on each participant’s tailored goals for desired outcomes, life situation, expected future contributions and other retirement-dedicated assets, including current savings accumulated, and any other retirement Benefit entitlements.
To improve effectiveness of engagement of the Participant, all of the complexity of the investment strategy is kept under the bonnet, out of sight. The user is asked a series of simple questions around their essential and their desired income targets. Once they achieve a very strong likelihood (more than 96 per cent) of reaching that desired income, they lock in an asset allocation to match that desired lifetime income at retirement.
Merton concludes, this is not a hypothetical investment strategy/approach. Such strategies are currently being implemented in Europe and the United States.
And, it begins and ends with turning the focus back onto what superannuation should be about — ensuring people have adequate incomes in retirement.
Therefore, the investment strategy is focused entirely on achieving the retirement income goal, no consideration is given to achieving more than that goal. Such a strategy limits the downside and upside relative to the investment objects – narrowing the variation of likely outcomes relative to a desired level of income in retirement.
Therefore, it increases the probability of reaching a desired level of income in retirement.
Now to the Body of the Article:
Merton identifies the shortcomings of the current retirement system, particularly the shift from Defined Benefit (DB) to Define Contribution (DC) has burdened the users with having to make complex decisions about issues in which they have no knowledge or expertise.
The current system is far from ideal.
Therefore, in considering how to reshape the system, Merton argues we should start by establishing the goal.
What are members seeking to achieve?
To his mind, people “want an inflation adjusted level of funding that allows them to sustain the standard of living in retirement that they have grown accustomed to in the final years of their working lives.”
Merton then asks: How do we define a standard of living in financial terms?
Traditionally this has been a sufficiently large lump sum. “Indeed, that is the premise of most DC plans, including most in the Australian superannuation system. The focus is on amassing a sufficiently large lump sum in the accumulation phase“.
However, “in reality, when talking about a standard of living, people think of income”.
For example a Government sponsored pension is described in terms of an annual/weekly payment. Likewise DB plans were expressed as income per year for life and not by its lump-sum value.
This is why DB plans were so attractive to the investor. The income was to be received and there were no complex decisions to be made.
Contrast this to the DC system, there is a mirror of products and investment decisions that need to be made and it is no wonder people sit in default funds and are not engaged.
Furthermore, over and above the complexity Merton notes: “most DC plan allocations take no account of individual circumstances, including human capital, housing and retirement dedicated assets held outside the DC plan. Those are all important inputs for an allocation decision customised to the needs of each person.”
Therefore, he argues the next generation of retirement solutions need to meet the following criteria:
- To be robust, scalable, low-cost investment strategies that make efficient use of all dedicated retirement assets to maximise the chance of achieving the retirement income goal and manage the risk of not achieving it.
- A risk-managed customised solution with individually tailored goals for each member — taking into account his or her age, salary, gender, accumulation plan and other assets dedicated to retirement.
- A solution that is effective even for individuals who never provide information or who never become involved in the decision making process at all. And, for those who do become engaged, we need a solution that gives them meaningful information about how they are travelling and what they can do if they are not on track to achieve their retirement income goals.
- Allows plan sponsors (or pension fund trustees) to control their costs and eliminate balance sheet risk.
Next-generation retirement planning
Merton argues: “The simplest retirement solution is one in which the members do absolutely nothing. They provide no information and make no decisions. In fact, they are not engaged in the process at all until they reach retirement.”
He acknowledges that such extreme behaviour is rare, nevertheless, a well-designed retirement solution would display such characteristics.
It has to be to a standard that when members do engage “(it) enhances the chances of success in achieving the desired income goal.”
But how is that achieved?
Investment solutions need to be designed based on questions that are meaningful for people, such as:
- What standard of living do you desire in retirement?
- What standard of living are you willing to accept?
- What contribution or savings rate are you willing or able to make?
The key point of these questions:
“Such questions embed the trade-off between consumption during work life and consumption in retirement and they make sense to people, unlike questions about asset allocation.”
Importantly the focus is not on what investments you should have or your “risk preference”, it is on what are your retirement goals.
The objective is to create a simple design with only a handful of relevant choices.
Merton also argues that “we need a design that does not change, at least in the way that users interact with it. An unchanging design leads to tools that people will be more likely to learn and use. In fact, a design that is unchanging is almost as important as a design that is simple.“
Something simple and consistent is easier for people to learn and remember than something complicated and changing.
A point made in the article, is that the design can be simple, but what is underneath can be complex. The underlying investment solution needs to flexible and innovative to improve performance over time. Not fixed, rigid, and independent of the changing market environments.
“We must, therefore, design a system that is user friendly, one that people can become familiar with and thus are willing to use — a system in which the designers do the heavy lifting, so users need only make lifestyle decisions that they understand and the system then translates into the investment actions needed to achieve those goals.”
Wealth versus sustainable income as the goal
The second dimension is the use of wealth as a measure of economic welfare.
Merton makes a strong case Income is what matters in retirement and not how big your pot of money is i.e. Lump sum, or accumulated wealth.
It is often said that if you have enough money you will get the income and everything will be fine. This may be true for the super wealthy but is not reality for many people facing the prospect of retirement.
By way of example: A New Zealander who retired in 2008 with a million dollars, would have been able to generate an annual income of $80k by investing in retail term deposits. Current income on a million dollars would be approximately $30k if they had remained invested in term deposits. That’s a big drop in income (-63%) and also does not take into account the erosion of buying power from inflation. You would be a bit concerned if you lost 63% of your lump sum!
The point being, knowing you had a million dollars did not tell you about a lifestyle that could be supported in retirement.
Focusing on accumulated wealth does not distinguish between the standard of living and wealth as the objective.
As Merton says “Sustainable income flow, not the stock of wealth, is the objective that counts for retirement planning.”
Merton makes another, and important point, the reporting of Investment results to members is not trivial. Crucially what is reported to members by providers heavily influences behaviour e.g. volatility of capital as a measure of risk influences behaviour, often bad behaviour.
Therefore, the measure of risk is important.
From this perspective, in Merton’s mind reporting should focus on the level of income that will be generated in retirement. This is the most important measure. The volatility of likely income in retirement is a better measure risk.
And from this standpoint it is encouraging that KiwiSaver providers are required to include retirement savings and income projections in annual statements sent to KiwiSaver members from 2020 onwards.
Essential and desired income goals – Goals-Based Investing
The system Merton is describing “seeks to increase the likelihood of reaching nominated income goals by sacrificing the possibility of doing significantly better than desired”.
In effect he is seeking to narrow the likely outcomes, technically speaking the “distribution” of income outcomes in retirement.
We do this by focusing on desired and essential target income goals.
These goals are what the member would see as a good retirement income given their set of circumstances and on how much risk would be acceptable in achieving those goals.
The desired income goal would be defined as a level of income that while not guaranteed, has a very high probability of being achieved and which serves to indicate the degree of risk of the member’s strategy.
Therefore, the investment objective is to maximise the estimated probability of achieving a desired level of income in retirement.
Accordingly, as the probability of reaching the desired level of income in retirement rises risk is reduced so as to “lock in” the chances of achieving the goal at retirement.
As Merton notes “by taking as much risk as possible off the table when it is no longer needed, we are trading off the possibility of achieving ‘even more’ against increasing materially the probability of achieving the goal.”
In this way, the investment strategy is focused entirely on achieving the retirement income goal, no consideration is given to achieving more than that goal.
Such a strategy limits the downside and upside relative to the investment objects – narrows the variation of likely outcomes relative to the desired level of income in retirement.
Therefore, it increases the probability of reaching desired level of income in retirement, particularly relative to a less focussed investment strategy.
Merton recommends that should a Member’s progress suggest they have a less that say 50% probability of reaching their retirement income goal they are contacted.
At which point in time they have three options:
- increase their monthly contributions;
- raise their retirement age; and/or
- take more risk.
The Member gets these alerts during the accumulation phase. This can be formal systematic process under which the plan sponsor and trustees, as part of their fiduciary responsibilities, seek to guide that member to a good retirement outcome.
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