Retirement solutions need a re-think

Nobel laureate Robert C Merton charts out a workable retirement plan for India

Developing solutions for funding the post-retirement period is going to get increasingly challenging in most countries. More thought needs to be given to developing solutions that ensure a steady stream of income that help an individual maintain the standard of living he/she is accustomed to.

This was one of the aspects addressed by Professor Robert C Merton, who won the Nobel Prize in Economics for developing the Black-Scholes-Merton model to value derivatives, in the annual R H Patil Memorial Lecture, recently.

In a career spanning almost half a century, Professor Merton has made significant contribution to research linking science and finance — finance theory — and to methods of valuing derivatives, options and corporate debt. His research on the lifecycle finance that helps plan for retirement in such a way that there is no sacrifice in the standard of living at any stage, has plenty of takeaways for financial planners in India and elsewhere.

In the lecture, Professor Merton stressed on the need for designing innovative products to finance retirement, and outlined the contours of one such product — the SeLFIES Bond. While there are impediments to adopting the SeLFIES Bond as envisaged by Professor Merton, it does help outline the areas in which the retirement products available in India need to improve.

SeLFIES Bond

Merton thinks that it will be best if SeLFIES (Standard-of-Living Indexed, Forward-starting, Income-only Securities) bonds are issued by the government. If an investor buys the bond today, it will start paying a certain sum at pre-determined periodicity from a future date, maybe from 2030 or 2040, depending on when the individual plans to retire.

There will be periodic payouts from the bond for a fixed period (for instance, 20 or 25 years) with no principal or ‘balloon’ payout at maturity. It works like an annuity with a pre-set period for payouts.

The payouts from the bond will be indexed to per-capita consumption index that will hedge both consumption inflation and standard-of-living risks.

For instance, let’s assume that each bond will pay the real value of $5 adjusted for the per-capita consumption index every year, starting from a specified date. If an individual spends $20,000 as expenses every year, he knows that he needs to accumulate 4,000 bonds by the time he retires to maintain his current living standards. He can work towards that goal during his working years. The bonds accumulated by retirement will give him the cash flow required to maintain his current standard of living, post-retirement, too.

Takeaways for regulators

Institutions floating retirement products and financial planners in India can have many takeaways from the product design of SeLFIES bonds. One, planning for retirement should not simply target accumulation of a corpus at a certain date. It should address providing a stream of income in post-retirement years, which is protected against both inflation and standard-of-living changes.

Two, retirement products should be simple so that any individual can do the maths and work towards her goal. SeLFIES bonds require just the retirement date and the current annual expenditure as inputs. The in-built inflation adjustments in the bonds take care of the rest.

Three, it’s also best if investors are not burdened with the hassle of investing the retirement corpus to ensure that it delivers inflation-beating returns. Most investors might not be savvy enough to be able to do that, and given the tighter finances post-retirement, hiring an advisor might not be an option either.

Professor Merton thinks that the government should use initial investment by participants to fund infrastructure projects. The pattern of delayed payouts for many years and then level payouts in SeLFIES match the infrastructure cash inflow pattern and provides a precise match to the cash flow needs of retirees, so no further transactions are needed by either the issuer or the buyer. He suggests using the GST revenue as a hedge for the payouts in SeLFIES bonds.

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