January 5, 2009


Under the Hood: Retirement Engine Rebuilt (Paul Gleason, Harvard Magazine)

Just about everybody needs to plan for retirement. Unfortunately, mixing domestic and international stocks with traditional and inflation-protected bonds and hoping they deliver the right payoff decades in the future is a daunting task, even for professionals. And what’s really absurd, says Robert Merton, McArthur University Professor at Harvard Business School and 1997 Nobel laureate in economics, is that most self-directed retirement plans expect everyone from professors to doctors to assembly-line workers to do that mixing themselves. “Imagine being wheeled in for surgery,” he says. “I’m kind of going under from the anesthetic, when suddenly my hand-picked surgeon says, ‘Mr. Merton, do you want 17 or 12 sutures?’ But that’s what they’re asking!”

Throughout the past decade, Merton explains, companies in general have moved from plans with defined benefits (pensions) to plans with defined contributions, such as 401(k)s. Pension plans guaranteed a certain standard of living but, Merton says, they have proved far more costly to employers than expected. Defined-contribution plans are more focused on the means of making money than on the end of having enough, and transfer the risk of accumulating sufficient savings to the prospective retiree. In future retirement plans, Merton believes, the buyers will set a goal and, aside from a few important questions (how much will you save each month?), it will be the provider’s job to reach it. [...]

The trouble with asking employees to pick among investment categories within defined-contribution plans, says Merton, is that the choices aren’t meaningful. What you want to know is how much you should be saving, how much you’ll be living on if you do, and whether or not you’ll be able to retire early. Instead, your 401(k) asks you whether you’d like more mid-cap stocks. What, he asks, does that have to do with the goal of “having the standard of living in retirement that I want”? Car buyers, he points out, don’t need to know the number of cubic centimeters in their engines in order to drive off the lot.

Merton’s solution, SmartNest (already installed at a European electronics firm), gives plan-holders a few simple choices, available as a computer program. The program asks users for both minimum and ideal retirement incomes (a floor and a ceiling). Users also tell the program how much they would be willing to save each month and their preferred retirement age. Based on these inputs, the program then calculates the odds of reaching the upper goal. The investment strategy remains under the hood, where Merton or other financial mechanics can give it periodic tune-ups.

The Right will moan about reducing people's freedom, but people don't want as much as the Right wants them to want. They want a healthy dose of security.

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Posted by Orrin Judd at January 5, 2009 5:37 PM
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