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Robert Merton on retirement incomes and Jane Austen

Given the recent discussion in Firstlinks on the home in the pension assets test and use of reverse mortgages, we republish the views of Robert Merton when we met him in 2014.

Nobel laureate Robert Merton is on a global crusade. At the moment, he’s travelling in Asia and Australia for the best part of a month, and after returning briefly to the United States, he’ll make his fifth trip for the year to Beijing. Around the world, governments and businesses are talking about pensions and retirement income.

In Australia, he’s arguing for a change in our superannuation thinking and culture. Although he recently turned 70 and was awarded the Nobel Prize for Economic Sciences in 1997, he still has boundless enthusiasm to make his case forcefully.

Even Jane Austen focussed on income

He’s almost indignant when he describes our fixation with accumulating a pot of money for retirement, rather than focussing on the income outcome. He likes nothing better than a platform to launch a tirade against the preoccupation with member fund balances, and to quote Elwood from The Blues Brothers movie, it’s like he’s on a ‘mission from God’. He says:

“The pile of money is the wrong measure. When someone wants to know how much a government pension is worth, they don’t ask for the present value. They want to know the cash flow, the regular income. ExxonMobil tells you how much your pension is for life, not a lump sum. Even Jane Austen understood this. To show how wealthy Mr Darcy was (in Pride and Prejudice), she writes that he has an income of 10,000 pounds a year. She does not refer to his assets. Standard of living is a cash flow issue. Talking about the pot is the abnormal thing.”

Merton believes this is far more than semantics. If you measure the wrong number, then you manage the wrong number. If a good standard of living in retirement is defined by a stream of income, it is unacceptable to expose a portfolio to market volatility that can upset that expected income.

Ideally, a good retirement amount should sustain the lifestyle enjoyed during the working life. It might have been acceptable to have $1 million invested in a term deposit at 5%, earning $50,000, but now in the United States, such deposits earn maybe 0.1%. The same client cannot live on only $1,000 a year. So having the $1 million pot was the wrong goal. And he adds, “If you think you don’t need as much in retirement as when you’re working, you’re wrong.”

An engineering problem with a solution

Merton is in Australia seeing institutional clients of Dimensional Fund Advisors, focussing on changing the conversation about retirement incomes. He’s confident better solutions can be found.

“Retirement is a global challenge, but it’s an engineering problem not a science problem. It’s not like cold fusion, where we don’t know whether the science can solve our energy needs. The good news is it’s addressable. The retirement challenge is due to demographics, the ageing of the population, plus people are living longer. That’s not a problem, it’s a good thing. It’s wonderful, but you have to do something about it.”

He gives a simple example. In the past, you worked for 40 years and lived for a further 10 years after retirement. So you needed to pay for 50 years of consumption with 40 years of work. If you want the same standard of living throughout, then you must save 20% each year and consume 80%. It’s simple mathematics (40 years at 20% gives 80% for the last 10 years).

What happens if you live another 10 years? You now have 40 years to save for 60 years of living, so you need to save 33% of your income and consume only 67% in your working years (40 years at 33% gives 67% for 20 years). Which means living longer requires a drop in your lifestyle from 80% of income to 67%.

This creates a problem:

“Most people are not interested in reducing their standard of living simply because they are living longer. Somehow, they want to maintain their standard of living by consuming more and then live longer, so what’s the magic answer? Earn a higher rate of interest. That is easy because it means you do not need to do anything. But this is misleading and not feasible. What about the extra risk?”

He says that at this stage in the discussion, people often tell him that over the long term, the sharemarket will deliver the required returns to solve the dilemma. He points out that the market often goes a long time producing poor returns, citing a wealthy, politically-stable country like Japan where the Nikkei index peaked at 39,000 some 25 years ago, and is now at 17,000. Any solution needs to take responsibility for the advice if it does not work, and he adds:

“Embedded in most solutions to the longevity problem is additional risk, as if that solves the problem.”

How do we ‘move the needle’ on the problem, other than working longer? There are only three possible sources of income for retirement:

1. Government, but funding problems make this an unlikely source

2. Employer savings plans, but ‘defined benefit’ schemes are no longer available

3. Personal savings. Where is the vast amount of wealth tied up for the majority of people, the millions of Australians heading for retirement without enough money? The only place is the family home.

The case for reverse mortgages

So Merton offers a surprising retirement income solution: reverse mortgages. He argues it can make a major contribution in most countries. The world has changed from where the family lived on a farm and the house needed to pass to the next generation to maintain the business. It is rare that a family home is a treasure that must be preserved for future generations. Children are unlikely to move back to the family home. In retirement, it’s a financial asset.

Merton believes showing people how to use the family home to supplement income is an important part of a retirement plan. This may come as a surprise to an Australian audience, as reverse mortgages are not popular, with only about 40,000 in existence and many former providers stepping back from the market (both ANZ Bank and Bank of Queensland recently cancelled their products).

Perhaps it’s a cultural issue, where we like to pass the full estate to our children, or the risk that comes from variable rate mortgages, where the debt can build quickly if rates rise.

To which Merton simply waves away the criticism. He said it’s like listening to a song and not understanding the lyrics at first. After you listen carefully, at the twentieth time of hearing, you’re singing along.

At the moment, in Australia on reverse mortgages, we’re just hearing the melody, but eventually, we’ll also understand the lyrics. Like in The Blues Brothers movie.


Graham Hand met Robert Merton at the Australian School of Business’s Institute of Global Finance, based at the University of NSW, and supported by PwC and Finsia.



Morningstar's Glenn Freeman and Graham Hand discuss the home in the assets pension test plus reverse mortgages in this short video.


November 26, 2019

Maybe I am wrong but I thought the value from the family home would be needed for bonds at a nursing home so you would not want that value depleted before that event ??

Roger Penhale
November 23, 2019

Very interesting article and comments too, however there appears to be a transcription error. Where your article says "It’s not like coal fusion..." should more sensibly read "It’s not like cold fusion..." which is an actual concept unlike the former.

jeff oughton
November 22, 2019

It’s a (public/private) market lacking effective competition – the financial engineering of the lifetime loan is easy – albeit selling with disinterested advice and overcoming buyer stress is difficult for some.

There's little, if any, equity or credit risk in unlocking a relatively small amount of savings in the owner-owned home of low income older Australians.

It's a AAA covered loan/bond/asset that should be funded or better packed by the govt or internalised by super funds and sold to their members or global investors at well less than the borrowing cost from both the govt's pension loan scheme and non-banks at 5% or more! Indeed, covered bonds issued by Australian banks sell at a margin of 0.8% over Aussie govt risk.

The govt at Centrelink and non-banks with related financial advisers are selling some today, but the price is way too high - so mainly low income, desperate or ill-advised people will buy and there’s a big opportunity cost.

There's a 3-month wait at Centrelink - so asset rich elderly low income Aussies that do not qualify or cannot wait, head for expensive non-bank offerings.

In short, the current market lacks effective competition and innovation by providers.

At a macro level, it's also not good for growth and jobs for younger Australians - or the national interest.

Currently, this market failure means a lot of low income older australians over save and die in their home or sell the home/pay off the loan and then enter aged care and younger australians stay unemployed and wait for a bigger inheritance.

The Treasurer has announced an inquiry, after it was raised by Australian Seniors! We do not need to wait for the retirement income review!

November 21, 2019

With respect, typical Fly In Fly Out misunderstanding about retirement in Australia, Rightly or wrongly, retirement in Australia is tax free whether it is income or capital gain - it just does not matter. You might like a deposit in your account for a dividend, you might like the associated franking credit but it is no better than a 7-8% capital gain. Get over the distraction of an "income", build tax free wealth and sell off a "bit" when you need it!

Merton's "stream on income", globally relevant, but we are different Down Under!

November 21, 2019

"reverse mortgages":

It currently costs about the value of about 2 houses for a couple on admission to an age hostel.

If said 2 houses or less have been reverse mortgaged then funding falls to government.

If said couple cease to respire while residing in said houses then government is off hook.

Longevity insurance please.

Chris Jankowski
November 21, 2019

If you have a pile of X dollars and invest them in a certain way as per your risk profile you would get a Y return.
If you have a pile of 2*X dollars and invest them the same way you would get a 2*Y return.

Focussing on the pile of money makes sense. Simple arithmetic.

But it gets better if you have 2*X pile of money. Implicitly, your risk profile has changed. You are less likely to become destitute in case of adverse investment outcome. Thus you can take slightly more risk and on average get result higher then 2*Y

November 21, 2019

"2*X dollars and invest them the same way you would get a 2*Y return":

Ignores time varying yield Z on same assets:

2*X*Zn = Yn
2*X*Zn+t = Yn+t.

November 12, 2019

November 09, 2014
With a government smart enough to plan decades ahead, every retiree in Australia could be provided for,
Consider this
1 there are about 265,000 births per annum
2 a single investment of $ 50,000 at birth by the government
3 Invested till retirement age of 70 at 6% would grow to 3.29 million or considering inflation of 3% about $405,000 in today's terms.
4 this $405,000 invested at a modest return of 5% would provide an income the same as the single age pension indefinitely.
5 the real benefit is that the capital of $405,000 is preserved for the next generation of retirees. It is not part of the estate. It is public money.
6 the retirement amounts would actually be higher as only 2/3 rds of births live to 70.
7 the initial cost of 13.25 billion per annum would be more than offset by removal of superannuation tax advantages that are disproportionately enjoyed by the wealthier.
8 those fortunate enough to be wealthier would obviously still save to provide for a more enviable retirement.
9 The aged pension would be provided for all, once the retirement age is reached.
10 retirement prior to retirement age would be self funded.
Interested in others thoughts. Maybe worth thinking about. Maybe all my calculations are wrong.

November 12, 2019

November 09, 2014
Interesting left field idea. What about migrants?

Peter Gray
November 21, 2019

I have heard way dumber ideas, the problem is because of ‘budget pressures’ the government will never do this

November 21, 2019

"single investment of $ 50,000 at birth by the government":

Or: 'Age Pension Future Fund' - for ALL age qualified regardless of assets.

People will continue avoiding individual responsibility and throwing themselves on the generous mercy of government regardless; so fund it.

November 22, 2019

Like many good ideas, this falls at the hurdle of short term thinking to gain re-election.
The other option often mentioned and quickly dismissed is to remove taxation from super contributions and earnings, but tax withdrawals as ordinary income. In an economic sense, it works fine; allowing faster build up of funds, but discouraging lump sum withdrawals.
Same problem, the government foregoes contribution and earnings tax income now, but doesn’t benefit from tax on pensions until much later.
If only we could wind the clock back.

November 12, 2019

November 08, 2014
Merton's recommendation of a reverse mortgage seems especially smart when house prices are already high, interest rates are low and you are 80 (as Steve suggests) or within 10 years of your expected lifetime. But working longer/retiring later has to be part of the story too.

Geoff Walker
November 12, 2019

November 08, 2014
Is anyone else having difficulty divining exactly what message Robert Merton is trying to articulate?
I thought I had it clear when he said “The pile of money is the wrong measure. When someone wants to know how much a government pension is worth, they don’t ask for the present value. They want to know the cash flow, the regular income.” I was nodding my head in agreement that we should focus on income in retirement, not market-value volatility.
But then he went and spoilt it by bagging the sharemarket for exhibiting market-value volatility; in other words by focusing on “the pile of money”. If he wants to bag the sharemarket, he should be doing so from a dividend-stream argument, not a market-value argument.

Peter Vann
November 12, 2019

November 07, 2014
Change the retirement conversation - yes, yes and yes.
The industry needs to better serve all members by making available estimates of retirement outcomes (i.e. the dollars one can live off). This is the solution to the “5 retirement myths?” Chris Condon and I discussed in our Cuffelinks article . The “engineering” to do this is available and can be implemented.
I do wonder how can any fund or financial advisor make investment and some other recommendations to members or clients without analysing the recommendation’s impact on the end liability, the retirement outcome? Focusing on account balance and risk tolerance relating to returns is simply missing the end-point; no wonder members find superannuation confusing when the industry doesn’t present it in terms of outcomes. This would be analogous to our banks assessing risk on only the asset side of the balance sheet rather than the total of assets and liabilities.

Cranky Pants
November 12, 2019

November 08, 2014
The answer is that many funds don't see their role as helping members to manage their income in the retirement phase, but to accumulate contributions and run a standard investment strategy so that members can take a lump sum at retirement.
The venerable Mr Merton has had an all-stops tour of Australia previously, where his work was well received and then studiously ignored by almost every fund in the country (and even those paying attention said that they wanted to do it themselves and not have Mr Merton manage the money).
As for recognition of the liability side of super (i.e. that the money is being invested for a reason) a number of funds are now saying that they believe this, but haven't changed their product design or investment approach because it was already the best thing for the member. I leave it to others to decide if that is true or not.
Unfortunately for ideas like this one, the minimal rate of returns generated by low risk assets makes them appear to be very unattractive to the average retiree. It would be IMPOSSIBLE given the contribution limits in place for Australian workers to save enough to live in retirement and buy annuities if interest rates were at US or Japan levels.
Many workers haven't saved enough for the retirement they expect, so investing large amounts of their super into shares can be see as a "There Is No Alternative" response to that situation.

Steve Schubert
November 12, 2019

November 07, 2014
I support Robert Merton's view that reverse mortgages have a key role to play, but ideally the drawings from the reverse mortgage should also be as an income stream (perhaps quarterly drawings) and should not start until the reality of longevity sets in (say age 80). In that way, the interaction with means testing is reduced as is the risk of the interest accruals eroding the equity in your home. Downsizing may be the right lifestyle choice for many, but to do it solely to release capital can be inefficient (stamp duty, legals, agents fees, not to mention means test impacts).

Jon B
November 12, 2019

November 07, 2014
What's interesting (so far) has been the responses to Robert Merton's comments. The "we've all got too much in equity crowd" see it as a vindication of their view of the world, but the example Merton uses is of CD rate volatility.
Somebody clever once said "If you think it's simple, you're stupid!".

Stuart Barton
November 12, 2019

November 07, 2014
Not sure of your logic there, Jon. That Merton used CDs and not equities as an example of a volatile asset doesn't mean equities aren't volatile. He's making the point that purportedly less volatile investments can prove highly volatile. Moreover, he cites as an example of equities' volatilty the fact that the Nikkei is sitting well below half of its peak 25 years ago. So, if anything, Merton has clearly vindicated the view of the "we've all got too much in equities" crowd with both examples - because this view is fundamentally not about equities, its about volatile returns and sequencing risk.


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