MARIDA BERTOCCHI Optimizing...MARIDA BERTOCCHI is Professor of Portfolio Theory, University of Bergamo. She taught numerous courses at the Universities of Bergamo, Urbino and Milan,

Marida Bertocchi Sandra L. Schwartz William T. Ziemba

Optimizing theAging, Retirement, and PensionsDilemma

Optimizing the Aging, Retirement, and Pensions Dilemma

Optimizing the Aging, Retirement, and Pensions Dilemma

BertocchiSchwartzZiemba

$75.00 USA/$90.00 CAN

P lanning for retirement is one of those issues that can be summarized in the observation that there is both good news and bad news:

the good news is that we are living longer, the bad news is that we have to pay for it. As we recover from the worst economic crisis since the 1930s—with large losses in pensions, incomes, and savings—we fi nd that old adages like “stocks for the long run” and the safety of index and exchange traded funds have not worked to protect asset values.

Ensuring suffi cient resources for retirement en-compasses a complex set of decisions involving tax issues, assumptions on future salaries and poten-tial loss with change of jobs, asset allocation for defi ned contribution pension plans, longevity, in-terest rates, infl ation, and, on retirement, whether to buy an annuity—all in the face of changing demographics and social factors. Each of these issues requires careful individual decision making in the face of increasing risk.

Written in a straightforward and accessible style, this book offers valuable advice on today’s toughest retirement issues, and shows how gov-ernment and corporate entities can help while assessing the risks to their own balance sheets. It also addresses some of the macroeconomic issues, asking whether an economy can effectively save without investing in productive assets.

The authors begin by exploring the key issues in retirement, including changing demographics and the shift from defi ned benefi t to defi ned contribu-tion plans. They discuss various asset classes and how they might be used for saving for retirement. The authors analyze the 2007–2009 economic cri-sis and its impact on retirement assets and future retirement practice. In Part II, they offer more in-depth analyses of key issues, such as asset allo-cation in government-owned pensions, individual asset-liability management and the role of annui-ties, insurance, and managed withdrawal plans, and more. Finally, in Part III, they bring the various issues together to present an all-encompassing

modeling framework. While complex to implement, such models provide a good way to plan and take various future scenarios into account in these un-certain, ever-changing times.

MARIDA BERTOCCHI is Professor of Portfolio Theory, University of Bergamo. She taught numerous courses at the Universities of Bergamo, Urbino and Milan, including basic and advanced calculus, mathematical finance, advanced mathematical fi nance, stochastic optimization, and parallel processing. Bertocchi has been Dean of the Faculty of Economics and Business Administration and is the Director of the Department of Mathematics, Statistics, Computer Science and Applications, University of Bergamo. She is the author of numerous publications on bond portfolio management, asset allocation, quantitative fi nance, and economic and fi nancial applications.

SANDRA L. SCHWARTZ received her interdisci-plinary PhD from the University of British Colum-bia in commerce, economics, and ecology. She has taught business policy, business and society, and topics in research and development and applied economics at Berkeley, UCLA, Tsukuba, UBC, and Simon Fraser. Schwartz designed programs and courses for the Open University of BC. She is the author of a number of books on energy policy, Japa-nese management and economy, and other topics, as well as numerous articles.

WILLIAM T. ZIEMBA is the Alumni Professor of Financial Modeling and Stochastic Optimization (Emeritus), University of British Columbia. He is a well-known academic with books, research articles, and talks on various investment topics and a columnist for Wilmott magazine. Ziemba has visited and lectured at MIT, University of Chicago, Berkeley, UCLA, Cambridge, LSE, Oxford, and the ICMA Centre. He trades through William T. Ziemba Investment Management Inc. He has consulted for various fi nancial institutions including hedge funds, pension, and other investment institutions.

“Aging populations in developed nations raise many challenges, and capital markets will play a critical role in addressing them. This volume offers a coherent and concise introduction to the fi nancial economic framework that will be vital for analyzing and ultimately

resolving these challenges.”

James PoterbaMitsui Professor of Economics, MIT, and President,

National Bureau of Economic Research

“An impressive collection of ideas and information. This will be a valuable reference and resource for investors, advisors, and fi duciaries.”

Edward O. Thorp Edward O. Thorp & Associates,

author of Beat the Dealer and Beat the Market

( c o n t i n u e d o n b a c k f l a p )

( c o n t i n u e d f r o m f r o n t f l a p )

Praise for

EAN: 9780470377345 ISBN 978-0-470-37734-5

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vi



Optimizing the Aging,Retirement, and

Pensions Dilemma

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Optimizing the Aging,Retirement, and

Pensions Dilemma

MARIDA BERTOCCHISANDRA L. SCHWARTZ

WILLIAM T. ZIEMBA

John Wiley & Sons, Inc.

iii



Copyright C© 2010 by Marida Bertocchi, Sandra L. Schwartz, and William T. Ziemba.All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Bertocchi, Marida.Optimizing the aging, retirement, and pensions dilemma / Marida Bertocchi,

Sandra L. Schwartz, William T. Ziemba.p. cm. – (Wiley finance series)

Includes bibliographical references and index.ISBN 978-0-470-37734-5 (cloth)

1. Retirement–Economic aspects. 2. Retirement income–Planning. 3. Pensions.I. Schwartz, S. L. (Sandra L.), 1943– II. Ziemba, W. T. III. Title.

HD7105.3.B475 2010332.024′014–dc22

2009031715

Printed in the United States of America

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To my nieces and nephews

—Marida

To Rachel who makes us so proud, and to Ruthwho lives the social security dream

—Bill and Sandra

v



vi



Contents

Acknowledgments xv

Preface xvii

PART ONEThe Aging Population: Issues for Retirement 1

CHAPTER 1Issues in Retirement 31.1 Longevity and Changing Demographics across the World 41.2 The Evolution of Retirement 8

1.2.1 Older Workers as a Growing Share of theWork Force 11

1.3 Provision for Retirement 111.3.1 The Earliest Pensions 111.3.2 Early Corporate Pensions 121.3.3 Total Assets on Retirement 151.3.4 The Contribution of Various Assets at Retirement 15References 19

CHAPTER 2The Various Costs of Pensions: Macro and Micro 212.1 Governmental Cost of Retirement 212.2 Pensions and Capital Formation 222.3 Regulating Corporate Pensions 24

2.3.1 US Regulations 242.3.2 Corporate Bankruptcies Leave a Trail of

Broken Promises 302.3.3 Comparing Regulation of Occupational

Pension Schemes in the EU and the United States 312.4 DC vs. DB: Shifting the Risks 33

2.4.1 Pensions, Corporate Earnings, and Tax Deferral 37

vii



viii CONTENTS

2.5 Freezing Pension Plans 392.6 Where Do We Go from Here? 40

References 41

CHAPTER 3The Various Pillars of Retirement: Social Security, CompanyPensions, Supplementary Pensions, and Private Savings 433.1 Pillars of Retirement 433.2 Reforming OECD Pensions 513.3 Changing Role of Private Pensions 51

3.3.1 Summarizing Pension Reforms in the OECD 553.4 Plans for Reforming Social Pensions 56

3.4.1 Increase Contributions, Cut Benefits, ExtendWorking Life 56

3.4.2 Use the Contributions to Buy Stocks insteadof Government Bonds 58

3.5 Rethinking Pension Promises: Breaking the FixedLink to a Monetary Value 613.5.1 Feldstein’s PRA with Guarantees 613.5.2 NDC: Notational or Nonfinancial

Defined Contributions 623.5.3 The PAAW (Personal Annuitized Average

Wage Security), a Variant of the NDC 663.6 Intergenerational Risk-Sharing 673.7 Conclusions 693.8 Case Study: Public Sector vs. Private Pensions 70

3.8.1 Government Plans Are Different: US 703.8.2 Government Plans Are Different: Canada 723.8.3 What Do We Learn from These Comparisons? 73References 73

CHAPTER 4Asset Classes: Historical Performance and Risk 774.1 Equities 774.2 ETFs: Exchange-Traded Funds 89

4.2.1 Levered ETFs 934.3 Bonds and Fixed Income 93

4.3.1 TIPS 954.4 The Bond-Stock Measure for Medium-Term Large

Crash Prediction 954.4.1 The 2000–2003 Crash in the S&P 500 103



Contents ix

4.5 Hedge Funds 1124.6 Real Assets 121

4.6.1 REITs 1214.7 Housing as an Asset Class 1214.8 Gold and Other Commodities 1254.9 Private Equity and Related Assets 1264.10 Currencies 1264.11 Evaluation of Great Investors 1294.12 Fundamental and Seasonal Anomalies of Asset Returns 135

References 141

CHAPTER 5The Current Economic Crisis and Its Impact onRetirement Decisions 1455.1 Household and Government Debt 1455.2 Were the Crash Models Helpful in Signaling the US

and Worldwide 2007–2009 Crash? 1465.3 The Subprime Crisis and How It Evolved 148

5.3.1 Favoring the Financial Sector: Evaluating thePolicy Responses 150

5.4 Impact on Retirement Expectations 1535.4.1 Plan Sponsors in Trouble 156

5.5 Pensions in Trouble 1605.6 State Pensions 1615.7 Future ERP 162

5.7.1 Companies Freezing Pension Plans 1655.7.2 The Ultimate Strategy: Bankruptcy 165

5.8 Future Inflation and Pensions 165References 166

PART TWOSpecial Issues and Models 169

CHAPTER 6The Impact of Population Aging on Household Portfoliosand Asset Returns 1716.1 Introduction 1716.2 The Empirical Evidence 172

6.2.1 The Empirical Evidence in a Micro-Perspective 1736.2.2 The Empirical Evidence in a Macro-Perspective 181



x CONTENTS

6.3 Models for Portfolio Choices and Life-CycleAsset Allocations 1936.3.1 The Seminal Models 1946.3.2 More Realistic Portfolio Models 1966.3.3 Life-Cycle Asset Allocation Models with

Uninsurable Labor Risk 1986.3.4 Life-Cycle Asset Allocation Models in the

Presence of Annuities 2046.4 Conclusions 207

References 210

CHAPTER 7A Continuous Time Approach to Asset-LiabilitySurplus Management 2177.1 The Rudolf-Ziemba (2004) Intergenerational

Surplus Management Model 2187.2 A Case Study Application of the Rudolf-Ziemba Model 222

References 226

CHAPTER 8Should Defined Benefit Pension Schemes Be Career Averageor Final Salary? 2278.1 Introduction 2278.2 Career Average Defined Benefit Schemes 2288.3 Cost Neutrality 2298.4 Choosing the Revaluation Rate 2308.5 The Adoption of Career Average Pension Schemes 2328.6 Advantages of a Switch to a Career Average Scheme 236

8.6.1 Employer 2368.6.2 Members 240

8.7 Disadvantages of a Switch to a Career Average Scheme 2418.7.1 Employer 2418.7.2 Members 245

8.8 Redistribution Effects of a Switch to CareerAverage Pensions 2458.8.1 Compensatory Salary Changes, Pension

Contributions, NIC, and Income Tax 2478.8.2 Model of the Redistributive Effects of a

Switch to Career Average 2488.8.3 Numerical Example of the Redistributive

Effects of a Switch to Career Average 2508.9 Conclusions 253

References 254



Contents xi

CHAPTER 9Applying Stochastic Programming to the US Defined BenefitPension System 2599.1 Introduction 2609.2 Integrated Corporate/Pension Planning Model 261

9.2.1 Multiperiod Stochastic Programming Model 2629.2.2 Alternative Goals 264

9.3 Assisting the Defined Benefit Pension System 2659.3.1 Industry Projections 2659.3.2 Applying Stochastic Programs to Industries

in Trouble 2709.4 Conclusions 273

References 274

CHAPTER 10Mortality-Linked Securities and Derivatives 27510.1 Introduction 27510.2 Longevity Risk Transfers 278

10.2.1 Pension Buy-Outs 27910.2.2 Securitization of Life Insurance Assets

and Liabilities 28110.3 Capital Market Solutions and the Development of

Mortality-Linked Securities and Derivatives 28210.3.1 The EIB Longevity Bond 28310.3.2 Mortality Catastrophe Bonds 284

10.4 Recent Trends in Mortality-Linked Securities 28610.4.1 Mortality Indexes 28610.4.2 Mortality Swaps and Forwards 28710.4.3 Mortality/Longevity Futures and Options 289

10.5 Hedging Pension Liabilities with Mortality-LinkedSecurities and Derivatives 29010.5.1 Cash Flow Hedge Paradigm 29010.5.2 Value Hedge Paradigm 29110.5.3 Longevity Risk Pricing and Optimal

Security Design 29210.6 Conclusion 296

References 296

CHAPTER 11Asset Allocation and Governance Issues ofGovernment-Owned Pensions 29911.1 Introduction 29911.2 Types of Sovereign Funds 301



xii CONTENTS

11.3 Is There a Common Asset Allocation forPension Funds? 303

11.4 Sovereign Pension Funds and InternationalCapital Markets 305

11.5 Governance Issues of Public Pension Funds 30611.5.1 Intergenerational Borrowing 306

11.6 Regional Trends 30911.7 Conclusion 313

References 314

CHAPTER 12Issues in Individual Asset-Liability Management for Retirement 31512.1 Own Company Stock 31512.2 The Role of Annuities 31912.3 The Role of Insurance 32112.4 The Role of Managed Withdrawal Plans 322

12.4.1 Mandatory Withdrawals 32212.5 Where and How to Retire? 322

12.5.1 New Type Retirement Communities 32312.5.2 Assisted Living 32312.5.3 Reverse Mortgages 32312.5.4 Does It Pay to Have Multiple Residences? 32412.5.5 Interest-Free Loan 326References 326

PART THREEModeling the Issues 329

CHAPTER 13Learning from Other Models 33113.1 Preserving Endowment Spending 331

13.1.1 Cloning the Yale Approach 33513.1.2 Dealing with Liquidity the Yale Way 33613.1.3 Swensen’s Rule and Others 336

13.2 Devising a Rule So That Spending Never Falls 33713.2.1 A Protective Spending Model 341References 343

CHAPTER 14The Innovest Austrian Pension Fund Financial Planning Model 34514.1 How Should Companies Fund Their Liabilities and

Determine Allocations among Asset Classes andHedging Instruments? 345



Contents xiii

14.2 Formulating InnoALM as a Multistage StochasticLinear Programming Model 349

14.3 Some Typical Applications 35214.4 Some Test Results 35614.5 Model Tests 359

14.5.1 Final Comments 362References 364

CHAPTER 15An Individual ALM Model for Lifetime Asset-Liability Management 365

References 371

CHAPTER 16Implementation and Numerical Results of Individual ALMModel for Lifetime Asset-Liability Management 375

References 392

CHAPTER 17Conclusions 393

Index 397



xiv



Acknowledgments

F irst, we would like to thank Costanza Torricelli and Mariana Brunetti,John M. Mulvey and Zhuojuan Zhang, Charles Sutcliffe, Enrico Biffis

and David Blake, Rachel Ziemba, and Vittorio Moriggia for contributingtheir knowledge and time to write new chapters for this book. Their breadthof knowledge expanded and strengthened this book.

Sandra would like to thank the women of the pilates coffee group forletting her practice her ideas on them.

Our editors at John Wiley & Sons in the United States, Bill Falloon,Meg Freeborn, Kevin Holm, and Tiffany Carbonier; and in the UK, CaitlinCornish, and Aimee Dibbens, have been very helpful throughout the processof producing this book.

This research was supported in part by the Italian research grant ofthe Ministry of Education and Research “Financial innovations and demo-graphic changes: new products and pricing instruments with respect to thestochastic factors aging” (coordinator Bertocchi).

Special thanks go to various universities which extended useful facilitiesto Sandra and William during the final stages of the preparation of thisbook; thanks especially go to St. Catherines College and the MathematicalInstitute, Oxford University, the ICMA Centre University of Reading, 7Cities, Wilmott magazine, the business school at the National TechnologicalUniversity of Singapore, the Toulouse School of Economics, the Universityof Bergamo, and the University of Venice.

xv



xvi



Preface

May you live in interesting times.

P aradoxically, this ancient Chinese saying is both a blessing and a curse.Interesting times are challenging times. In regards to many economic,

social and political issues, we can affirm that these are interesting times.Planning for retirement, however, is one of these issues which can be encap-sulated in the observation that there is good news and bad news: the goodnews is that we are living longer, the bad news is we have to pay for it.

In 2009, we are in the worst economic crisis since the 1930s, with largelosses in pensions, incomes, and savings. Renewal from the crisis will requirea global shift in consumption and saving patterns. These are indeed very in-teresting times, if you look at issues in economics and finance, but especiallyfor pensions and retirement. Old adages like stocks for the long run andthe safety of index and exchange-traded funds have not worked to protectasset values. Moreover, losses of retirement assets in the near term havecoincided with job losses and reductions in value of other assets, includingproperty. Almost all asset classes have become increasingly correlated ascredit has contracted and economic growth has slowed sharply. Many indi-viduals and investment vehicles charged with saving for retirement lookedto make up gaps in financing by shifting into different asset allocations.Major corrections in corporate bonds, exchange traded and private equity,and alternative assets mean that making up the shortfall may be prolongedas individuals face the risk of elevated unemployment for a long period.

This book began as an attempt to fill the gap identified by the OECD andothers on the need to improve financial education for retirement. As orig-inally envisioned, this was mainly a question of wealth and asset liabilityallocation over time. Ensuring sufficient resources for retirement encom-passes a complex set of decisions involving tax issues, assumptions of futuresalaries and potential loss of income with change of jobs, asset allocation fordefined contribution (DC) pension plans, longevity, interest rates, inflationand, on retirement, whether to buy an annuity. All this in the face of changing

xvii



xviii PREFACE

demographics and social factors, including increased life expectancy and theswitch to defined contribution pension plans. All of these issues requirecareful individual decision making in the face of increasing risk.

The shortcomings of individuals in providing for their retirement arelegion: insufficient savings, inability to access and deal with risk, lack ofunderstanding of asset allocation, inability to read and understand reportsfrom their pensions, lack of determination of the funds needed to retire, lackof understanding of longevity risk, and so on. This book will help individ-uals plan better for retirement, making use of government and corporateentities to help them while assessing the risks to their own balance sheets.It also addresses some of the macro economic issues such as whether aneconomy can effectively save without investing in productive assets. Ratherthan setting a retirement age, we suggest that society as a whole to considerretirement a phase that depends on ability to work, gets phased in, and lastsa limited time until expected death. This would be a reversion to long-heldlife cycle ideals. In doing so, we would likely need to create a path for workthat could continue as strength declines.

All that said, the scope of this book has been expanded to include adiscussion of the current worldwide economic crisis and how that impactsretirement savings. We are sitting on a potential retirement time bomb, butthere is still time to defuse it—and that is what this book is about.


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PART

OneThe Aging Population:

Issues for Retirement

1



2



CHAPTER 1Issues in Retirement

We begin by discussing the changing demographics and theevolution of retirement.

O ver the course of decades we have evolved a hodge-podge of promises andpolicies relating to retirement. Our image of retirement has evolved from

that of an infirm old age into a picture of ceasing work at a vigorous middleage, perhaps 60, having a life of leisure activities in a nice home with easyaccess to health care when it is needed and no financial worries. A confluenceof issues have put this idyllic picture at risk. First is demographics: we areliving longer. Second is affordability. Both public and private retirementprovisions are at risk.

Roots of the Problem

Social provision for retirement grew over the decades, without prior plan-ning, as a series of responses to a variety of economic and social issues. Theroots of the growing retirement and pension problem come from a numberof areas:

1. The social desire to avoid poverty in the aged population, to insureincome when one is too old to work.

2. The entitlement to leisurely old age meets up with changing demograph-ics, age distribution becoming top heavy with fewer workers to supporteach retiree.

3. The attempt to put off labor negotiations by trading off current incomefor retirement income This led to company pensions.

Number 1 is both a reflection of a charitable instinct and the social trendsof the elderly living independently of their families, who have often scattered

3



4 THE AGING POPULATION: ISSUES FOR RETIREMENT

to other regions and no longer directly support them. This was the beginningof social security legislation. This is important; even though economics isconsidered the selfish science, nevertheless a social instinct exists.

Number 2 became a problem over time. This is the modern feeling thatone should not need to work all of one’s life. This led to various methods ofshifting income into the future. When retirement benefits were first granted,the population was younger, originally few people were eligible and thebenefits were modest. The program grew far beyond its roots into a full-blown provision for retirement income.

Number 3 is akin to the subprime crisis: business put off to the futurethe hard decisions and gave in to labor in the short term to avoid the longer-term issues of labor-management relations—this was good for neither andhas left the economy deprived of real innovation, with huge unpayable debtand further distrust.

All jurisdictions and corporations have attempted to tinker with theproblem: programs have been changed in marginal, efficiency-improvingways. Countries might, for example, increase the number of years used tocalculate the base of the social security payment (for example, France wentfrom counting the best 10 years to the best 25). These tactics do not solvethe problem but they do ameliorate it. (See Chapter 8.)

In this chapter we look first at the changing demographics. Then weexplore the evolution of the concept of retirement and the assets availableon retirement. We conclude with a road map for the rest of the book.

1.1 LONGEVITY AND CHANGING DEMOGRAPHICSACROSS THE WORLD

Let’s look at a compilation of various tables from the UN cited in Haas(2007). Together these paint a vivid picture of changing demographics.Table 1.1 shows that fertility rates have dropped below replacement in allcountries in the survey except India. Japan was the earliest in the late 1950s;China was the latest through severe penalties for families with more thanone child, a policy that began in 1979 and dropped the country belowreplacement beginning in the 1990s.

Table 1.2 shows the rapid growth in life expectancy from 1960–1965 to2000–2005. There has been an average increase of 14.5 years in a 40-yearperiod. In China the increase was more than 30 years and India almost 25.Russia added less than one year, so leaving it out would raise the average tomore than 16 years. All these years are essentially added to retirement undercurrent cultural expectations!

Table 1.3 presents the percent of the population over 65 in 1950, 2000,and projections for 2050. The numbers are astounding. On average almost



Issues in Retirement 5

TABLE 1.1 Fertility Rates by Country over Time

Years Years Fell belowCountry 2000–2005 Replacement

Germany 1.32 1970–1975Japan 1.33 1955–1960Russia 1.33 1965–1970UK 1.66 1970–1975France 1.87 1975–1980China 1.70 1990–1995US 2.04 1970–1975India 3.07 2025–2030

(projected)

Source: Haas (2007).

TABLE 1.2 Life Expectancy

Country 1950–1955 2000–2005 % Increase

Japan 63.9 81.9 28.17France 66.5 79.4 19.40UK 69.2 78.3 13.15Germany 67.5 78.6 16.44US 68.9 77.3 12.19China 40.8 71.5 75.25Russia 64.5 65.4 1.40India 38.7 63.1 63.05


TABLE 1.3 Population over 65 by Country over Time, %

Country 1950 2000 2050

India 3.3 4.9 14.8US 8.3 12.3 20.6Russia 6.2 12.3 23.0UK 10.7 15.9 23.2China 4.5 6.8 23.6France 11.4 16.3 27.1Germany 9.7 16.4 28.4Japan 4.9 17.2 35.9

Average 7.4 12.8 24.6





TABLE 1.4 Median Age by Country over Time

OverallCountry 1950 2000 2050 % Change

Japan 22.3 41.3 52.3 134.53India 20.4 23.4 38.7 89.71China 23.9 30.1 44.8 87.45Russia 25.0 36.4 43.5 74.00US 30.0 35.3 41.1 37.00Germany 35.4 40.0 47.4 33.90France 34.5 38.0 45.5 31.88UK 34.6 37.7 42.9 23.99

Average 28.3 35.3 44.5 64.1


25% of the population of these countries is projected to be over 65 in 2050.Already in 2000 the average (unweighted) is 12.8% so that would be adoubling of the proportion in the 65+ age bracket.

Table 1.4 presents the median age for selected countries in 1950, 2000,and projections for 2050. Again, the numbers are astounding. On average(unweighted), the median age is expected to rise from 28.3 in 1950 to 44.5in 2050. The four countries that started with the lowest median ages havethe highest increases: in the case of Japan more than doubling. The westerncountries starting out with median ages above 30 have lower increases, butstill the level is significant.

Table 1.5 considers these numbers another way, presenting the supportratio by country, the number of workers per person over 65. In line with

TABLE 1.5 Support Ratios by Country over Time

Country 1950 2000 2050

India 17.2 12.4 4.5US 7.8 5.4 3.0Russia 10.5 5.6 2.6UK 6.2 4.1 2.6China 13.8 10.0 2.6France 5.8 4.0 2.1Germany 6.9 4.2 2.0Japan 12.1 4.0 1.4





10987

6

5

4

3

2

11950 1960 1970 1980 1990

PAST FUTURE

US

Europe

Japan

2000 2010 2020 2030 2040 2050

1.29

1.80

2.72

Source: Data obtained from the U.N. Demographic Commission.

F IGURE 1.1 Ratio of Population Aged 20–65 to Population Aged 65 and OlderSource: Siegel (2008).

the above numbers, this ratio goes from an average of about 10 in 1950 to6.2 in 2000 and down to 2.6 in 2050. Figure 1.1 dramatically shows thechanging age distributions over time in the three regions, the US, Europeand Japan.

Looking at the support ratios, it is indeed frightening to realize howfew workers would be supporting the retirees. However, there have beentimes in the past when an aging population was also a concern. Europe inthe 1920s to 1950s after much loss of population from two wars projectedthat problems would arise from an aging population. For example, in theUK they worried that the percentage over 65 would rise from 7.2% in 1931to 17.5% in the late 1970s. This did not happen, of course, but as thesetables show, we cannot think of all these older people as being unproductiveand no longer contributing to their own support. A vigorous older age mustmean a more productive 65-year-old! We will come back to this issue later.

Figure 1.2 shows most dramatically the impact of aging on the workingage distribution. This is for Japan at three points of time, 1950, 2005, andprojected for 2050 as the shape evolves from a tree to a kite. Children aregenerally less costly to support, and there is a long history of tax incentivesand community support for child rearing including schools and after schoolactivities. While in the older years, health care and other costs expand.




1.2

100

80

60

40

20

0

Total:83m

Source: National Institute of Population and Social Security Research.

Total:128m

Total:95m

Age100

80

60

40

20

0

Age100

80

60

40

20

0

Age1.20.8

1950 2005 2050, forecast

Men WomenFrom tree to kiteJapanese population pyramids, m

0.4 0 0.4 0.8 1.2 1.20.8 0.4 0 0.4 0.8 1.2 1.20.8 0.4 0 0.4 0.8

F IGURE 1.2 Changing Age Distribution in Japan, 1950, 2005, 2050 estSource: The Economist, 2007.

Initially, when people retired out of necessity, the costs of support werelower. Now with the expectation of an active retirement the costs are greater.

Biffis and Blake in Chapter 10 consider financial instruments to insureindividuals and pension schemes against longevity risk.

1.2 THE EVOLUTION OF RETIREMENT

People used to work as long as they could, often till they dropped. In order toretire in good health, there must be funds available to support the activitiesof the nonworking years.

When retirement came from necessity, and before modern health care,the requirements of the retired were minimal—keeping them comfortableand fed. Now people are retiring younger and in more vigorous health, sotheir consumption requirements are higher, and also modern health care isable to offer more services for the elderly and that too costs more.

The first income security insurance program was established by Ottovon Bismarck in 1881. In part this was a response to social unrest at thetime. This plan paid out the insurance at 70, at which age few workingmales were still alive (though at that time Bismarck himself was 74). Thepurpose was to offer protection from poverty when workers physically couldno longer work and to protect widows and orphans of working males who




died young from loss of income. The minimum age was lowered to 65 in1916 and became the initial standard of the US social security program.

There were some limited occupational plans in the 19th century. Belgiumhad compulsory insurance for seamen in 1844 and Italy in 1861. The UK hadearly plans for customs and civil servants (1859) and paid 1.67% of salaryper year of employment up to two-thirds of salary, and blue collar planspaid about half the rate. Bismarck’s plan was the first with broad coverage(40% in 1889 and 54% by 1895) (Clark, Munnell, and Orszag 2006). Thedestruction of net worth in wartime and depression led Europeans to pushfor more public income security plans.

Originally when the retirement age was set at 65, the majority of peoplehad already died. Then with slightly increased life spans, retirement waspossibly the last 10% of adult life; about 40 years of work followed byperhaps 5 years of retirement. Now the ratio of working life to retirementhas been squeezed on both sides. The average age at retirement has declined,and the life span has increased. Now in some countries people work only 30years followed by 30 years of retirement (OECD 2008). The average rate ofemployment in OECD countries for ages 55–64 is 48% (and only 25% inFrance, 70% in Switzerland).

In 1880 75% of men older than 64 were working, by 1950 it was47% and by 1998 less than 20%. Later people began to expect 10 years ofretirement after 40 years of work. Clearly, for many people, retirement ismore attractive than working. The ability to be idle for such spans of lifewas helped by the growth in pensions and income support. In 1961, whensocial security was amended to allow early retirement at 62 at a lower benefitthere was a spike in people commencing retirement. But with a remaininglife expectancy of more than two decades this is a huge waste of talent.

A study in 1930 looking forward to 1990 foresaw those 64+ would rep-resent 12.6% of the population (underestimating the population growth).The report was not concerned as retirement needs were thought to be mini-mal (physical needs, health, comfort) so they underestimated the changes inexpectation.

Some 75% of retirees go from full-time work to no work, while in thepast people would hang onto some work as long as they could, moving intosupervisory positions even on the farm.

The changes in the last 60 years in the US are striking: In 1910 theaverage retirement age for men was 75, in 1940 it was 68, by 2001 it wasabout 62. In 1960 men were expected to spend 50 of their 68 years of life inpaid work. In 2000 they worked for only 38 of their 76 years. As recentlyas 1965, about two-thirds of workers did not begin drawing social securitybenefits until they were 65 or older. Now, more than half retire at 62 oryounger, and three-quarters receive their first benefit checks before they are




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F IGURE 1.3 Labor Force Participation Rates of Men Age 65 and Over byDecade, PercentSource: Short (2006).

65 (Toner and Rosenbaum 2005). The notion of an active retirement hasbeen invented, and retirement has become a 20-year stage in life. Companypensions clearly encompass three aspects: insurance (being old is like a dis-ability), compensation (reward for a faithful career), and severance (paymentto allow termination). Together these factors have led to an increase in theliabilities of the overall system. Under the social insurance program, work-ers earn entitlement to family benefits upon retirement, disability, or death.This breaks down into retired workers (61%), disabled workers (10%),families of retired and disabled workers (12%), and survivors of deceasedworkers (17%) (Schwartz and Ziemba 2007).

The trend toward earlier retirement and longer years of retirement willneed to be reversed. Policies are being put in place to foster this transition.It is predicted that by 2030 at the latest, the age at which full retirementbenefits start will have risen to the mid-70s in all developed countries, andbenefits for healthy pensioners will be substantially lower than they aretoday. Indeed, fixed retirement ages for people in reasonable physical andmental condition may have been abolished to prevent the pensions burdenon the working population from becoming unbearable.

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MARIDA BERTOCCHI Optimizing...MARIDA BERTOCCHI is Professor of Portfolio Theory, University of Bergamo. She taught numerous courses at the Universities of Bergamo, Urbino and Milan,