This blog is by Dr. Arun S. Muralidhar

Author: Arun S. Muralidhar, Ph DCo-founder and Client Portfolio Manager/Designed of SeLFIES and Education Bond; Alpha Engine Global Investment Solutions LLC

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, Social Security’s 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. All these challenges do not bode well for retirement security and will force an already financially stretched government to have to bail out citizens (and burdening tax payers). With increasing borrowing needs, we will show that a simple innovation, pioneered by G20 President Brazil, might offer a multi-dimensional solution to the UK’s many challenges.

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, and NEST has not managed to provide an effective solution (making current investment choices risky relative to one’s desired retirement lifestyle). Defined contribution (DC) pensions typically do not offer a real, guaranteed retirement income (ideally through expiration), and this leaves participants’ retirement lifestyles 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 “SELFIES” (Standard-of-Living, Forward-starting, Income-only Securities) first proposed by one of the authors in 2015.

What is this unique instrument and how does it help improve retirement security, especially for Gen Z that will probably have limited to NO access to defined benefit (DB) plans?

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, and even with many of these financial products, they cannot offer any guarantee of a target wealth. More importantly, 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 DB pension plan, they are too illiquid, complex, potentially risky, 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 2025 would typically plan to work for 40 years, until 2065. This person would like to receive, for example, UK₤ 50,000 real/year for 20 years in retirement (from 2065-2085) as supplemental income to say social security (i.e., say from their NEST account). 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 2065) 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 2025 – 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 – SELFIES. The UK already has all the infrastructure needed to issue this bond and hence SELFIES can be issued with minimal additional effort, while creating a win-win-win for citizens, the government, and the financial services industry. SELFIES is a single, liquid, low-cost, low-risk (government-issued) instrument, potentially purchased in slices as small as ₤5 at a time, and easy-to-understand for even the most financially unsophisticated individual, because it embeds accumulation, decumulation, compounding and inflation-adjustments. Since the safe asset in DC plans (focused on target real retirement income) does not exist, SELFIESs are designed to mimic pension payments in Figure 1 and complementary to social security payments. Governments can issue SELFIESs, and they can be purchased directly by any individual (to create a type of “individual DB”) or by any institution (pension fund, NEST, insurance company or asset manager).

SELFIESs 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 SELFIESs that start paying in 2065 for 20 years. The sharp negative bar in 2025 is the potential purchase amount (i.e., the price of SELFIES) made today to acquire the desired real retirement cash flow stream in the future. Figure 2 projects both the guaranteed REAL payments and potential nominal payments for some assumed inflation. SELFIESs 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 gilts that index solely to inflation (and offer a massive cash flow mismatch relative to the desired cash flows in Figure 1), ideal SELFIESs 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 2065 SELFIESs: Pay ₤5 real per year from retirement date (2065) for 20 years (till 2085)

SELFIESs are designed to pay people when they need it and how they need it. It greatly simplifies retirement investing. A 55-year-old in 2025 would buy the 2035 bond, which would start paying coupons at age 65, and keep paying, for say 20 years, through 2055. SELFIESs cater to all individuals, independent of retirement date. For example, if our 25-year-old in 2025 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 SELFIESs (₤50,000 divided by ₤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 SELFIESs (and conversion of other assets into SELFIESs-equivalents), relative to the target (10,000), thereby allowing easy course corrections prior to retirement. In addition, SELFIESs can be bequeathed to heirs, who can then either continue to collect the coupons or sell the SELFIESs in the secondary market. If SELFIESs are well-designed, they can also ensure longevity risk protection.

SELFIESs require only the most basic information and offer choices for buyers of any educational strata as has been the case in Brazil. The two required inputs are: Anticipated date of retirement (i.e., the SELFIESs payment start date) and target income goal for a good retirement (which determines the number of SELFIESs needed to reach this goal). If they change their retirement date, they could easily sell/buy the relevant SELFIESs with little effort and cost. This has been the experience in Brazil; namely, that while the bulk of the transactions have been purchases, some individuals have sold current holdings for cash flow needs pre-retirement. 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 SELFIESs 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 SELFIESs purchased minimizes costs, decision effort and errors. And they are sharia-compliant too (for NEST investors and general citizens).

In Brazil, the SELFIESs (RendA+ bonds) can be purchased inexpensively through the Brazilian Treasury Direct facility, via a mobile phone application. Currently, a citizen can purchase slices of RendA+ in sizes as small as ₤5 at a time. It is liquid and can be sold back to the government. In the case of the United Kingdom, the retail version of these SELFIESs 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 SELFIESs can be seen as a specific savings bond targeted specifically for retirement savers. A more detailed paper discusses how SELFIESs facilitate the hedging of longevity risk through multiple avenues.

SELFIESs are a good deal for governments too. SELFIESs 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 SELFIESs payments. They can also fund infrastructure projects which is a major challenge globally as the cash flows of SELFIESs are synergistic with these long-term investments. As a result, SELFIESs have been proposed for countries as diverse as the United States, France, Japan, India, and Turkey. Brazil is also using it to ensure gender pension equity, but most importantly, given the increased borrowing needs experienced by His Majesty’s Treasury (HMT), the case can be made that issuing SeLFIES might be an innovative way to extend the yield curve and improve retirement security, given the HMT’s borrowing needs.

SELFIESs 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 SELFIESs 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. SELFIESs 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.

SELFIESs are a win-win-win for all and is a bipartisan issue and should have support from Labor and Conservatives, as was the case in Brazil. 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.