Corporate America began to really take notice of the looming retirement crisis in the wake of the dot-com crash, when companies in major industries went bankrupt in large part because of their inability to meet their pension obligations. The result was an acceleration of America's shift away from employer-sponsored pension plans toward defined-contribution plans--epitomized by the ubiquitous 401(k)--which transfer the investment risk from the company to the employee. With that transfer has come a dangerous shift in investment focus, argues Nobel Laureate Robert C. Merton. Traditional pension plans were conceived and managed to provide members with a guaranteed income. And because that objective filtered right through the scheme, members thought of their benefits in those terms. Ask a member what her pension is worth and she'll reply with an income figure: "two-thirds of my final salary," for example. Most DC schemes, however, are designed and managed as investment accounts with the goal of accumulating the largest possible pot of savings. Communication with savers is framed entirely in terms of assets and returns. Ask a saver what his 401(k) is worth and you'll hear a cash amount and perhaps a lament to the value lost in the financial crisis. The trouble is that investment value and asset volatility are simply the wrong measures if your goal is to secure a particular future income. In this article, Merton explains a liability-driven investment strategy whose aim is to improve the probability of achieving a desired retirement income rather than to maximize the capital value of the savings.
New products and services are created to enable people to do tasks better than they previously could or do things they couldn't before. But innovations also carry risks. Just how risky an innovation turns out to be depends in great measure on the choices people make in using it. Attempts to gauge the riskiness of an innovation must take into account the limitations of the models--formal and informal--on which people base their decisions about how to use the innovation, warns Robert C. Merton, MIT professor and Nobel laureate in economics. Some models turn out to be fundamentally flawed and should be jettisoned, he argues, while others are merely incomplete and can be improved upon. Some models require sophisticated users to produce good results; others are suitable only to certain applications. And even when people employ appropriate models to make choices about how to use an innovation--striking the right balance between risk and performance--experience shows that it is almost impossible to predict how their changed behavior will influence the riskiness of other choices and behaviors they make, often in apparently unrelated domains. It's the old story of unintended consequences. The more complex the system an innovation enters, the more likely and severe its unintended consequences will be. Indeed, many of the risks associated with an innovation stem not from the innovation itself but from the infrastructure into which it is introduced. In the end, any innovation involves a leap into the unknowable. If we are to make progress, however, that's a fact we need to accept and to manage.
In this edited conversation with HBR senior editor David Champion, Merton, a professor at Harvard Business School, casts light on the role of derivatives in the current financial crisis. Merton was awarded the Nobel Prize in 1997 for his part in developing a new method to value derivatives, and after publication of that development, the markets in derivatives exploded: Today, the estimated notional value of derivative contracts exceeds $500 trillion. Merton posits that derivatives themselves cannot be the cause of a financial crisis. They are simply tools that can be used either functionally (to reduce risk) or dysfunctionally (in ways that increase risk without offsetting benefits). He also offers prescriptions for making the financial markets safer.
Senior executives typically delegate responsibility for managing a firm's derivatives portfolio to in-house financial experts and the company's financial advisers. That's a strategic blunder, argues this Nobel laureate, because the inventiveness of modern financial markets makes it possible for companies to double or even triple their capacity to invest in their strategic assets and competencies. Risks fall into two categories: either a company adds value by assuming them on behalf of its shareholders or it does not. By hedging or insuring against non-value-adding risks with derivative securities and contracts, thereby removing them from what the author calls the risk balance sheet, managers can release equity capital for assuming more value-adding risk. This is not just a theoretical possibility. One innovation--the interest rate swap, introduced about 20 years ago--has already enabled the banking industry to increase dramatically its capacity for adding value to each dollar of invested equity capital. With the range of derivative instruments growing, there is no reason why other companies could not similarly remove strategic risks, potentially creating billions of dollars in shareholder value. The possibilities are especially important for private companies that have no access to public equity markets and, therefore, cannot easily increase their equity capital by issuing more shares. The author describes how derivative contracts of various kinds are already being employed strategically to mitigate or eliminate various risks. He also shows how companies can use the risk balance sheet to identify risks they should not bear directly and to determine how much equity capacity they can release for assuming more value-adding risk.
The List is HBR's annual attempt to capture ideas in the state of becoming--when they're teetering between what one person suspects and what everyone accepts. Roderick M. Kramer says it isn't bad when leaders flip-flop. Julia Kirby describes new efforts to redefine the problem of organizational performance. Joseph L. Bower praises the "Velcro organization," where managerial responsibilities can be rearranged. Jeffrey F. Rayport argues that companies must refocus innovation on the "demand side." Eric Bonabeau describes a future in which computer-generated sound can be used to transmit vast amounts of data. Roger L. Martin says highly reliable corporate systems such as CRM tend to have little validity. Kirthi Kalyanam and Monte Zweben report that marketers are learning to contact customers at just the right moment. Robert C. Merton explains how equity swaps could help developing countries avoid some of the risk of boom and bust. Thomas A. Stewart says companies need champions of the status quo. Mohanbir Sawhney suggests marketing strategies for the blogosphere. Denise Caruso shows how to deal with risks that lack owners. Thomas H. Davenport says personal information management--how well we use our PDAs and PCs--is the next productivity frontier. Leigh Buchanan explores workplace taboos. Henry W. Chesbrough argues that the time is ripe for services science to become an academic field. Kenneth Lieberthal says China may change everyone's approach to intellectual property. Jochen Wirtz and Loizos Heracleous describe customer service apps for biometrics. Mary Catherine Bateson envisions a midlife sabbatical for workers. Jeffrey Rosen explains why one privacy policy won't fit everyone. Tihamer von Ghyczy and Janis Antonovics say firms should embrace parasites. And Jeffrey Pfeffer warns business-book buyers to beware. Additionally, HBR offers a list of intriguing business titles due out in 2005.
Nobel laureate Robert C. Merton explains that companies sometimes misvalue capital investment opportunities because they fail to adjust their cost-of-capital calculations to reflect pension risks.
Should stock options be recorded as an expense on a company's income statement and balance sheet, or should they remain where they are, relegated to footnotes? The authors believe the case for expensing options is overwhelming. In this article, Nobel laureate Robert Merton, one of the inventors of the Black-Scholes option-pricing model; his co-author on the classic textbook Finance, Zvi Bodie; and Robert Kaplan, creator of the Balanced Scorecard, examine and dismiss the principal claims put forward by those who continue to oppose options expensing. They demonstrate that stock-option grants have real cash-flow implications that need to be reported and detail the distortions that relegating stock-option accounting to footnotes creates. The authors agree that options are a powerful incentive, and failing to record a transaction that creates such powerful effects is economically indefensible. Worse, it encourages companies to favor options over alternative incentive systems.
In early 1997, Smith Breeden Associates, a money management and consulting firm, was pondering the future of the Equity Plus Fund. The Equity Plus Fund was an S&P enhanced-index fund that tried to outperform the S&P Index by replicating the index using low-cost derivative strategies and investing the remaining cash in a hedged portfolio of mortgage-backed securities. The fund had performed well since inception, with an annualized total return above that of the S&P Index. However, this performance had not resulted in significant growth of the fund's assets. With its performance record, Smith Breeden had a number of options. It could market the fund more aggressively, it could offer other sector-specific funds, or it could set up an enhanced index fund based on an international stock-market index.
Provides a brief overview of the history of the savings and loans, the savings and loans crisis of the 1980s and 1990s, and the creation of the mortgage markets in the United States. Also explains briefly the most common types of mortgage-backed securities available.
In early 1997, Harrington Bank, a small Indiana savings and loan (thrift) wondered what its next move should be. Harrington was acquired in 1988 by the principals of Smith Breeden Associates, a money-management and consulting firm specializing in the application of modern financial technology to the pricing, hedging, and risk management of mortgage securities. The Smith Breeden principals had established an arms-length contract with Harrington, where Smith Breeden advised Harrington on the pricing, hedging, active management, and risk management of Harrington's assets and liabilities. Since the acquisition, the bank had done very well. Assets had grown from $75 million in 1988 to over $520 million at the end of 1996. Its net interest margin had more than tripled, core operating profits had grown by over 400%, and return on equity had been substantially increased. Still, Harrington in 1996 was not an average thrift. 80% of its assets consisted of mortgage-backed securities (vs. 30% for the median thrift), and most of its liabilities were not deposits but other forms of wholesale funding.