Arun Muralidhar is a campaigner for turning pots to pensions and he is speaking on the adoption of his solution – the Retirement Security Bond (RSB) – in countries around the world.
He has asked me to publish this paper on how the RSB works and the advantages it brings in advance of him speaking at a Stefan Lundberg event on 23rd March – invitation link is here.
Scroll to the bottom for the paper’s authors – all eminent. I’m happy to help publish this good simple idea.
A Solution to a Key Challenge in the UK Retirement Market: The Retirement Security Bond
There is a looming retirement crisis in the UK as the country faces the challenge of an aging population. The British citizens are fortunate to be living longer and enjoying increased life expectancy. At the same time, the country has experienced a declining birth rate, and perhaps, slower economic growth. Hence, the Social Security sustainability has been questioned.
With underfunded Social Security, the United Kingdom has responded by creating complementary investment systems to give individuals the opportunity to undertake personal saving in a separate account to enhance their retirement income. The challenge is that many individuals are not financially educated and yet, they are now being asked to take responsibility for complex financial decisions: How much to save, how to invest, and how to decumulate one’s portfolio at retirement. The challenge in pensions systems around the world rest on three pillars: (a) access; (b) effective investments; and (c) effective decumulation. Many individuals, called “uncovered workers” do not have access to pension funds and hence do not have an appropriate vehicle to save for retirement.
Fortunately, in the UK, the creation of the National Employment Savings Trust (NEST) Corporation has permitted many without access to a pension fund to start accumulating assets in pension pots that are professionally managed and at low cost. Furthermore, there is a well-developed investment management industry for the effective management of the assets. While the first two pillars are adequately taken care of, the third critical pillar in retirement, effective decumulation, remains a challenge. Defined contribution (DC) pensions typically do not offer a real, guaranteed retirement income (ideally through expiration), and this leaves participants very vulnerable to potentially bad outcomes.
A recent innovation in Brazil, the creation of the RendA+ (or “Extra Income”) bond, issued through their Treasury Direct facility, is a very effective instrument that might serve as a model for the UK to adopt/adapt. This bond was designed along the lines of the “RSBs” or Retirement Security Bond first proposed by us in 2016.
What is this unique instrument and how does it help improve retirement security?
A commonly accepted retirement goal for a healthy pension is to be able to sustain the standard-of-living to which they are accustomed in the latter part of their working life, throughout retirement (and that they do not outlive their assets). Compounding the earlier noted challenges, current financial instruments, and products (e.g., T-Bills, Inflation-Linked Bonds, or Target Date/Life Cycle Funds) are risky because they focus on the wrong goal – a wealth sum at retirement, as opposed to steady income flow during retirement. That is, current products do not guarantee how much retirement income can be provided to support one’s pre-retirement standard-of-living.
Moreover, while annuities are an effective means for providing income in retirement with longevity protection, for those not in a defined benefit pension plan, they are too illiquid and inflexible to employ during the accumulation period. Financial innovation and a change in the metric for measuring retirement success could address some of these challenges and help individuals achieve their retirement goals – a financially and socially desirable outcome for any country, especially the United Kingdom.
What is the desired retirement income stream or cash flow of an individual?
Assume a 25-year-old in 2023 would typically plan to work for 40 years, until 2063. This person would like to receive, for example, UK₤ 50,000 real/year for 20 years in retirement (from 2063-2083). The exact income stream is not important, and these figures are chosen for ease of illustration and discussion. Figure 1 plots the likely real retirement cash flow that this 25-year-old desires/needs. It shows that the goal requires no cash flows for 40 years (through 2063) and then a steady stream of real income for 20 years. This is very different from a single wealth number that individuals are asked to think about as their “retirement number.”
Figure 1: Projected Real Retirement Cash Flows of a 25-year-old in 2023 – work 40 years; live for 20 years in retirement.
We recommend an easy, and efficient solution for the UK to address its citizens’ retirement income management and to improve their retirement security by creating and issuing an innovative new bond – the RSB. The UK already has all the infrastructure needed to issue this bond and hence RSBs can be issued with minimal additional effort, while creating a win-win-win for citizens, the government, and the financial services industry. The RSB is a single, liquid, low-cost, low-risk (government-issued) instrument, easy-to-understand for even the most financially unsophisticated individual, because it embeds accumulation, decumulation, compounding and inflation-adjustments. Since the safe asset in defined contribution plans (focused on target retirement income) does not exist, RSBs are designed to mimic pension payments in Figure 1. Governments can issue RSBs, and they can be purchased directly by any individual (to create a type of “individual DB”) or by an institution.
RSBs start paying investors (i.e., individual citizens) upon retirement (i.e., forward-starting), and pay real income-only (e.g., UK₤ 5 real/year), indexed to aggregate per capita consumption (to hedge standard-of-living risk), or inflation for ease of initial implementation, for a time period equal to a period linked to the average life expectancy at retirement in the UK (e.g., 20 years). Figure 2 shows a very simple cash flow chart of RSBs that start paying in 2063 for 20 years. The sharp negative bar in 2023 is the potential purchase amount made today to acquire the desired retirement cash flow stream in the future (i.e., the price of RSBs). RSBs are a purely market-based instrument and the market forces at the time of issuance will determine its issue price and its secondary market price. Most importantly, instead of current bonds that index solely to inflation, ideal RSBs cover both the risk of inflation and standard-of-living improvements by indexing to per-capita consumption to ensure that retirees preserve their standard-of-living. This is critical especially since retirement planning is potentially a 60-year (40 years of work and 20 years of retirement) process and standard-of-living risk is a key unmanaged risk globally today. RendA+ currently is indexed to the IPCA – the local inflation index to which TIPs are set in Brazil, as that is currently a liquid and well-accepted market, and the inflation-linked market is well established in the UK too.
Figure 2: Real Cash Flows of 2063 RSBs: Pay UK₤5 real from retirement date (2063) for 20 years (till 2083)
RSBs are designed to pay people when they need it and how they need it. It greatly simplifies retirement investing. A 55-year-old in 2023 would buy the 2033 bond, which would start paying coupons at age 65, and keep paying, for say 20 years, through 2053. RSBs cater to all individuals, independent of retirement date. For example, if our 25-year-old in 2023 wants to guarantee UK₤50,000 annually, risk-free for 20 years in retirement as in Figure 1, to maintain their current standard of living, they would need to buy 10,000 RSBs (UK₤50,000 divided by UK₤5) over their working life. Periodic DC plan statements can easily inform individuals as to how much retirement income they can expect to receive based on current holdings of RSBs (and conversion of other assets into RSBs-equivalents), relative to the target (10,000), thereby allowing easy course corrections prior to retirement. In addition, RSBs can be bequeathed to heirs, who can then either continue to collect the coupons or sell the RSBs in the secondary market. If RSBs are well-designed, they can also ensure longevity risk protection.
RSBs require only the most basic information and offer choices for buyers of any educational strata. The two required inputs are: Anticipated date of retirement (i.e., the RSBs payment start date) and target income goal for a good retirement (which determines the number of RSBs needed to reach this goal). If they change their retirement date, they could easily sell/buy the relevant RSBs with little effort and cost. The three (current) complex decisions of saving, investing and decumulation are simply folded into an easy calculation of how many bonds to buy (and in the case of Brazil displayed on the Treasury website and the app designed for this purpose). Even the most financially illiterate individual can be self-reliant with respect to retirement planning. Since RSBs do not make payments until the retirement date, the buyer does not need to make any further transactions or decisions to reinvest coupon or principal payments during the entire accumulation period. One transaction, one time, for each RSBs purchased minimizes costs, decision effort and errors.
In Brazil, the RSBs (RendA+ bonds) can be purchased inexpensively through the Brazilian Treasury Direct facility, via a mobile phone application. It is liquid and can be sold back to the government. In the case of the United Kingdom, the retail version of these RSBs could be issued through the UK Government’s Individual Savings Account (ISA) scheme for complementary pension or through institutional issuance for the likes of NEST, insurance companies and asset managers to create effective products for the DC industry. ISA currently allows for the purchase of savings bonds and RSBs can be seen as a specific savings bond targeted specifically for retirement savers. A more detailed paper discusses how RSBs facilitate the hedging of longevity risk through multiple avenues.
RSBs are a good deal for governments too.
RSBs are a good deal for governments too. RSBs not only improve retirement outcomes and hence, social stability through income predictability for all citizens, they also reduce the need for government support and potential bailouts. Furthermore, they also have spill-over benefits, as the bond improves balance sheet management. Governments with value-added taxes have a hedge against future RSBs payments. They can also fund infrastructure projects which is a major challenge globally as the cash flows of RSBs are synergistic with these long-term investments. As a result, RSBs have been proposed for countries as diverse as the United States, France, Japan, India, Brazil, and Turkey.
RSBs also serve a useful purpose by becoming the “currency of retirement.”; namely, a simple way to gauge the impact of changes in current economic policy on future retirement outcomes. For example, substantial monetary stimulus (as was being experienced in 2020) has potentially raised the cost of securing retirement income and had RSBs existed, this would have been transparent. Furthermore, one of the challenges with inadequate savings is that other assets owned by individuals will need to be considered to bolster the retirement pot – with one asset, one’s house – holding potentially the greatest promise. RSBs will allow individuals to clearly understand how much potential retirement income (and protection of pre-retirement standard of living), their current assets are likely to generate.
RSBs are a win-win-win for all. The time to act is NOW – the longer the delay, the higher the cost of ensuring retirement security for future generations and increasing the burden and cost to government.
By Prof. Robert C. Merton, Dr. Arun S. Muralidhar, Wesley I. Paul and Azita Sharif
Author 1: Prof. Robert C. Merton
Title: Distinguished Professor of Finance, Nobel Laureate – Economics 1997
Organization: MIT Sloan School of Management
Author 2: Arun S. Muralidhar, Ph D
Title: Co-founder and Client Portfolio Manager
Organization: AlphaEngine Global Investment Solutions LLC
Author 3: Wesley I. Paul
Title: Co-Founder & Managing Partner,
Organization: NextGenHydrogen Ltd (Former Managing Director & Global Head of Investments at JP Morgan Asset Management)
Author 4: Azita Sharif
Title: Chief Executive Officer