Nobel Prize economist recipient Robert C Merton explains how Reverse Mortgage is wise for families.
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