«Ageing populations are a critical problem and a unique opportunity for the investment industry as a whole to come together and try to make an impact.»

«Ageing populations are a critical problem and a unique opportunity for the investment industry as a whole to come together and try to make an impact.»

«Ageing populations are a critical problem and a unique opportunity for the investment industry as a whole to come together and try to make an impact.»

Lionel Martellini started the discussion by pointing out that ageing populations are one of the most critical economic problems facing the world, but that they are also a unique investment opportunity.

Pension systems across the world are typically based on three pillars: state-funded social security pensions, professional pension plans, and personal retirement savings. The problem is that these pillars are weakening. Moreover, with the shift from defined-benefit pension plans to defined-contribution pension plans there is a massive transfer of risk to individuals who are ill-prepared to make long-term investment decisions. Retirees may end up being short of income when living through the different stages of retirement, he warned.

PRESENT RETIREMENT PRODUCTS ARE NOT ADEQUATE

The existing products to solve this, both on the insurance and the investment management side, fall short of meeting the objectives. For example, annuities give security, but are inflexible and irreversible, so they are not popular. You cannot get your money back unless you pay high surrender charges, and you cannot pass it on to your heirs.

Another option is individual investment in specialized funds. There are balanced funds, draw-down funds, target-date funds, and title-guarantee funds, among others. From an individual perspective, or even from a defined- contribution pension plan perspective, it is unclear how well or poorly these products fit the main goal, which is generating replacement income.

Target-date funds are most often used as the default option in direct- contribution retirement plans. When you are younger, you start with a higher equity allocation to harvest the equity-risk npremium. As you get closer to the target retirement date to secure your investment you increase allocations to short-term bonds. This is good, since it is flexible. At any point in time you can exit the strategy. However, it may not be safe, since short-term bonds are not, warned Mr. Martellini.

All of these products, including target-date funds, give you flexibility without security. On the other hand, you have insurance products that give you security without flexibility. So what are the options to get out of this dilemma, asked Mr. Martellini?

«Unless heavily incentivised from a tax perspective or forced on individuals, annuities are not an option that is well accepted by individuals.»

«Unless heavily incentivised from a tax perspective or forced on individuals, annuities are not an option that is well accepted by individuals.»

NEW MODELS – RETIREMENT GOAL HEDGING PORTFOLIO, TARGET-DATE FUNDS

Since the goal is cost-of-living adjusted replacement income in retirement, a solution is to split cash flows into two parts. The first would be for the first twenty years of retirement when people are not so concerned about late-life longevity risk with associated health costs. For these years you do not need annuities, which are meant to take care of the uncertainty of the date of death. Instead you need fixed income products.

This kind of program is called a Retirement Goal Hedging Portfolio. It is a bond portfolio designed to make the income payments people need in retirement; a kind of “retirement bond”. One can use available bond instruments to assure the required cash flows. The missing piece is what happens when you reach age 85. At this point, you will need a deferred late-life annuity, which should hopefully be less expensive, since the first twenty years of retirement were already taken care of.

Another option is designing an improved form of target-date fund, with a safe sales component. You have to look at the purchasing power of the bond portfolio in terms of replacement income. But when you do this, he explained, you find that over the last 20 years, interest rates have been going down and bond values have been going up. The present value of replacement income has been going up much faster than the value of this short-term bond portfolio. As a result, someone buying investment bonds would have lost 40% of purchasing power over the last 20 years, in terms of retirement income.

If you use the retirement bond portfolio instead, nothing happens. Volatility of the funding ratio stays flat because it is the safe asset. Put in a different way, when investing in a safe asset, we expect no consumption of risk budgets, he elaborated. However, the so-called safe asset in existing target-date funds and balanced funds consumes a large portion of your risk budget, and not for good reasons bsince there is no premium associated with holding an bequally- matched duration bond portfolio.

On the other hand, equity generates much more volatility, so a starter target- date fund will have a lot of equity in the early days, with associated volatility spikes. As you get closer to retirement it slows down, although not as much as it should because you are not using the proper safe asset; you are using the short-term bond portfolio.

If instead you use an improved form of target-date fund based on a retirement bond portfolio, it is like an annuity for the first twenty years in retirement, giving you more security with much lower spikes, especially at the end. However, with a starter target- date fund you can lose more than 20% purchasing power in the worst years when equity markets and interest rates go down at the same time, as they did in 2008 or when the tech bubble burst. With an improved target-date fund, on the other hand, based on a better safe asset, the maximum losses are usually lower.

We can use financial engineering to conceive complex and expensive structured products and mortgage-based securities to make it look like an asset is safe and inexpensive, when it is not, Mr. Martellini warned. But it is better to use financial engineering to secure against a maximum loss – to pre-fund the loss of your portfolio.

He ended by mentioning the EDHEC-Princeton Goal- Based Investing Indices, which he started with academic colleagues, which incorporate the concepts he mentioned. “We make them more concrete, almost investable by coming up with these indices and trying to tell the world – we in academia, even though we are safe in our ivory tower, we also care about what is going on out there.”

«You can actually use financial engineering to secure a maximum loss – to prefund the loss of your portfolio. This is important in secure, flexible retirement solutions.»

«You can actually use financial engineering to secure a maximum loss – to prefund the loss of your portfolio. This is important in secure, flexible retirement solutions.»