SM Bonds—A New Product for Managing Longevity Risk

• Published date: 01 March 2019
• Author: Shauna Ferris,Piet Jong
• DOI: http://doi.org/10.1111/jori.12203
• Date: 01 March 2019

©2017 The Journal of Risk and Insurance. Vol.86, No. 1, 121–149 (2019).

DOI: 10.1111/jori.12203

SM Bonds—A New Product for Managing

Longevity Risk

Piet de Jong

Shauna Ferris

Abstract

A new type of retirement bond is proposed called an SM bond. SM bonds

are long dated government bonds divisible into two parts: a survivorship

(S) part and a mortality (M) part. Each SM bond is associated with a par-

ticular age. SM bonds associated with a particular age are only purchasable

by (originators) of that age. The SM bond is then splittable into an S and M

component. The S part must be retained by the originator, who receives the

face value of the bond if he/she is alive at maturity.For originators who die

prior to the maturity date, the maturity value of the SM bond is assigned to a

mortality pool. The holder of the M part of the bond receives the annual bond

coupon, and at maturity a pro rata share of the mortality pool. M bonds are

tradable: holders can sell their M bonds to anyone, at any time. It is envisaged

different age bonds are issued every year for ages say 30–64 each with say

a 35-year term. The market will be regularly informed about the mortality

experience, and the market price of the M bonds will vary over time to reflect

that experience.

Introduction

SM bonds proposed in this article aim to address key problem areas for individuals

planning their retirement, for governments grappling with budgetary problems due

to the social security demands of an aging population, and for the private sector

attempting to develop, market, and price longevity products. SM bonds will facilitate:

1. The ability of individuals to, in effect, buy government-guaranteed retirement in-

come streams at competitive market prices.

2. The ability of governments to directly facilitate and incentivize retirement income

planning by individuals, whereby incentivized savings can be used to provide for

individual retirement income streams that cannot be capitalized before death and

cannot be passed to heirs.

3. The ability of governments to absolve themselves of longevity risk.

4. The operation of transparent and deep longevity risk markets.

Piet de Jong and Shauna Ferris are at the Department of Applied Finance and Actuar-

ial Studies Macquarie University, Sydney, NSW 2109. De Jong can be contacted via e-mail:

piet.dejong@mq.edu.au.

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122 The Journal of Risk and Insurance

Individuals planning for retirement face a great deal of uncertainty: uncertainty about

their own lifespan, uncertainty about future investment returns on retirementsavings,

and uncertainty about the future cost of living. Retirees can manage these risks by

purchasing indexed lifetime annuities. Economic models, such as those presented in

Yaari(1965) and extended by many others (Davidoff et al., 2005), suggest that rational,

risk-averse, utility-maximizing investors should invest at least part of their savings

in lifetime annuities.

Despite this theory,retirees appear reluctant to buy lifetime annuities. This reluctance

has been observed in annuity markets in several different countries (Rusconi, 2006;

Brown, 2009). The discrepancy between the theoretically optimal behavior and ob-

served behavior is commonly described as the “annuity puzzle” (Modigliani, 1988;

Benartzi et al., 2011).

Many authors (Antolin, 2008; Brown et al., 2008; Brown, 2009; Rusconi, 2008; Lloyd,

2014) have attempted to explain the annuity puzzle. Possible explanations include:

rCost. Surveys have shown that many retirees regard lifetime annuities, purchased

from life insurance companies, as poor value for money. Lifetime annuities can be

expensive (for reasons given in later on in this article).

rLiquidity needs. Lifetime annuities provide a predetermined sum of money each

year, and do not usually allow for ad hoc withdrawals. Retirees may well be con-

cerned about the availability of money to cover unexpected large expenses, for

example, health care costs or the cost of home repairs. Flexibility and control are

important for many retirees (Stewart, 2007; Beshears et al., 2014; Echalier et al.,

2015).

rBequest motives. Lifetime annuities usually cease on the death of the annuitant.

The retiree may wish to provide bequests to others.

rHealth status. Those in poor health (or with shorter life expectancies than the aver-

age annuitant) may be especially reluctant to buy lifetime annuities, since the value

of benefits received is likely to be lower than the cost of the annuity. Economic mod-

els allowing for health uncertainties indicate that this might explain the low level

of demand for annuities (Reichling and Smetters, 2013).

rSocial security interactions. The retiree may prefer to spend money maintaining a

better standard of living in the early years of retirement, and then rely on govern-

ment provided safety-net benefits to cover income needs at advanced ages. Safety-

net systems might “crowd out” annuity products. The potential for “crowding out”

will depend on the design of the safety-net system; hence, demand for annuities

may vary across countries (Rusconi, 2008).

rInsolvency risk. The retiree may be concerned about the risk that the annuity

provider (a pension fund or insurance company) will become insolvent and hence

fail to pay promised benefits. Beshears et al. (2014) find that “worry that the com-

pany may not be able to pay me in the future” was a key concern for American

survey respondents.

rFinancial illiteracy and poor decision making. People may have trouble under-

standing annuity products (which are often quite complex) and/or may have a

poor understanding of the risks arising from reliance on account-based retirement