LifeCycle Pension Model: Theory and Practice

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Life-Cycle Pension Model Theory and Practice

• Zvi Bodie
• Boston University and Netspar Scientific Council
• Henriëtte Prast
• Dutch Central Bank, Tilburg University, and
  Netspar

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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.

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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.

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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

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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

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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.

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Prototype Products

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

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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.

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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.

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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.

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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

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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

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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?)

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Does employee want autonomy?
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Preference for delegation depends on

• Education ()
• Risk tolerance (-)
• Expertise (-)

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Preferred stocks in portfolio

• Does not depend on
• age
• income
• education
• partner

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Does depend on

• Gender (? ) after controlling for risk
  tolerance and expertise
• Financial expertise ()
• Subjective risk tolerance ()
• Objective risk tolerance ()

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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

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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

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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

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Challenges to institutions

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