Thoughts on the Future: Life-Cycle Investing in Theory and Practice

Advances in financial science have made possible an improved menu of life-cycle investment products. Global population aging and deregulation have created opportunities for innovative investment firms to create new products and services that address the needs of people saving for retirement and other life-cycle goals. It will be a challenge to frame risk–reward trade-offs and cast financial decision making in a format that ordinary people can understand and implement. Fortunately, advances in financial science have made possible a new generation of user-friendly investment products.Among the important insights of modern financial science are the following:A person's welfare depends not only on her end-of-period wealth but also on the consumption of goods and leisure over her entire lifetime.Multiperiod hedging (rather than “time diversification”) is the way to manage market risk over time.Portfolio managers can and should make greater use of the information about interest rates and implied volatilities embedded in the prices of derivatives, such as swaps and options.The value, riskiness, and flexibility of a person's labor earnings are of first-order importance in optimal portfolio selection at each stage of the life cycle.Habit formation can give rise to a demand for guarantees against a decline in investment income.Because of transaction costs, agency problems, and limited knowledge on the part of consumers, dynamic asset allocation will and should become an activity performed by financial intermediaries, rather than by their retail customers.The tendency in the last several years has been to offer participants in self-directed retirement plans more and more investment alternatives. But when people do not have the knowledge to make choices in their own best interests, increasing the number of alternative investments does not necessarily make them better off. In fact, it may make them more vulnerable to exploitation by opportunistic salespeople or by well-intentioned but unqualified professionals.The modern theory of contingent-claims analysis provides the framework for the production and pricing of new and improved life-cycle contracts that combine features of insurance and investment. For example, consider an escalating life annuity with a minimum benefit linked to the cost of living. Payments would increase with inflation and with the performance of a market index, and increases would be locked in for life. It could be dynamically hedged and priced by using default-free inflation-protected bonds and index futures or options. This product would be very different from a mutual-funds-based variable annuity contract, which passes the investment risks directly through to the consumer.Longer life expectancies have coincided with increased health care costs near the end of peoples' lives, which raises the specter that many elderly people may need several years of expensive long-term care. A “bundled” insurance/investment contract could help to deal with this problem by combining an escalating life annuity with long-term care insurance. Combining the coverage would mitigate the adverse selection that can occur in the demand for each of the two products on a stand-alone basis.