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PERILOUS choices await retirees. The number of people over 60 will increase from 14.4 million today to 40.6m by 2050. A big majority will not be able to maintain its lifestyle.
Life expectancy and health care costs are increasing. The financial capacity of children to support elderly parents is diminishing. The centuries-old decline in the real yields of sovereign bonds is unlikely to reverse. Stock markets crash unexpectedly and can stay low for extended periods. New financial products bring complexity. Numeracy declines with age.
The last nail in the coffin is the popularity of, and a policy shift towards, defined contribution plans. The narrative is shifting from income security to asset accumulation. Aggressive marketing of financial products is promoting a culture of investing, trading and speculation.
“Our approach to life saving is all wrong: we need to think about monthly income, not net worth,” said economist and Nobel laureate Robert C Merton.
Most individuals are clueless about investments beyond bank deposits. To top it all, managing a portfolio during the decumulation phase is a problem of an entirely different magnitude. Vicissitudes of nature, capital markets and bad luck can hasten financial ruin even if a retirement nest egg is 15, 20 or even up to 35 times of the last-drawn salary.
Retirees cannot bear the monstrous burden of becoming financial plannern, portfolio managers and insurance underwriters all at the same time
Retirees cannot bear the monstrous burden of becoming a financial planner, portfolio manager and insurance underwriter all at the same time. All they need is a simple income solution and a periodic reminder on money mistakes.
Pension bonds
The income solution is easy. The government through Central Directorate of National Savings (CDNS) can issue pension bonds with the following features.
Amortisation periods of 25 years, 30 years, 35 years and 40 years
Principal to be repaid in equal annual instalments, which will be adjusted for inflation (or deflation) plus one per cent real profit
Eligibility requirements of Pakistani citizenship, tax residency and a minimum age of 60 years
Maximum lifetime investment of Rs30m per person. The maximum amount will be adjusted for inflation (or deflation) annually
Issued quarterly to minimise operational hassles
Inheritable but not redeemable, collateralisable, or transferable
A 25-year pension bond will deliver inflation-adjusted lifelong income to at least 66pc people based on current mortality estimates. The 30-, 35- and 40-year bonds will provide such income to at least 82pc, 93pc and 98pc people, respectively.
Five money mistakes
Pension bonds will protect retirees from five treacherous money mistakes.
One, they will protect the wallet from frivolous shopping. Determining the right amount of sustainable spending is a complex task even for big endowments. Asset allocation, prevailing interest rates, stock market valuation and economic outlook have a bearing. The unique situation of each retiree adds another layer of complexity.
Two, income from pension bonds will increase with inflation. Research in America shows that life gets more expensive as people age. Same is true for Pakistan. Retirees’ living expenses have increased by more than 352pc in the last 20 years.
Most retirees cannot buy floating rate PIBs and sukuk. The balloon maturity structure of fixed income securities is ill-suited for the decumulation phase. Allocation to stocks has to be low and declining as we grow old. The retirement quiver needs a new arrow.
Three, pension bonds will eliminate the sequencing risk — a risk that the beginning period of retirement will face low returns or losses. There have been 43 negative and 242 positive five-year return cycles since the beginning of the KSE-100 index. The average annual loss during negative cycles was 6.24pc and the average annual return during positive cycles was 19.61pc.
Assuming historical returns and an initial spending amount equal to 4pc of savings, which then grows at an inflation rate of 7pc, alternating periods of five-year return that begin with the negative cycle would deplete the capital in the 17th year. But if alternating periods begin with a positive cycle, the same savings will last for approximately 30 years.
Investment in fixed income securities cannot eliminate the sequencing risk. Nor can a combination of stocks and bonds. Systematic income plans or systematic withdrawal plans are also not immune to the sequencing risk.
Higher subsequent returns cannot compensate for beginning period losses.
Four, pensions bond will protect against social siphoning — a common malady in our culture. The influx of money at retirement is keenly awaited among family and friends. There is a relentless pressure to advance temporary loans to a struggling son-in-law, help finish the house construction for a cousin and finance the wedding or overseas education of a relative.
Widows and orphans are more vulnerable to social siphoning risk. High return and ‘no’ risk investment ideas make a beeline for homes with new money.
Unsuspecting families can’t say no. Pension bonds can save proverbial fools from parting with their money.
Five, pension bonds will save us from ourselves. The literature on behavioural finance has a long list of judgment errors that we repetitively make. There is no vaccine yet against greed, over-confidence, recency bias, endowment effect, euphoric buying and panic selling.
Retirees should heed Warren Buffett’s words on money management: investing is simple but not easy.
Why not annuities?
Some actuaries will object to pension bonds on technical grounds. A standard annuity provides lifelong income to everyone. It also offers a higher internal rate of return (IRR) to retirees who live beyond average life expectancy. Upshot: an annuity is a superior product.
But annuities are complex, lack inheritability and remain unpopular in the west. They will find Pakistan less friendly. Adapting classic annuities to shariah would be expensive if not downright impossible.
Another problem. Annuities are not widely available in Pakistan. The price quotes on rare occasions are too expensive.
The winning advantage of pension bonds lies in their simplicity. They hold many strengths of annuities and state pensions — non-redeemability, non-transferability and inflation indexing. They do not guarantee lifelong income to all but they compensate through inheritability feature to everyone.
There are benefits for the government. Retirement bonds will extend the maturity profile and reduce the cost of fiscal debt. They are a pre-funded income solution. Prevailing yields will not deter their issuance. They can easily adapt to the shariah and thus open a floodgate of new investors. They are a condition precedent to shifting public pensions to defined contribution plans.
The distribution network of the CDNS will save a significant deadweight financial intermediation cost to investors.
Every government has a moral duty to safeguard the retirement capital of its senior citizens and enable its steady decumulation.
Our government should issue pension bonds in haste. Delay will sink a large number of innocent families into financial distress.
The writer is CEO of Magnus Investment Advisors. Views expressed in this article are his own.
Published in Dawn, The Business and Finance Weekly, August 4th, 2020
