Retirement Security, Finance Science, SeLFIES and The Flex MMM Plan
30 Pages Posted: 6 Nov 2019
Date Written: March 2019
Prof. Merton’s attempts to improve retirement security over the last 40 years, when viewed through his preferred lens of using “finance science” to address societal challenges, results in the creation of SeLFIES (Standard-of-Living indexed, Forward-starting, Income-only Securities) to improve retirement outcomes. SeLFIES have been proposed in countries as diverse as Australia, Chile, Colombia, France, India, Japan, Portugal, Spain, South Africa, South Korea, Turkey, and the United States – all interested in funding infrastructure and improving retirement security.
Merton (1984) introduced the idea of government-issued consumption-linked bonds as a way to allow a fully funded public pension fund to offer consumption-indexed annuities. Later, Merton (2007) would address the challenges of defined contribution (DC) plans and argue that the welfare of individuals should be expressed in units of retirement income, and not wealth. A key insight is that the traditional “risk-free” asset in Modern Portfolio Theory (MPT) was risky from a retirement income perspective. Muralidhar, Ohashi and Shin (2014), in developing the Relative Asset Pricing Model (RAPM), leveraged the Merton (2007) idea that in retirement planning (or in any goals-based portfolio), investors care about (the utility of) funded status, defined as wealth divided by stochastic liabilities, and not expected utility of wealth. In RAPM, an additional variable – the relative risk-free asset or the asset that replicates the stochastic goal – is critical to asset allocation and asset pricing (and CAPM is just a special case of RAPM; namely CAPM assumes a deterministic goal). Currently in DC plans, the goal replicating portfolio (an annuity) is illiquid, costly and complex and Modigliani (1986) highlights the “annuity puzzle”. Muralidhar (2015) and Muralidhar, Ohashi and Shin (2015) recommend the creation of a new bond that replicates the desired cash flow profile in DC plans – a bond (called BFFS) that pays a fixed currency coupon, in real-terms, that starts paying once an individual retires for a period equal to the life expectancy of the country. Merton and Muralidhar (2017b) recommend linking these bonds to per-capita consumption (leveraging Merton 1984) thereby creating SeLFIES and show why SeLFIES are a good deal for governments too. BFFS/SeLFIES help complete financial markets and this idea is easily extended to other goals. The paper concludes by demonstrating how finance science can be used to design effective DC pension plans for uncovered workers.
Keywords: Finance Science, Retirement Security, Consumption-linked Bonds, BFFS, SeLFIES, Relative Wealth, Funded Status, MPT, Relative Asset Pricing Model, Financial Innovation, Market Completion, Flex MMM Plan
JEL Classification: G10, G11
Suggested Citation: Suggested Citation