Creating a duration matched LMP/floor is consistent with the lifecycle model. Someone with a utility function of the form u(c-x) where u(.) is a CRRA utility function should create an LMP that funds a floor of $x per year and invest the rest in a risk portfolio with a fixed asset allocation given by the Merton share. Such preferences would effectively be decreasing relative risk aversion (DRRA). i.e. Floor + CRRA = DRRA. The learn section of TPAW planner explains why this is the case (in the paragraph about a guaranteed spending level under Extra Spending) and ConstantChrysalis illustrates this with an example here.
TPAW allows for floors. After duration matching is implemented, there will be a separate section where you can enter a duration matched floor. For now, the hack is to enter it as an extra essential expense for all of retirement (which gets funded by 100% bonds), or for more accuracy, as income during retirement (while subtracting the LMP bonds from the portfolio balance.)
In the lifecycle model without risk, there are only bonds and so there is only a duration matched floor. There is no risky asset and so no risk portfolio. So some might refer to creating a duration matched floor as lifecycle finance. But in the presence of a risky asset, the floor is only part of the solution. We also have to think about how we invest in stocks. It can't be ad hoc. It has to flow from a utility function which specifies preferences over risk and return.
The articles by Merton that bobcat2 shared above are proposals by Merton to improve on the current state of retirement planning. His target audiences are entities like employers, 401K plan administrators and governments. He is laying out what he sees as problems with the current state of affairs and what he believes would be a feasible improvement on the present system.
He has frequently described the problem with the current system in these and other articles as well as in his interview with Rational Reminder (episode 234): While defined benefit (DB) systems communicated the right thing—how much income the worker will have in retirement—defined contribution (DC) plans causes investors to inappropriately focus on the value of the portfolio. Converting the value of the portfolio to a stream of income in retirement is nontrivial and most people cannot be counted on to do that. So he wants employers and plan administrators to take on more of the responsibility of managing the money, and to communicate only meaningful numbers in a simple way that employees can understand.
Merton feels that many investors don't have the necessary expertise to make sound financial decisions:
I think that the TPAW approach can work for a wide group of people. We have worked at making the online planner easy to use, and have been encouraged by the number of people who have reached out to say that they found the tool quite accessible. Nevertheless, we can see that the TPAW approach or the survey approach might not work well as the default planning method for the types of entities that Merton is speaking to in these articles. These entities have to serve a broad audience which will invariably include people who won't want to put much time or thought into the planning process. So a full blown lifecycle approach might not be feasible in this context, and we'll have to resort to something simpler.
In these articles, Merton suggests asking for an income goal and then trying to maximize the probability of achieving that. Haghani and White demonstrated the problem with maximizing the probability of achieving a goal (The Missing Billionaires, page 98). But it's possible that this is the best we can do if we have to cater to a broad audience that includes investors who require a very simple framework.
This is not a new and improved version of the lifecycle model, as bobcat2 claims. It's a proposal regarding what can be realistically done to improve planning for a broad audience and change their focus from the portfolio balance to retirement income.
TPAW allows for floors. After duration matching is implemented, there will be a separate section where you can enter a duration matched floor. For now, the hack is to enter it as an extra essential expense for all of retirement (which gets funded by 100% bonds), or for more accuracy, as income during retirement (while subtracting the LMP bonds from the portfolio balance.)
In the lifecycle model without risk, there are only bonds and so there is only a duration matched floor. There is no risky asset and so no risk portfolio. So some might refer to creating a duration matched floor as lifecycle finance. But in the presence of a risky asset, the floor is only part of the solution. We also have to think about how we invest in stocks. It can't be ad hoc. It has to flow from a utility function which specifies preferences over risk and return.
The articles by Merton that bobcat2 shared above are proposals by Merton to improve on the current state of retirement planning. His target audiences are entities like employers, 401K plan administrators and governments. He is laying out what he sees as problems with the current state of affairs and what he believes would be a feasible improvement on the present system.
He has frequently described the problem with the current system in these and other articles as well as in his interview with Rational Reminder (episode 234): While defined benefit (DB) systems communicated the right thing—how much income the worker will have in retirement—defined contribution (DC) plans causes investors to inappropriately focus on the value of the portfolio. Converting the value of the portfolio to a stream of income in retirement is nontrivial and most people cannot be counted on to do that. So he wants employers and plan administrators to take on more of the responsibility of managing the money, and to communicate only meaningful numbers in a simple way that employees can understand.
Merton feels that many investors don't have the necessary expertise to make sound financial decisions:
- To begin with, putting relatively complex investment decisions in the hands of individuals with little or no financial expertise is problematic. (page 44, The Crisis in Retirement Planning)
Consumer education is often proposed as a remedy, but to my mind it’s a real stretch to ask people to acquire sufficient financial expertise to manage all the investment steps needed to get to their pension goals. (page 48)
Choosing not to educate customers is not a radical idea. Many technologically sophisticated products are actually designed to minimize learning requirements on the part of the user. (page 48)
The bottom line is that we have to be realistic about what we can expect people to understand (or what they should have to understand). Rather than trying to make employees smarter about investments, we need to create a smarter dialogue about how the plan provider or its investment management agents can help them achieve their goals. (page 48)
I think that the TPAW approach can work for a wide group of people. We have worked at making the online planner easy to use, and have been encouraged by the number of people who have reached out to say that they found the tool quite accessible. Nevertheless, we can see that the TPAW approach or the survey approach might not work well as the default planning method for the types of entities that Merton is speaking to in these articles. These entities have to serve a broad audience which will invariably include people who won't want to put much time or thought into the planning process. So a full blown lifecycle approach might not be feasible in this context, and we'll have to resort to something simpler.
In these articles, Merton suggests asking for an income goal and then trying to maximize the probability of achieving that. Haghani and White demonstrated the problem with maximizing the probability of achieving a goal (The Missing Billionaires, page 98). But it's possible that this is the best we can do if we have to cater to a broad audience that includes investors who require a very simple framework.
This is not a new and improved version of the lifecycle model, as bobcat2 claims. It's a proposal regarding what can be realistically done to improve planning for a broad audience and change their focus from the portfolio balance to retirement income.
Statistics: Posted by Ben Mathew — Thu Feb 20, 2025 1:32 am — Replies 78 — Views 7567
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