The Next Generation of Life-Cycle Investment Products

1. The Next Generation of Life-Cycle Investment Products Zvi Bodie Conference on Risk Sharing in DC Pension Schemes University of Exeter, January 8, 2010 1

2. Main Idea Advances in finance theory, market innovations, and information technology have made it possible to improve the welfare of people who are trying to provide for their own financial security. 2

3. Key Points Life-cycle investing will be about choosing among features of products designed for consumers by scientists and 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. 3

4. Life-cycle investment products in the U.S. today Target-date retirement accounts Target-date college tuition 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 4

5. 5 http://www.pathtoinvesting.org/categories/investingessentials/invandsaving/invandsaving_011.htmhttp://www.pathtoinvesting.org/categories/investingessentials/invandsaving/invandsaving_011.htm

6. 6 http://smg.bu.edu/exec/elc/lifecycle/ http://www.cfawebcasts.org/modules/Catalog/Package.aspx?CourseGroupID=946http://smg.bu.edu/exec/elc/lifecycle/ http://www.cfawebcasts.org/modules/Catalog/Package.aspx?CourseGroupID=946

7. 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. 7

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9. Simulated Retirement Benefits from a 70 Year Target Date Strategy Accumulation and Decumulation of retirement savings over a 70 year period (age 25-95): 40 years of contributions and 30 years of benefits. Using a TIPS (inflation-indexed bond) real rate of interest of 2%, the annual benefit is 2.8 times the contribution. That is the safe benchmark shown in red. Target-Date asset mix at age 25 is 90% stocks and 10% bonds and at age 65 it is 50% stocks and 50% bonds. It stays that way throughout the 30 year retirement phase. The actual historical performance is shown in black. The average real rate of return on stocks was 9% and annual standard deviation was 19%. The blue and green paths are simulations drawn at random from the same historical probability distribution. 9

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11. The fallacy of time diversification 11

12. 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. 12

13. Safe Investing in Risky Times Conventional investment advice today is based on a mistaken principle of �time diversification� and leads to portfolios that are riskier than consumers realize. Starting point should be 100% inflation-proof, guaranteed annuities. Hope for the best, but prepare for the worst. Principal-protected investment products. Escalating Equity-Indexed Annuities 13

14. 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. 14

15. BMS Life-Cycle Model* *Bodie, Merton, Samuelson, �Labor Supply Flexibility and Portfolio Choice� Journal of Economic Dynamics and Control, Vol. 15, 1992. Step 1. Estimate the value of the individual's human capital by valuing future wage income as if it were a traded asset and determining its risk characteristics. Step 2. Compute the individual's total wealth � the sum of financial wealth and human capital. 15

16.  BMS Model (2) Step 3. Determine the individual's optimal level of spending on consumption and leisure at time t. Step 4. Determine the optimal gross amount and proportion of the individual's total wealth (found in step 2) to invest in the risky asset. 16

17. BMS Model (3) Step 5. Estimate the individual's �implicit� exposure to risk embodied in his uncertain future wage income. Adjust the gross amount in step 4 by subtracting this implicit investment in the risky asset to determine the optimal "explicit" investment out of current financial wealth to make in the risky asset. 17

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19. 19 http:/zvibodie.comhttp:/zvibodie.com

20. WFI Investment Toolkit For a given time horizon, risk is defined as the possibility of earning less than the corresponding risk-free interest rate, and reward as the possibility of earning more. There is a complete set of default-free bonds of all desired maturities and a single well-diversified portfolio of risky assets (a market-index fund). The investor hedges essential cash-flow requirements with bonds and buys mutual fund shares or call options to gain exposure to the market index. 20 The following websites were included: Quicken.com, MoneyCentral.com, Morningstar.com, FinancialEngines.com, mPower.com.The following websites were included: Quicken.com, MoneyCentral.com, Morningstar.com, FinancialEngines.com, mPower.com.