The very description of DC retirement savings arrangements as pensions is a gross abuse of the English language, as a pension is an income in retirement. Without a mechanism for converting the invested savings assets into income cash flows they can hardly be considered as pensions. It is unfortunate that actuarial modelling of pensions has digressed into asset, liability and solvency projections, when the need is for estimation of the cash generative capabilities of the investment portfolio and the payment obligations over time of the pension liabilities.
It is worth noting that the long-term returns of both equity and bond investments are dominated by the income received. Over the long horizon, the capital values of these listed equities typically do no more than maintain their value in purchasing power terms while bonds return the nominal principal at maturity. It is also notable that the income properties of bonds and of portfolios of equities are far more predictable than their market prices.
One solution that is often proposed for DC pension saving is known as life-styling, where the assets of the fund are progressively moved from equities to bonds as retirement approaches. This has a cost, not just in the transactions costs incurred in the transition but more importantly in terms of the lower expected returns of bonds. The earlier article, Decumulation Part One, drew attention to the importance of post-retirement investment performance.
Though these articles are concerned with decumulation, it should be remembered that it is possible to avoid this issue entirely by purchasing, during the accumulation phase, securities and instruments that offer post retirement income, and are rightly pensions. The deferred annuity is one such instrument. These usually extend beyond the savings issues of DC by offering longevity insurance. It is important to understand that self-provision of longevity insurance is intrinsically extremely costly and inefficient. In order to provide for an indeterminately long retirement, it is necessary to save sufficient for the longest life feasible, and for most that means leaving some pension savings as bequests at death. It also means that one’s heirs have a financial interest in your early death. Of course, it is also possible to utilise partial or later age annuitisation to deal with the extended longevity issue, as is recommended by the OECD.
For an individual the sale of securities to generate cash for the pension is an awkward process as these are odd lot sales. This is not particularly problematic or expensive when these are equities, but odd lot bond sales may incur very high transaction costs. There is also the question of market price volatility to be considered – liquidation in adverse markets may be very uncertain and expensive. In general, it is desirable in any decumulation plan to avoid dependence upon sale in a financial market. This should be a particular concern as liquidity has a tendency to be systemic, affecting the marketability of all securities. Amortising bonds, such as term annuities resolve this issue – they are self-liquidating. Though they have fallen from favour in terms of preferred methods of issuance, largely as a result of the trading community’s preference for bullet, vanilla issues, such amortising securities were commonplace as recently as the 1970s. The twenty five year corporate bond with 15 years grace , followed by ten equal repayments of ten percent of the capital was almost a standard in the early Eurobond market; this of course could otherwise be described as a deferred term annuity – ten years, fifteen years forward.
This can be taken to its ultimate limit in the form of a long-discussed security known as an “Evergreen”. Here the security is zero coupon, issued at a discount and it repays a set proportion of its nominal capital value in each year. A ten-year security repays ten percent of its outstanding value in every year, a five-year twenty percent, and so on. It is trivial to make the issuance of any particular term fungible preserving and enhancing market liquidity. Securities of this design marry well with the survival curves of collective pensions schemes and will be discussed more fully in Decumulation Part Three. These forms of security may be issued in real form, with values and cash flows linked to price indices.
The issuance of amortising debt instruments is attractive to many issuers. Infrastructure often requires long periods of investment and completion of the capital investment before any use and revenues may be generated. The management of municipal debt would be greatly facilitated by the issuance of term annuities, which marry well with annual receipts such as property taxes. Even the corporate sector would find the burden of repayment easier when it is diffused over time rather than a single bullet sum at maturity.
This is a prime example of the interests of the intermediary trading community gaining superiority over those of the users of a market – the issuers and investors.
Finally, there is, of course, the possibility of using preference stock to generate the pension income. When these have indefinite term, they may go far in producing income that covers the individual’s entire lifetime. Indeed, in one overseas jurisdiction, a private company, advised by the author, annually issues participating redeemable preference stock, which vests on retirement, to its staff as their private pension.
For the individual, innovation in instrumental or security design may help, but there are entire classes of solution which are superior, which will take us to collective, co-operative arrangements the subject of Decumulation – Part Three.