an “annuity”) and a given savings pattern pre-retirement, what rate
of return ensures the right amount of target wealth?
In such a simple approach, the next step would be to ask: What
portfolio ensures such a rate of return over the life of the individual? The optimal savings decision is more complex because many
parameters (e.g., real income growth, consumption growth, taxes,
post retirement-consumption, life expectancy, inflation) are not
known with certainty, and typically the rate of return is also volatile. But the purpose of the example in figure 1 is to highlight that
the driving force behind the optimal savings decision is the desired
post-retirement consumption/income or liability.
We briefly discuss the basic investment instruments available to an
individual and institutional investor (i.e., what they can buy) as a
precursor to discussing the traditional portfolio theory/investment
models, which focus on how much of each to hold.
Today, the typical investor has to choose among the following
assets: stocks, bonds, commodities, alternatives, and annuities. We
briefly describe each instrument, its cash-flow profile, costs and
liquidity, and its place in retirement portfolios based on current
practices and the ability to hedge the liability from LCH. We also
briefly discuss real estate (i.e., home ownership) because many
individuals hold a substantial portion of their net worth in a home
and some seek to convert this asset into retirement income via
Stocks: Stocks or stock indexes can be acquired at low cost and are
typically very liquid. Many have argued for the inclusion of stocks
in retirement portfolios because of their growth potential and
potentially long duration (Dechow et al. 2002).
3 However, these
instruments have unpredictable cash flows and typically would not
be a good hedge against the liability described above.
Bonds: The current maximum maturity achievable in the U.S.
Treasury market is effectively thirty years, though a few longer-dated corporate securities do exist.
4 For countries with sufficient
debt and regular debt-issuance profiles, as these instruments age,
they provide investors with bonds that mature all along the thirty-year spectrum. In most markets, nominal bonds dominate the
bond markets though some countries have well-developed inflation-linked instruments.
5 These instruments are traded at low cost, typically are liquid, and lend themselves to derivative instruments that
alter this basic profile. These include zero-coupon bonds and
swaps. In addition, through financial engineering, one can purchase interest-only cash-flow streams and principal-only cash-flow
streams of traditional or mortgage bonds and hence these streams
are limited in maturity to the maturity of the original bond. Bonds
engender credit risk, though the bonds of governments issued in
their own currencies usually are considered default-free. Their key
limitation for the purpose of this paper is that they have limited
maturity (as noted above) and have a cash-flow timing mismatch,
especially for young investors, relative to the liability in figure 1.
For example, Bodie (2001) discusses the use of inflation-linked
bonds to hedge a minimum standard of living after retirement
(along with other tools), but this hedging will involve risk if the
yield curve does not extend to the entire working and retirement
profile. This implies that to recreate the cash-flow profile in figure 1
would require a fair amount of complex financial engineering (e.g.,
Merton 2014), which in turn would raise costs and risks.
Commodities: These instruments typically mimic the price of the
underlying commodity and are believed to be a hedge against inflation risk (Froot 1995), which then leads to their inclusion in institutional retirement portfolios. Like stocks, the capital is entirely at
risk and unlike bonds, these investments do not have periodic cash
flows. They are accessed at low cost and are very liquid, but they
are not a good hedge against individual liabilities.
Alternatives: Many institutional investors recently have invested
heavily in hedge funds, real estate, and private equity investments;
some institutions have tried to offer this in DC plans (e.g., Intel
Corporation), which has led to class action lawsuits about the suit-ability of such investments in DC portfolios. With the exception of
certain real estate investments, these investments typically do not
have predictable cash flows either during the life of the investments
or at maturity. As a result, these investments are not a good hedge
for the individual liability described above. They typically are high-cost and illiquid investments. Their appeal in the institutional world
stems from the perceived higher return offered for bearing illiquidity risk (and potentially more-relaxed investment constraints). More
critically, given that most institutional pension funds are underfunded, the belief that they offer a higher expected (not necessarily
achieved) return than traditional stocks or bonds leads to their
inclusion in institutional portfolios as a way to juice up the overall
return of the portfolio. Some claim that because these assets have a
low correlation to other assets they offer diversification benefits, but
some part of the lack of correlation is driven by the fact that these
investments are opaque, not marked-to-market daily, and lack a
transparent price until liquidation. These assets usually correlate
poorly with individual and institutional liabilities.
Annuities: Because none of the basic instruments described above
offers the desired cash-flow stream to hedge individual liabilities,
insurance companies have stepped in and offer annuities to investors. At its most basic level, an annuity offers an individual, for a
specific (upfront) payment, a cash-flow stream from the insurance
company, starting at some future date (say retirement), typically
until death. Annuity products can be categorized based on:
( 1) timing (i.e., either immediate or deferred); ( 2) investment type
(i.e., fixed or variable, which influences what assets the portfolio
is invested in); and ( 3) liquidity (i.e., with or without withdrawal
penalties). These instruments are not very common in individual
portfolios and only now are being included in institutional DC
plans (Denmark 2014a), though with limited success in large part
possibly because investors are afraid of leaving money on the table