Financing Retirement: Collective and Individual Approaches

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Financing RetirementCollective and Individual
Approaches

• William F. SharpeSTANCO 25 Professor of Finance
• Stanford Universitywww.wsharpe.com

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Per Capita Income and Spending,United States
Source U.S. Bureau of the Census (Spending
2005, Income 2007)
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Consumption and Investment
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Sharing Rules

• Key questions
• What will retirees receive under expected
  economic conditions?
• How will retirees shares change when economic
  conditions differ from expectations?

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Population, United States1950
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Population, United States2009
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Population, United States2030
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Population, United States2050
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Population, Italy2009
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Population, Italy2030
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Population, Italy2050
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Percentage of Population 65 2009, 2030 and 2050
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Percentage of Population 702009, 2030 and 2050
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Percentages of Population 2009 (65), 2030 (70)
and 2050 (75)
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Social and Financial Contracts

• All methods rely to an extent on social contracts
• Pure social contracts make sharing of output more
  explicit
• Financial contracts allow more variation in
  individual risk-taking

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Alternative Approaches

• Intra-family Social contracts
• Collective Social Contracts
• Employer-based Defined Benefit Plans
• Defined Contribution Plans

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Retirement FinancingWithin the Family
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Intra-Family Social Contracts

• Predominant but not exclusive method for sharing
  worker output with children
• Evolutionary imperative
• Used predominantly in agrarian economies
• Risk typically shared by all generations
• Lower worker income results in reduced standard
  of living for most or all family members

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Social Security
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Collective Social Contracts

• Social Security or Social Insurance
• Workers provide mandatory contributions of
  portions of their output
• Retirees and their families receive payments
  based in part on their contributions
• Minimum floors
• Progressive formulas
• Little or no value at death

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Collective Social Contracts Benefit Adjustments

• Cost-of-living index
• Worker/retiree shares depend on worker
  productivity and employment
• Index of productivity per worker
• Worker/retiree shares depend on employment
• Gross Domestic Product
• Worker/retiree shares could be independent of
  productivity and employment

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Retirement FinancingDefined Benefit Plans
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Employer-based Defined Benefit Plans

• Implicit contributions
• Workers paid less in explicit wages and salaries
• Benefits provided as a single or joint annuity
• In some cases, lump sum payments allowed
• Benefits based on years of service and possibly
  salary
• Payments can be inflation-indexed
• Employer financial risk may be mitigated by
  government-sponsored insurance

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Retirement FinancingDefined Contribution Plans
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Defined Contribution Plans

• Depend on financial instruments and institutions
• Workers allocate part of their salary to a
  personal investment fund
• Workers choose their own investments
• At retirement, workers may purchase annuities but
  may not be required to do so
• Employers or social policy may constrain
  contributions, investments and/or annuitization

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Defined Contribution PlansThe Hope
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Defined Contributions PlansRecent Experience
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Morgan Stanley World IndexMay 28, 2004 May 28,
2009
Source mscibarra.com
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U.S. Household Net Worth
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Evaluating Saving and Investment Plans Monte
Carlo Simulation

• Produce one scenario
• Draw one periods asset returns from joint
  probability distribution
• Calculate portfolio return
• Adjust for new saving or spending
• Repeat for required number of years
• Determine final outcome
• Repeat thousands of times
• Generate many possible scenarios
• Determine the range of possible final outcomes

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Downside, Median and Upside Outcomes
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Chance of Reaching a Goal
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Sharing Productivity

• How should productivity be shared?
• Between workers and retirees as a whole
• Among retirees individually
• Thesis
• The larger the proportion of the population that
  is retired, the greater the need for the average
  retiree to bear some economy-wide risk
• Question
• Should every retiree bear the same risk or should
  people be allowed to bear different amounts of
  risk?

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Risk-sharing

• Collective risk-sharing
• Economy-wide social programs
• Common risk-sharing within groups
• Employer-based defined benefit plans
• Collective insurance for employer bankruptcy
• Individual risk-sharing
• Defined contribution plans
• Require financial instruments and institutions

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Financial Instruments and Institutions

• Traditional instruments
• Government bonds
• Corporate bonds
• Corporate Stocks
• Financial instruments
• Mutual fund shares
• Derivatives
• Financial Institutions
• Derivative counterparties
• Annuity providers

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Counterparty Risk

• Added risk due to the possibility that the
  provider of a financial instrument will not
  deliver the promised amount on time and in full
• Counterparty risk can be present for
• Annuities
• Derivatives
• Any financial contract in which another party has
  promised to make a payment in the future

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Lehman Zertifikates
When Lehman collapsed it took with it about 500
million Euros that belonged to 60,000 small
investors
Dresdner Bank Bank Adviser Lehman Victim
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Lehman Zertificates

• Sold by banks
• Dresdner, Citibank, Frankfurter Sparkasse
• Example
• Yearly payments based on how high the DAX rose
• Limited losses if the DAX fell
• A bearer bond issued by Lehman
• All major ratings agencies gave Lehman good
  marks until it collapsed

Source The New York Times, October 15, 2008
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Lehman Minibonds
A man who invested in Lehman Brothers minibonds
was among those who protested outside the Bank
of China in Hong Kong this month. (Bobby
Yip/Reuters)
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Lehman Minibonds
Product Summary This product is designed for
defensive investors seeking exposure to high
grade assets that provide steady coupons and
enhanced yields. Investors can gain exposure to
the credit risks of the reference entities
without directly holding the debt obligations of
the reference entities and without involving any
reference entity in the transaction.
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The Economist, Nov. 20, 2008

• Asian pensioners are the latest victims of
  Lehmans bankruptcy
• From 2006 onwards, banks and brokers sold
  minibonds to individuals desperate to earn more
  than the 1 or less on guaranteed deposits
• Buyers were betting on modest returns, typically
  5-6, low enough perhaps for them not to have
  been too suspicious about the instruments
  complexity

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The Economist (continued)

• Although many different securities were
  affected, they shared a common trait fiendish
  complexity
• One firm would arrange the structure and handle
  dividend payments. This was often Lehman
• Below the arranger were half a dozen or so
  reference banks which held collateralised-debt
  obligations and sometimes equity, issued by as
  many as 100-150 institutions.

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The Economist (concluded)

• most securities were sold with lengthy
  prospectuses that made clear the lack of
  principal protection
• lawsuits are likely to rest on the premise
  that the investments were unsuitable for the
  customers, or not understood by the salespeople.

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Mitigating Counterparty Risk
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Ex Post Bailouts
Subject to Moral hazard the prospect that a
party insulated from risk may behave
differently from the way it would behave if it
were fully exposed to the risk. -
Wikipedia
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Attributes of Financial Instruments with Minimum
Ex Ante Counterparty Risk

• Transparent
• Collateralized
• Audited
• Regulated

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Providing Upside Potentialand Downside Protection

• Trust Account
• Underlying asset pool
• e.g. the world market portfolio
• Audited
• Regulated
• A single maturity date
• Share Classes
• Different payoff patterns
• Participation unambiguous with oversight
• Proportions add to 100 in every scenario

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M-Shares
Source W. F. Sharpe, Investors and Markets
Portfolio Choices, Asset Prices, and Investment
Advice, 2007
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Henri de Tonti

• American Explorer
• Son of Lorenzo de Tonti, Neapolitan banker and
  creator of the first Tontine in France, 1653

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An Annuity Tontine

• A single maturity date
• All investors have the same birth year
• Investments are irrevocable
• Fully collateralized
• Transparent, audited and regulated
• Share Classes
• Participation unambiguous with oversight
• Proportions add to 100 in every scenario
• Payments made only to living investors

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Behavioral Finance
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Hal Now
Hal Ersner-Hershfield, Stanford Longevity Project
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Hal at Retirement
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Current Savings
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Too Much Savings
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The Best Choice?