Life-Cycle Pension Model: Theory and Practice Zvi Bodie Boston University and Netspar Scientific Council Henriëtte Prast Dutch Central Bank, Tilburg University, and Netspar

Key Points A new paradigm is emerging for personal retirement accounts: life-cycle structured products. Retirement investing will be about choosing among features of products designed for consumers by financial engineers. Technological progress will make these products affordable for middle-class consumers, not just the wealthy. Investor education will focus on helping consumers choose appropriate product features they can afford.

Economic principles No free lunch. The present value of achieving a future target cannot be lowered by taking risk. But it can be lowered through contingent contracts that only pay off when needed. Example: life annuities only pay off if annuitant is alive.

Principles of life-cycle investing Human capital is the most important asset for most people throughout most of their lives, and it is non- tradable. There are three dimensions of choice: Work/leisure Consumption/saving (time dimension) Safe/risky portfolio (risk dimension) Main function of financial intermediaries is to serve the needs of consumers by transforming market instruments into user-friendly products

Retirement investment products today Target-date retirement accounts Health saving accounts Common characteristics Specific purpose Specific maturity date Tax advantaged because society wants to encourage saving for this purpose Most of the money in these accounts is invested in mutual funds

The trouble with mutual funds Not matched to the purpose or the target date of the account For a matching strategy, the basic building blocks must be denominated in units that match the purpose and have known maturities.

Prototype Products Escalating inflation-proof annuities Life-care annuities Home equity conversion mortgages

The role of guarantees Caveat emptor -- Can a client trust a firm that does not guarantee its products? Risk is most efficiently managed by the investment firm, not by the client. A guarantee transfers risk from the client to the investment firm. If risk is truly small, then the cost of the guarantee will be low. If the cost of the guarantee is high, then the risk is obviously not small.

Equity participation notes This is a model of an equity participation note (EPN). It assumes that the amount invested is 100. The model allows you to change the parameter values--volatility of the underlying equity index, interest rate, and dividend yield, and to adjust the features of the note -- the maturity, the strike price, and the level of the guaranteed floor. Based on these input values, it computes the present value of the guaranteed floor, the price of the embedded call option, and the participation rate. The price of the embedded call is computed using the Black- Scholes-Merton model. The participation rate is computed as 100 minus the PV of the guaranteed floor divided by the price of the embedded call.

Escalating Annuities Part of the retirement fund is used to buy an inflation-proof fixed annuity and part is invested in equities or equity call options. Each year part of the equity account is used to purchase additional lifetime income.

Behavioral evidence People know what is in their best interest But… they do not act always act according to their best interest and need help - in choosing - in committing themselves

Consumer preferences in NL Van Rooij, Kool & Prast (JPubE, 2007) What do employees know? What do they want? How would they choose? Determinants of choice

Employees prefer DB for two reasons Do not want to think about investing for retirement – “finance is like medicine” Are afraid they would save too little for retirement – self control problem (Status quo bias?)

Does employee want autonomy? Leave choice to pension fund Wants autonomy Indifferent Don’t know

Preference for delegation depends on Education (+) Risk tolerance (-) Expertise (-)

Preferred % stocks in portfolio Does not depend on age income education partner

Does depend on: Gender (♂ +) – after controlling for risk tolerance and expertise Financial expertise (+) Subjective risk tolerance (+) Objective risk tolerance (+)

Help in choosing: default Default: what you choose when you do not choose plan participation savings rate portfolio choice withdrawal at job change at retirement

Wanted: guarantees Desired pension guarantee in a mixed DB/DC system equals 69% of the net final wage DB-supporters: 55% wants a guarantee of more than 70% DC-supporters: 51% want a guarantee of more than 50%

Current policy in NL: defaults New Pension Act: any DC plan should offer a collective arrangement Individual default portfolio depending on time to retirement Obligation to inform plan participant about pension rights

Challenges to institutions Design commitment mechanisms Develop optimal standard choices (defaults) Provide meaningful information: