Optimizing the Aging, Retirement, and Pensions Dilemma

Acknowledgments xv

Preface xvii

Part One The Aging Population: Issues for Retirement 1

Chapter 1 Issues in Retirement 3

1.1 Longevity and Changing Demographics across the World 4

1.2 The Evolution of Retirement 8

1.2.1 Older Workers as a Growing Share of the Work Force 11

1.3 Provision for Retirement 11

1.3.1 The Earliest Pensions 11

1.3.2 Early Corporate Pensions 12

1.3.3 Total Assets on Retirement 15

1.3.4 The Contribution of Various Assets at Retirement 15

References 19

Chapter 2 The Various Costs of Pensions: Macro and Micro 21

2.1 Governmental Cost of Retirement 21

2.2 Pensions and Capital Formation 22

2.3 Regulating Corporate Pensions 24

2.3.1 US Regulations 24

2.3.2 Corporate Bankruptcies Leave a Trail of Broken Promises 30

2.3.3 Comparing Regulation of Occupational Pension Schemes in the EU and the United States 31

2.4 DC vs. DB: Shifting the Risks 33

2.4.1 Pensions, Corporate Earnings, and Tax Deferral 37

2.5 Freezing Pension Plans 39

2.6 Where Do We Go from Here? 40

References 41

Chapter 3 The Various Pillars of Retirement: Social Security, Company Pensions, Supplementary Pensions, and Private Savings 43

3.1 Pillars of Retirement 43

3.2 Reforming OECD Pensions 51

3.3 Changing Role of Private Pensions 51

3.3.1 Summarizing Pension Reforms in the OECD 55

3.4 Plans for Reforming Social Pensions 56

3.4.1 Increase Contributions, Cut Benefits, Extend Working Life 56

3.4.2 Use the Contributions to Buy Stocks instead of Government Bonds 58

3.5 Rethinking Pension Promises: Breaking the Fixed Link to a Monetary Value 61

3.5.1 Feldstein’s PRA with Guarantees 61

3.5.2 NDC: Notational or Nonfinancial Defined Contributions 62

3.5.3 The PAAW (Personal Annuitized Average Wage Security), a Variant of the NDC 66

3.6 Intergenerational Risk-Sharing 67

3.7 Conclusions 69

3.8 Case Study: Public Sector vs. Private Pensions 70

3.8.1 Government Plans Are Different: US 70

3.8.2 Government Plans Are Different: Canada 72

3.8.3 What Do We Learn from These Comparisons? 73

References 73

Chapter 4 Asset Classes: Historical Performance and Risk 77

4.1 Equities 77

4.2 ETFs: Exchange-Traded Funds 89

4.2.1 Levered ETFs 93

4.3 Bonds and Fixed Income 93

4.3.1 TIPS 95

4.4 The Bond-Stock Measure for Medium-Term Large Crash Prediction 95

4.4.1 The 2000–2003 Crash in the S&P 500 103

4.5 Hedge Funds 112

4.6 Real Assets 121

4.6.1 REITs 121

4.7 Housing as an Asset Class 121

4.8 Gold and Other Commodities 125

4.9 Private Equity and Related Assets 126

4.10 Currencies 126

4.11 Evaluation of Great Investors 129

4.12 Fundamental and Seasonal Anomalies of Asset Returns 135

References 141

Chapter 5 The Current Economic Crisis and Its Impact on Retirement Decisions 145

5.1 Household and Government Debt 145

5.2 Were the Crash Models Helpful in Signaling the US and Worldwide 2007–2009 Crash? 146

5.3 The Subprime Crisis and How It Evolved 148

5.3.1 Favoring the Financial Sector: Evaluating the Policy Responses 150

5.4 Impact on Retirement Expectations 153

5.4.1 Plan Sponsors in Trouble 156

5.5 Pensions in Trouble 160

5.6 State Pensions 161

5.7 Future ERP 162

5.7.1 Companies Freezing Pension Plans 165

5.7.2 The Ultimate Strategy: Bankruptcy 165

5.8 Future Inflation and Pensions 165

References 166

Part Two Special Issues and Models 169

Chapter 6 The Impact of Population Aging on Household Portfolios and Asset Returns 171

6.1 Introduction 171

6.2 The Empirical Evidence 172

6.2.1 The Empirical Evidence in a Micro-Perspective 173

6.2.2 The Empirical Evidence in a Macro-Perspective 181

6.3 Models for Portfolio Choices and Life-Cycle Asset Allocations 193

6.3.1 The Seminal Models 194

6.3.2 More Realistic Portfolio Models 196

6.3.3 Life-Cycle Asset Allocation Models with Uninsurable Labor Risk 198

6.3.4 Life-Cycle Asset Allocation Models in the Presence of Annuities 204

6.4 Conclusions 207

References 210

Chapter 7 A Continuous Time Approach to Asset-Liability Surplus Management 217

7.1 The Rudolf-Ziemba (2004) Intergenerational Surplus Management Model 218

7.2 A Case Study Application of the Rudolf-Ziemba Model 222

References 226

Chapter 8 Should Defined Benefit Pension Schemes Be Career Average or Final Salary? 227

8.1 Introduction 227

8.2 Career Average Defined Benefit Schemes 228

8.3 Cost Neutrality 229

8.4 Choosing the Revaluation Rate 230

8.5 The Adoption of Career Average Pension Schemes 232

8.6 Advantages of a Switch to a Career Average Scheme 236

8.6.1 Employer 236

8.6.2 Members 240

8.7 Disadvantages of a Switch to a Career Average Scheme 241

8.7.1 Employer 241

8.7.2 Members 245

8.8 Redistribution Effects of a Switch to Career Average Pensions 245

8.8.1 Compensatory Salary Changes, Pension Contributions, NIC, and Income Tax 247

8.8.2 Model of the Redistributive Effects of a Switch to Career Average 248

8.8.3 Numerical Example of the Redistributive Effects of a Switch to Career Average 250

8.9 Conclusions 253

References 254

Chapter 9 Applying Stochastic Programming to the US Defined Benefit Pension System 259

9.1 Introduction 260

9.2 Integrated Corporate/Pension Planning Model 261

9.2.1 Multiperiod Stochastic Programming Model 262

9.2.2 Alternative Goals 264

9.3 Assisting the Defined Benefit Pension System 265

9.3.1 Industry Projections 265

9.3.2 Applying Stochastic Programs to Industries in Trouble 270

9.4 Conclusions 273

References 274

Chapter 10 Mortality-Linked Securities and Derivatives 275

10.1 Introduction 275

10.2 Longevity Risk Transfers 278

10.2.1 Pension Buy-Outs 279

10.2.2 Securitization of Life Insurance Assets and Liabilities 281

10.3 Capital Market Solutions and the Development of Mortality-Linked Securities and Derivatives 282

10.3.1 The EIB Longevity Bond 283

10.3.2 Mortality Catastrophe Bonds 284

10.4 Recent Trends in Mortality-Linked Securities 286

10.4.1 Mortality Indexes 286

10.4.2 Mortality Swaps and Forwards 287

10.4.3 Mortality/Longevity Futures and Options 289

10.5 Hedging Pension Liabilities with Mortality-Linked Securities and Derivatives 290

10.5.1 Cash Flow Hedge Paradigm 290

10.5.2 Value Hedge Paradigm 291

10.5.3 Longevity Risk Pricing and Optimal Security Design 292

10.6 Conclusion 296

References 296

Chapter 11 Asset Allocation and Governance Issues of Government-Owned Pensions 299

11.1 Introduction 299

11.2 Types of Sovereign Funds 301

11.3 Is There a Common Asset Allocation for Pension Funds? 303

11.4 Sovereign Pension Funds and International Capital Markets 305

11.5 Governance Issues of Public Pension Funds 306

11.5.1 Intergenerational Borrowing 306

11.6 Regional Trends 309

11.7 Conclusion 313

References 314

Chapter 12 Issues in Individual Asset-Liability Management for Retirement 315

12.1 Own Company Stock 315

12.2 The Role of Annuities 319

12.3 The Role of Insurance 321

12.4 The Role of Managed Withdrawal Plans 322

12.4.1 Mandatory Withdrawals 322

12.5 Where and How to Retire? 322

12.5.1 New Type Retirement Communities 323

12.5.2 Assisted Living 323

12.5.3 Reverse Mortgages 323

12.5.4 Does It Pay to Have Multiple Residences? 324

12.5.5 Interest-Free Loan 326

References 326

Part Three Modeling the Issues 329

Chapter 13 Learning from Other Models 331

13.1 Preserving Endowment Spending 331

13.1.1 Cloning the Yale Approach 335

13.1.2 Dealing with Liquidity the Yale Way 336

13.1.3 Swensen’s Rule and Others 336

13.2 Devising a Rule So That Spending Never Falls 337

13.2.1 A Protective Spending Model 341

References 343

Chapter 14 The Innovest Austrian Pension Fund Financial Planning Model 345

14.1 How Should Companies Fund Their Liabilities and Determine Allocations among Asset Classes and Hedging Instruments? 345

14.2 Formulating InnoALM as a Multistage Stochastic Linear Programming Model 349

14.3 Some Typical Applications 352

14.4 Some Test Results 356

14.5 Model Tests 359

14.5.1 Final Comments 362

References 364

Chapter 15 An Individual ALM Model for Lifetime Asset-Liability Management 365

References 371

Chapter 16 Implementation and Numerical Results of Individual ALM Model for Lifetime Asset-Liability Management 375

References 392

Chapter 17 Conclusions 393

Index 397