Research proposal
Title: Essays about private retirement planning
Motivation:
The aging trends is ominous around the world, not only in developed countries but also in developing countries. Furthermore, with the pension reform taking place in many countries, changing from defined benefit to defined contribution schemes, individuals now have more responsibilities in minding their own retirement planning.
In my research, I would like to study about how a person accumulate wealth and spend the accumulated amount for her retirement. The aim is to contribute to the literature of personal financial planning and give recommendations to help build up effective and consistent retirement scheme for each individuals. Retirement benefit is an essential part of social security, which in turn is vital to maintain the stability of the society.
Literature Review:
The core of my research is based on a book written by Moshe A. Milevsky, “Are you a stock or a bond? Create your own pension plan for a secure financial future” and a line of articles about pension and retirement planning developed by my supervisor, Professor Wade D. Pfau.
The book written by Milevsky which gives a good overview about personal financial planning. The author pointed out that in today’s volatile economic environment and financial markets, investors are constantly reevaluating their attitude to financial risk on virtually a daily basis. However, financial risk approach should not be based on a psychological mindset based on your temper du jour, but instead on the composition of your entire personal balance sheet. The broadly defined investment account is no longer a retirement income supplement or a part-time hobby but the means by which an investor will be able to finance the and support the last 20 or 30 years of her life.
In the book, Milevsky drafted out the way to help manage and grow an investor’s nest egg so that it can eventually be converted and allocated into a pension. The ultimate goal is retirement income planning by using the unique nature and composition of your human capital.
Milevsky then went on by summarizing the unique financial risks that retirees have to face such as longevity risk, unique inflation risk and particular type of financial market risk (sequence of returns). Then he suggested various strategies to deal with those risks.
One interesting idea of Milevsky book is to incorporate human capital into the personal balance sheet. The traditional accounting measures of personal financial net worth and equity, which is computed as the value of assets minus the value of liability. However, Milevsky argued that the single most precious asset on a young person’s financial balance sheet is the present value of all the salary, wages, and income he will earn in his working life. The greater your income prospects, the greater your human capital. The balance sheet should include human capital along with tangible assets to truly reflect the value of a person. As a person ages, she converts human capital into financial capital. Individuals who expect to receive little or no income from a defined benefit pension plan must be even more careful to manage that conversion in order to secure a smooth income stream over their entire life cycle.
The author also stressed the importance of diversification over space and time. An investor should have exposure to bonds, (domestic) stocks, international stocks and alternative asset classes altogether. Human capital’s riskiness should be incorporated into all investment decisions. Depending on the job riskiness, it can be considered as a stock or a bond. An investor can afford to take more diversified investment risk when she is saving for retirement because the investment in human capital may behave more like a bond than a stock. Also, over long time horizons, the probabilities favor investing in stocks.
Milevsky also pointed out another important factor which should be taken into account for personal financial planning: Personal inflation and retirement cost of living. Personal cost of living and the population inflation rate should be distinguished. The inflation rate is likely higher for retired people because they spend their money on goods and services that tend to appreciate at a higher rate over time.
One important point stated in the book is that when you accumulate wealth, and invest for the long run, the exact sequence of investment returns does not matter (with buy-and-hold strategy – no cash flow goes in or out). But when withdrawing money, the sequence of investment returns counts as you can earn a positive average return but still end up exhausting your portfolio early in retirement. Thus, in retirement, the fundamental axiom of modern portfolio theory and current investment management that investments can be ranked solely on the basis of their mean return and variance no longer applies.
Milevsky defined longevity risk as the inability to precisely know how long we are going to live and spend in retirement falls under the label of “longevity risk. If there is a downward shock and your mortality rate declines, and you live longer, you face the risk that your nest egg will not suffice or provide enough income to last for the rest of an investor’s life.
Then Milevsky presented a solution to eliminate that risk - annuities are personal pensions. Annuity is not only an invaluable hedging tool against longevity risk, provide a mechanism for pooling, sharing, and hedging longevity risk over a large population, which leads to a higher yield for annuitants but also provide stable and predictable income that is not subject to vagaries of the stock market
The author concluded the book by pointing out the importance of product allocation for retirement phase. He argued that at retirement one should strive to create a diversified portfolio of products that protect against various retirement risks and make sure to allocate a portion of the money to some sort of annuity instrument, whether fixed or variable, immediate or deferred to get some mortality credits. In the retirement income phase, product allocation is the much more important than asset allocation. Product allocation means the decision of how much of your retirement income should come from conventional financial instruments, such as mutual funds or exchange traded funds, and how much should be generated by pension-like products, such as life annuities, variable annuities, and other guaranteed insurance products. Retirement priorities will be assessed to select optimal retirement product along the frontier. A guiding concept should be the economic trade-off that is implicit within any selected product allocation: security for oneself versus security for one’s heirs. In most cases retirees will not be able to finance a sustainable retirement income with only one or two traditional product classes. All three product categories – income annuities, mutual funds, and variable annuities with embedded guarantees mixed and matched in various combinations are required to maximize one’s retirement sustainability quotient.
At the same time, Professor Pfau is doing a line of comprehensive research about pension and capital asset allocation. He applied the method of historical and Monte Carlo simulation first used in retirement planning by John Ameriks, Robert Veres, and Mark J. Warshawsky (2001) and made popular by Cooley, Hubbard, and Walz (2003). Professor Pfau found out some interesting and ground breaking results such as the failure of the 4% withdrawal rate rule and the importance of international diversification in capital asset allocation. What professor Pfau found also showed that there are many potential aspects in retirement planning that need further exploration.
Research questions:
The book of Milevsky provides a broad picture and a good framework for retirement planning research while the articles of Professor Pfau showed me some issues that need more attention. I started to get interested in the following research questions:
1) The role of annuity in the decomposition (spending) phase of the retirement scheme need further study (e.g. the difference between male and female, the combination of annuity and other financial instruments, etc.). There are quite a lot of researches about the development of annuity markets. In my research, I will assume the existence of a well-functioned annuity market and will look at the issue from the investor’s point of view and find a way to optimize his use of different kind of annuities.
2) How to test the applicability and usefulness of some techniques and financial instruments using in portfolio management and personal financial planning such as “bucket of money” and inflation indexed bonds. (In his book, Milevsky rejected the role of bucket of money in retirement planning but is it really useless? )
3) How to combine the phrases (accumulation and spending) as a whole to maximize the person’s utility, i.e. life cycle asset allocation ?
During my research period, I will try to find the answers to those questions.
Data:
Data will be obtained from various sources, e.g. www.globalfinancialdata.com; http://www.who.int/en/ ; OECD Insurance statics, National Association of Insurance Commissioners, etc. As I would like to use the historical and Monte Carlo simulation, I will use data of developed courtiers which has a long history of financial markets and pension instruments.
Methodology:
Similar to the research of Milevsky and my supervisor, my research will apply Monte Carlo and historical simulation models with minor modifications to deal with serial correlation, mean reversion, etc.
Research schedule:
I am enclosing the tentative research plan herewith. I plan to ask for the extension as I envision that it is not realistic to finish the research in 14 months. In general, I am going to have 14 months for research only and 2 months for summarizing and preparing for the defense of the thesis. Along side with doing research, I would like to seat for the CFA exams which are good complements for doing research in the financial field.
| Time | Tasks | Remarks |
| Jul-11 | Finish research proposal | |
| Literature Review - Annuity | ||
| 1st month for Research | ||
| Aug-11 | Intensive research work - Continue literature review | Summer Vacation |
| 2nd month for research | ||
| Sep-11 | Intensive research work - Continue literature review | Summer Vacation |
| CFA Level 2 application | ||
| Start revising for CFA | ||
| 3rd month for research | ||
| Oct-11 | Intensive research work - Start running models | |
| CFA Level 2 Group Formation | ||
| 4th month for research | ||
| Nov-11 | Intensive research work | |
| 5th month for research | ||
| Dec-11 | Intensive research work | |
| 6th month for research | ||
| Jan-12 | Intensive research work | |
| 7th month for research | ||
| Feb-12 | Advanced QE | Winter Vacation |
| Intensive revision for CFA Exam Level 2 - Self Study | ||
| Mar-12 | Intensive revision for CFA Exam Level 2 - Self Study | Winter Vacation |
| Apr-12 | Intensive revision for CFA Exam Level 2 - Group Work | |
| New Alien Card Application | From April 24th | |
| May-12 | Intensive revision for CFA Exam Level 2 - Group Work | |
| Jun-12 | CFA Level 2 exam date - Self Study | |
| Back to research | ||
| 8th month for research | ||
| Jul-12 | Intensive research work | |
| Application for study period extension in GRIPS | ||
| 9th month for research | ||
| Aug-12 | Intensive research work | Summer Vacation |
| 10th month for research | ||
| Sep-12 | Intensive research work | Summer Vacation |
| CFA Level 3 application | ||
| VISA Application | End of September | |
| 10th month for research | ||
| Oct-12 | Intensive research work | |
| CFA Level 3 Group Formation | ||
| 11th month for research | ||
| Nov-12 | Intensive research work | |
| 12th month for research | ||
| Dec-12 | Intensive research work | |
| 13th month for research | ||
| Jan-13 | Intensive research work | Have to finish writing at least 3 articles by the end of January 2013 |
| 14th month for research | ||
| Feb-13 | Intensive revision for CFA Exam Level 2 | Winter Vacation |
| Mar-13 | Intensive revision for CFA Exam Level 2 | Winter Vacation |
| Apr-13 | Intensive revision for CFA Exam Level 2 | |
| May-13 | Intensive revision for CFA Exam Level 2 | |
| Jun-13 | CFA Level 2 exam date | |
| Intensive Writing and Preparing for Thesis defense | 1st month for Thesis Compilation | |
| Jul-13 | Thesis defense | End of July 2013 (30th or 31st) |
| 2nd month for Thesis Compilation | ||
| Aug-13 | Thesis revision for submission | |
| 3rd month for Thesis Compilation | ||
| Sep-13 | Thesis submission |
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