Solutions for the future

February 2010

Most corporate retirement plans saddle either employers or workers with an unsustainable burden. Traditional defined benefit (DB) plans serve employers poorly by weighing them down with unpredictable costs and significant long-term financial liability. Traditional defined contribution (DC) plans, on the other hand, serve employees poorly, because the plans leave workers to fend for themselves in a complex and risky financial world.

DC plans encumber workers with responsibility for making important and technically complex micro-financial decisions involving risk – such as detailed asset allocation and estimates of the optimal level of saving for retirement – decisions that they did not have to make in the past, are not trained to make in the present, and are not likely to execute efficiently in the future, even with attempts at education.

Most people do not like managing their personal finances, and never look at their DC plans again after setting them up. As a result, responsibility for ensuring that workers can support themselves in their retirement has increasingly spun back around to employers. This is right, I believe, because the stakes are so high and because most people look to their employer as the most trusted source of guidance about their retirement savings.

Employers and governments around the world are struggling to find a way to give employees more help. The financial services industry has leapt into action with a variety of alternatives such as target-date funds, which are aimed at providing investment advice and execution to plan participants. These funds have had some marketing success, but they still aren’t solving the problem. The advice they provide is based entirely on a single variable – retirement age – which makes this option an extreme of “one size fits all” and surely not a personalized retirement plan. Then, at retirement, target-date funds send employees out on their own again, with no guidance about how to protect or use the lump-sum payment they receive.

The only way to solve this problem, I believe, is to step back and look at the retirement planning problem from the retiree’s perspective. Accumulated wealth is a means to an end, but it really isn’t the goal. What retirees need is to have a standard of living in retirement similar to what they experienced in their latter working years.

The structured DC solution

‘Structured DC’ is an individually tailored pension program that requires little or no input from employees. The employee can make a few meaningful choices, such as savings rates, retirement age, and the minimum amount they would feel comfortable living on in retirement. However, the system is designed to work effectively even if the employee never makes any choices at all. This default option sets a replacement ratio at the employee’s annual income earned in the last few years of employment, targeted to maintain his or her late-work-life standard of living throughout retirement.

This personal information is then integrated with other data, such as the employee’s salary and retirement assets from sources such as national insurance and DB plans. The structured DC solution then optimizes the individual’s portfolio and manages it dynamically on an individual basis to maximize the chances of achieving the employee’s goal for retirement income. Over time, the portfolio adjusts for changes in salary and takes into account risks presented by inflation, interest rates, and longer life expectancy. At retirement, instead of providing employees with a lump-sum payment, the structured DC solution directs employees to inflation-protected annuities, which will provide them with a reliable income stream in their retirement years.

We believe it is important that this new pension solution be transparent, with no hidden charges. We have also designed the solution to keep plan participants up-to-date on how they’re doing. Participants can view their account at any time and check the probability of reaching their goal. If they drift off course, they can get themselves back by adding some years to their retirement age or by lowering the annuity they would feel comfortable living on. For workers who don’t check on their progress proactively, the system will send an alert when the prospect of reaching their retirement goal becomes unlikely, prompting them to make adjustments to regain their momentum.

Market experience

The proper goal for retirees is income for life that is protected from inflation. So far, structured DC is producing results that are consistent with that goal. SmartNest, our structured DC solution, is operational in the Netherlands, Germany and the UK. Over the period of August 2008 through March 2009 – the worst equity market since the 1929 crash – SmartNest performed as designed, continuing to meet employees’ retirement objectives.

As a test, we have compared the actual performance of SmartNest to that of a typical target-date fund (from one of the largest providers of target-date funds in the world). The chart left shows what plan participants with 20 and 10 years to go until retirement would have experienced during that very difficult seven-month period.

We are excited about these results, and believe they indicate that we’re on a good path. We built the solution on market-proven technologies, and intend to make continuous improvements to ensure that we’re always doing the best possible job of meeting the needs of future retirees.

Robert C. Merton is a Nobel laureate, Harvard Business School lecturer and resident scientist at Dimensional Fund Advisors.