Rethinking Retirement Planning

Many of us are relying on defined contribution plans to help fund retirement. But Harvard Business School professor Robert C. Merton believes today's plans are not sustainable. So what's next? A new way to look at the problem. Key concepts include:
  • Defined contribution plans currently offered by the majority of employers place an undue burden on workers who don't have the interest, time, or expertise to manage their finances.
  • A new pension program focuses on an inflation-protected annuity rather than an endpoint with a lump sum of accumulated wealth.
  • The program requires few interactions from users: "set it and forget it."
by Julia Hanna

Many of us are sailing toward retirement with the hope that Social Security, personal savings, and money saved in an employer's 401(k) or 403(b) plan will add up to the magic sum required to enjoy our remaining years in reasonable style.

But how to reach that goal can be a bit of a mystery. We all know we should be saving for retirement, but how much should we be squirreling away? And of the funds our company's plan offers, which should we choose?

According to Harvard Business School professor Robert C. Merton, the defined contribution (DC) plans currently offered by the majority of employers place an undue burden on workers who don't have the interest, time, or expertise to manage their finances. A pioneer in translating finance and mathematics into practical, Wall Street-ready models, Merton was awarded the 1997 Nobel Memorial Prize in Economic Sciences for his work on what has come to be known as the Black-Scholes option pricing model.

"Don't misunderstand me—getting some education about your financial affairs is a good idea, just as having some understanding of your medical needs is a good idea," Merton says. "But that knowledge won't qualify you to decide how much mid-cap European stock you should have in your portfolio, any more than it would enable you to perform surgery on yourself."

Intelligence is not the issue, he emphasizes; it really is a question of knowledge and time. Retirement planning as it is currently administered is in a transition phase; it simply doesn't represent a sustainable solution for consumers.

Yet employers are the natural gatekeepers for retirement plans, he believes. For example, when focus groups were presented with a new retirement product, individuals balked at signing on until they were told that the product would be offered through their 401(k). "They didn't see anything wrong with it," Merton says. "They just didn't believe it could be that good until it had their employer's seal of approval. Most people trust their employer more than banks or some other third-party provider."

This trust was no doubt engendered in an earlier day when defined benefit (DB) pension plans were offered by lifelong employers like IBM and General Motors. Today, that system is all but extinct. Merton explains that employers underestimated the cost and risk of DB plans from the start.

"The accounting system in place projected a sure-thing return of 9 percent. The problem that we've seen in the past, and that we see in our current crisis, is the tendency to talk only about return and forget risk. Risk means risk, not just a wink and a nod. 'It will all work out in the end' is not a supportable claim."

When the global stock market and interest rates began to decline in 2000, many corporations faced a double whammy when returns on pension assets were well below expectations and pension liabilities rose by much more than expected.

"At that point, CEOs began paying attention to this as a strategic issue," Merton says. "They had been offering unions the choice of a dollar's worth of salary or what they thought was a dollar's worth of benefits. Most unions picked the benefits, which were in fact worth $1.50."

Retirement Planning Reborn

So where does this leave us? Still in transition, unfortunately, but Merton has an idea for a different approach that would provide an integrated solution to the retirement conundrum. "Think of it as an answer, but not the only answer," he says.

The plan incorporates many of the aspects of the current DC system, with one important difference: a focus on an inflation-protected annuity rather than an endpoint with a lump sum of accumulated wealth.

"This is not anything new or radical," says Merton. "In Pride and Prejudice, Jane Austen didn't describe Mr. Darcy by saying he was worth 100,000 pounds. She'd say that he was worth 4,000 pounds a year. That's how we usually think of our standard of living."

Merton says we're used to the mutual fund industry as a vehicle for getting to our retirement goal, yet few of us have a deep understanding of the mechanics behind it. "It's like compression ratios on car engines. Or dual overhead camshafts. What does that mean in terms of what matters to me? Does it get me more gas mileage? In the same sense, what you're really worried about is your standard of living, not what's under the hood in terms of the rate of return distributions to get you to that goal."

With that in mind, Merton and a team of financial engineers created SmartNest, an individually tailored pension program that requires just a few simple inputs from employees before they "set it and forget it"—what most of us do by default, anyway.

First off, employees are asked to input their desired annual income in retirement. If they are not sure, the recommended target to maintain one's standard of living is around 70 percent of your annual income earned in the last few years of your work life. They are then asked to input the minimum amount they would feel comfortable living on. ("It's a device to calibrate your risk tolerance," Merton says.)

That information is then integrated with the employee's additional sources of retirement income such as Social Security, a DB plan, or an IRA (when you leave an employer, you typically roll your 401k into an IRA) to determine and implement a dynamically optimized portfolio strategy that maximizes the chance of achieving your desired retirement income goal.

Over the years, that managed portfolio adjusts for factors such as increases or decreases in salary and takes into account explicitly the risks of changing life expectancy, inflation, and interest rates.

Course Corrections

Merton uses the analogy of an ocean liner sailing from England to New York. When just out of port, there are many unforeseen things to correct for along the way so a precise course is not necessary. But as the ship nears port, greater and greater accuracy is required if it's to avoid running aground and miss achieving its goal.

"We have your goal in mind and do the dynamic trading with the target vision to get you there," Merton explains. "We don't try to pretend we can outperform the market. I'm not saying people can't do it, but if something is going to be scalable to the millions of workers who will be entering the system in the coming years, that idea doesn't work as a core strategy."

Participants in the system can view their account at any time and check the current probability of reaching their desired retirement goal. If they're uncomfortable with that figure, they can breathe a little easier by upping their contribution or deciding to add a year or two to their retirement age. Or they may decide to lower the annuity they'd feel comfortable living on. Any or all of these factors can be adjusted until a more acceptable probability is reached.

"These are real decisions for you, not how much mid-cap stock to buy," says Merton. "If you choose to save more, your paycheck will be smaller. You're trading off consumption now for consumption in retirement. This is real. The idea is to provide meaningful choice, objective analysis, and a system that will work even if you make no choices at all."

"I'm not saying it can't be done better," Merton says of the program. "We anticipate making continuous improvements. But this is something we've built with market-proven technologies that is addressing a real need right now. As more and more people are brought into employer retirement plans, it's going to have major implications for how this service is delivered."

SmartNest is currently used by Philips in Holland, Germany, and the United Kingdom.

So stay tuned. Retirement as we know it is an evolving concept. For one person it may be the classic vision of a condo on a golf course in Florida. For another, a sojourn in Africa with the Peace Corps. Now it seems that the way we achieve our retirement dreams, whatever they may be, soon could be changing as well.

About the Author

Julia Hanna is Associate Editor of the HBS Alumni Bulletin.