Monetary policy: It's all relative

Robert Merton
Robert Merton

We have each separately made the case that asset pricing theory and investment practice for funding retirement should focus on how much income the member has in retirement instead of the amount of wealth at retirement. This applies whether the pension benefit is generated by a defined benefit plan or a defined contribution plan.

Current practice for DB asset management is to optimize the funded status (assets divided by liabilities), where liabilities are the promised retirement income benefits to be paid in the future. However, current practice for DC asset management is to optimize wealth at retirement, which is not the correct goal (“Everyone is focusing on the wrong goal in retirement planning,” Pensions & Investments, Nov. 24, 2014, and “Adding liabilities as a reference point to MPT,” P&I, Dec. 8, 2014).

Risk measures and asset allocation are now liability-centric, and the risk-free asset would mimic the liability profile of the investor and need not be the U.S. Treasury bill, the commonly treated definitive risk-free asset. DB funds in the U.S., Europe, and U.K. typically hedge their liabilities by a long-duration bond index (in some cases, with credit). In the DC context, the risk-free asset is an inflation-indexed deferred annuity, which can be hedged during the accumulation phase by a duration-matched, inflation-protected bond portfolio. The rebalancing that investors should be provided to ensure a target retirement income is an intelligent dynamic allocation between the risky asset and duration-matched inflation-protected bonds; not a naive target-date fund approach, in which risk and return are measured in terms of wealth instead of retirement income. In short, the focus should be on relative wealth, measured in the amount of income that can be purchased in retirement — not absolute wealth — and we need to make (retirement) income the ultimate outcome.

What does this have to do with monetary policy? Your recent editorial (“Damage of low rates,” P&I, Jan. 26) discusses the effect of low rates on pension funds, and we describe why those in charge of monetary policy should consider an additional cost/benefit analysis of policy as it relates to pension and retirement security.

A straightforward approach probably familiar to most chief investment officers is that the amount of retirement income that can be purchased by a given value of assets depends on interest rates. A higher interest rate implies that more income can be purchased for the same wealth (i.e., lower liability value for DB funds). Alternatively, lower interest rates mean that more wealth will be needed to purchase the same income stream. So, with policies to change interest rates, central banks change the price of retirement income. One of the goals behind quantitative easing in the U.S., Europe and even Japan has been to pursue the “wealth effect” — pumping up the value of assets to make individuals richer, thus getting them to spend more and, thereby, prevent deflation. Furthermore, the belief that lower long-term rates leads to more investment has led the Federal Reserve, and now the European Central Bank, to depress long-term interest rates. However, if decision-makers for institutional and retail pension funds and insurance companies are not focused on wealth (as in the standard portfolio selection model), but instead on retirement income as measured by funded status, then the outcome desired by central banks might not be realized. By reducing long-term interest rates, the price of the same retirement income level goes up and the price of other assets measured in terms of income units declines — i.e., relative wealth (funded status) declines and investors are actually poorer, thereby experiencing a negative wealth effect. In a perverse way, lowering long-term rates has dramatically increased the liabilities of DB funds in the U.S., U.K., Canada and Europe (as noted in “Damage of Low Rates,” P&I, Jan. 26), and has lowered funded status dramatically in 2014. Lower rates also raise the cost of the deferred annuity that targets a specific retirement income affecting DC investors.

So, while QE has increased absolute wealth, it has simultaneously lowered relative wealth for a large class of investors. This could lead to the opposite of the desired effect for this group of investors. Lower relative wealth means investors need to save more to improve their funded status, especially where regulations are strict (i.e., divert funds from the business to the corporate pension fund or raise contributions for DC investors), and it results in less consumption and investment, and may not remove the deflationary overhang. Alternatively, investors could try to earn a higher return to improve their funded position. However, from 2003 to 2007 — before the financial crisis — funded status declined for most U.S. funds due to declining long rates, and the data shows it possibly led to an increased allocation to risky assets, which ended very badly in 2008. Depending on the size of absolute and relative investors, the central banks' moves may have no impact or may unintentionally lead to less consumption and investment.

An alternate, more sophisticated approach to explaining why QE may not work to stimulate aggregate consumption is, perhaps, because the demographic mix of the U.S. (and most parts of the developed world) has shifted toward older people. Unlike 30 or 40 years ago, the enormous baby boomer generation, and even retirees, are much wealthier (including human capital) than in the past, and they are wealthier than current generations earlier in their life cycle. Since the older cohort would surely assign higher importance to funding retirement, the funded status effect is more pronounced. When long rates go down, baby boomers start saving more instead of consuming, driving asset prices even higher (especially for risky assets, but not housing assets which they already own). So the wealth effect does not lead to an increase in consumption and, potentially, has the opposite outcome. Similarly, business fixed investment is driven not by the level of the risk-free rate, but by the cost of risky capital, which does not move in lockstep with interest rates, especially when there is an intervention. When baby boomers were in the sweet spot for housing needs, expenditures on children and cars, etc. 30 to 40 years ago, the effect the central banks were expecting from QE might have worked better, as they expected it would, but that need not be a reliable prediction under the changed current demographic and wealth distribution.

A recent study by the Center for American Progress shows that millions of Americans (as high as 50% of households) are in danger of retiring with insufficient money to maintain the standard of living to which they are accustomed, and the problem is getting progressively worse. Your previous editorial argues that QE by the central bank may impose unintended costs on pensions, at both the institutional and retail level. This suggests more research needs to be conducted to examine how monetary policy affects relative wealth, not just absolute wealth, and whether traditional approaches are outdated given the current retirement landscape. This may call for central banks to use a different set of policy tools than manipulating long-term rates, and may even argue for the Fed to actually raise long-term rates faster than what is recommended by traditional monetary policy.

We believe it is imperative for central banks and academia to examine this perspective immediately and develop a new monetary policy toolkit, because it would be tragic if the central banks' attempts to improve economic security with the current orthodoxy leads, instead, to less consumption, less investment and greater retirement insecurity.

Robert C. Merton, 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 resident scientist at Dimensional Fund Advisors and university professor emeritus at Harvard University.

Arun Muralidhar is adjunct professor of finance at George Washington University, academic scholar adviser at the Center for Retirement Initiatives at Georgetown University as well as founder of Mcube Investment Technologies and AlphaEngine Global Investment Solutions.