Percentage of Population 65+ 2009, 2030 and 2050
Percentage of Population 70+ 2009, 2030 and 2050
Percentages of Population 2009 (65+), 2030 (70+) and 2050 (75+)
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
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
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
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
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
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 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.
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.”
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 Potential and 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
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