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Life-Cycle Pension Model: Theory and Practice

Life-Cycle Pension Model: Theory and Practice. Zvi Bodie Boston University and Netspar Scientific Council Henri ë tte Prast Dutch Central Bank, Tilburg University, and Netspar. Key Points. A new paradigm is emerging for personal retirement accounts: life-cycle structured products.

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Life-Cycle Pension Model: Theory and Practice

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  1. Life-Cycle Pension Model: Theory and Practice Zvi Bodie Boston University and Netspar Scientific Council Henriëtte Prast Dutch Central Bank, Tilburg University, and Netspar

  2. Key Points • A new paradigm is emerging for personal retirement accounts: life-cycle structured products. • Retirement investing will be about choosing among features of products designed for consumers by financial engineers. • Technological progress will make these products affordable for middle-class consumers, not just the wealthy. • Investor education will focus on helping consumers choose appropriate product features they can afford.

  3. Economic principles • No free lunch. The present value of achieving a future target cannot be lowered by taking risk. • But it can be lowered through contingent contracts that only pay off when needed. Example: life annuities only pay off if annuitant is alive.

  4. Principles of life-cycle investing • Human capital is the most important asset for most people throughout most of their lives, and it is non-tradable. • There are three dimensions of choice: • Work/leisure • Consumption/saving (time dimension) • Safe/risky portfolio (risk dimension) • Main function of financial intermediaries is to serve the needs of consumers by transforming market instruments into user-friendly products

  5. Retirement investment products today • Target-date retirement accounts • Health saving accounts • Common characteristics • Specific purpose • Specific maturity date • Tax advantaged because society wants to encourage saving for this purpose • Most of the money in these accounts is invested in mutual funds

  6. The trouble with mutual funds • Not matched to the purpose or the target date of the account • For a matching strategy, the basic building blocks must be denominated in units that match the purpose and have known maturities.

  7. Prototype Products • Escalating inflation-proof annuities • Life-care annuities • Home equity conversion mortgages

  8. The role of guarantees • Caveat emptor -- Can a client trust a firm that does not guarantee its products? • Risk is most efficiently managed by the investment firm, not by the client. • A guarantee transfers risk from the client to the investment firm. • If risk is truly small, then the cost of the guarantee will be low. • If the cost of the guarantee is high, then the risk is obviously not small.

  9. Equity participation notes • This is a model of an equity participation note (EPN). It assumes that the amount invested is 100. • The model allows you to change the parameter values--volatility of the underlying equity index, interest rate, and dividend yield, and to adjust the features of the note -- the maturity, the strike price, and the level of the guaranteed floor. • Based on these input values, it computes the present value of the guaranteed floor, the price of the embedded call option, and the participation rate. • The price of the embedded call is computed using the Black-Scholes-Merton model. • The participation rate is computed as 100 minus the PV of the guaranteed floor divided by the price of the embedded call.

  10. Escalating Annuities • Part of the retirement fund is used to buy an inflation-proof fixed annuity and part is invested in equities or equity call options. • Each year part of the equity account is used to purchase additional lifetime income.

  11. Behavioral evidence • People know what is in their best interest • But… they do not act always act according to their best interest and need help - in choosing - in committing themselves

  12. Consumer preferences in NL Van Rooij, Kool & Prast (JPubE, 2007) • What do employees know? • What do they want? • How would they choose? • Determinants of choice

  13. Employees prefer DB for two reasons • Do not want to think about investing for retirement – “finance is like medicine” • Are afraid they would save too little for retirement – self control problem • (Status quo bias?)

  14. 15 10 49 26 Leave choice to pension fund Wants autonomy Indifferent Don’t know Does employee want autonomy?

  15. Preference for delegation depends on • Education (+) • Risk tolerance (-) • Expertise (-)

  16. Preferred % stocks in portfolio • Does not depend on • age • income • education • partner

  17. Does depend on: • Gender (♂ +) – after controlling for risk tolerance and expertise • Financial expertise (+) • Subjective risk tolerance (+) • Objective risk tolerance (+)

  18. Help in choosing: default Default: what you choose when you do not choose • plan participation • savings rate • portfolio choice • withdrawal • at job change • at retirement

  19. Wanted: guarantees • Desired pension guarantee in a mixed DB/DC system equals 69% of the net final wage • DB-supporters: 55% wants a guarantee of more than 70% • DC-supporters: 51% want a guarantee of more than 50%

  20. Current policy in NL: defaults • New Pension Act: any DC plan should offer a collective arrangement • Individual default portfolio depending on time to retirement • Obligation to inform plan participant about pension rights

  21. Challenges to institutions • Design commitment mechanisms • Develop optimal standard choices (defaults) • Provide meaningful information:

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