Industry Voices

An Effective DC Plan for Uncovered Workers: The Flex MMM Model

Prof. Robert C. Merton and Dr. Arun S. Muralidhar propose a model for the design of state-run retirement plans.

By PS | February 08, 2017
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A financial crisis of retirement pensions is brewing in the fifty states. Many private-sector workers, typically at the lower-end of the income spectrum (so-called “uncovered workers”), do not participate in pension plans for a host of reasons. If they retire with low, or no, savings, as projected, they become the responsibility of the state and federal government. Only eight states have passed legislation to address this issue, and have provided reasonably specific details about a preferred pension model. However, the proposed reforms require no additional liability to the state. After further review by consultants, these states have retracted some of the less feasible design features.

We propose the Flex MMM Model, incorporating the Merton model of retirement planning; Modigliani’s[1] innovative approach to allow borrowing from retirement plans; and Muralidhar’s proposed new retirement bond. The “Flex” connotes the flexibility for each state to customize this model to fit their unique situation.

Successful reforms must incorporate key objectives of all the stake-holders to ensure maximum buy-in. Analysis in California showed that uncovered participants want/need a target (real) guaranteed retirement income until death, some choice, and they would need access to the funds pre-retirement, in an emergency. Employers want a simple system devoid of legal risks; states want to ensure retirement security; and the financial industry does not want to be disintermediated.

The various stakeholder objectives can be distilled to a simple moniker: SUPER ACCESSIBLE (Simple for participants, Universal, Portable, Easy for governments, Returns that are high, Adequate pension, Choice, Certainty of outcome, Easy for employers, Smoothing of consumption, Simple report to participants, Insulated from political risk/bad governance, Be inclusive to allow the private sector to offer solutions, Low cost, and Easy to regulate), a virtue in itself.

Previous reform models do not appear to address all these SUPER ACCESSIBLE objectives. One model, for example, forces participants into a single portfolio, to lower costs and hedge against investment and longevity risks, but pooling forces a single uncertain return/replacement rate on all participants. Moreover, it transfers wealth from participants with shorter life-spans to those with longer life-spans.

Another plan goes further, by promising guaranteed returns far in excess of rates on government bonds, supposedly achieved from investing in costly, risky assets. This approach violates basic finance principles on risk-free returns and the states’ objective not to bear any liability if the portfolio does not achieve the guaranteed return. Finally, a third plan defaults participants into target-date funds that provide no guarantee of retirement income and force a cohort of participants into a single, uncertain replacement rate. Moreover, participants must purchase their own costly, opaque, complex, and illiquid annuity. Given that studies show widespread financial illiteracy, and that participants make “behaviorally affected decisions” (BADs), asking them to also make complex investment and annuity purchase decisions could lead to negative outcomes.

NEXT: The Flex MMM model

[1] The late Prof. Franco Modigliani won the Alfred Nobel Memorial Prize in Economic Sciences in 1985.