ROBERT C. Merton, a recipient of the 1997 Alfred Nobel Memorial Prize in Economic Sciences, is the School of Management Distinguished Professor of Finance at the MIT Sloan School of Management. He is also the resident scientist at Dimensional Fund Advisors, a Texas-based global asset management firm, and University Professor Emeritus at Harvard University.
Assets Versus Income
Traditional defined-benefit pension plans were conceived and managed to provide members with a guaranteed income. And because this objective filtered right through the scheme, members thought of their benefits in those terms. Ask someone what her pension is worth and she will reply with an income figure: “two-thirds of my final salary,” for example. Similarly, we define Social Security benefits in terms of income. A graded annuity whose income payments grow at the expected rate of inflation can also be used when inflation-protection is not available. The annuity could provide a joint survivorship feature for a spouse but would provide no other death benefits or payouts.
The seeds of the coming pension crisis lie in the fact that investment decisions are being made with a misguided view of risk. Case in point: When wealth maximization is the goal of retirement saving, the T-bill is seen as a risk-free investment. But when volatility is measured in terms that matter to retirees (how much a saver would receive annually if the investment were converted into an income stream), we clearly see that th;e T-bill is actually quite risky.
Investing in T-bills will keep your principal safe…
Consider an individual who invests retirement savings of $1 million in T-bills. As the chart below shows, the change in asset value over time is close to zero, so the saver has minimal risk of losing any of the invested principal.
…but the income you can buy with the principal is highly volatile.
But consider the same individual who wants to convert the T-bills into an income stream to live off in retirement. The return (change in how much annual income the saver receives) depends enormously on exactly when he makes the conversion.
The graph shows the percent change in the amount of inflation-protected income that could be purchased with the T-bill portfolio at a given time (for example, by converting it into a deferred inflation-proof annuity).
This simulation is done by totaling the current market value of a portfolio of traded U.S. Treasury inflation-protected securities bought so as to provide adequate funds to purchase the income stream in 20 years. In the absence of an active market in deferred inflation-proof annuities, this provides an estimated value of the deferred income.
To understand what that means in commonsense terms, consider a person who plans to live off the income from $1 million invested in T-bills. Suppose he retires in a given year and converts his investments into an inflation-protected annuity with a return of 4% to 5%. He will receive an annual income of $40,000 to $50,000. But now suppose he retires a few years later, when the return on the annuity has dropped to 0.5%. His annual income will now be only $5,000. Yes, the $1 million principal amount was fully insured and protected, but you can see that he cannot possibly live on the amount he will now receive. T-bills preserve principal at all times, but the income received on them can vary enormously as return on the annuity goes up or down. Had the retiree bought instead a long-maturity U.S. Treasury bond with his $1 million, his spendable income would be secure for the life of the bond, even though the price of that bond would fluctuate substantially from day to day. The same holds true for annuities: Although their market value varies from day to day, the income from an annuity is secure throughout the retiree’s life.
