SELFIES: AIOS RED PLAC SEMINAR URUGUAY, APRIL 9, 2019 - A GLOBALLY-APPLICABLE BOND INNOVATION TO IMPROVE RETIREMENT SECURITY, INFRASTRUCTURE ...
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SeLFIES:
A Globally-Applicable Bond Innovation to Improve
Retirement Security, Infrastructure Funding, and
Government Borrowing Cost
ARUN MURALIDHAR, PH.D.
MCUBE INVESTMENT TECHNOLOGIES, LLC
AIOS RED PLAC Seminar
Uruguay, April 9, 2019
Disclaimer
This presentation contains the views of AlphaEngine Global Investment Solutions’ (AEGIS) Research Team as of the date on the cover. It is provided for limited
purposes, is not definitive investment advice, and should not be relied on as such. The information presented in this report has been developed internally and/or
obtained from sources believed to be reliable; however, AEGIS does not guarantee the accuracy, adequacy, or completeness of such information. References
to specific securities, asset classes, and/or financial markets are for illustrative purposes only and are not intended to be recommendations. All investments
involve risk and investment recommendations will not always be profitable. AEGIS does not guarantee any minimum level of investment performance or the
success of any investment strategy. As with any investment there is a potential for profit as well as the possibility of loss.
This information is not meant to provide guidance with respect to pension plan administration in any country. AEGIS makes no representation that the
techniques described in this document comply with the law of any country. This information is not intended as legal or investment advice.
General Disclosures: The simulated performance presented may differ from live performance experienced using the strategy for the following reasons:
The simulation assumes that we adjust the allocations to each asset on a daily basis after the close and at the closing price on that day, whereas the live
product may not adjust the allocations exactly at that time or at that price and may have execution lags that affect the execution prices.
The simulation assumes certain transaction costs with respect to trades made, whereas the live portfolio might incur different transaction costs.
The simulation assumes implementation of the allocation shifts by buying and selling the underlying indices, whereas live portfolios may use other instruments
(i.e. futures, forwards, active or passive managers) with a different return or cost.
Hypothetical or simulated performance results have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual
trading. Also, since the trades have not actually been executed, the results may have under or over compensated for the impact, if any, of certain market
factors, such as lack of liquidity. Simulated trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No
representation is being made that any account will or is likely to achieve profits or losses similar to those shown.
2
My Background: All Sides of the Fence
Issued Bonds, Managed Pension Assets, Worked on Pension Reform,
Founded an Asset Manager+Technology Firm
World Bank: Issued Bonds (early 1990s); Manager, Pension &
Investments Depts (late 1990s)
JP Morgan/FX Concepts: MD, Head, FX Research (1999-2007)
Mcube/AEGIS: Manage Institutional Assets (2001 – Current)
GWU: Adjunct Professor of Finance
Author: Innovations in Pension Fund Management (2001)
Rethinking Pension Reform, with late Prof. F. Modigliani, Nobel Laureate (2004)
SMART Approach to Portfolio Management (2011)
Fifty States of Gray: An Innovative Solution to the Defined Contribution Crisis (2018)
3
Agenda: Addressing Two Major Challenges
with a Simple Innovation
Retirement security is a major challenge globally
Most adults are financially illiterate
Funding infrastructure is also a challenge
Innovation can address these challenges
Implications for public finance/regulation/markets
Requires governments and development banks to be creative
*Source: Muralidhar, A, K. Ohashi and S. Shin. 2016. The Most Basic Missing Instrument in Financial Markets: The Case for Forward-Starting Bonds. Journal of Investment Consulting 16, no. 2: 34–47.
4
Global Pension Challenges
All Pillars Shaky
PAYGO DB Systems - Not Sustainable
Employer DB Systems - No Longer Offered
Employer or Central DC Systems - Many Challenges
Financial Illiteracy, Increasing Longevity, and Low
Coverage and Savings plague all countries
Retirement Risk being Transferred to Individuals; Need Reform/Innovation
*Source: Muralidhar, A. 2018. Fifty States of Gray: An Innovative Solution to the Defined Contribution Crisis. Investments and Wealth Institute, Denver, CO
Modigliani, F. and Muralidhar, A. 2004. Rethinking Pension Reform. Cambridge University Press, London, UK
5
DC Pension Plans: Multiple Challenges
Going to Lead to a Global Retirement Crisis
Bad
Risk transferred to individuals (one lifetime) Bad Use of
Financial
Three big/complex decisions to make: Theory
Instruments
How much to save?
Invest: What to buy? How much? Rebalancing?
How best to decumulate? What annuity to buy?
Big time-gap between savings and retirement
Financial illiteracy of most participants
Have to deal with multiple parties = High cost
Results in High Cost, Complex, Risky, Illiquid Options (“Annuity Puzzle”)
6
DC Pensions: Most Adults Financially Illiterate
Most Individuals Cannot Answer Three Basic Finance Questions
WB study* on literacy – dire cautions
Individuals do not understand 3 concepts:
How compounding works
Impact of inflation
How diversification works
Latin America/Asia – reasonably low
financial literacy (25% - 45%)
How do we ensure safe retirement with this challenge?
*Klapper, L., A. Lusardi, and P. van Oudheusden. 2015. Financial Literacy Around the World: Insights from the Standard & Poor’s Ratings Services Global Financial
Literacy Survey. World Bank Development Research Group, November 2015, Washington DC
7
What Constitutes a Good Retirement?
Guaranteed income
In real terms
Preserves pre-retirement standard-of-living
Ideally till death
Annuity Puzzle – Despite Attractive Aspects, Low Usage
Source:
Modigliani, F.. 1966. The Life Cycle Hypothesis of Saving, the Demand for Wealth and the Supply of Capital. Social Research 33, no. 2 (summer): 160–217.
8
Modigliani. F. 1986. Life Cycle, Individual Thrift and the Wealth of Nations. Economic Sciences (based on Lecture on receiving Nobel Prize in Economics). Pp 150-170.
DC Goal: Guaranteed, Real, Target Retirement
Income Till Death
Retirement Income Stream: Need Steady Real Cash Flow
$60.000 Accumulation Decumulation
Work for 40 Years (25-65)
$50.000
Thousands of real pesos
$40.000
Retired for 20 Years
Maintain pre-retirement lifestyle
$30.000
Need steady real cash flow
$20.000
Till death, ideally (longevity risk)
Goal: Looks more like a bond than a stock
$10.000
$0
2018
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®
Liability Cash Flow for Retirement
9
Problem: No Asset Has This Profile/Bridges The Time Gap; Annuities Not Popular
The Challenge: Finance Theory
Modern Portfolio Theory Focused on the Wrong Goal (Wealth)
T-Bills or even regular bonds considered “safe”
Protect principal (wealth)
Volatile: Annuity/income perspective
Current assets, retirement products (including
Life-cycle Funds) are very risky
During Privatization (1990s-2000s), govts forced high
allocation to bonds to protect principal
Revised Perspective Has Interesting Implications for Macro Theory As Well
10 Merton, R.C. 2014. The Crisis in Retirement Planning. Harvard Business Review. July-August 2014, https://hbr.org/2014/07/the-crisis-in-retirement-planning#The Challenge: Bad Instruments
Even Inflation-Linked Bonds are Risky in Retirement Plans
Cash Flow Mismatches/Reinvestment Risk
120 5
Traditional 30 Year TIPS Cash Flow ($)
4
80
Max US TIPs maturity = 30 years =
3
Reinvestme
2
nt Risk
40
Slightly longer in countries like South Africa 1
0 0
Inflation adjustment embedded in principal
Can only hedge 10 years pre-retirement -40
® -1
-2
Do not need coupons when working Principal (LHS) Interest (RHS)
Do not need Principal repayment
-3
-80
Accumulation Decumulation
Financial engineering to create annuity -4
profile = risky, costly, illiquid, complex -120 -5
More pertinent risk is Standard-of-Living risk
11Solution: New Retirement Bond
SeLFIES Idea with Nobel Laureate Robert Merton
SeLFIES Cash Flows
Government/supras issue new bonds (based on TIPs Curve as of 10/10/2018)
Key features of each bond: $20
Starts paying at age 65 $10
Pays coupons-only for 20 years (life expectancy) $0
01-01-2019
01-01-2021
01-01-2023
01-01-2025
01-01-2027
01-01-2029
01-01-2031
01-01-2033
01-01-2035
01-01-2037
01-01-2039
01-01-2041
01-01-2043
01-01-2045
01-01-2047
01-01-2049
01-01-2051
01-01-2053
01-01-2055
01-01-2057
01-01-2059
01-01-2061
01-01-2063
01-01-2065
01-01-2067
01-01-2069
01-01-2071
01-01-2073
01-01-2075
01-01-2077
Pays real $5/year
Goal = $50,000 per year/$5 per year = 10,000 bonds
-$10
-$20
®
Establish demand for safe retirement asset -$30
Cash Flows (Nominal) Cash Flows (Real)
Original idea with Professors from Japan, Korea: BFFS
-$40
- Bonds for Financial Security Periodic savings invested in SoL-Adjusted
SeLFIES Retirement Income
Merton version: SeLFIES - Standard-of-Living indexed -$50
No coupons before 2059 for 20 Years
Forward-starting Income-only Securities -$60
Source: Muralidhar, A, K. Ohashi and S. Shin. 2016. The Most Basic Missing Instrument in Financial Markets: The Case for Forward-Starting Bonds. Journal of Investment Consulting 16, no. 2: 34–47.
Merton, R.C. and A. Muralidhar. 2016. Time for Retirement SeLIFES. Investments and Pensions Europe, June 2016
12 Muralidhar, A. 2019. Can (Financial) Ignorance Be Bliss? Financial Analysts Journal, Volume 75, 2019 - No. 1.Solution: A Number of Key Innovations
The Importance of Standard-of-Living Adjustments
Cash Flows of Bond match Cash Flows of Goal
– No bullet repayment, just a steady Cash Flow
Payments based on real amounts, not coupon (%)
– E.g., $5 real/year or $5,000 pesos/year
Nominal link relates to index connected to goal
– Standard-of-Living risk is real for retirees
Forward-starting – no cash flows when not needed
Designed for financially unsophisticated population
– Embeds inflation and compounding
Could also be issued by insurance companies
– Will need government to start process
Source: Muralidhar, A, K. Ohashi and S. Shin. 2016. The Most Basic Missing Instrument in Financial Markets: The Case for Forward-Starting Bonds. Journal of Investment Consulting 16, no. 2: 34–47.
Merton, R.C. and A. Muralidhar. 2016. Time for Retirement SeLIFES. Investments and Pensions Europe, June 2016
13 https://www.zerohedge.com/news/2019-02-21/study-warns-americans-and-europeans-are-terrified-about-retirementUruguay: Issued Wage-Indexed Bonds
Targeted to Pension Funds/Insurers – Pensions Linked to Wages
Uruguay SeLFIES
Wage-Indexed (“Pension Units”) Standard-of-Living Indexed
Principal Repayment Amortized Coupon-only Structure
Typical Coupon Structure (%) Coupon in Nominal Terms
Immediate Payment Forward-starting
Other Features Identical (e.g., Semi-Annual Payment;
Regular Issuance, Auction Process)
14Value of Indexation to Standard-of-Living
Comparing Different Options vs SeLFIES for Colombia
Cumulative Returns 2003-01-02 / 2018-06-29
Colombia SeLFIES would have generated ret S&P500=9.51%
1000 ret Colcap=13.98% 1000
15.51% p.a. (01/03 – 06/18) ret SelFIES$=15.51%
Beat IGBC/Colcap = 13.98% p.a., 800 800
S&P 500 = 9.51% p.a. 600 600
2003: Long-term real interest rate above 7%
400 400
2018: Would generate lower yield (real
interest rates close to 4%) 200 200
Key: It is a safe asset. Provides protection
from Inflation and Standard-of-Living Jan 02 Jan 03 Jan 05 Jan 05 Jan 05 Jan 02
2003 2006 2009 2012 2015 2018
Source: Data is from January 2003 – 2018. Prof. Mantilla’s presentation on SeLFIES
15Value of Indexation to Standard-of-Living
Comparing Different Options vs SeLFIES for Korea
Source: Prof. Merton Presentation at Knowledge Forum, Seoul, Korea, Sept 2018 “SeLFIES: A Globally Applicable Bond Innovation to Improve Retirement Funding and Lower Government Funding Costs”
16Demand for BFFS/SeLFIES: Retail, Institutional
Broad Group of Investors, Regular Purchases
Individuals
uncovered by any public/private pension plan, ensures
retirement through personal saving
covered by pension plan but low benefits, must
accumulate additional assets through personal saving
covered by pension plan but part of the plan requires
personal decision-making in which to invest the plan asset
Pension Funds and Insurance Companies (pension,
annuity benefit liabilities) want effective, low-cost hedge
Institutional and Retail Investors who would want
efficient, low-cost core “best-diversified” portfolio
Source: The Economist, May 2018
Source: Prof. Merton Presentation at World Knowledge Forum in Seoul, Sept 2018. See also, Muralidhar, A. 2019. Can (Financial) Ignorance Be Bliss? Financial Analysts Journal, Q1 2019 Forthcoming
17BFFS/SeLFIES: Good for Governments+Supras
Unique Cash Flow Profile Synergistic with Infrastructure Investing
Reduces risk of retirement poverty/bailouts
Helps finance infrastructure projects
Key goal of many governments
Cash flows from bond = Infrastructure needs
VAT regime = government is hedged
Boosts national demand for debt; sustained demand
Provides near-term budget relief (DANGER)
Insurance companies – lower annuity costs
Could be transformational in typically under-developed
emerging markets (I issued the first Greek drachma
bond by a development bank)
18Additional Considerations
Does not address Longevity Risk
Covers poor/low income individuals
Longevity Indexed Variable Expiration (LIVE) Bonds
Does it effectively measure Standard-of-Living?
Per-capita consumption
VAT receipts adjusted for tax rate and population
Wage-indexed Securities (WISE)
How much demand for SeLFIES? How to Price SeLFIES?
Demand: Large DC markets: Australia; Latin America; US
How to price these bonds? Demand and supply….
Can there be alternative issuers? WB? IFC? IDB? EIB? EBRD?
Source: Nikkei, June 2018
Source: Prof. Merton Presentation at World Knowledge Forum in Seoul, Sept 2018. See also, Muralidhar, A. 2019. Can (Financial) Ignorance Be Bliss? Financial Analysts Journal, Q1 2019 Forthcoming
Muralidhar, Arun, Managing Longevity Risk – The Case for Longevity-Indexed Variable Expiration (LIVE) Bonds (October 10, 2018). Available at SSRN: https://ssrn.com/abstract=3224236 or http://dx.doi.org/10.2139/ssrn.3224236
19Implications for Regulation
Who?
Independent agency with authority (Netherlands)
What: The Goal?
Focus on adequacy of retirement income (not wealth)
Can measure through funded status or level of retirement income
What: Role of Intermediaries?
Ensure intermediaries acting in the interests of individuals
How: Reporting?
Reporting should be simple: report guaranteed retirement income
Should also provide suggestions on achieving objectives (savings; risk)
Solution: SeLFIES Can Greatly Improve Regulation
Muralidhar, Arun. 2018. 50 States of Gray: An Innovative Solution to the DC Retirement Crisis, Investments and Wealth Institute, Denver, CO
20Summary: SeLFIES Achieve Multiple Goals
Current DC trend necessitates need to innovate
SeLFIES = Forward-starting IO-only Real Bond
Lowers cost, risk, complexity, and illiquidity
Good for Governments/Development Banks
Lowers bailout likelihood; funds infrastructure;
creates new investor segment
Good for Individuals
Secures and simplifies retirement planning
21Thank You! 22
Comparing Retirement Outcomes – Benefit of Locking-In
Comparing a 60 Stock/40 Bond, Life-Cycle Portfolio and SeLFIES
16.000
BFFS Real Annual Income
Simple experiment: Invest $100,000 for 10 yrs 14.000
(Use historical data) 60% Equity / 40% Bond Real Annual Income
– 60% in Stocks (S&P500 Index)/40% in Bonds 12.000
TDF (Equity & Bond)
(Barclays Agg Index)
– TDF: Start with 90% Equity; Sell Equity, Buy
10.000
Bonds every Year 8.000
– Buy BFFS/SeLFIES Every Month
After 10 years, purchase annuity at retirement 6.000
Buy 20-year income stream 4.000
Jul-87
Jul-90
Jul-93
Jul-96
Jul-99
Jul-02
Jul-05
Jul-08
Jul-11
Jul-14
Jul-17
Apr-88
Jan-89
Apr-91
Jan-92
Apr-94
Jan-95
Apr-97
Jan-98
Apr-00
Jan-01
Apr-03
Jan-04
Apr-06
Jan-07
Apr-09
Jan-10
Apr-12
Jan-13
Apr-15
Jan-16
Oct-89
Oct-92
Oct-95
Oct-98
Oct-01
Oct-04
Oct-07
Oct-10
Oct-13
Oct-16
Other approaches highly volatile; SeLFIES “safe”
This period: historic secular decline in rates
Source: Data is from January 1977 – 2017. Kobor, Adam and Muralidhar, Arun, How a New Bond Can Greatly Improve Retirement Security (March 23, 2018). Available at SSRN: https://ssrn.com/abstract=3148747
23Open-Questions: Future Research
No pressing need to innovate? Steady state debt structure?
GDP-linkers did not work; TIPS liquidity not great
Default Risk
Neither bond has a natural goal it hedges (Pecking Order)
Debt levels could be high – data quality questions
Will they replace existing debt with SeLFIES?
Japan just revised historical wage data….
Danger that MoFs/Treasury want to issue too much
Allows them to postpone debt service to a future government
Debt Managers Data Quality
May need IMF to monitor Are Conservative High Debt Levels
Creates a potential default pecking-order
24You can also read
