MarketWatch. Msn money 6/25/14



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Nobel laureate says seeds of a 401k crisis are sown

MIT finance professor Robert C. Merton warns that recent moves to upgrade the retirement plans have missed the point.

By Money Staff 5 hours ago

This post comes from Anne Tergesen at partner site MarketWatch. MSN Money 6/25/14

Since the dark days of 2008, employers have taken some steps to fix the 401k, the backbone of the nation's private retirement savings system. But Nobel laureate Robert C. Merton says that in the rush to upgrade these plans, sponsors and administrators have overlooked one big problem: They are managing the plans with the wrong goal in mind.



robert merton, nobel laureate and finance professor © john hanna/ap

"The seeds of an investment crisis have been sown," the MIT professor of finance writes in an article in the July-August issue of Harvard Business Review, which was published Tuesday. "The only way to avoid a catastrophe is for plan participants, professionals, and regulators to shift the mind-set and metrics from asset value to income," writes Merton, who won the Nobel Prize in Economics in 1997.

In recent years, employers have tried to improve 401k's by introducing features such as automatic enrollment and products including target-date funds. But in his article and in a recent interview with Encore, Merton said these moves are not likely to be sufficient.  To fix the 401k, he argues, employers and the financial services companies that manage the plans must get past the ongoing obsession with two things: account balances and annual returns. These metrics, Merton says, are far less important than the amount of sustainable income an employee can expect to receive in retirement.

By disclosing annual income, instead of (or in addition to) an account balance, Merton says, employers would help employees quickly and easily calculate how much of their annual salary they can expect to replace in retirement, together with Social Security. As a result, employees would be better able to take action to ensure they are on track to retire as planned.

But that’s only half of it. In order to accurately calculate how much retirement income a participant's 401k balance will purchase, the plan sponsor must assume the money will be invested in an inflation-adjusted deferred annuity or in long-term U.S. Treasury bonds. These investments, Merton writes, ensure "spendable income" that's "secure for the life" of the bond or annuity and are "the very assets that are the safest from a retirement income perspective."

That's not to say that 401k money shouldn't be invested in stocks. In fact, Merton says, 401k investment managers should invest participants' savings in a mixture of "risky assets," including equities, and "risk-free assets," such as long-term U.S. Treasurys and deferred annuities. Moreover, investment managers should shift the investment mixes over time to optimize the likelihood of success.

Employers, he says, should begin by asking employees not about their tolerance for investment risk but about their expectations for income needs in retirement.

If the investments are managed well, employees upon retirement should have enough money to buy a deferred, inflation-indexed annuity that (together with Social Security) will replace a salary in retirement. Retirees who don't want to buy an annuity don't have to have one. But once they achieve their retirement income goals, he says, they'd be foolish to leave their money at risk in the stock market.



"Think of risk as a tool," he writes. "When you don't need it, get rid of as much of it as you can, because it's costly. When we take a risk, it's generally for a good reason. You wouldn't normally put yourself in harm's way for no reason."
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