Robert C. Merton
Corporate America began to really take notice of the looming retirement crisis in the wake of the dot-com crash, when companies in major industries went bankrupt in large part because of their inability to meet their pension obligations. The result was an acceleration of America’s shift away from employer-sponsored pension plans toward defined-contribution (DC) plans—epitomized by the ubiquitous 401(k)—which transfer the investment risk from the company to the employee. With that transfer has come a dangerous shift in investment focus, argues Nobel Laureate Robert C. Merton. Traditional pension plans were conceived and managed to provide members with a guaranteed income. And because that objective filtered right through the scheme, members thought of their benefits in those terms. Ask a member what her pension is worth and she’ll reply with an income figure: “two-thirds of my final salary,” for example. Most DC schemes, however, are designed and managed as investment accounts with the goal of accumulating the largest possible pot of savings. Communication with savers is framed entirely in terms of assets and returns. Ask a saver what his 401(k) is worth and you’ll hear a cash amount and perhaps a lament to the value lost in the financial crisis. The trouble is that investment value and asset volatility are simply the wrong measures if your goal is to secure a particular future income. In this article, Merton explains a liability-driven investment strategy whose aim is to improve the probability of achieving a desired retirement income rather than to maximize the capital value of the savings.
The Risk Problem
The move to saver-managed defined-contribution pension plans—most notably 401(k)s—has increased the likelihood of a pension crisis down the line as the baby boomers retire.
Why It’s Happening
Pension savings are invested so as to maximize capital value at the time of retirement, an objective imposed by regulation. But the goal of most savers is to achieve a reasonable level of retirement income. This mismatch almost guarantees that savings are badly managed, because an investment that is risk-free from an asset value standpoint may be very risky in income terms. At the same time, the defined-contribution process requires savers who often have little or no financial expertise to make complicated decisions about risk.
Investment practice and regulation need to be changed to prioritize income security over capital gain, and communication needs to focus on variables the saver understands and give a clearer idea of the likelihood of reaching a given income target rather than emphasize investment returns.
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.
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 liabilities of business, it has, if anything, increased the likelihood of a major crisis 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. (To some extent, biases can be compensated for by appropriately framing choices. For example, making enrollment in a 401(k) plan the default option—employees must opt out rather than opt in—has materially increased the rate of enrollment in the plans.)
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.
In the following pages I will explore the consequences of measuring and regulating pension fund performance like a conventional investment portfolio, explain how retirement plan sponsors (that is, employers) and investment managers can engage with savers to present them with meaningful choices, and discuss the implications for pension investments and regulation.
These recommendations apply most immediately to the United States and the United Kingdom, which have made the most dramatic shift among developed nations toward putting retirement risks and responsibilities in the hands of individuals. But the trend toward defined-contribution plans is ubiquitous in Asia, Europe, and Latin America. Thus the principles of providing for retirement income apply everywhere.
Assets Versus Income
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 thought 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 defined-contribution investment is very different. Most DC schemes are designed and operated as investment accounts, and communication with savers is framed entirely in terms of assets and returns. Asset value is the metric, growth is the priority, and risk is measured by the volatility of asset values. DC plans’ annual statements highlight investment returns and account value. Ask someone what his 401(k) is worth and you’ll hear a cash amount and perhaps a lament about the value lost in the financial crisis...
Published on Harvard Business Review in July-August, 2014.
ABOUT THE AUTHOR
Harvard Business School