Robert Merton Discusses a Framework for Improving Defined Contribution Plans

The MIT World website is a great source for interesting lectures on many topics including finance and economics.  In this lecture, Nobel Laureate Robert Merton discusses a framework for the defined contribution (DC) plan of the future.

This video includes a long introduction, and Merton makes some opening remarks about the financial crisis.  His discussion of retirement plans starts about 17 minutes into the presentation.

Merton suggests that the DC plan of the future should require investors to make three simple decisions which will in turn drive the investment choices which are made (for them) within their portfolio. The three “sliders” which investors can adjust to control the decisions made in their portfolios are contribution level, number of working years, and minimum acceptable retirement income (i.e. a risk adjustment).

An interesting take-away from the presentation is Merton’s suggestion that risk be evaluated in terms of an asset’s volatility when valued in “annuity units”. Merton’s point is that many investments we perceive as “safe” would appear less safe if we translated them in the units that really matter…i.e. how much are they worth in terms of income at retirement.

I am not completely sold on Merton’s plan because, as a “do it yourself” investor, I don’t want to lose control of my investment decisions.  Also, I don’t trust that the money management industry will provide a solution which keeps costs low.  Nevertheless, it is interesting to see how Merton frames the retirement problem, and I would be very interested to see some portfolio construction tools which determine an asset allocation based on the three inputs he proposes.

For those interested in this topic, here is an article written by Merton which covers some similar ground.