Observations on Individually Funded Pension System Design: Advances for the Future Robert C. Merton Harvard Business School Developing the Potential of the Individually Funded Pension Systems 2010 FIAP International Seminar Vi ñ a del Mar, Chile May 7, 2010

Pension Goal and Means for Achieving it : Desired income: An inflation-protected annuity for life adequate to maintain standard of living enjoyed in last part of work life. Ways to improve the probability of achieving desired income –Efficient and effective use of all available assets of the employee and low-cost of investment services –Increase contribution rate: save more –Increase retirement age: work longer –Increase risk of investments 2010 Robert C. Merton 2

Household Pension Investment Management in the future What is the “risk-free” asset for retirement funding? Managing real interest-rate risk Managing duration mismatch between contributions and payouts Managing inflation and longevity risks Benefits of global diversification Floor and ceiling products Structured DC: dynamic optimization Products to mitigate behavioral dysfunctions Housing: risky asset or pre-paid consumption, or both? Funding retirement and bequests: Reverse mortgage Managing longevity tail-risk Product efficiency: long-term care and life annuity 2010 Robert C. Merton 3

4 Effect of Real Annuity as Numeraire on Risk-Return Frontier 2010 Robert C. Merton

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Source: André F. Perold, Joshua N. Musher (2002), “The World Market Portfolio” © November 20, 2002, by André F. Perold and Joshua N. Musher 6 Benefits of Global Diversification Performance of World Equity and Bond Markets,

Relative Advantage of Equity Swaps for Globally Diversifying Risk Minimizes Moral Hazard of Expropriation or Repudiation Locals perform industrial governance, trading in shares in local market, receive benefits/losses of local-country-specific component of industry returns, thus avoids political risk of “selling off corporate control of the country” Credit Risk: no principal amounts at risk; set frequency of payments (.25,0.5,1.0 years); “right-way” contract [pay when country is better able]; potential for credit guarantee and/or two-way-marked-to-market collateral Policy is non-invasive: doesn’t require change in employment patterns and behavior, changes in industrial structure or changes in financial system design Policy is reversible by simply entering into an off-setting swap Robust with respect to local financial system design: even works with capital controls Potential Gains: From , a gain of b.p. in average return for same risk level by efficient diversification 2010 Robert C. Merton 7

Transform Shape of Payoffs from Investing in the Equity + Debt Portfolio $100,00 0 $95,000 Minimum Guarantee Floor Value of Investor “Insured” Portfolio, $ Value of Equity + Debt Portfolio, $ “Insured Equity” Payoff “Uninsured Portfolio” Payoff Insurance Transform Payoff Pattern to fit preferences: custom design $95,000 $95,000 Minimum Guarantee Floor Value of Investor “Collar” Pattern Portfolio, $ Value of Equity + Debt Portfolio, $ Desired Maximum Payout $190,000 0 Copyright © 2010 by Robert C. Merton 8 “Collar” Strategy Between Desired and Minimum Payout

Enhancements in the Future Age, means, and interest-rate-dependent contribution rates Dynamic portfolio strategies to maximize probability of achieving Desired Income Standard of living risk: consumption-linked annuities Mitigate behavioral dysfunctions: choice but not too much Tail-insurance on longevity: >85 life annuities Contract efficiency: long-term care and life annuity Bequests and asset efficiency: reverse mortgage Copyright © 2010 by Robert C. Merton 9