Feature: Nobel Prize-winning economist Robert Merton

Written by Jessica Guerin

Robert C. Merton has been called a groundbreaking economist, an options guru and one of the finest minds in finance. For those in tune to the finance world, Merton is as high-profile as it gets.

A sought-after speaker on the investor circuit, Merton caught the attention of the crowd at an asset management conference in St. Louis last fall when he commented on the value of reverse mortgages. “Americans have wrongly steered clear of reverse mortgages,” he said. “This is going to become one of the key means of funding retirement in the future.”

Merton’s advocacy of reverse mortgages coincides with support from other leading academics and financial experts. It just might signal the beginnings of a shift in public opinion. Certainly, support from someone as influential as Robert Merton is a tremendous boost for reverse mortgages, one that might help elevate the product in the financial community, in the press and in the public eye.

Who is Robert Merton

Robert Cox Merton is a longtime student of economics. He holds a B.S. in engineering mathematics from Columbia University, an M.S. in applied mathematics from the California Institute of Technology and a Ph.D. in economics from MIT, in addition to honorary degrees from 13 universities. (Merton’s father, a prominent sociologist, was also a noted academic, known for pioneering the focus group and coining the terms “role model” and “self-fulfilling prophecy.”)

In 1997, Merton was awarded the Nobel Prize in Economics for his work in developing a new method to determine the value of derivatives. His options-pricing method, the Black-Scholes model, has been labeled one of the most revolutionary concepts in modern finance.

Nowadays, Merton sits on the faculty at MIT’s Sloan School of Management, serves as a professor emeritus at Harvard University, and is a resident scientist at global asset management firm Dimensional Fund Advisors. His current research includes a focus on lifecycle investing and retirement funding solutions, a topic that has led him to assess the benefits of home equity conversion. His work takes him around the world, where he speaks before groups of riveted followers and sometimes extols the reasons why reverse mortgages have such value.

The Global Retirement Crisis

According to Merton, home equity conversion stands to play a key role in solving the retirement crisis—a problem that plagues countries around the world, not just the U.S.

The global financial crisis that exploded in 2007/2008 depleted savings for many and volatile markets prevented a significant rebound. Add to this a dramatic increase in the 65-plus population and increasing life expectancies around the world, and it’s clear that the world economy is experiencing pressure like never before. Faced with an aging population, government benefits and pension plans in many countries are stifled as resources once earmarked for retirement funds are being funneled toward health care and other services to accommodate aging.

“The world is getting older,” Merton says. “With our baby boomers in the U.S., we are an older society. China is aging even faster than the U.S., and Korea faster than China. Increasing demographics is putting pressure on funding.”

This means that the traditional three-legged stool of retirement funding—government benefits, employer pensions and personal savings—is getting awfully wobbly. It appears that now, the responsibility to fund retirement has mostly shifted to the individual.

Rethinking Retirement

But the picture is not entirely bleak, as Merton points out. “There is good news, and I underscore, it is very good news: Future generations are going to live longer. This is great. But, as with many good things, there comes another challenge, which is simply how to fund those extra years.”

If you live 10 years longer than your parents, but still want to retire around 65 as they did, you now have to save enough to support 20 years of retirement, Merton points out. “The only way you can do that is to save 33 percent of your income.”

If saving more during your working years proves impossible, the alternative is to alter your lifestyle in retirement. 8 “If you want to work the same number of years your parents did, fine, but you’ll have to accept a lower standard of living,” he says. “If you want to have the same standard of living as your parents, you can have 12 years of retirement—they only had 10—but you have to work 48 years, not 40.”

Basically, Merton says it boils down to this: “You either have to work longer or accept a lower standard of living. What you can’t do is work the same number of years as your parents, live longer and enjoy the same standard of living. That’s not feasible.”

Finding a Solution

For those who can’t work longer or save more, Merton draws attention to another solution.

“There is one more thing we can do to try to address the challenge, and that is to take the assets people have and get more benefits from those assets. Now, I don’t mean get higher returns; we’re already trying to get the highest returns on our investments that we can for the level of risk, we can’t just dial up the return… So how do we get more from the assets? Well, we use them differently and we develop tools that are efficient for doing that.”

One specific asset that needs to be tapped, says Merton, is the house.

“There’s no magic potion here. For working middle-class people, the biggest asset they have is not their retirement pension, it’s their house. And it’s typically the only major asset they have, but it is big. I’m talking about the house they want to live in in retirement.”

Merton says we need to start thinking about the house differently, viewing it as an asset rather than treating it as part of our legacy.

“The house is like an annuity: It provides the housing you need for as many years as you need it,” he says, adding that the idea of leaving the house as a bequest is flawed. “In our society, and even in Asian societies that are transforming from agrarian to industrial, the children don’t move into the house. No matter how precious the house is, how sacred, in any culture, in the end when you don’t need it anymore, it’s going to get sold, and that makes it a financial asset. So it’s an annuity while the retiree needs it, and then it becomes just a financial asset.”

Overcoming Obstacles

While Merton praises the concept of a reverse mortgage, he takes issue with the name itself, which he says has hindered the product’s acceptance.

“I hate the name. First of all, it’s misleading because saying it’s a mortgage makes it sound like it’s a loan. But with reverse mortgages, you don’t pay anything as long as you stay in the house. So it’s a very different animal. It also sounds like you’re leveraging your house.”

Merton points out that other countries with similar equity conversion programs have much better names. “In England they call it equity release, that’s a little more neutral. I like the Korean name; they call it a home pension. It’s more descriptive. The house itself provides you a pension, and the home pension allows you to take some of the value from the house to provide you additional pension. It doesn’t say anything about a mortgage or imply that you may owe money.”

Merton admits that confusion about the product is problematic, and says the HECM program as it currently stands may need some tweaking to help the product reach its full potential.

“We also have to educate people as to the proper use of them and in general make them much more efficient,” he says.

“You hear some people say reverse mortgages are bad, but I think what they may mean is the way that they are currently being produced and sold, and the cost associated with them, is not a good example of the product,” he says. “I think that’s what they mean, but people hear it as, ‘Reverse mortgages are not a good idea and we should ban them.’ I say that a reverse mortgage is a good idea, but maybe we need to fix the design a bit. Let’s fix it if we need to, but don’t get rid of it.”

Merton says making product improvements, which have already taken place with recent changes from HUD, is a large but feasible undertaking.

“It’s going to require a lot of hard work and innovation, which we know how to do. It’s a simple engineering problem,” he says, adding that he doesn’t believe a government-sponsored program is the right way to go.

“There’s going to be a need to find wide-based funding sources, and I don’t believe government is the answer. HECMs are about the only reverse mortgages out there, and it’s a government plan, but government balance sheets just aren’t big enough,” he says. “We have to find very efficient ways to provide the funds for the reverse mortgages, but we can do it.”

Global Acceptance

Merton predicts that home equity conversion—whether it’s called a home pension, an equity release or a reverse mortgage—is going to be a crucial part of solving the retirement income problem.

“I believe it is going to be essential for a good retirement around the world. In Asia, they are paying a lot of attention to it, they are working on it. There is a lot of interest in developing it in many countries. Even in Colombia and Latin America, where they don’t have a reverse mortgage, they are very interested in finding out about it.”

“Sooner or later, to have a decent retirement, a number of people are going to have to tap into this. It’s not a matter of choice. This is going to be an essential part of the foundation for funding retirement around the world.”

  • George Owellia

    Merton suggests three things: 1) reverse mortgages only be proprietary, 2) the name be changed so that the mortgage nature of the product becomes translucent, and 3) that the proceeds be viewed as income.

    Merton shows misconceptions of what HECMs are by stating: “There’s going to be a need to find wide-based funding sources, and I don’t believe government is the answer.” Ask any lender where they go to get the money to fund their HECMs. It is not the government (or a GSE, i.e., Government Sponsored Entity) as it once was when Fannie Mae acquired all HECM production.

    We still are dependent on a division of a department of our government to ultimately help us find private and public parties to acquire our securities but our secondary market is much broader than a single GSE as it was before 2007, and our principal funding source for 2007, 2008 and early 2009.

    So is Merton familiar with our current long-term funding solution? Or do the Ginnie Mae required issuer (and rippled) guarantees give him pause as to the true nature of the HECM secondary market?

    It seems Merton is attempting to show us the flaw in our marketing compliance. The vast majority of us are more than aware that calling this tool a mortgage does not help sell the transaction. Yet how else would one describe what is essentially a negatively amortizing non-recourse mortgage? This name game is not exactly new with Merton but as of yet, regulator, Congress, and consumer protection organizations seem reluctant to approve any change that would transform into less transparent into translucent.

    Having heard an address by Merton where these issues were discussed, it is clear his ideas about reverse mortgages are in the formative stage. It would be interesting to have him speak about the further development of these ideas at a NRMLA convention and hold that convention in DC where regulatory policy makers, senior legislative staff members, and leadership from the personal financial planning community could attend.

  • The_Cynic

    Why is there a need to classify reverse mortgage proceeds as something they are not. They are clearly cash inflow but since they are expected to be repaid, they cannot be classified as income. As the axiom goes, “at origination every reverse mortgage participant is expected to make income except the borrower.”

    A name change is not a bad idea but to remove the word “mortgage” from its name may make it less objectionable to prospects but not to those we must give an accounting. It is hardly more descriptive. The name reverse mortgage is far too off-putting but what about retirement mortgage which seems less offensive and yet adds to the meaning of this mortgage. However, if this or a similar name are adopted in place of reverse mortgage, many laws, regs, and other authoritative legal documents will have to be changed.

    The Doctor is a smart guy. It would be good to have him apply his genius to changing HECMs and proprietary products to what he has in mind.

    • LibelFreeZone

      “They are clearly cash inflow but since they are expected to be repaid, they cannot be classified as income.”

      Sure, they can. The loan is expected to be repaid, but NOT necessarily in the borrower’s lifetime. Therefore, the house provides income to the borrower through the liquidation of his/her equity. Such semantical gibberish coming from you on every article, Mr. Cynic. Shame on you.

      • The_Cynic


        What does the following statement even mean? “Therefore, the house provides income to the borrower through the liquidation of his/her equity.” What equity? That is nonsense.

        The cash proceeds comes from a lender based on a loan document. Otherwise, if the line of credit has a $100,000 in it but the value of the home is $300,000 and the balance due on the HECM is $310,000 where is the equity being liquidated from so that the borrower can take $50,000 or more (or less) at will? There is no equity from which it is coming from. Equity is the answer to a math problem not a reserve to pay out proceeds on a mortgage.

        A HECM is debt, not equity!! The borrower has as much legal equity when he owes $5,000 on a home worth $200,000 as he does if he owes $205,000 as long as the borrower is meeting the terms of the HECM. Legal equity is one thing and a math problem quite another.

        How is equity ever income to a borrower? Your logic and reasoning are sophomoric at best. Your understanding of HECMs is quite confused. I suggest you seek help from HUD personnel.