The Next Generation of LifeCycle Investment Products
Zvi Bodie
Singapore
December 2009
1
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.
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Key Points
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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.
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Life-cycle investment products in the
U.S. today
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Target-date retirement accounts
Target-date college tuition accounts
Health saving accounts
Common characteristics
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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
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Popular literature
Financial Economics
Saving is for the short run.
Investing is for the long run.
Saving means income minus
consumption; investing
means selecting your
portfolio of assets.
The only way to reduce risk is
to diversify.
The simplest ways to reduce
risk are to hedge, insure, or
hold safe assets. A safe way
to achieve a future
consumption target is with
CPI-linked (inflation-indexed)
bonds.
Stocks become safe in the long Stocks do not become safe
run due to “time
even in the long run. If they
diversification.”
did, they would not have a
risk premium.
5
http://smg.bu.edu/exec/elc/lifecycle/
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The trouble with mutual funds
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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.
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8
Simulated Retirement Benefits from
a 70 Year Target Date Strategy
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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.
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Annual Retirement Benefit
10,000
Target-Date asset mix:
Simulated Run 1
Target-Date asset mix:
Actual historical
performance
1,000
2%
historical
Run 1
Run 2
100
Target-Date asset mix:
Simulated Run 2
YEARS
10
0
2
4
6
8
10 12 14 16 18 20 22 24 26 28 30
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The fallacy of time diversification
0.5
0.5
0.4
0.4
0.3
0.3
0.2
0.2
0.1
0.1
0.0
0.0
0
5
10
15
20
25
Fraction of investment
Probability
Probability of shortfall vs. cost of shortfall insurance
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Time Horizon in Years
6% risk premium
Cost of shortfall insurance
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The role of guarantees
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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.
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Safe Investing in Risky Times
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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
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Economic principles
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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.
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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.
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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.
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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.
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WFI Investment Toolkit
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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 welldiversified portfolio of risky assets (a marketindex 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.
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