financing retirement: collective and individual approaches
DESCRIPTION
Financing Retirement: Collective and Individual Approaches. William F. Sharpe STANCO 25 Professor of Finance Stanford University www.wsharpe.com. Per Capita Income and Spending, United States. Source: U.S. Bureau of the Census (Spending: 2005, Income: 2007). Consumption and Investment. - PowerPoint PPT PresentationTRANSCRIPT
Financing Retirement:Collective and Individual
Approaches
William F. Sharpe
STANCO 25 Professor of FinanceStanford Universitywww.wsharpe.com
Per Capita Income and Spending,United States
0%
20%
40%
60%
80%
100%
120%
15-24 25-34 35-44 45-54 55-64 >64
Age Group
Pe
rce
nt
of
Ma
xim
um
Spending
Income
Source: U.S. Bureau of the Census (Spending: 2005, Income: 2007)
Consumption and Investment
Consumption: 65+
Consumption: <65
Investment
Sharing Rules
• Key questions:– What will retirees receive under expected economic
conditions?
– How will retirees’ shares change when economic conditions differ from expectations?
Population, United States1950
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US 1950
MALE FEMALE
Population, United States2009
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US 2009
MALE FEMALE
Population, United States2030
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US 2030
MALE FEMALE
Population, United States2050
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US 2050
MALE FEMALE
Population, Italy2009
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Italy 2009
MALE FEMALE
Population, Italy2030
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Italy 2030
MALE FEMALE
Population, Italy2050
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Italy 2050
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Percentage of Population 65+ 2009, 2030 and 2050
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
2009 2030 2050
Per
cen
t 65
an
d O
ver
US
Italy
Percentage of Population 70+2009, 2030 and 2050
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
2009 2030 2050
Perc
ent 7
0 an
d O
ver
US
Italy
Percentages of Population 2009 (65+), 2030 (70+) and 2050 (75+)
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
2009 (65+) 2030 (70+) 2050 (75+)
Pro
po
rtio
n o
ver
Ag
e
US
Italy
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
Alternative Approaches
• Intra-family Social contracts• Collective Social Contracts• Employer-based Defined Benefit Plans• Defined Contribution Plans
Retirement Financing:Within the Family
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
Social Security
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
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
Retirement Financing:Defined Benefit Plans
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
Retirement Financing:Defined Contribution Plans
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
Defined Contribution Plans:The Hope
Defined Contributions Plans:Recent Experience
Morgan Stanley World IndexMay 28, 2004 – May 28, 2009
Source: mscibarra.com
U.S. Household Net Worth
Evaluating Saving and Investment Plans: Monte Carlo Simulation
• Produce one scenario– Draw one period’s 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
Downside, Median and Upside Outcomes
Chance of Reaching a Goal
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?
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
Financial Instruments and Institutions
• Traditional instruments– Government bonds– Corporate bonds– Corporate Stocks
• Financial instruments– Mutual fund shares– Derivatives
• Financial Institutions– Derivative counterparties– Annuity providers
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
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
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
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)
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 thecredit risks of the reference entities without directly holdingthe debt obligations of the reference entities and without
involving any reference entity in the transaction.
The Economist, Nov. 20, 2008
“Asian pensioners are the latest victims of Lehman’s 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…”
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.
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.”
Mitigating Counterparty Risk
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
Attributes of Financial Instruments with Minimum Ex Ante Counterparty Risk
• Transparent
• Collateralized
• Audited
• Regulated
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
M-Shares
Source: W. F. Sharpe, Investors and Markets: Portfolio Choices, Asset Prices, and Investment Advice, 2007
Henri de Tonti
• American Explorer
• Son of Lorenzo de Tonti, Neapolitan banker and creator of the first Tontine in France, 1653
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
Behavioral Finance
Hal Now
Hal Ersner-Hershfield, Stanford Longevity Project
Hal at Retirement
Current Savings
Too Much Savings
The Best Choice?