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Financial Innovation and Pension Reform

Financial Innovation and Pension Reform. Zvi Bodie. Key Points. Responsibility for providing retirement income is shifting from government and business to individuals.

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Financial Innovation and Pension Reform

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  1. Financial Innovation and Pension Reform Zvi Bodie

  2. Key Points • Responsibility for providing retirement income is shifting from government and business to individuals. • Financial innovation can facilitate international risk-sharing, improve the tradeoff between risk and reward, and improve product design.

  3. Some Problems With International Investing • Governments in “emerging-market” countries fear massive capital outflows from international investing. • Investors in developed countries fear manipulation in emerging-market countries.

  4. Financial Innovation Can Help To • Permit separation of risk transfers from capital flows • Improve hedging possibilities • Improve diversification possibilities • Mitigate manipulation problems

  5. Better Risk-Reward Tradeoff

  6. Example of Improved Hedging Tinyland pension fund swaps the total rate of return on its domestic stock index for a fixed rate of interest. • Notional principal: $1 billion. • Payment frequency: 1 time per year. • Maturity: 10years.

  7. Example of Improved Diversification Tinyland pension fund swaps the total return on its domestic stock index for the total return on a global stock index. • Notional principal: $1 billion. • Payment frequency: 2 times per year. • Maturity: 10years.

  8. Problems With Individual Retirement Accounts Choices offered to ordinary people in self-directed accounts are often quite limited or poorly understood.

  9. Need Better Product Design • More “user-friendly” menu of choices • Focus on maintaining standard of living after retirement • Inflation-protected annuities • Equity-participation contracts with principal protection

  10. Conclusions • Financial innovation can help to: • Permit separation of risk transfers from capital flows • Improve hedging possibilities • Improve diversification possibilities • Improve product design and delivery

  11. Further Reading • Zvi Bodie, “Financial Engineering and Social Security Reform,” in Risk Aspects of Investment-Based Social Security Reform, edited by John Campbell and Martin Feldstein, University of Chicago Press, 2000. • Zvi Bodie and Robert C. Merton, “International Pension Swaps,” Journal of Pension Economics and Finance, January 2002.

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