Academics come up with replacement for annuities

Academics come up with replacement for annuities

A pair of academics have come up with a new ‘retirement bond’ concept they claim will solve the looming pension crisis.

Professors Lionel Martellini, director of EDHEC Business School risk institute, Robert C Merton, an American economist and professor at the MIT Sloan School of Management, and Arun Muralidhar, an associate professor of finance at George Washington University, called on governments to start issuing retirement-targeted bonds, which would promise a fixed income for a set period of time, typically covering the main period of retirement.

The bonds would be sold to investors in the later stages of accumulation or in the transition period of retirement between the ages of 55 and 65 or form part of auto-enrolment, where a fraction of every contribution could be invested in retirement bonds.

Retirement bonds would differ from conventional bonds in that they would not pay a coupon and lump sum at the end but a fixed income over time.

For example, a 55-year-old today would buy a 2028 bond, which would start paying cash upon retirement at 65 (in 2028) and keep paying for 20 years, until 2048.

For the remaining years of their life the pensioner would take out a deferred later life annuity to give them a secure income without the flexibility, so the theory goes.

The way the products are sold would be simplified, so investors would buy the bonds at market price for the whole of the 20-year period.

In other words, the cashflow received by the investor is simply the unit cashflow size multiplied by the number of bonds purchased.

For example, assuming a unit payment size of £5, an investor buying 10,000 bonds would secure an annual income of £50,000 for 20 years, on an immediate or deferred basis.

Technically, the absence of arbitrage opportunities will ensure the price of the bond is set at a fair level comparative to other bond prices, or consistent with the current yield curve level, Mr Martellini said.

The products, which would be issued by governments and other related agencies, would also serve the hedging needs of pension institutional investors, he added.

Because of their deferred nature and payout structure they would allow governments to invest more in long-term projects such as infrastructure.

Mr Martellini said: "Insurance is good for risk pooling that is why they are good for later in life. But it is highly inefficient to rely on insurance companies in the early part of pensions when restructured bonds would do the job.

"Retirement bonds would not only solve the asset management liability management problem for individuals but also for most issuers of bonds because of the timing of the cashflow.

"The end of annuitisation has left the [retirement landscape] looking like a jungle with lots of retirement products but none of them are well designed for retirement.

"We think retirement bonds would be extremely helpful in addressing the needs of investors preparing for retirement."