(The interview appeared in SAFE Newsletter Q2 2015)
 

Raimond Maurer holds the chair of investment, portfolio management and pension finance at Goethe University Frankfurt. He earned his habilitation, dissertation, and diploma in business administration from Mannheim University and has various experiences in policy and industry consulting (e.g., for the World Bank, European Central Bank, FED, Ministry of Social Affairs Baden Württemberg). He holds the degree of an honorary doctor from the University of St. Petersburg.

Which research questions are you currently focusing on?

A large part of my current work is on retirement income security. Given that, all over the world, state organized retirement security systems are complemented by privately funded schemes, we focus on two key questions: what can be done to improve public pension systems and what are appropriate privately funded products? From the perspective of the individual investor, we are also interested in the optimal mix of these two schemes.

A key challenge in this respect is to incentivize people to make provisions for retirement. A recent publication of yours looks at a relatively new product that proves to be quite successful in this endeavor.

Many people are hesitant to invest in defined contribution retirement products – even if they know of their importance – because of the complexity of the matter and the risks behind equity investments. For fear of making mistakes, too many households do nothing. A way to address this problem is to give people more confidence in these products by providing appropriate guarantees. You can think of, for instance, a money-back return guarantee, such as downside asset protection from capital market shocks, in the accumulation phase, as well as, in the decumulation phase, lifelong income guarantees, such as longevity risk protection. These are the key features of the investment linked retirement products, which our paper analyzes (Horneff et al. 2015).

What are your findings?

We investigate, by means of a realistically calibrated life cycle consumption and portfolio choice model, how households can benefit from an addition of the above mentioned guarantees. We look at a retirement product that provides an appropriate balance between well-designed return and income guarantees and sufficient up-side potential, based on a diversified mutual-fund style equity portfolio. It foresees an initial investment as well as further annual contributions. In addition to the guarantees, investors are allowed to withdraw parts of their assets during the entire accumulation phase. Most people will not use this flexibility which, of course, comes (like the guarantees) at a certain price. But it serves like an insurance against unforeseen income shocks, such as unemployment, when it helps to satisfy consumption needs. This feature thus makes it easier for people to commit to such a long-term retirement product. After retirement, investors are free to use the accumulated money as they like. They can take out everything at once or only a fraction. Or they can convert the entire sum or a fraction into a lifelong income stream.

What amount of their savings should households invest in this kind of product?

We look at the optimal asset allocation in a portfolio of stocks, bonds and investment-linked annuities. Naturally, for every individual, the optimal allocation will depend on the factors wealth, level and risk of labor income, age, and the overall economic situation on capital markets (interest rates, volatility). To give you an example: a 40-year-old single woman without children, average earner with high school degree, with moderate risk aversion, who has an initial wealth of 120,000 USD should optimally invest about 30% of her savings in such a retirement product and the rest in a combination of liquid stocks and bonds. This share should be increased as she comes nearer to retirement.

At the age of 65, she would take out parts of her accumulated assets and convert the rest into a lifelong annuity. In an alternative setting, we allow to convert parts of the accumulated retirement assets into a longevity income annuity that would start paying out only at the age of 85. This feature increases her income at a time when she has probably spent most or all of her other savings and she is definitely no longer able to work. We find that this kind of hedging against living longer than the average population is quite cheap because it uses the possibility of risk pooling.

Is it possible to estimate the benefits for policy-holders of these products?

We analyze the welfare gains of individuals over their life cycle with and without this product assuming average labor income risk and interest rate risk. Figure 1 displays the differences in consumption opportunities between these two scenarios. The red bars show the consumption gains over the life cycle for the full sample. As you can see, in the accumulation phase, the gains are moderate, but after retirement they become quite considerable. The blue bars show the consumption benefits to those households who, without this product, would have been among the bottom 5% when looking at consumption opportunities. These are the people which get hit by phases of unemployment, stock market crashes and other misfortunes you may think of. As the figure shows, these especially unfortunate people would benefit enormously from the provided income and return guarantees. Again, the relative consumption gains are greatest after retirement. As an overall result, we can say that investment-linked retirement products with income and money-back return guarantees increase the lifetime welfare of an individual by around 6.5%.