The Most Basic Missing Instrument in Financial Markets: The Case for Forward Starting Bonds

Abstract

There is a looming retirement crisis globally with the three pillars of retirement threatened because of insufficient funding, improper investment decisions, and transferring risk to individuals who are least capable of bearing such risk. This paper argues that the introduction of a unique financial instrument, basically an inflation linked bond which pays coupons when you need it, might help ameliorate this crisis.

The Life Cycle Hypothesis (LCH) demonstrated why people save; namely, they try to set aside resources during their working lives, to be able to tap into them to ensure retirement income when labor income stops. Modern Portfolio Theory (MPT) attempted to help individuals make optimal investment decisions on these savings by investing in stocks, bonds and other assets to ensure sufficient retirement wealth. There are three problems with using MPT approaches for retirement planning: (a) MPT ignores the uses of funds; (b) focuses on wealth as opposed to retirement income maximization; and (b) none of these assets is an ideal hedge for a desired retirement income. As a result, seemingly safe MPT assets are risky from a retirement income perspective (because the Capital Asset Pricing Model (CAPM) is a specific case of a more general Relative Asset Pricing Model (RAPM)).

The need for our bond is simple: the riskless retirement asset is an inflation-indexed, coupon-only bond that defers payment until retirement and pays till death. All attempts to recreate this profile through traditional stocks and bonds, or purchase such a profile through annuities are sub-optimal, risky, complex or expensive thereby threatening retirement security. The paper goes further to demonstrate that there is a potentially willing supplier of such bonds, and that this bond offers the perfect offsetting cash flow profile to infrastructure projects, thereby completing the market. It also addresses challenges, issues and opportunities surrounding such an instrument and examines issues relating to the creation of a market for FSBs.

Keywords: Forward Starting Bond, Individual DB, myRA, DC, deferred annuity, RAPM

JEL Classification: G11, G12