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