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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. - PowerPoint PPT Presentation
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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: