Life-Cycle Pension Model: Theory and Practice

Zvi BodieBoston University and Netspar Scientific Council

Henriëtte PrastDutch Central Bank, Tilburg University, and Netspar

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.

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.

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

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

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.

Prototype Products

Escalating inflation-proof annuities Life-care annuities Home equity conversion mortgages

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.

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.

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.

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

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

6312

10

15

Defined benefitDefined contributionNo preferenceDoes not know

Preference for pension schemesPercentage of respondents

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?)

Does employee want autonomy?

49

26

10

15

Leave choice to pension fund

Wants autonomy

Indifferent

Don’t know

Preference for delegation depends on

Education (+)

Risk tolerance (-)

Expertise (-)

Preferred % stocks in portfolio

Does not depend on

age

income

education

partner

Does depend on:

Gender (♂ +) – after controlling for risk tolerance and expertise

Financial expertise (+)

Subjective risk tolerance (+)

Objective risk tolerance (+)

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

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%

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

Challenges to institutions

Design commitment mechanisms Develop optimal standard choices (defaults) Provide meaningful information: