How Much Retirement Income Can Your 401(k) Produce?

In the wake of the Enron scandal and the credit crisis of 2008, employers have taken some steps to shore up the 401(k), the backbone of the nation’s private retirement-savings system. However, Nobel laureate Robert C. Merton says that plan sponsors and administrators have overlooked one big problem. Simply, 401(k)s are often managed with the wrong goal in mind.

While reforms have focused on increasing employee participation with features like automatic enrollment and easy to use target-date funds, Professor Merton writes, ““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.”

Merton, who won the Nobel Prize in Economics in 1997, argues that employers and plan participants alike must turn their attention away from account balances and annual returns and focus instead on the amount of sustainable income an investor can expect in retirement. In his view, annual income should be displayed instead of (or in addition to) the account balance. Merton says this will help employees calculate how much of their annual salary they are on track to replace in retirement.

To that end, Merton also suggests that rather than allocate assets according to their risk tolerance, investors should explore their expectations for income needs in retirement. That should lead, he says, to portfolios comprised of “a mixture of risky assets, including equities, and risk-free assets, such as long-term U.S. Treasuries.”

Once investors reach their retirement income goal, Merton 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.”

Merton has been working with Dimensional Fund Advisors to turn his ideas about 401(k) reform into a commercially viable strategy. This recent Forbes article by Matt Schifrin details those efforts.

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