Articles - The Need for Flexicure Retirement Solutions

A major global pension crisis is threatening the sustainability of pension systems across the globe. The first pillar of pension systems, which is made of public social security benefits and aims at providing a universal core of pension coverage to address basic consumption needs in retirement, is strongly impacted by rising demographic imbalances. Pillar 1 pension arrangements are seriously weakening, as most so-called ‘funded systems’ are severely underfunded.

 In the UK, for example, the deficit of the funded public pension system is currently estimated to be $4 trillion and is expected to grow to reach a $33 trillion by 2050. For countries that have unfunded pay-as-you-go systems, such as France and Germany, the situation is also extremely worrying.

 What are the problems facing individual investors who are becoming increasingly responsible for their own saving and investment decisions?
 Looking at the second pillar, private pension funds have been particularly impacted by the shift in accounting standards towards the valuation of pension liabilities at market rates, instead of fixed discount rates, which have resulted in increased volatility for pension liabilities. This new constraint has been reinforced in parallel by stricter solvency requirements following the 2000-2003 pension fund crisis. The evolution of accounting and prudential regulations have subsequently led a large number of corporations to close their defined-benefit pension schemes to new members and increasingly to further accrual of benefits so as to reduce the impact of pension liability risk on their balance sheets and income statements. Overall, a massive shift from defined-benefit pension to defined-contribution pension schemes is taking place across the world, implying a transfer of retirement risks from corporations to individuals.

 What are the shortcomings of existing pensions products?
 In response to these concerns, a number of so-called retirement products have been proposed by insurance companies and asset management firms. Asset management products offer a wide range of investment options, but none of these options really address retirement needs because they neither allow investors to secure a given level of replacement income, nor explicitly intend to do so.

 This is also true for target date funds, even though they are often used as default options by individuals saving for retirement.

 In contrast, insurance products, such as annuities and variable annuities, can secure a fixed level of replacement income throughout retirement. However, this security comes at the cost of a severe lack of flexibility, because annuitization is an almost irreversible decision, unless one is willing to bear the costs of high surrender charges, which can amount to several percentage points of the invested capital. This rigidity is a major shortcoming in the presence of life uncertainties such as marriage and children, changing jobs, health issues, changing locations to lower or higher cost cities or countries, decisions about retirement dates, etc.

 Why is the UK pensions regulator particularly concerned about the current situation?
 For all these reasons, and even though they offer the security that investment products lack, annuities are in low demand overall unless annuitisation is either heavily incentivised or simply mandatory, as was the case in the UK before the passing of the Pension Freedom Act in 2015.

 To sum up, individuals in the UK were constrained to use annuities before 2015, which offer security without flexibility, and they now massively choose to use investment products that provide flexibility but no security with respect to the level of future replacement income. This is a particularly strong concern for the UK regulator since the replacement income risk is now fully borne by retirees.

 What is the optimal balance between security and performance?
 Fortunately, existing financial engineering techniques can be used to design new forms of “flexicure” investment solutions that can offer individuals both security and flexibility when approaching retirement investment decisions, thus providing a way out of the impasse of a choice between annuities and target date funds.

 What type of new pensions products are needed and why is there increased interest in these from investment firms?
 Costly and quasi-irreversible annuity products are not needed to secure replacement income for a fixed period of time in retirement.

 To generate income for, say the first 20 years of retirement, a period which roughly corresponds to the life expectancy of a 65 US individual, one can design a dedicated cash-flow-matching portfolio made of liquid fixed-income securities, while protection against the risk of living longer than expected can be achieved by purchasing a deferred late life annuity. On the other hand, and precisely because of this security, investing in this “retirement bond portfolio” cannot generate upside in terms of replacement income. To increase the achievable level of replacement income without relying only on additional contributions, investor may also invest in stocks and other asset classes that are expected to outperform the retirement bond in the long run.

 Investment retirement solutions mixing stocks and retirement bond portfolios can be used to help individuals and households secure minimum levels of replacement income while generating upside exposure through liquid and reversible investment products.

 Let us note that the pension crisis will not be solved by financial engineering only. Part of the solution lies in the hands of individuals themselves, who need to start contributing earlier so as to more efficiently complement the benefits expected from the first two pillars of pension systems. However, the investment industry does face an ever greater responsibility to provide suitable retirement solutions.

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