©Olivia S. Mitchellmitchelo@wharton.upenn.edu

Financial Innovations for Analyzing & Managing Retirement Risks

Issues in retirement income market:!Demand Side

➥ Undersaving is widespread➥ Asset risk not diversified➥ Dissaving poorly managed

!Supply Side➥ Narrow purview of financial advisers➥ Assets inefficiently and unproductively invested

!Result: elderly vulnerable to old-age income insecurity

The Challenge:

" Identify risks to retirement accumulation & decumulation

" Use risk management tools to guide better retirement planning & products

" Make retirement income products more accessible & more widely used

The Life Cycle Model

$

AgeR D

Saving

Dissaving

Earnings

Consumption

Difficult for many to know: how much to save, in what assets?

" Little known on variability of and correlations in returns to assets (human capital, financial capital, pension assets, housing).

" Co-movements in asset prices and inflation not known. " Projecting medical costs difficult." Projecting government support risky.

Retirement Systems in Flux:Systems rely on one or more of the following

institutional forms: # Support from family or community;# Pension plans from employers/labor unions;# Social insurance programs run by governments; # Personal saving (e.g. real & financial assets

including equity in one’s home or business, saving accounts, insurance contracts, etc).

Mix must change…

" Demographic change: in industrialized countries people are living longer and having fewer children.

" Financial system evolving: disintermediation$ less reliance on institutions of family, employer,

and government; $ more reliance on financial markets.

" Govt programs face insolvency

OECD Social Security Debt(% of GDP to 2050; IMF)

0 20 40 60 80 100 120

UK

Sweden

US

Canada

Italy

Japan

Germany

France

Average

% of GDP

Developments in Retirement Accumulation & Decumulation

" Financial planners focus on narrow risks/rewards:" Many emphasize investment, insurance

purchase" Not same as risk management

" But risk and investment management must be integrated.

Distinguish 3 risk-management tools:

" Hedging: cut loss by sacrificing potential for gain. EG: US govt inflation indexed bonds.

" Insuring: pay fixed sum to cut risk of losing larger sum. EG: principal guarantee funds.

" Diversification: reduce exposure to risk without lowering expected ROR. EG: don’t hold only domestic assets; value = f(correlations across risky assets).

New Retirement Planning Models

" Personal Funding Ratio (Leibowitz): user selects target replacement ratio. Software converts to EPDV, compares to assets on hand. Computes shortfalls & saving objectives.

" ESPlanner (Bernheim): Life insurance focus for financing consumption; tax rules; no uncertainty.

" Financial Engines (Sharp): Markov simulation of pension self-directed account returns, projects probability of success/failure.

Challenges in retirement planning field:" How do workers, retirees, policymakers process

information and act on it? " How to extract & handle risk tolerance toward uncertainty

and investor ability to change behavior?" How to measure correlations across risky assets? (human

wealth, housing equity, and pension wealth from both public and private sources)

In other words: how to incorporate, communicate, manage uncertainty?

Developments in Retirement Saving Accumulation" The Dominant 401(k) Model" Cash Balance: A few major US corporations

" Rationale: cut DB early retirement incentives, reduce overfunding

" Main effect: larger/more portable benefits to younger and more mobile employees; cut spikes in accruals at high seniority

" Financing controversy: sponsors offer bond returns, invest in equities.

Pension asset limits cut performance: % Many countries limit retirement investments: EG domestic assets,

bonds vs stocks% Rationales given: safety, currency controls, flow of domestic K,

infant industry protection

Asset Class Argentina Chile

Government Bonds 65% 50%

Stock & Mutual Funds 53% 47%

Corporate Bonds 70% 45%

Bank Deposits 28% 50%

Foreign 17% 9%

Other 40% 39%

TOTAL 273% 240%

Srinivas (1999)

Problem:

% Limits expose plan participants to lower returns with inferior risk exposure.

% Restrictions impose implicit tax on investors:% Restricts pension members to worse risk-

return tradeoff % Globally diversified portfolio would be

preferable.

Estimated Efficient Frontier for World Stock Markets

-0.004

-0.002

0

0.002

0.004

0.006

0.008

0.01

0.012

0.014

0.016

0 0.0002 0.0004 0.0006 0.0008 0.001 0.0012 0.0014 0.0016 0.0018 0.002

Variance (risk)

USA

EuropeAsia-Pacific ex Japan

Japan

Latin America

Expected Return

Source: MS Total Return Indices, Real $US, Continuously Compounded Returns, 1/88 6/99, assumes normal returns.

Annual Vanguard Expenses(in hundredths of a percent or basis pts, 1999)

Account Type Expenses (BP) Fund SizeInt’l Growth (1981) 58 $9.7BWindsor II (1985) 39 19.1Wellington (1929) 30 26.9Windsor (1958) 28 17Growth Index (1992) 22 15.2Bond Mkt index (1986) 20 9.5Prime MM fund: Inst (1989) 15 1.7Value Index:Inst (1998) 12 32.5

Note: recordkeeping costs additional.

Developments in Consumption Protection After Retirement

" What is the risk? Consumption shortfalls due to outliving assets & inflation

" Key instruments of consumption protection:$ must be free of default risk;$ must match the maturity and time pattern of the

spending target; $ must be protected against adverse selection and moral

hazard.

But in real world…

Nominal bonds and annuities have not done well to transfer resources safely over time.

! Costs have been high.! Issuers have defaulted/confiscated. ! Nominal bonds suffer inflation. ! Life expectancy changes hard to predict.! People want liquidity against unanticipated eventualities.! Asymmetric information: Those who ‘need’ the product buy

and those who have it use it more

Confiscation problems:

" Insolvency: insurers may lack supervision, regulation, assets adequate to guarantee benefits.

$ Response: reporting/disclosure; mark assets/liabilities to market; report ROR and risk; better ratings; more competition; possibly new assets required and international diversification.

" Taxation: high taxes on elderly consumption (e.g. pension tax, life insurance payout tax, capital gains tax, wealth tax) and indirectly via means testing for safety net programs.

$ Response: Individual accounts may reduce political risk.

The Problem of InflationInflation-indexed bonds can be a long-run hedge.

• 1981 UK; 1994 Canada; 1997 US TIPS; 1998 US I-bonds. • Pensions hold these in UK, Israel, Australia.

■ Market considerations:– Low commissions make planners unlikely to sell.– Some illiquidity at first – Low anticipated inflation level/volatility; higher expected

returns on stocks and belief that stocks are not risky.

■ The future: growth in individually-managed retirement accounts to drive growth, reduce commissions, cut adverse selection.

Stock prices can go down in retirement and not recover

Inflation-Adjusted NYSE Index

0102030405060708090

100110

1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984

End of Year

The Problem of Longevity

" Annuities key to retirement payout issue" Adverse selection important, probably falling over

time" Prediction problems remain:

" Sweden indexed benefits to cohort-specific life expectancy

" Survivor bonds may protect a cohort against unexpected mortality changes: but require cross-generational contracts (supported by governments).

Annuities are looking better over time…EPV/$1 premium

Year Gen Mortality Annuit. Mortality

1985 0.704 0.7901990 0.757 0.8561995 0.756 0.853

Source: Brown, Mitchell, Poterba, Warshawsky (1998). (corp. yield curve, after tax)

US Men Age 65: 1985-95Adverse Selection now ~ 10%

The Problem of Desired Liquidity" Annuitization problematic if need cash for nursing

home care. " Possible response: a bundled/integrated

instrument that combines life annuity with long-term care insurance.

" Mitigates adverse selection in the demand for each of the two products on a stand-alone basis (Warshawsky)

How to Access Housing Wealth?" US housing ~$150K for people near retirement.

" But few draw down housing wealth to smooth consumption

" Rather, housing wealth accessed at crisis (eg death of spouse, when ill; self- insurance).

" Need for "reverse annuity mortgages”: " Homeowner sells some of net home equity to financial

institution which pays fixed monthly income flow for life. " At death, the financial institution sells the home and

recovers remaining equity.

RAM market slow to develop…" Buyers are those who expect to live long (assym info)

and if do buy, might not keep up the house (moral hazard).

" US case: So far ~50,000 sold. # Homeowner equity capped at ~1/2.# Upfront costs ~ 14% of capital.# Risk of foreclosure.# Uncertainty about tax status.

" Need simpler and more transparent, less costly, and better regulated, to meet retiree needs.

Major lessons:" Information re retirement risks hard to obtain &

process." Retirement models fall short thus far. " Innovations are coming: Financial products include inflation-linked

annuities, survivor bonds, long-term care insurance, reverse annuity mortgages.# Some bundle existing insurance products. # Some slowed by market failures and institutional

rigidities as well as information barriers.

Background: an increasingly financially disintermediated world…

" Financial decision-making must be cast so ordinary people can understand and implement.

" Choice and diversification required for asset accumulation and decumulation phases.

" Savers and retirees need higher returns while cutting risk.

" New role for education: train the financially unsophisticated.