Podcast: Nobel Prize Winner Robert Merton on Fixing Retirement
Episode 11 of the NewRetirement podcast is an interview with Nobel Prize winner Robert Merton. Professor Robert Merton is a globally recognized economist and expert on life cycle and retirement finance (among other things). We discuss what’s wrong with the current focus on just building assets and why we should focus on retirement income instead. We also cover ideas that can help main street people prepare for and live better in retirement. Some of his research on these topics include:
- The overall challenges around retirement planning
- Why we should focus on Income over Assets for retirement planning
- Liability driven investing
- Other ways of funding & hedging retirement income: Annuitization & Home Equity, Target Date Funds & how to improve them
Listen to find out more on all of these topics and get Professor Merton’s thoughts on steps people can take to fix their own retirement plan.
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Full Transcript of Steve Chen’s Interview with Bob Merton
Steve: Welcome to the 11th podcast for NewRetirement. Today, we’re going to be talking with Nobel Prize winner Robert Merton, a nationally recognized economist and professor at MIT about the retirement planning landscape, why do we face an impending crisis and what kinds of changes can materially improve retirement outcomes for people.
He has a very big list of accomplishments some of which include:
- He’s currently School of Management Distinguished Professor of Finance at MIT and John & Natty McArthur University Professor emeritus at Harvard University
- His areas of research include lifecycle and retirement finance, optimal portfolio selection, capital asset pricing, option pricing, credit risk, and dynamics of institutional change
- He received the Nobel Prize in Economic Sciences in 1997 for a new method to determine the value of derivative securities
- He is past President of the American Finance Association, a member of the National Academy of Sciences and a fellow of the American Academy of Arts and Sciences. He holds honorary degrees from eighteen universities
- He’s been recognized across the world for translating financial science into practice
- He’s the Resident Scientist at Dimensional Fund Advisors, where he created Target Retirement Solutions
We’ll be talking about target date funds a little bit further down here.
With all that, Professor Merton, welcome to our show. I’m honored that you would take your time to join us.
Merton: Thank you. It’s a great pleasure to be here.
Steve: All right. I’m going to just jump in to some quick questions. First, I’d love to just learn a little bit more about your early life and your education and kind of what led you to economics, because I know that you started with applied math at Caltech.
Merton: Yeah. I started entering mathematics at Columbia and then I went to do a PhD in applied math at Caltech. I got two of my course work, passed my qualifiers and was thinking about a thesis. I bought my first share of stock when I was 10 years old. I’ve always been involved in the markets. Didn’t know what I was doing. Didn’t know I didn’t know what I was doing but learned a lot about markets from the experience and traded all the way through in lots of different things.
I had a lot of experience in all different kinds of financial markets. I never thought of that as a day job. I decided, at one point, I was thinking about what to do with my thesis on, water waves in the tank or plasma physics didn’t excite me. I was thinking about all the economics and things and I kind of felt I had a little flair for that and it’s what intrigued me, got me interested.
Then, I sort of heard of an economist speak in which he talked about solving the major problems of macroeconomics and how the impact of that. Of course, he was very optimistic but as a young person, I said, “Wow, if you could do something even a little something for so many people that would be really cool.” As I thought more about it, I did a crazy thing which was I decided to change fields and I opted and applied to many economics departments having essentially know of formal economics for PhD.
Everybody turned me down except for MIT, which is probably the best department in the world at that time. They gave me money so it made my decision easy. I switched to MIT to do economics and that’s where I did my PhD and now I’m here today.
Steve: Nice. You’ve been trading since you were 10 years old, have you continued to invest as a retail person, a retail investor in the stock market all the way through your life?
Merton: No, not really. I had enough of that. At various times, I guess, when I learned what I didn’t know and I found out what I did know, it just didn’t make a lot of sense for me. I’ve done it for a long time. I don’t trade individual shares or anything like that. I don’t trade options even though I made a big contribution there.
What I do is essentially help design solutions for big institutions, for retirement plans to help people. I find this makes much more sense to use what skills I have to help large numbers of people than what I can do for myself. I really think that this is big disadvantage for individual trying to do it. If it’s a hobby, well, okay. That’s not something I want to spend a lot of my time for myself.
Steve: Nice. I think it’s great that you’ve chosen to apply all of your math skills and economic skills to help as many people as possible. I know that a lot of people speak really highly of the solutions that you’re building at DFA. It’s awesome to see that. Before I move on, since you’ve got this unique experience of winning a Nobel Prize, I was just curious if you could share kind of what it was like at the moment in time when you found out and also how it affected your life once you won that?
Merton: In that case, I could start by saying, I highly recommend it. I mean the call always comes very early in the morning because this comes from Stockholm and I had no expectations to get it. I just actually was walking out the door to catch a plane when they called. When I found out, I was, I guess you could say, really quite surprised, shocked.
It was pretty good. I mean, if you’re a scientist in the area of your field and your field offers that prize. If you were fortunate enough to receive it, there’s really nothing comparable. It may not matter to other people but if you’re in the field where it happens, they only give one in the world every year. Of course, it’s a great recognition.
Also, you have to be lucky. It’s always good to be lucky in the … you have to be to win a prize like that as well. The recognition of your colleagues and others that they think the work was of that quality is really incomparable in terms of what it matters.
Steve: Just a quick question about kind of at the worldwide level. I know that some people look at Japan because it’s got a more rapidly aging population than we do. Do you think that there’s lessons that we can take from what’s happening with their society and economy as they face a much more rapidly aging population?
Merton: Sure. I don’t think Japan … I mean, Japan is a specialist and that it has almost no immigration. I think that people there live longer than almost anywhere else in the world. They don’t even start to think about that they are retiring until at least 75. It’s a different environment. They’ve had, in terms of their stock market over the last generation, I think in, off the top of my head in January of 1990, the Nikkei that’s index for the Japanese stock market was 39,000. Today is 21,000, 28 years later.
Obviously, they haven’t had a lot of growth in their stock market. The interest rates are very low there. Despite that, it’s still a very wealthy nation. I think many people live well certainly in the cities. I think there’s something to be learned but not much. I think the bigger picture is, it’s happening everywhere, the age is everywhere. The other thing I would say is, well, we want to look to the past to learn. Best practice is not good enough.
In other words, if we’re going to rebuild or redesign retirement systems to deal with the future, looking at best practice, which are legacy systems, is like driving your car looking in the rear view mirror. If what’s in front of you is the same as the bus behind you, that works. That’s not the world we’re in. We know the world itself is changing very much, Asia, the whole region that is growing very fast.
Even in the United States, things are changing, the way we work is changing, technology is changing. With all these changes, the way we provide for retirement, what we should be learning has to be on a prospective basis. Using everything we know in terms of available financial technology, in terms of computers and all the technology that we have for facilitating the management of resources and disbursement of them.
We need to use all of that. We can’t just look to the past and learn from who’s done the best job. That’s a starting place but it’s not close to being good enough. We have to be very careful not to just try to too much depending on looking at the different systems and then trying the best parts of them and say that’s what we should do going forward.
Steve: I think it’s pretty interesting when you … we are going through this or have been going through this transition from pensions where the risk was on the company or on some entity that was kind of taking care of the individual to define contribution, where individuals are responsible for saving and then investing properly.
All that risk has been shifted to them. What we are seeing right now is pretty bad metrics as we go through this transition. Right today, half the population essentially has almost nothing saved. The people that do have savings or an average, the savings rates are very low given what people … given the extending time horizons and lifespans, people need to fund.
I know you’ve written a lot about kind of what’s wrong. I want to introduce the idea that one thing you’ve mentioned is, everything has been kind of geared around accumulating assets but I know you believe that we’re looking at the completely wrong metric. We need to be looking at kind of lifetime income. I just want to get your take on how you think we got here and how we go forward.
Merton: Okay. That’s a very good question and a very important one. From now on, at least in terms of our discussion, let’s presume that we’re talking about a defined contribution plan because as you say already, the other types of plan, the members that really don’t have much to think about anything. It’s all run by the company or the sponsor and their responsibility is one way or another to provide what they promised.
If we’re talking about in the DC (Defined Contribution like a 401K plan) world, which is really likely to be the future almost everywhere, how do we think about what is a good retirement? That’s what the system is all about. I would say, this is not original with me for sure, a good retirement is that if you could sustain the standard of living that you’ve enjoyed in the latter part of your work life throughout your retirement for the rest of your life. That would be a good retirement.
We all like more but I’m telling you, someone who’s at that age, you don’t want less. If you accept that as a good goal target, what a good retirement would be is to be able to sustain your standard of living. Then the first question I’ll ask is how do I define a standard living? I have to have something financial to look at in order to decide how to manage the resources and what resources are needed.
If I can visit you in your hometown and I said, “Hey, this is a nice town. I like to move here.” Then, I looked at how you’re living and I said, “Well, I like the way you’re living. What would it take for me to live in your town like you?” I doubt you’d say to me, “You need $3,637,550 in the bank.” I think you’d say, “Well, if you want to live like me here, you have to be earning about so much a year, right?” That’s how people would say. “You got to earn about that amount, you can live like me.”
What is that saying? I was describing a standard living and your response was the amount of income, not a pot of money. I’ll give you another example, social security around the world. When you retire, what do they give you? What do they tell you they have? Do they tell you, you have a pot of money accumulated? No. They tell you, they will pay you so much per month for the rest of your life, and they will adjust it for inflation, right?
One again, an income concept. Then, we talk about defined benefit plans, which most employers, with the type of plan they’ve always had, pensions, they don’t tell you that you have a pot of money. They say, “Here’s what you have, the rights to this for the numbers of years’ worked and we will pay you this much a month, sometimes, protected for inflation, sometimes not, for the rest of your life.”
Again, an income scheme. The only place that I know of in any big place of where the amount of wealth or how much is in your pot as they say, how much you would have retirement money is the issue or even talked about or even used to measure things is in the case of DC plans. It’s the exception, not the norm. Why? There’s a bit of a historical reason and just briefly, when DC plans come in the United States, they grew out of a reason, creation of the whole pension system in the 1970s and it was really a footnote.
It was somebody who slip to one of those things in the big bill and it was really designed for supplemental above your social security and your pension for higher paid workers, who were capped out in their pensions and so forth but wanted to save more. It’s even questionable whether it was really for retirement or whether it was really more almost a nice savings account which had … they got tax benefits or there was tax benefit saving.
Because it was supplemental for hiring from people, nobody paid much attention to it. There wasn’t so much regulatory, I mean, there’s regulation but nobody spend a lot of time worrying about it. Because people already had lots of income in retirement from their social security and their pension plan, some said, “I don’t need to take income. I’ve already got plenty there. I want to have cash. Maybe I’ll just use it to say, get a boat, give some money to people,” or whatever.
That’s the history. That was fine. Now that it’s being used for full retirement, for working middle class people who are fine. They’re not poor, they’re fine. They just don’t have a lot of extra. That’s a very different use of that DC. Now, it needs a lot more attention because if this doesn’t work out, it’s going to be very painful for people.
That focus on money rather than income, it probably comes from that. If you have any doubt about income, I’ll tell you this, if you look at a corporate plan, big corporation, if you are the CFO, the chief financial officer, who’s usually the most senior person who reports about the pension to the board and the CEO. I’ll give you two stories that you could have to go in and ask, “What do you think the CFO would choose?”
Story number one. We made a 20% return on our pension assets but our funded ratio and that’s nothing more than a jargon for saying, the amount of retirement income we could buy with that money has gone down. Assets up 20% but the amount of return income we had plan we could get has gone down. Or, we made 4% on assets and the amount of retirement income that we’ll be able to have is going up.
I promise you, they always take the second one. Why? Because if it’s the first one, then he has to say or she has to say to the board and the CEO, the hundred million that you’re planning to spend on expanding the business, you got to need it for the pension plan. That’s not a good story. The second one, they could say, “Hey, you know the hundred million that you budgeted for the pension? We don’t need it this year. Go spend it on developing the company.”
I say that as the shorthand not into getting to base whether what people will think about. Sure, people want some cash for things but by and large, people like pensions. They always like pensions. I’ve known of no employee group in the world who’s marched in their employers and say, “Get rid of the DP plan.”
Overwhelmingly, I’m trying to make the case the thing that matters for retirement is the amount of income you get and not how big your pot is. Those are very different. Sometimes people say, “If I have enough money, I’ll get the income. It will be fine.” That’s reality. You want a quick reality, let me just give you a simple case I think everybody can imagine.
Ten, 12 years ago in the United States, you could walk into any bank in the United States and get a fully insured certificate of deposit. It gets 4%, 5% on your money. If you had a million dollars, you get 40 or $50,000 a year interest. Okay. Now someone says, “I want to keep you very conservative, so just keep your money in the safe CDs, your principal … your million dollars is absolutely safe, insured.”
Say three, four years ago just to keep it away from today, you go into the bank, what would you get? Not 4%. No, no. You get a tenth of 1%. Today, you can get it up there but you would have gotten the tenth of 1%. To put that for you, that’s $1,000 per million. My million has been absolutely safe, no risk, right? What happened to my income? It went from 40 or $50,000 a year to $1,000 a year. You’re in total trouble.
You’ve lost 98% of your income. If I lost 98% of your retirement wealth, you’d hang me. First, you sue me then you’d hang me. My point is that there’s a big difference between wealth and income. Knowing I have a million dollars doesn’t tell me the lifestyle that I can enjoy from that million and what we care about is the lifestyle. Let’s be clear the goal, the purpose for retirement. Not for the silly other things but for retirement is a stream of income sufficient to sustain standard living and that standard living is measured by income.
What matters for retirement is income not the value of the pot of money. If you measure the wrong thing as we are in DC plans, I’m required if I’m a provider. I have to show all the members the value of their pot. Every time you go in your accounts quarterly, whenever you get a report, it shows a green if the pot is bigger, it shows you a red if the pot is smaller.
If you see it go way up, you smiling. If you see it go way down, you’re frowning. In fact, that’s not really telling you how you’re doing for retirement because what you really want to know is, how much income could I get in retirement from what I have in my account? How far am I from where I would like to be? How far am I from my goal?
That’s the thing that really matters. Just like that CFO, he wants to know or she how close are they to funding what they’ve promised people in income. We’re showing people and we’re required to show people the wrong number. We’re showing them what’s happening to the value of their pot and what they should be and really are worried … should be worried about. Or what is the amount … how close am I to my goal?
If I need a replacement of $56,000 a year to sustain my standard living after I retire, where I don’t to save anymore. I say I was making 80,000 or something and now I need about 56,000 because I’m not saving. What I want to know is, how am I on track to getting that? How close am I in terms of the amount of income, risk-free income not hopeful income but risk-free income, guaranteed income could I buy with what I have.
If that’s 50,000, then I’m 6,000 short. If it’s 40,000, I’m 16,000 short. If it’s 20,000, I’m 36,000 short. Whatever amount of pot it takes to buy that is irrelevant. It’s where I am and how much I can actually buy. As you heard from my example, that depends on where interest rates are. If you look at the real world, the world we’re in, I can tell you that they vary a great deal.
The difference between the high, low and long term interest rates in the United States in the last 10 years, if you retired … with a given pot of money, if you retired and you got an income of a hundred, whatever that means, at the peak of interest rates, when they’re high, you get a hundred. At the trough, at the low end of interest rate, the same amount of money, you’d only get 74.
In other words, you’ll be 26% lower. Think about that, 26% less of income, that’s a big hit especially for working middle class people but for any of us. Just knowing the amount of money you have doesn’t tell you how you can live. That’s the message and we have to get that clear both so that savers and people in plans are trying to figure out how they’re doing. We need to tell them the amount they can buy as an indicator of how close to where they are.
The number of people when they say the pot, they say, “I have $500,000. That’s more money I’ve ever seen in one place. I’m rich.: Until you find out that the amount of money that you can get from that to live on is like $18,000 or $20,000 a year. They say, “Whoa, that doesn’t sound too rich to me.” That’s the kind of things that we have to get. It’s at many, many levels.
We have to have people to know where they are and therefore if they don’t like where they are, they’ll be able to take action to improve it. They need to have the right information so we need to show them the amount of income they can buy and they can relate to that. I just got back from South Africa where we do something like this.
They passed a law there that you got to have to show the amount of income that you could buy with your pot to people on regular basis. Just think of this, let’s say you were living on 10,000 rand a month which that’s about 1,000 US dollars, 10,000 rand a month. Then, you see you have a pot of, I don’t know, 500,000 rand. You say, “Oh, I’m rich.” When you show the amount of income, its 2,000 rand a month.
It doesn’t take anybody. Anybody can understand, they don’t need any education. They just have to have lived. That if they’re living on 10,000 and they’re making 10,000 a month, and that’s how they’re living and someone shows them that the amount they have with their pot will buy them retirement income of 2,000. They realize that they’ve got a long way to go.
A very few people can convert $500,000 or any amount of pot money into that relevant number which is, how am I to where I need to be? I know I’m emphasizing this very strongly because it’s really very important and it’s had some very unfortunate effects by looking at the wrong number, therefore, how we define risk is wrong. If we don’t measure risk correctly, we can’t possibly manage for people directly. That’s the core thing that has to change.
The only thing I would say is … not the only thing, the thing I would say so I don’t sound like Mr. Naysayer Doomsday is slowly but we are as an industry and people, we’re moving from the no attention to this that now more and more you see the discussion of income, the discussion of how much income, discussion of when people get to retirement, how can they convert this to income and what’s the ways to do that and so forth.
In effect, I think we are slowly moving in that direction as are the systems elsewhere in the world. It’s moving pretty slowly and we need to help it to pick up a little bit. That’s, I think, where we are.
Steve: Yeah, that’s great. It’s great to get that context and the history. It’s interesting when you step back and looked at it. Yeah, we’re all focused on wealth and building that number and how that focus has changed the entire ecosystem so now you have wealth managers and their whole job is to make that $500,000, two million bucks.
Then, the way that most of them are paid is strip of assets. If they can earn or get 1% of your million dollars in like 10,000 a year if you, together, grow it to two million, then they’re making $20,000 a year. They’re not having that discussion. Yet, their title itself, wealth manager, it’s not like income manager. It shows you how in grandness this focus is on just growing that top line number.
You’re saying basically we should … just to finish, we should refocus completely in terms of defining risk around the risk of not being able to achieve this income?
Merton: Yes. I don’t see inherently a conflict that people are getting paid on AUM. I think your point is right that we’re measuring the wrong thing. If we measured instead of measuring in dollars, how much is your account worth in dollars, if we just measure it in the amount of retirement income you could buy with your account using market prices. Okay.
Not income earned in the account but how much … if I took the money in the account and bought US treasury’s bonds, they started paying when I retire and paid the cash out throughout or we bought an annuity or something, we could look at those prices. If we measure things in terms of how much retirement income and you paid me a percentage of retirement income, then we could do that. If I increased your retirement income, you pay me more and then I’d be very happy too as a provider.
It isn’t an inherent conflict as so much as it’s … I believe, we’re showing people the wrong number and that has a bad effect. For example, if I do the right thing for you. You’re 62, you’ve done well in your retirement account and I say to you, “Hey, you’ve got enough money to basically lock in your goal. I can buy you inflation protect, US Treasuries with funding that will take care of you throughout retirement guaranteed full faith and credit, the government protected for inflation at this level income, that’s your goal. Then I say, “You do want to increase your goal?” You said, “No, I’m happy with that, that’s my lifestyle. If I have some extra money, I’ll do something with it but basically, I’m happy with that. That’s what I want to live on and the safety and security, that is what matters to me.”
The rationale thing for me, the right for me to do is to buy you those bonds. Your income is absolutely for sure safe but if I buy you those bonds and interest rates go up, the price of those bonds will go down, that’s how bonds work. Interest rates go up, bonds and prices go down, the income stays the same. Yes, the bond price is lower but because the interest rate is higher, you get more dollars of income for each dollar of your bond value. That’s the whole point.
Income is absolutely stable in a bond. Its value will fluctuate with interest rate. If interest rate, especially long-term bonds, which is what you would need for retirement, if the interest rates go up and let’s say your bonds go from 100 to 85 and I send you or put it on your account that your account has gone down 15% and you’re 62, you see that, you’ll go berserk. You’re going to say, “You told me you’re being safe for me and I’ve lost 15% of my retirement.”
In fact, that’s not correct statement. Your retirement is defined by how much income you get for life. That hasn’t changed. The value of that has, that example is the problem at the core. It’s misinformation because we show them the wrong number.
They get happy when it goes up but they’re actually no better off because if interest rates fall, the bond price will go up. They’re richer in terms of money but the bond doesn’t earn as much so their income doesn’t go up. Therefore, they don’t have any better retirement. They see it as, “Oh, I’m richer,” or “I’m poorer,” or “You’ve lost my retirement.”
That, from my experience, is the biggest problem. It’s not a conflict between the asset managers or anything. It’s just, we’re showing them the ruling number and we’ve taught people. They didn’t ask for that number, you didn’t ask for that number to see it when you put your money in.
You know what I’m saying? Most people don’t even know. It’s the number we show them so they get used to doing it. If you’ve been in a DC plan for 30 years, you keep getting the account, you figure they must be … they’re showing the thing with the green or the thing with the red. They’ll show it to you for a reason so that must be what you should look at.
Green means good and red means bad. We’re all that way. This does not have anything to do with I2 or training or anything else. This is just common sense. We’ve taught all the members in DC plans that that’s what they should look at and that they’re better off with that numbers up, green and they’re worse of if it’s red down.
The reality is, that isn’t true. It’s like showing people numbers that aren’t relevant and teaching them to look at them and that creates all kinds of complexity and then the management of the money, not because there’s a conflict in making money but because we’re measuring risk wrong, rules are being written which are … that supposedly reduce risk. All of them are written with the idea of risk of volatility, of the value of the account rather than volatility of the income.
Again, if you bought certificates of deposits or treasury bills for the last 12 years, your million dollars is still worth a million dollars. I don’t know what to say about inflation. The amount of income you’ve got has gone from four, 5% down to practically nothing. That is the message. We have to fix it in several levels but starting with, we have to agree that this is what we should be doing, we should change the way we’re required to present things.
Even if you’re required to show them the account balance, I would put it on page seven. By the way, if you want to liquidate your retirement account, it would be worth a thousand dollars today. Of course, that’s not what you’re going to do so it’s not relevant. What’s relevant is, how close are you to your goal of how much income you need to have a good retirement.
Steve: Got it.
Merton: That’s how it should be.
Steve: Right. We have to kind of retrain a few generations of people about what’s the right thing to focus on is. It’s interesting listening to you describe those. On the one hand, you compare how people talk about pensions, which is in many cases, they’re talking about, “Hey, pensions are have all these unfunded liabilities.” Then, that’s probably because lo and behold, maybe they’re measuring things right away.
They’re measuring what’s their ability to make good on their publications to pay a stream of payments. They’re actually measuring the right stuff and saying, “Oh, looks like we’re under funded.”
Meanwhile, you got all these people saving and they’re like, “I’m saving big piles of cash but I’m looking at the wrong metric. I don’t really know. How does that translate into me actually having enough income for life?” We’re not really saying exactly how big is that problem and people, I think, I’d rather say concerned about it, but it’s kind of interesting compering how we look at these pension plans through one lens and the DC plans as you’re describing it through another lens.
Merton: Yes. Again, I underscore for pensions with professional managers, CFOs or oversee, that CFO is asking for the right number. He’s asking for how much income or the plan assets be able to buy. That’s what he looks at, she looks at. This is not about when you say retraining people, this is not about retraining people who are professionally in the pension system. They understand that.
They understand that’s what matters is the income. Believe me, the problem in the DC world is for you and I and my 150 IQ brilliant MIT colleagues, three PhDs, nanotechnology designs and they don’t know what to do with their account either. No, that’s true. Why we would expect them to be able to do that?
I’ll give you an example, I have to give them the test history of all the mutual funds that they can invest in, okay? I’m required to give them that. Remember, these are some of the smartest, most curious people in the planet, okay? You won’t find any better educated, smarter, more curious people. I give them that, they don’t know what to do with it. I don’t know what to tell them to do with it. What are they supposed to do with it?
I’m required to give it. What are they supposed to do with that? How are they supposed to look at the past? Pick a good manager for the future.
If you’re in this industry, if you’re in the financial service industry, if you have the skill set to look at the past history, which is available to everyone, of mutual funds, returns and predict who’s going to have good returns in the future? You will get paid millions of dollars a year for that skill. People are, okay? Is it reasonable to expect even my super smart MIT people, in their spare time to be able to look at these things and figure out which managers are going to do well from that data, those data, and do anything meaningful?
Of course, not. It is so absurd to even suggest that. Yet, that’s what we do but we create frustration because then like my colleagues say, “Well, why are they giving it to me? These are serious people. This is retirement system. I must have to do something with it.” The answer is that some of them just get frustrated, they say, “I think, I’m a pretty smart guy or gal, but I don’t know what to do with it and I’m just frustrated.”
Others say, “Oh, I’m smart. I guess what I should do is find whichever funds were up the most the last 10 years and invest in full my money in them.” What else could I think to do? Of course, we all know as professionals, that’s called return chasing. That’s a terrible investment strategy. Chasing after whoever did best last time. We know that whatever is right, that’s not a good one.
Yet, what are they supposed to do? Some part of it, without overbearing this, is some part of it is we have to sit down and just use common sense. What do we expect people even very, very smart educated people? They’re very curious people. What do we expect them to be able to do with this? What decisions are meaningful and what are not? What choices are meaningful and what are not?
I think if you investigate, you’ll find most of what we ask people, what asset allocation they want? How much real estate? Do they want a conservative fund? All of that stuff is meaningless to people. They don’t know what to do with it. They don’t know how to calibrate it and they get frustrated with it. One of the things we can do in connection with getting the right information to people, mainly his income, is to have a rule. A rule says, “Only give people and clients meaningful information and actionable choices. Don’t ask them to make decisions about things that they don’t understand, can understand, don’t have the data and don’t have the experience and don’t have the time to evaluate and the skills.”
It’s like, if your doctor, if you’re going to surgery says, “Mr. Jones, would you rather have 12 or 16 sutures?” That’s a choice, right? Do you have any idea? No, I say to the doctor, “That’s what you’re supposed to do. I had to find you and I have to trust you to do it right. I can’t make that decision.” If you look at most of the financial positions that we ask people to make in DC plans, the choices of funds and risk aversion, all these kinds of things.
Most of it, most of it is of that nature. It’s really not meaningful. In fact, if you just go after the meaningful information, I believe, you can put the meaningful information and the meaningful or actionable choices on one page. Not a lot of complexity, not a lot of investigating funds and so forth and all that sort of things.
It’s a little bit like if somebody gave you all the parts list for your car and said, “Okay, here’s everything. All the information, here’s all the part and now you assemble your own car.” How do you think that would work?
Steve: Yeah, not too well.
Merton: Not too well.
Steve: Right. Do you see any organizations or, I guess, you mentioned South Africa but organizations of countries kind of making a lot more progress in moving down this path of helping people, one, measuring the right things and focusing on the right metrics, income and then making it simpler for people to actually have successful outcomes?
Merton: Yes. We’re talking about a lot in the United States whether we’ll implement it well and how long it will take to implement, I’m not sure. There is no question in my mind here and in the UK, for example. Actually, in most countries, in Hong Kong, Singapore, they’re all talking about that we should be thinking an income.
South Africa has taken this step, others are doing it. By the way, if you’re a provider today, you could put that number up if you wanted to. You still have to show the other, the AUM, but you could put that number up.
The problem is, you won’t train people right. Look, the way they’re training people is if you start putting that number, you have some explanation but people … it’s pretty intuitive to know. Look, you need income to live in retirement and here’s the level of income you can buy. That’s not a hard one. You don’t have to do any translating.
If it’s 2,000 rand you can buy and you’re living on 10,000 rand, you got a long way to go. You don’t need a whole bunch of other analysis. I think, if we start doing that as a rule and we actually de-emphasize the value of the account, you put that on page two or three and call it the liquidation value. That’s what I would say.
Liquidation value is X dollars. If you liquidate your retirement now, this is what you’ll get. That’s not what a retirement account is there for. It’s not there to be liquidated. It’s there to support you in retirement. You put this other number. I think it won’t take long for people to get very used to it because they’ll start … they’ll see their income go up. They’ll see a green arrow and they’ll be happy and they should be.
If they see their income go down, they’ll get on the phone and call up and say, “Why did my income go down?” They’ll get an answer. They may not like the answer but they’ll get it. In other words, they will look at things in the right way. I don’t think it would take that long if it’s uniform. If one provider does it, it’s not going to have the impact.
If we became the law, the regulation, and everybody had to do it and it was done probably, it’s no different from saying you mark portfolio assets properly. Put them on a wish. There are rules for it. You have rules for how you would mark the income. That’s just the detail. I think it wouldn’t take very long at all especially if we have little green and reds.
People will see. I think they’ll find it more intuitive. Just think about it. You know what you’re living on and you know what this will buy. That’s about the easiest thing for you to figure. It’s like someone says, “I give you a race,” you will understand that, right? You don’t need to have to have a financial engineer or a technician or an adviser to spell that one out to you. That’s what I’m trying to … we can do it, I think we will get here.
I hope we could do it better and sooner. This is absolutely a necessity. We can’t keep running a system on the wrong metrics.
Steve: Yeah. I think the reality is that it’s already been tested. I mean, people that had pensions or easily able to assess, “Oh, I’m going to get $40,000 a year starting at age 60 from my pension as being a firefighter.” They completely understand it. They can plan for it. That’s all they know. They can kind of know where they stand.
What I see a lot in our business is people kind of think about safe withdrawal rates. They’re still focused on piling up a bunch of money and then they’re starting to think, “Okay, here’s how I’m going to take this money down. How do I draw it down? What’s my safe withdrawal rate? What’s my sequence of return going to look like? Which assets will I tap at which time?” Then, they’re basically managing the drawdown.
Do you think that’s realistic for people to do, for a lot of people to do or how do you see that building?
Merton: Look, let me start with, first of all, the answers are at some level the same for everyone no matter whether they’re working class, middle class, upper middle class, mass affluent. The super wealthy or the very, very wealthy, this is not an issue period, okay? I mean, their retirement is just not a thing.
For the rest of us, it is different. I mean, if you’re a working middle class person, you’re fine but you don’t have a lot of extra. Then, you’re focusing … you don’t have a lot extra. Therefore, if something goes wrong on your income or like you put your money in stocks and the stock market goes down, that’s going to be very painful.
If you’re upper middle class, you probably have more reserves and if you’re mass affluent, you probably have other reserves, you have various goals maybe you have requests. You want to do some wealth management, intergenerational transfers, you may want to do some philanthropy. Modest. I’m not talking about gazillion dollars.
You have other goals besides a good retirement. That’s fine. People have that money. You have to be careful. I’m talking only … my job is to get you a good retirement. I’m not your financial planner and it’s a very bad thing to integrate into a financial, to a retirement solution like a pension or a retirement, integrate that in your other desires. Do you understand what I mean?
In other words, if you want me to be your financial adviser if you’re affluent or mass affluent, you have adviser, great. Then, their job is to look at your whole package of everything, all the things you want, all the things you wanted, you’re hoping to achieve, all of that stuff and integrate it. That’s great. If it’s retirement that you’re focused on, and as I say, for working middle class people, there really isn’t an awful lot extra beyond that, okay?
It depends on who you are. In every case, what you want to be looking at is drawdowns are risky. Say, “You could take 4% out a year and 96% of the time, you’ll be fine.” You think that’s pretty safe. Actually, what’s the penalty, the other 4%? You ran out of money. You’re there and you literally ran out of money. The 4%, is it a rolling 4% if your portfolio goes down, do you mean 4% of the lower value? That’s like having a floor which is a floor of an elevator.
If you mean literally 4%, so you retire with a million dollars, you say, “I’m going to take $40,000 out every year no matter what.” You could outlive that. If you put it in stocks, your million could become 600,000. That’s what happened between September of 2008 and March of 2009, less than a year, six months. Markets around the world more or less decline about 40%.
Now you’re taking 40% out of 600,000, 40,000 out of 600,000, that’s not 4%, that’s 7%. Do you see what I’m saying? There’s lots of nice rules of thumb and if you’ve got extra things, I say, “Look, if it doesn’t work out, I won’t give that gift to my favorite charity. I’m sorry, I was going to do it but,” if you got that kind of wiggle room, that’s a very different situation when you say, “You know, if my retirement income isn’t there, I’m going to have to move in with the kids or I’m going to have to do something maybe not quite so radical but I’m not going to be happy.”
To answer your question, the way I like to look at it is a little bit like when you get on a plane and they tell you all the things to do, seatbelts? Do you remember when those masks drop down? They always have a picture of a sweet little girl next to you and your natural inclination is to put the mask on her first, right? What do they tell you? No. Put the mask on yourself first. What’s the message?
First, take care of yourself because if you don’t take care of yourself, you can’t help anybody else. You’re going to end up having them having to help you. You’re going to be a burden. That’s the message. That’s my message on retirement.
You ask me about retirement, I say, “First, focus make sure you got your retirement.” One way to do that is if you have a standard living, which you’re happy with or pleased with and we’d all like more. You say, “That’s good enough for that.” Then, one way to do it is to lock that in by buying a life annuity. Life annuity will pay … and you can get ones that are next to inflation, if you want to keep your standard living.
If you lived 120, as all the good books promises or wishes, okay, and maybe your next generation or two will start living that long. Even if you live to 120, you get paid every month. There’s no chance you can run out. Any drawdown policy has a risk that you’ll run down, unless your drawdown is interest. The problem is that’s very expensive. You have to be very, very well off and that’s not the case to do that.
Let me explain to you that once you get to retirement, you have a certain amount of money. I mean, that’s the fact. If you just say, “I’m going to live on interest because I can’t … I don’t know how long I’m going to live. I can’t spend down on principal, because if I spend down on principal, I might outlive my money.” People, where everybody worries of retirement, I don’t care what your IQ is. Everybody worries that they’re going to outlive their money.
That’s why so many people, when they request something, they request it by saying, “You can have my house and you can have all my money, if there’s any, when I die.” I’m really saying, “I’m going to hang on to everything because I may need it and if I don’t need it, you can have it.” That’s not a request function. That’s just an inefficient market because certainly, your beneficiaries … beneficiaries, that’s not a good deal for them. They could use the money when they need it, not when you die and those are usually not the same time but anyway.
To go back to the point, if I just live on interest let’s say it’s, I’m going to give you numbers so you get an idea. I’m earning 2%, now, if I’m willing to buy an annuity with my money or not … you don’t have to put everything in that but let’s say you did everything. What happens? When I buy the annuity with the money, it agrees to pay me every month for the rest of my life.
In return, so they will pay me money for as long as I need money. Then, when I no longer need money, I’m going to some place where I don’t need money, some place better, I hope, okay? I give up money because I don’t need it. That seems to me a pretty good deal.
I’ll give your money for as long as you need money and in return, you give up your money when you don’t need it. If you see of it that way, what’s the amount that you get? Instead of 2%, you get 5%. The deal says, if you hold your bonds, you just spend the 2% interest or whatever, you get 2%. If you give up your money when you don’t need it, which could be tomorrow or 35 years from now, okay? I’ll pay you 5% as long as you need it.
Do you see? For the same amount of money by moving from just living off your portfolio, interest, to accepting that if I don’t need the money, when I don’t need the money, I give it up in return, I can increase my benefit for the rest of my life, even if I live 40 years by 5%. That’s the way to improve benefits without having more money. That’s what’s so powerful about that.
Steve: Right. I think what’s happening as you’re kind of running in … theories running into practice. The reality is a lot of people are uncomfortable giving up their liquidity and want to have access for psychological reasons, that chunk of cash. They don’t want to give it over to an insurance company to get that higher stream of payments.
Merton: Yeah. Okay. Let me just quickly say on that. If it’s expensive to buy, a lousy product, a lousy version of a product doesn’t mean the product is bad. You had a car that only starts one in four times and I ask you, “How do you like the car?” You’d say, “I hate it.” I don’t know whether they’re saying they don’t like it because it’s expensive.
If they say they want liquidity, fine. You keep 10% of your accumulation for liquidity. You don’t need a 100% for liquidity. That’s my point. Remember, what your choice is. You can live on 2% a year or you can live on 5% a year. Sometimes, liquidity is nice but that’s pretty expensive to have liquidity and be able to play in your sandbox with the money. That’s what I’m trying to say. If you’re working in middle class, the difference of getting two or five is huge.
It’s the difference of … and that’s the way you’ve got to look at these things. It’s not like I’ve got so much money, I would like to have this and I like liquidity and I like to have a boat and I’d like to be able to give money away. I’d like all those things too. The reality is, that’s why it’s a crisis. If people have that much extra money and was easy to get there, we wouldn’t be having a crisis. We wouldn’t be talking about this.
Let’s deal with the real world. In the real world, we’re going to have to have people annuitize just the same way they got a pension. They may not like it. They had wished they have more money. When they’re faced with a choice of having a very small fraction, I did an analysis using real numbers from groups that work on that here, work conventional on this.
I said, “For someone in the 75th percentile income in the United State, it’s like $86,000 or whatever it is I forgot the number precisely and if they have a replacement and they show like $56,000 and if they have accumulation of 300,000 in their DC plan and they have a house that they buy a reverse mortgage to it.” All right, I’ll just give you some quick numbers.
Just living on the interest on their accumulation plus social security, you always get social security. They would get to about roughly 50% of their goal. In other words, they would have only half of what they need to have a good retirement, half of the standard living, the replacement ratio they would like. If you annuitize, you get about another, you get from half to about 75%, okay?
Remember, it’s not up this much because we have social security, which is actually an annuity to begin with. Everybody starts with the social security annuity to begin with. That’s why it’s not just proportional as I said before. I will give you numbers. Fifty percent then you annuitize, now you’re 75%. If you do a reverse mortgage on your house and let’s say, you live in the Boston area and you’re that income bracket, you have a 500,000 or $600,000 house or apartment.
You do a reverse mortgage on that, you can get enough to buy an annuity, not to earn interest, to buy an annuity so that you get to the other 25%. You can go to 100% coverage. The difference of just living as you say, a drawdown. This is a drawdown where you’re not taking anything down, just interest. That’s zero withdrawal, you’re living on interest. That would give you 50.
The annuity plus the reverse mortgage in your house and use that money from your house to buy the annuity, which is safe to do because the annuity will pay you for the rest of your life and you don’t have to pay anything on the reverse mortgage until you leave the house, which is at the end of your life. It all works out. That’s the way to move the needle from 50% to 100% coverage.
I’m saying, as a practical matter, and this isn’t just for the United States because it turns out that the saving patterns around the world are very, very similar for working middle class people. The only personal saving they do, I’m not saying about retirement accounts, personal savings, is their house and a bank account. The house is usually the biggest asset that a family has at retirement, often bigger than their pension.
That house, this is true in China, this is true in Hong Kong, Singapore, you name it, Mexico even, believe it or not. That is such a big asset. It is a perfect asset to do this with because it’s an asset that people have. It’s an asset that gives them an annuity itself because they live in it and it’s the house they want to live in so it covers it. If you do a reverse mortgage on it and you do this, you can move yourself that far. Anything that big, in my view, has to be looked at.
I don’t say everyone should get a reverse mortgage. I’m not saying that. I’m saying you need to look at these two things because these are the only two things, the annuity and the reverse mortgage are the only two things for working middle class that will move the needle other than increasing mandatory contributions.
If the Government of the United States says, everybody has to contribute, like in Singapore, 31% of the salary, we could do it that way too. I’m saying, under the conditions we are now as a practical matter, you’re not going to get there with the kinds of saving rates we have. We’re not going to change people’s saving behavior. We can mandate it, you understand.
The law says you have to, but if you think you’re going to psychologically prepare people to educate them to do it, forget it. That’s going to take a long, long time. It’s extremely hard to change behavior of that kind. That’s what their parents did, that’s what their friends did. We have to be practical here. They may not like annuities actually I’m saying it’s just like request. Request is a rich person’s consumption good.
If I’m rich enough to give a request then I don’t have a retirement problem. You know what I mean?
Steve: I also think that like for instance with annuities, you’ve got misalignment in the system where if you have a wealth manager who’s making a percent of your assets and then you go them and say, “Hey, I want to take half of my assets, say, a million bucks, I’ll take 500,000 bucks and buy an annuity.” Then, they’re going to stop being paid on that money because it’s going to be parked with an insurance company.
They may dissuade you from doing that because it’s going to drop their income. I also think with the house, a lot of children are probably interested in like, “Do I want my parents to get a reverse on the house when that means it’s going to be less money coming to me at the end.” I just wanted …
Merton: Yeah. Let me respond to that because you’re asked, this is a longer conversation, but I think I need to deal with that. I’ve actually worked a lot on, first of all, how to properly design a reverse mortgage, that’s a longer story. Even with these things, everybody always says this, first, if you were … let’s just start at the beginning.
Supposed you’re a retiree with no beneficiaries, no children. It’s great, right, because anything you leave is wasted. You leave the house it’s wasted. It goes to the state. Or it goes to your 14th cousin you don’t even know. Okay. This is great because what you want to do is get the most money you can from the house because you’re never have to pay anything on it and then you can put the money in annuity and for the rest of your life live better. That’s a pretty easy decision.
They say, “Oh yeah, but with the children they don’t like it.” Let me ask you this, if I’m 65, retiring, you’re my son, you’re probably 38, you’ve got a 9-year-old and 11-year-old. You reach your peak spending for your house, you’re moving in your children, double digit they’ve got more expensive and you also have college in front of you. You have the most housing you need and you have the biggest dispenses you probably need in your life cycle.
I say to you, “Son, when I die you can have the house. In fact, I’m going to give you the house.” That could be 30 days from now or 30 years. If I live to be 95, you will get it when you’re 68. That’s going to be really helpful for you, right, getting this house at 68. You’re not going to move in to it, you’re just going to sell it.
How about this one? Suppose you say, “Dad, don’t do a reverse mortgage because it’s bad for you and I’ll find plenty of literature to say that.” Then, you know how I would talk? I’d say to you, “Okay,” if I’m the person trying to convince your dad I’d say, “Dad, if you do what your son says you have no interest in this so leave the room.” Now I’m going to talk to you. I’m going to say, “Okay, if we did a reverse mortgage, if your dad did the reverse mortgage he would get $500,000 in cash.” I’m just picking a number, it’s a million dollar house, $500,000 in cash.
If he does what you would do, he won’t get any of that, right? He’ll be no worst off. Why don’t we give the $500,000 cash to you right now you’re 38 with two kids nine and 11 living in this house? Here’s the deal for you. You get the house when your father dies, your father and mother, in 30 years or 30 days. By the way, to win this lottery you got to have something bad happen to your parents and most people don’t like to wish for that. It’s not psychologically much fun but let’s follow it through.
Here’s your choice son, your dad is out of the room. Here’s your choice son, you can do what you told your dad and you’ll have this lottery, you’ll get this house someday. Or, I’ll give you $500,000 now today and you have a call option that when you get the house, you can either choose to pay principal and accumulated interest because remember, there’s no interest paid on the mortgage which falls out. There’s no way that you can default on the mortgage by not making a payment because there’s no payment to make. Okay?
Five hundred thousand now plus when the house comes to you whether it’s in 30 days or 30 years, you have the option. You have the option to say to the banker, whoever did this, keep the house forget it. You do that if the house is worth less than you owe, right, okay. You get nothing more, you have your $500,000. What if the house goes up like Southern California houses grew 20 years ago or Singapore houses the last 10 years.
It goes from a million dollar house to a $10 million house. Okay. What happens? You pay the mortgage principal and interest and you have all the upside. I’m offering a choice of $500,000 now, never has to be repay, it’s yours, do whatever you want with it, no matter what happens you got it. Plus, if there’s any big upside of the house, you’ll get it. Versus just getting the full upside in the house someday. I’ll bet you, there are an awful lot of 38-year-olds … and now, we’re not talking about wealthy, we’re talking about 38-year-olds in middle or even upper middle income families.
If you chose, I think there’d be a lot of 38-year-olds who would like to get the $500,000 now when they need it and still have the upside. They’re not selling the house and then they’re going to regret it when they say, “Gee, we sold the house back there at a million and now it’s worth 10.” Because they got the upside but now they have the 500 grand.
Of course, once if you as my 38-year-old person says, “Oh well, I like that I’ll do that.” What have I done? I moved you away from your original statement to your parents don’t do it, right, because now you think it’s a good idea to do. Then, I say to you, “Well, it’s like the old joke, once you establish the principal, we’ll haggle the price. Once I got you say that you’ll do the reverse mortgage, I say, “You know, how about giving dad 100 grand of the 500? You still get 400 and the upside. How about giving a hundred to your dad?
How far I’d go, I don’t know as what that makes. I know that if your dad gets a hundred, he’s better off, right, than if he did what the son said, you agree? He’s happy because he’s got 400 grand plus the upside which is he chooses to do it, that means he like that better than … so do you see, I’m just trying to tell you by showing you that request function that everybody says, “Oh that’s normal,” is so crummy I know I can get a deal.
I don’t want to sound like our president, but I know I can make a deal between the beneficiaries and the retiree, where both of them would be better off. By the way for, more affluent people, this is great. Think of a, what do you call it, I don’t know if you call them, mass affluent people, they’re well off. They’re not super rich but they’re well off. Typically, a big chunk of their net worth is a house that they live in. It’s a very nice house. It’s the one they want to live in the rest of their life. It’s at Florid coast or wherever part of the world or West Coast, whatever. A house is a big thing.
They’re looking at the new tax law, estate taxes and gift taxes and they say, “Hey, we can give away now an extra $5 million,” if that they have that much. We can give away a lot of money tax free and by the way, which is probably a good idea not just because the money would then appreciate outside of our state, but if the other political party gets in, they’re liable to reverse it. That’s happened before.
If you died in 2009, you pay the biggest state tax. If you died in 2010, you paid no state tax. If you died in 2011, you pay the state tax. Plenty of people who have extra money now are saying, “It’s going to be wise idea to take advantage of this new higher amount that you can give away because if you give it away they don’t claw it back if they change the law.”
A lot of people are going to want to give it away. You’re sitting there saying, “But I can’t give away that much money because, well, I’m quite well off a big chunk of my wealth is in the house. I can’t give them half the house. I can’t change the ownership, I’ll get a capital gain. It’s just a nightmare.” Instead, I get a reverse mortgage. I give the money to my children now. I’ve done the estate planning. I’ve gotten that out of my state, it’s like law changes, I’m okay.
What about me? I don’t have to make any payment on it. It’s not like borrowing on a house and then having to pay interest and principal, what happens if I lose my job? What happens if the market goes south? I’m making a leverage bet when I borrow. This thing, I never have to pay anything as long as I stay in the house. If this is house I’m going to live in … I’m trying to get you to see how powerful … and this is far better than getting an extra 50 basis points or a hundred basis points or the alpha or what do you call it, superior performance on your portfolio.
In terms of outcomes, this is the thing that this kind of using the tools that are out there effectively and efficiently is going to add so much more to the experience of people getting to a good place than getting a manager who can add, you’re just killing yourself to get an extra 1% by having a really sharp manager and so forth. I just try and get you to see this in a frame that … and if you don’t get a little of the lyrics of this, it’s like a good song.
If you’ve ever heard a good song that if you don’t like the song, you don’t care. Suppose it’s the song you like, I don’t know about you, but me, if I head a good song I say, “I really like that.” She’s sing and she’s gone what … I have no idea what’s she’s saying.
I like the song so I put it on replay over my machine and I hear it 10, 20, 30 times. I listen to it quite often. Guess what? By the end, I know every lyric. If everything I’ve said to you, you didn’t get all the lyrics, I hope you got the melody that there are many things we can do that are feasible with things that we have today. We can improve them and we should.
What we have today if we do it right, if we do the things, all kinds of things and don’t just sit there and say the same old same old same story, same reason can’t do it, can’t do it this is the way you used to it in the past da, da, da, da, da. That luxury, I’m just trying to point out to you, if you get the melody that we can solve this problem. I don’t consider solving the retirement problem a science problem. It’s an engineering problem. We know how to do it. We can get people to good places. We can’t do magic.
If people save 1% they’re not going to get here. We can get them there. We have the tools to do it. We can design things, we can do things, we can do it but we have to do it. It’s a big task. It’s doable so I guess you could call that overall for a crisis, it’s a crisis where I think we have a way to solve it.
Steve: Right. I appreciate that. Let me just reiterate. One, that 65% of people are worried about retirement and how to pay for it. It’s the number one worry from a financial perspective for people. I’m just going to try and playback to you my take away from our conversation here. One is, first measure the right thing instead of measuring assets, focus on income and what will your lifetime income be.
The second thing is give people simpler controls. Give them more actionable choices, don’t clutter up their heads with like every little detail about all the different fun choices and whatnot. It’s like more, “Hey, what do you need from an income perspective. How much risk are you going to take? How much are you going to save?” What are those big levers that they can pull and kind of illustrate for them what their future looks like based on those simple controls.
I think the third thing is make the whole mechanics of how the investing is done. Not necessarily hidden but just a lot … a more abstract from the person. Don’t make them get involved with every detail but make sure that it’s being done in an efficient way that is focused on this income at the end.
The last thing would be, really focus on … or, be open to using different or existing tools that out there today like annuitization, like accessing home equity through reverse mortgage, target date funds, whatever it is, use the products that are available today to actually realize income versus pulling your hair out trying to manage your portfolio in a perfect way for all these unknowns around inflation, life expectancy, volatility in the market, interest rate changes and everything else. Did I get that right?
Merton: I think so. I think the only thing I would want to underscore, you mentioned target date funds that I don’t think target date fund satisfies solution. I think because they have no goal and because they don’t update information about the person. The only thing that they do is give you a glide path based on your age.
If I know your age today, I know what your age would be a year from now or 40 years from now. That means, they have an investment strategy for you that is designed to manage your money with no updates because you learn nothing. The target date fund, the only thing it uses is age and I know in advance exactly what your age will be.
Would you really think that you could … that the best are approximately best strategy could be something … that something gets complex that you’re starting out at 28 and you’re working doing one thing and you’re going to retire at 68 and you don’t even know where you’re going to be and who you’re responsible for and all the things that will happen in between. Somehow that I don’t need to use any information about you such as for example, you and your twin start out exactly the same, same firm, same everything, the same income, the same job.
One day, you get called in by your boss and he says, “You’re doing a really great job. We think you’re very good. We’re promoting you, we’re going to bump your income up 20,000 a year from 35,000 or 40,000,” big jump, right, 50% income. Your twin didn’t get that. You and your twin were identical just before this, right, you’re getting everything to saying.
Now you’re 50% higher standard living than your twin, do you need the same amount retirement money as your twin? No. Do you have the same investment profile? No, Does the target date fund differentiate? No. You’re the same age, you were born 20 minutes apart.
Target date funds don’t use any new information. It is not conceivable in a world that we’re in that something that simple could solve the problem even closely. Is it better than other things? Oh yeah, I could find lots of things that are worst. Creating four X on your screen after work and your retirement account probably would not do very well, putting all your money in collectibles. I mean, I can find an infinite number of ways that poorly perform.
The fact that it’s better than some of the things we used to do, I give credit to but not much. The thing you need is diverse versions. I’m not going to advertise any but you need a system that adjust to both market and personal information and adjust what is best for you. If your goal changes because you get a big income increase because now you need to have a higher standard of living you’re going to have to do catch up. Why? Because you’ve been saving for one standard of living now you’re going to have to save for a higher standard of living. You have to make up for it for a while to catch up where your twin didn’t.
Target date funds don’t do that. I’m sorry, I won’t sign on to target date funds are good enough. They’re not. A target income fund, target date income fund is better than a target date fund because at least the target date income fund recognizes that income is the goal and puts your fixed income part in appropriate maturity bonds or annuities to match.
Let me be very clear, I do not think that target date funds qualify as a proper retirement solution. We can do much better than that. I just want to make clear, I’m not endorsing as good enough by a long shot from what we can do. One last thing, we all hear about Syntech and robos, well, I’ve been doing Syntech for almost century using computers and other things. It’s not new in that sense.
What it will do is just going to accelerate all of this because we can now do much more complicated things than just look at your age, which requires nothing. Therefore, people are going to get … just by competition, you’re going to find people providing things that allow you to adjust to changing circumstances. They’re going to put in on computers. They’re going to make these services available eventually with trust created by whoever does it. That’s important. They’re going to have it.
You’re sitting there telling people, “It’s good enough. I knew you when you were 28, I know your age when you’re 68. That’s good enough to manage your money for the next 40 years.” I don’t think you’re going to find yourself competitive. I think that it’s not that Syntech is going to be the thing, Syntech is certainly part of the enabler. My guess is that this is going to accelerate the process in which management of money takes place.
I think if you’re a professional on the management side, you better start to realize that life as usual isn’t going to stay that way. Which is, to me, just fine because I think we can build much better things.
Merton: All right. Sorry, I run off on that but I wanted to make sure …
Steve: No, no, no. Yeah, no I appreciate that. It will have to … In another 30 days I’m going to have to ask you, I’ll send you what we’re doing with our planning tool because it does let people build kind of high fidelity or a pretty precise picture of where they are today and then the ideas that it’s a living plan. It does let them kind of model different switches like, “Okay, what if I delay social security? What if I work longer? What if annuitize half of my assets at a certain point? What if I sell my house and downsize or get a reverse mortgage?”
There’s all kinds of things they can model in your tool. We totally agree. Technology is going to enable hopefully better decision making, simplify this for people, make it more efficient, lower cost, which I think everybody wants. Hopefully, lead to much better outcomes, which is what you’re trying to solve and we’re working towards that as well.
Merton: Yeah. Just also, on what you sent me. I had created target retirement solution but somehow it was referred to as target date income funds.
Steve: Target date income funds. Right, is that not correct?
Merton: No, dimensional does have target date income funds and yes because I brought income, l concept and everything to dimensional and so forth, in that sense, I am also at least part creator of that. I do not say that’s a solution. I say it’s better than a target date fund. Target retirement solution is the thing that you know a version of what you know because you did all the programming.
I mean, so you know that it does adjust to changing goals, change personal situations as well as market conditions. I just want to be clear on that because sometimes, if something gets in print or put on the podcast, it never goes away and then someone pulls a clip and says, he said target date funds are fine. I don’t want that ever on the record because that’s not true.
Steve: Yeah. We’ll definitely be clear about it. I will make sure it’s clear. Is the target retirement system, is that live?
Merton: I say we. I just got back from South Africa where it was aversion, it’s a South African version but it was just launched by Alexander Forbes, which is the largest institution for DC in the country. I think it is 25% of the market and DC is the entire retirement system in South Africa. In other words, the safety net is so small you can’t see it and there is no, in that sense, no social security except what you put in your DC plan.
In that sense, it’s kind of similar to Australia but without the safety net. I think the name of their product version of this is called Clarity. It does all the things that I said. Can you improve it? Yes. Does it have to satisfy South Africa law today? Yes. In fact, it does adjust to both personal as well as market conditions. It does focus on income. It does put people’s income part of their portfolio into indexed proper maturity done. It’s essentially immunized based on their retirement dates.
They’re doing it. South Africa, as you know, I don’t know if you’ve looked at it but it’s actually got a fairly sophisticated financial system. It has linkers out to 2050. It’s got a very well developed annuity market. Alexander Forbes is a huge full service thing. It has annuities, it has everything, it has platforms, it has custodian. It’s a very big entity in South Africa. They’ve launched it.
Steve: Awesome. I’m glad to see it getting used out there.
Merton: Yeah. It’s going to launch in some other countries too. It’s a little slower in the US. We got it here but it’s a little slower in the US partly because of regulation but any case.
Steve: Okay. Hopefully it gets fully realized because I think that would be awesome. Thanks Professor Merton for being on our show. Thanks Davorin Robison for being our sound engineer. Anyone listening, thanks for listening hopefully you found this useful. Our goal at NewRetirement is to help anyone plan and manage their retirement so they can make the most of money in time.
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