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

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.

Flex MMM incorporates the best features of defined benefit (DB) and defined contribution (DC) plans, ensuring retirees a target, “guaranteed”, real, retirement income, and equipping them with a pension system based on their level of sophistication, eliminating BADs, while using retirement savings to smooth life-cycle consumption and investment patterns.

• The Merton model for retirement allows participants choice of their desired level of retirement income, provides a soft guarantee through a dynamic asset allocation approach across assets, all with a single entity, thereby eliminating many of the challenges of current DC plans. Participants also choose their level of engagement in this system.
• Muralidhar’s proposed retirement BFFS bond, namely, that the U.S. Treasury should issue new forward-starting coupon-only real bonds, that start paying at retirement, with a maturity equal to average life expectancy, enhances the Merton model. They greatly improve retirement planning and security by ensuring a simple, effective, liquid, low-risk and low-cost assurance of predictable real retirement income. They hedge the cost of an annuity until the time at which the retiree chooses to purchase an actual life annuity, and facilitate regulation and easy reporting to participants. This bond, with their retiree-focused cash flow profile, would also be a good deal overall for the United States.
• Modigliani’s innovation allows participants to borrow from their own retirement accounts, while preserving retirement wealth, by setting limits, penalties and controls, and it is cheaper than credit card debt or pay-day loans.

In short, if states adopt the Flex MMM reform model, participants can avail of a simple, low-cost, low-risk retirement program, with guaranteed real retirement income, that permits a choice of replacement rates and the ability to smooth consumption.

California governor, Jerry Brown, noted, “[P]ension reform can be hard to talk about. In the long run, reform now means fewer demands for layoffs and less Draconian measures in the future. It's in the best interest of all Californians to fix this system now.”[1] We agree, and it is critical to adopt the right model to achieve all the SUPER ACCESSIBLE objectives.

Dr. 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, a Texas-based global asset management firm, and University Professor Emeritus at Harvard University.   

Dr. Arun Muralidhar, is author of 50 States of Grey and Rethinking Pension Reform (with the late Prof. Franco Modigliani), adjunct professor of finance at George Washington University, Academic Scholar Advisor at the Center for Retirement Initiatives at Georgetown University, as well as founder of Mcube Investment Technologies and AlphaEngine Global Investment Solutions.