Observations on Individually Funded
Pension System Design:
Advances for the Future
Robert C. Merton
Harvard Business School
Developing the Potential of the Individually Funded
Pension Systems
2010 FIAP International Seminar
Viña del Mar, Chile
May 7, 2010
Pension Goal and Means for Achieving it:
• Desired income: An inflation-protected annuity
for life adequate to maintain standard of living
enjoyed in last part of work life.
• Ways to improve the probability of achieving
desired income
– Efficient and effective use of all available assets of
the employee and low-cost of investment services
– Increase contribution rate: save more
– Increase retirement age: work longer
– Increase risk of investments
Copyright @ 2010 Robert C. Merton
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Household Pension Investment
Management in the future
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What is the “risk-free” asset for retirement funding?
Managing real interest-rate risk
Managing duration mismatch between contributions and payouts
Managing inflation and longevity risks
Benefits of global diversification
Floor and ceiling products
Structured DC: dynamic optimization
Products to mitigate behavioral dysfunctions
Housing: risky asset or pre-paid consumption, or both?
Funding retirement and bequests: Reverse mortgage
Managing longevity tail-risk
Product efficiency: long-term care and life annuity
Copyright @ 2010 Robert C. Merton
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Effect of Real Annuity as Numeraire on
Risk-Return Frontier
In USD
In units of real annuities (Q)
Cumulative Total Return Index in $ (Rescaled to 100 in 1997)
Cumulative Total Return Index in Q (Rescaled to 1 in 1997)
180
1.60
160
1.40
1.20
140
1.00
120
0.80
100
0.60
80
CM30Y Annuity
3m Bill
MSCI World Free
SP500
60
40
CM30Y Annuity
3m Bill
MSCI World Free
SP500
0.40
0.20
0.00
1997
1999
2001
2003
2005
$-Return
9.0%
8.0%
7.0%
CM30Y
Annuity
MSCI World
Free
6.0%
5.0%
4.0%
3.0%
SP500
3m Bill
2.0%
1.0%
0.0%
0.0%
5.0%
10.0%
15.0%
$-Volatility
Copyright @ 2010 Robert C. Merton
20.0%
25.0%
1997
1999
2001
Q-Return
1.0%
0.0%
-1.0%
CM30Y Annuity
-2.0%
-3.0%
3m Bill
-4.0%
-5.0%
-6.0%
-7.0%
-8.0%
-9.0%
0.0%
5.0%
10.0%
2003
2005
MSCI World
Free
SP500
15.0% 20.0%
Q-Volatility
25.0%
30.0%
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Copyright @ 2010 Robert C. Merton
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Performance
of worldof
equity
andDiversification
bond markets, 1972- 2001,
Benefits
Global
30 years
of monthly
data 1972-2001
Performanceannualized
of Worldfrom
Equity
and Bond
Markets,
WMP
US equity
18%
Developed X-US equity
Japan equity
16%
UK equity
Europe equity
Germany equity
Return
14%
France equity
Emerging equity
US bond
12%
Developed X-US bond
Japan bond
10%
UK bond
Europe bond
Germany bond
8%
France bond
Emerging bond
Risk-free
6%
0%
5%
10%
15%
20%
25%
CAPM line
Volatility
Source: André F. Perold, Joshua N. Musher (2002), “The World Market Portfolio”
© November 20, 2002, by André F. Perold and Joshua N. Musher
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Relative Advantage of Equity Swaps for
Globally Diversifying Risk
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Minimizes Moral Hazard of Expropriation or Repudiation
Locals perform industrial governance, trading in shares in local market,
receive benefits/losses of local-country-specific component of industry
returns, thus avoids political risk of “selling off corporate control of the
country”
Credit Risk: no principal amounts at risk; set frequency of payments
(.25,0.5,1.0 years); “right-way” contract [pay when country is better able];
potential for credit guarantee and/or two-way-marked-to-market collateral
Policy is non-invasive: doesn’t require change in employment patterns and
behavior, changes in industrial structure or changes in financial system
design
Policy is reversible by simply entering into an off-setting swap
Robust with respect to local financial system design: even works with capital
controls
Potential Gains: From 1972-2001, a gain of 600 + b.p. in average return for
same risk level by efficient diversification
Copyright @ 2010 Robert C. Merton
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Transform Shape of Payoffs from Investing in the
Equity + Debt Portfolio
“Uninsured Portfolio” Payoff
Value of Investor
“Insured” Portfolio, $
• Insurance
• Transform Payoff Pattern to fit preferences: custom design
$95,000 Minimum
Guarantee Floor
“Insured Equity” Payoff
0
Value of Equity + Debt Portfolio, $
0
$100,00
0
Value of Investor
“Collar” Pattern
Portfolio , $
$190,000
Desired Maximum Payout
“Collar” Strategy Between
Desired and Minimum Payout
$95,000 Minimum
Guarantee Floor
0
Value of Equity + Debt Portfolio, $
0
Copyright © 2010 by Robert C. Merton
$95,000
$190,000
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Enhancements in the Future
• Age, means, and interest-rate-dependent contribution
rates
• Dynamic portfolio strategies to maximize probability of
achieving Desired Income
• Standard of living risk: consumption-linked annuities
• Mitigate behavioral dysfunctions: choice but not too
much
• Tail-insurance on longevity: >85 life annuities
• Contract efficiency: long-term care and life annuity
• Bequests and asset efficiency: reverse mortgage
Copyright © 2010 by Robert C. Merton
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