IPE at 20: Time for retirement ‘SeLFIES’?
To address the looming retirement crisis, many governments are introducing new pension programmes tied to employment for uncovered workers (NEST in the UK and Secure Choice in some US states). These attempt to improve access to pensions, and continue a trend of transferring responsibility for retirement security from governments and employers (via defined benefit [DB] plans) to the individual (via defined contribution [DC] plans), as neither governments nor companies are willing to bear the liabilities associated with pension obligations. This shift requires new thinking about how portfolios are managed and which instruments are available to investors. Our proposed SeLFIES (Standard of Living indexed, Forward-starting, Income-only Securities) make individuals self-reliant and are also advantageous for governments.
For optimal portfolio management, members of DC plans should focus on maximising funded status or retirement income (not wealth, as in traditional investment approaches)1. Further, unlike multi-generational DB plans, DC plans must achieve their objectives in a single lifetime, and it is hard to pool risks because these plans are inherently flexible: (a) participation is often voluntary; (b) participants may require liquidity; (c) retirement ambitions, risk tolerance and life expectancy vary; and (d) employment patterns change over time (ie, the gig economy does not tether an individual to a single company). A new financial instrument is needed to enable financial security for retirees in the current environment.
DC investors seek to ensure a guaranteed, real income, ideally from retirement to death. It is also reasonable to assume they would want to lead a lifestyle comparable to pre-retirement. Investing in existing assets (stocks, bonds, or REITs) is risky because these do not provide a simple cash flow hedge against desired retirement income. For example, viewed through the retirement income lens, a portfolio of traditional, ‘safe’ government securities, unless heavily financially engineered, would be risky because of the cash flow (and potential maturity) mismatch between traditional bonds and the desired income stream.
There is thus a need for governments to issue a new ‘safe’ bond instrument, which we call SeLFIES. These will ensure retirement security and the government is a natural issuer2.
The innovative SeLFIES design
A default-free bond offers certainty about two characteristics critical for DC retirement portfolios: (i) a commitment to pay over a particular time horizon (how/when one is paid); and (ii) a specific cash flow (what is paid). DC investors require a guaranteed cash flow that protects their real purchasing power in retirement. Two simple innovations could create the ‘perfect’ instrument.
The first innovation addresses (i) ‘how/when one is paid’ by creating forward-starting, income-only bonds. These would start paying investors upon retirement, paying coupons-only for a period equal to the average life expectancy at retirement (eg, US bonds would pay for 20 years)3. Investors saving for retirement do not need coupon payments while still employed (which have to be re-invested and thereby engender interest rate risk), or a stub principal payment at the end, but rather a smooth stream of real cash flows. SeLFIES are designed to pay people when and how they need it. SeLFIES blend accumulation and decumulation by incorporating the retiree’s desired annuity-like cash flow profile in the payout phase.
The second innovation addresses (ii) ‘what’ is paid, by indexation to per-capita consumption. Preserving standard of living requires inflation-protected payments. With increasing longevity, a fixed standard of living may not be adequate, because cumulative increases in the standard of living can leave a retiree feeling ‘left behind’, much like inflation causes nominal fixed income retirees to experience a decline in standard of living.
So, instead of a Treasury inflation protected securities (TIPS)-like adjustment, solely focused on inflation, SeLFIES would cover both the risk of inflation and the risk of standard of living improvements. This coupon would be ideal for people who assess their economic well-being on the basis of their standard of living relative to those around them.
How SeLFIES foster self-reliance
In effect, SeLFIES would pay the holder annually for 20 years, starting at a fixed future date, a fixed amount (say €5), indexed to aggregate per capita consumption4. So, 55-year-olds today would buy the 2027 bond, which would start paying SeLFIES coupons upon retirement at 65 in 2027, and keep paying for 20 years, through 2047.
These innovations ensure even the most financially illiterate individual can be self-reliant with respect to retirement planning (without requiring a forecast of expected returns, optimisers/retirement calculators, or even intermediaries). For example, if investors want to guarantee $50,000 annually, risk-free for 20 years in retirement, to maintain their standard of living, they would need to buy 10,000 SeLFIES (50,000 divided by 5) over their working life.
The complex decisions of how much to save, how to invest, and how to draw down are simply folded into a calculation of how many to buy. In addition to being simple, liquid, easily traded, and with low credit risk, SeLFIES can be bequeathed to heirs, unlike high-cost, inflexible and illiquid annuities. The inheritability of SeLFIES overcomes investor fears that premature death means leaving money on the table. Buying SeLFIES would be similar to creating an individual DB scheme, with the guaranteed pay-out determined simply by the number purchased.
SeLFIES greatly simplify retirement investing by allowing participants to be self-reliant in managing their portfolios. It is easy to see why these bonds would be preferable to inflation-linked or GDP-linked bonds5, the current practice of investing in target-date/lifecycle funds (which rotate into traditional bonds, or annuities with age). Asset pricing models greatly simplify when the numeraire for measuring returns is consumption (versus either wealth or real wealth)6. So bonds denominated in consumption units are a natural asset for investors.
Moreover, SeLFIES could become the safe asset in these target-date strategies. They could also be used as safe, liability-hedging assets in dynamically managed target-income strategies – allowing investors to target a higher retirement standard of living/income by investing in risky assets early in their life cycle, but dynamically locking in gains by investing in SeLFIES. Further, simple statements would illustrate the level of real, locked-in retirement standard of living, based on the number of bonds purchased. In today’s DC plans, statements focused on wealth accumulated give investors no sense of retirement standard of living or what to do to achieve their retirement objectives.
Advantages for governments
SeLFIES would be advantageous for governments, making them efficient issuers. First, SeLFIES will give governments a natural hedge of revenues against the bonds, as revenues earned from value-added-taxes (VAT) are essentially proportionate to consumption. This means less risk, more control, and perhaps higher ratings for the government (with a VAT system) to issue consumption-linked rather than inflation-linked or GDP-linked bonds. Investors from all parts of the lifecycle would find them attractive.
Second, as governments struggle to finance infrastructure, bonds with steady payments and forward-starting payment dates offer an effective mechanism to finance such needs. Cash flows from SeLFIES offer governments an effective way to collect monies today for upfront capital expenditures for infrastructure projects, and pay these back in the future, once the projects generate revenues.
“A new financial instrument is needed to enable financial security for retirees in the current environment”
Third, if DC plan investments do not facilitate safe and adequate outcomes, governments will be forced to bail out participants, thereby privatising gains but socialising risks. SeLFIES potentially reduce those costs and risks to governments.
There are other benefits. Many US DC corporate and endowment pension plan sponsors are being sued for allegedly costly or risky investment and pay-down options. There is a danger that many sponsors may choose not to offer any plans (DB or DC) to avoid legal risk. This inconveniences employees who would have to make their own arrangements, and the uncertainty raises the cost of ensuring retirement security for governments. The design of SelFIES provides plan sponsors with a low-cost, low-risk default option for participants, and a safe harbour from legal risk. Furthermore, SeLFIES could be valuable to the insurance industry, since it allows them to offer new low-cost annuities, with an improved ability to hedge liabilities.
Simple or dynamic investments in SeLFIES will not solve issues like insufficient savings (resulting in low retirement income), insufficient income growth (which locks in a low standard of living in retirement), or hedging longevity risk. Longevity risk is potentially handled through complex measures, such as trading longevity swaps or bonds. However, since longevity for cohorts changes slowly (low-frequency), it may be adequate to periodically review the change in longevity and adjust the portfolio goal. SeLFIES hedge the relatively rapidly changing (high frequency) interest rate, inflation, and standard of living growth risks, which are important as one nears retirement, until the retiree chooses to purchase a life annuity, providing longevity risk protection. For longevity risk protection, participants could purchase long-deferred annuities that pay out beyond the age of 85. The deferred annuity approach combined with SeLFIES, would be an efficient way to hedge individual longevity risk while preserving financial flexibility and control, and can be incorporated into a well-designed target income product.
SeLFIES would require an appropriate measure of consumption to be articulated for the index; specifically, how consumer-durable purchases are treated and whether or not to include leisure time, not normally included in consumption. This is the same challenge embedded in TIPS. In any case, SeLFIES are materially closer to covering inflation and standard of living changes than nominal bonds. Of course, further work is needed to establish other technical design details of SeLFIES (eg, are they paid quarterly or annually? Are bonds re-opened monthly, quarterly or less frequently when DC contributions are collected? Is €5 an optimal size of real coupon or should it be double that to make calculations simpler and require fewer purchases?).
These are not insurmountable, given the potential benefits of the bonds to the concerned parties. As an initial solution, the current technical approach used in TIPS can be adopted.
To thine own SeLFIES be true
The potential global retirement crisis needs to be addressed by timely innovation, because the longer governments wait, the higher the cost will be. SeLFIES are a safe and sound solution for governments.
But, equally importantly, SeLFIES give investors more control over their retirement planning and lower costs, complexity, risks, and illiquidity of retirement outcomes relative to existing or other conceived options. It is critical to ensure effective retirement outcomes, and to paraphrase William Shakespeare’s Hamlet: ‘This above all, to thine own SeLFIES be true.’
Dr Robert C Merton, recipient of the 1997 Alfred Nobel Memorial Prize in Economic Sciences, is the School of Management Distinguished Professor of Finance at the MIT Sloan School of Management. He is also resident scientist at Dimensional Fund Advisors, a Texas-based global asset management firm, and University Professor Emeritus at Harvard University. Dr Arun Muralidhar, is author of 50 States of Grey and Rethinking Pension Reform (with the late Prof Franco Modigliani), adjunct professor of finance at George Washington University, academic scholar advisor at the Center for Retirement Initiatives at Georgetown University, and founder of MCube Investment Technologies and AlphaEngine Global Investment Solutions.
1 R.C. Merton (2014). The Crisis in Retirement Planning, Harvard Business Review, July–August 2014.
2 Governments frequently serve the function of completing financial markets. Two examples related to meeting retirement funding needs are Japan’s issuing of a 40-year ultra-long bond in 2007 to provide a hedging instrument for pension funds and insurance companies, and UST issuing TIPS in 1997 to allow hedging of inflation risk.
3 See A. Muralidhar (2016). An Inventive Retirement Solution. Investment & Pensions Europe, June 2016.
4 A variation of this idea was first addressed in Robert C Merton (1984). On Consumption Indexed Public Plans. Financial Aspects of the US Pension Systems. Eds. Z. Bodie and J. Shoven, National Bureau of Economic Research, Cambridge, MA.
5 Admittedly, this is not a fair comparison as proponents of GDP-linked bonds have tried to use this bond to create pay-as-you-go like pension plans, and ensure counter-cyclical payments (ie, high returns when market rates of interest are low or negative). See J. Frijns, T. van der Klundert and A. van Nunen. 2016. Why the Netherlands Should Issue Retirement Bonds. Investment & Pensions Europe, August 2016.
6 D.T. Breeden (1979). An Intertemporal Asset Pricing Model with Stochastic Consumption and Investment Opportunities. Journal of Financial Economics, 7 (September): 265-96.