Merton: Combine these 2 financial products to fund retirement

Nobel laureate and MIT Sloan professor Robert Merton is proposing an approach to funding retirement that combines two existing financial institutions: reverse mortgages and annuities.

By using them in conjunction, Merton wants to help middle-class retirees maintain the same standard of living during retirement that they’d had during their working years.

Merton, who last year was named the recipient of the S. Donald Sussman Fellowship­­­, explained how to do this in his second Sussman award lecture on Oct. 4. Here are his ideas:

Getting more from the assets people already have
For those in the middle class, typically their home is their biggest asset. They need it to live in it during their retirement years, but after they die, it often gets sold instead of staying in the family.

A reverse mortgage is a loan that retirees can take based on the value of their home. Unlike a typical mortgage, the loan-taker is not required to pay either interest or principal on the loan as long as he or she lives in the house, typically until death (though they still have to pay property taxes and homeowners insurance). In effect, they need not pay anything on the mortgage while alive. After they have passed away, whoever would inherit the home has the option of paying off the remaining balance and keeping the home or allowing the lender to sell it.

The advantage for retirees is that they can reap the benefits of what is likely their biggest asset while they are alive.

Reverse mortgages have a mixed reputation — if retirees fail to pay their property taxes or homeowners insurance, they could be subject to foreclosure — and a name that doesn’t really describe what they do. (Merton said that “home pension,” the name for the Korean version, is far more descriptive.) But in an interview Merton urged people “not to throw out a good concept because it is poorly executed. Fix how it is executed, instead.”

Right now, the U.S. government is the only entity that offers reverse mortgages, but for them to be more effective, Merton believes they need to be moved into the private sector, where there are ways to ensure that the money to pay out reverse mortgages can always be accessible.

“The idea is to make reverse mortgages available to everyone,” Merton said.

Trade money when they don’t need it for money when they do need it
Annuities are the second practice Merton thinks retirees should take better advantage of.

The way they work is that a person gives a company, often an insurance company, a lump sum. The company invests that money, and in return pays the person back a fixed monthly income for the rest of their life — no matter how long they live.  

Merton included a caveat with regard to annuities: “There are good annuities and bad annuities — I am talking about a well-designed version,” he said, referring to annuities with low fees from highly rated issuers that normally start paying recipients immediately. There are also deferred annuities — that do not start payments until a specified later date, such as after reaching age 85 — which can be used to provide longevity insurance to fit more tailored needs. Retirees need to do their homework on annuities, since there are many variations — including some that have complex terms and hidden higher fees — and retirees are sometimes pressured into plans that aren’t best for them.

When chosen wisely, annuities can help alleviate the deep and pervasive uncertainty many retirees feel about potentially running out of money before they pass away. Essentially, people are “trading money when they don’t need it for money as long as they do need it,” said Merton.

Putting it all together
When annuities and reverse mortgages are used in conjunction, they can ensure regular income for retirees, functioning similarly to the defined benefit or pension plans that worked well in the past.

As Merton explained it, if a person receives $160,000 from a reverse mortgage, and they put that money in an annuity, that could translate into thousands of dollars extra each year for as long as they live — enough to make a material difference in someone’s standard of living. Merton believes these are the only way to really “move the needle” on improving retirement benefits, without radically changing people’s saving behavior.

These practices have already started to be implemented in areas of the Netherlands and the U.K. — since the concepts Merton outlined are based on universal financial principles, they can be applied globally with slight tweaks for specific countries.

More widespread adoption may take a while. For that to happen, Merton said, “there is an absolute need for a comprehensive revisit of the design — starting with changing the name and image — and with marketing integrated into the retirement drawdown decision, streamlined regulation, and development of a reliable and low-cost funding structure based on global capital markets instead of being primarily government funded.” 

Merton recognizes that this is a big challenge, but he believes it is one that can be met largely using market-proven technologies. Ultimately, he said, “the goal is to make this an available part of everyone’s retirement plan.”