Download risk management

Financial Innovations for Analyzing
& Managing Retirement Risks
©Olivia
S. Mitchell
[email protected]
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
$
Earnings
Consumption
Saving
Dissaving
R
D
Age
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)
Average
France
Germany
Japan
Italy
Canada
US
Sweden
UK
0
20
40
60
% of GDP
80
100
120
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%
273%
240%
TOTAL
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 riskreturn tradeoff
Globally diversified portfolio would be
preferable.
Estimated Efficient Frontier for
World Stock Markets
Expected Return
0.016
0.014
0.012
0.01
Latin America
0.008
USA
0.006
Europe
0.004
Asia-Pacific ex Japan
0.002
0
0
-0.002
0.0002
0.0004
0.0006
0.0008
0.001
0.0012
0.0014
0.0016
Japan
-0.004
Source: MS Total Return Indices, Real $US, Continuously Compounded Returns, 1/88 6/99, assumes normal returns.
0.0018
0.002
Variance (risk)
Annual Vanguard Expenses
(in hundredths of a percent or basis pts, 1999)
Account Type
Expenses (BP)
Int’l Growth (1981)
Windsor II (1985)
Wellington (1929)
Windsor (1958)
Growth Index (1992)
Bond Mkt index (1986)
Prime MM fund: Inst (1989)
Value Index:Inst (1998)
Note: recordkeeping costs additional.
58
39
30
28
22
20
15
12
Fund Size
$9.7B
19.1
26.9
17
15.2
9.5
1.7
32.5
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 Inflation
Inflation-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
110
100
90
80
70
60
50
40
30
20
10
0
1972
1973
1974
1975
1976
1977
1978
1979
End of Year
1980
1981
1982
1983
1984
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 crossgenerational contracts (supported by governments).
Annuities are looking better over
time…EPV/$1 premium
Year
Gen Mortality
Annuit. Mortality
1985
1990
1995
0.704
0.757
0.756
0.790
0.856
0.853
US Men Age 65: 1985-95
Adverse Selection now ~ 10%
Source: Brown, Mitchell, Poterba, Warshawsky (1998). (corp. yield curve, after tax)
The Problem of Desired Liquidity


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Annuitization problematic if need cash for nursing
home care.
Possible response: a bundled/integrated
instrument that combines life annuity with longterm 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.


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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.

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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…

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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.