Financing Retirement:Collective and Individual

Approaches

William F. Sharpe

STANCO 25 Professor of FinanceStanford Universitywww.wsharpe.com

Per Capita Income and Spending,United States

0%

20%

40%

60%

80%

100%

120%

15-24 25-34 35-44 45-54 55-64 >64

Age Group

Pe

rce

nt

of

Ma

xim

um

Spending

Income

Source: U.S. Bureau of the Census (Spending: 2005, Income: 2007)

Consumption and Investment

Consumption: 65+

Consumption: <65

Investment

Sharing Rules

• Key questions:– What will retirees receive under expected economic

conditions?

– How will retirees’ shares change when economic conditions differ from expectations?

Population, United States1950

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US 1950

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Population, United States2009

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US 2009

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Population, United States2030

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US 2030

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Population, United States2050

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US 2050

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Population, Italy2009

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Italy 2009

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Population, Italy2030

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Italy 2030

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Population, Italy2050

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Italy 2050

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Percentage of Population 65+ 2009, 2030 and 2050

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

2009 2030 2050

Per

cen

t 65

an

d O

ver

US

Italy

Percentage of Population 70+2009, 2030 and 2050

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

2009 2030 2050

Perc

ent 7

0 an

d O

ver

US

Italy

Percentages of Population 2009 (65+), 2030 (70+) and 2050 (75+)

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

2009 (65+) 2030 (70+) 2050 (75+)

Pro

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Ag

e

US

Italy

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

Retirement Financing:Within the Family

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

Social Security

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

Retirement Financing:Defined Benefit Plans

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

Defined Contribution Plans:The Hope

Defined Contributions Plans:Recent Experience

Morgan Stanley World IndexMay 28, 2004 – May 28, 2009

Source: mscibarra.com

U.S. Household Net Worth

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

Downside, Median and Upside Outcomes

Chance of Reaching a Goal

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 thecredit risks of the reference entities without directly holdingthe 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.”

Mitigating Counterparty Risk

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 Potentialand 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

Behavioral Finance

Hal Now

Hal Ersner-Hershfield, Stanford Longevity Project

Hal at Retirement

Current Savings

Too Much Savings

The Best Choice?