TABLE OF CONTENTS
Abstract
1. Introduction
1.1. Problem Statement
1.2. Structure of the paper
1.3. Delimitation
2. Portfolio theory – A life cycle perspective
2.1. One period portfolio theory – traditional mean variance
2.2. Multi-period portfolio theory
2.2.1. Life-Cyle theory of saving
2.2.3. Life Cycle model of portfolio choice
2.2.4. Human capital
3. Frameworks for advising
3.1. Bodie, Treussard, and Willen
3.1.1. Three principles from the life-cycle approach
3.1.2. Five key concepts form the life-cycle model
3.2 Malkiel
3.2.1. Guidelines to a life-cycle investment plan
3.2.2. Life-Cycle Investment Guide: Recommended Asset or Saving
Allocations
4. Retirement planning
4.1. Active (saving) phase
4.1.1. Investment Policy Statement
4.2 Dissaving phase
5. An alternative framework for advising
6. The Structure of the Faroese Pension System
6.1. Pillar 1 – Publicly – funded Scheme
6.1.1 National pension (Old age pension)
6.1.2. Special Retirement Savings (Samhaldsfasta)
6.1.3. Civil servants’ pension
6.2. Pillar 2 – Employer - Sponsored Scheme
6.3. Pillar 3 - Private Pension Scheme
6.3.1. Capital Pension
6.3.2. Rate Pension
6.3.3. Life Annuity
6.4.Some observations from the Faroese viewpoint
6.4.1. Survey
6.4.2. Difficulties of saving for retirement
6.4.3. Framework used by a local savings bank, Nordoya Sparikassi
7. Conclusion
Bibliography
Appendix 1. National pensionist, who is receiving private pension
Appendix 2. The life-cycle model – an Event tree (Original version)
Abstract
Every investor needs the guiding hands of a reliable and well-informed financial advisor, who has the knowledge and the appropriate strategies to build the ideal financial portfolio that could be crucial to the investor’s future retirement income. Being able to convey essential information, which is comprehensible to an average investor, is perhaps one of advisor’s main goal.In addition, with the help of an effective framework in advising, he would be able to identify the investor’s needs and at the same time his limitations.
Therefore, this paper will attempt to develop an alternative framework which Faroese financial advisors could apply in advising their investors. Finding the best possible framework that could work for both the investors and the financial institution will not be simple, but by looking at different frameworks that are presented here and then selecting the most realistic parts of each framework could be the basis of an alternative framework.
Previously, only few scholars and academics who were interested in the life-cycle theory but as more and more found out that it made sense, many scholars and academics today have tried and succeeded in modifying the theory and as a result, millions of people around the world have started paying attention to life cycle saving and investing, searching for answers to some fundamental issues they have.
It is any individual’s objective to maximize their utility over the entire life cycle in order to have a fairly comfortable life even after retirement. This involves saving some stages in life to be able to consume later in life. Consequently, most academics found out the significance of human capital to the financial wealth of an individual that they started to inform everyone how important it is to their total wealth. Human capital is an individual’s most important asset thus should be taken in consideration when building their portfolios. How investors chose to allocate their assets is of great importance for the outcome of their portfolios.
1. Introduction
Given the uncertainties customers/investors have today concerning future pension income, there has never been a greater need for well-informed financial advisors, who have the knowledge and the appropriate strategies to build the ideal financial portfolio. Being able to convey essential information, which is comprehensible to an average investor, is one of advisor’s main goal.By being up-to-date with recent developments in the financial world, a competent advisor would be capable of providing his customers the best advice possible with regards to developing their financial portfolio.In addition, with the help of an effective framework in advising, he would be able to identify the investor’s needs and at the same time his limitations.
Although retirement planning today presents a big, challenging problem, italso offers big opportunities for banks and other financial institutions to findsolutions to address the problem. Finding the best possible framework that could work for both the investor and the financial institution will not be simple.
Today, millions of people around the world have started paying attention to life cycle saving and investing, searching for answers to some fundamental issues they have e.g. when will they start saving and how much of their current wages they should save for the future (including retirement), and how they should invest it or whether they should buy or rent a house and so on. For years, whenever customer’s wealth (total capital) is discussed, it generally means financial capital e.g. housing, car, stocks and bonds.Nowadays, there are a growing number of financial planners and advisors who are acknowledging that an investor’s total capital (TC) consists of two parts: financial capital (FC) and human capital (HC), and specifically, that risk and return features of human capital should be considered when building portfolios for individual investors since HC is the biggest asset an individual have.
However, the bigger question comes right after retiring whether the investor will manage to efficiently distribute his total wealth throughout his remaining years. Is Life-cycle theory of saving and investing the answer to all these questions?
1.1. Problem Statement
The main purpose of this paper is to put togethera realistic framework which Faroese financial advisors can use in advising personal savers and investors. This framework will bebased on theories about modern portfolio, human capital, and life cycle saving and investing and other frameworks introduced by scholars and academics. Answering some of the questions below will helpin putting up togetherthis framework.
- Explain the life cycle perspective of the Portfolio theory?
- What is human capital (HC)? What is its significance to an investor’s decisions?
- What is Life-Cycle saving and investing theory? How is this theory associated with human capital?
- How can Life-Cycle saving and investing theory affect retirement planning?
- What is the structure of the Faroese pension system?
- What is the current framework in investing used by financial advisors e.g. from a local savings bank?
- How will the alternative framework looks like? Is the local savings bank prepared to try this framework for advising customers?
However, after the framework is presented, there is still one major question to consider. Will this alternative framework, which is fundamentally based on Life-Cycle theory, be realisticto implementin the Faroe Islands?
1.2. Structure of the paper
This paper is divided into two parts, a theoretical part and an empirical part. The theoretical part starts with chapter 2 up to chapter 4, while the empirical part literary starts with chapter 5 up to the last chapter. However, in some instances, there are practical examples in the theoretical part with the intention of clarifying the theories and at the same time using data related to the main topic instead of using the original examples from the source. For example, instead of using dollars, crowns were used.
Chapter 2 will basically explain the portfolio theory in life-cycle perspective wherein one-period model and multi-period model will be discussed. Human capital will also be discussed in this chapter since it is an important element in the life-cycle theory.
In Chapter 3, different frameworks introduced by different scholars will be presented. By looking at these, and with the help of other models, a new framework will be developed, which hopefully could help financial advisors.
The idea of retirement planning will be presented in Chapter 4 alongside Investment Policy Statement, which is a framework commonly used in Denmark within the pension sector. This is also where saving and dissaving phases will be introduced.
After reading and evaluating the different frameworks presented in the previous chapters, the author will present in Chapter 5, an alternative framework that Faroese financial advisors can use for advising investors.
The empirical part will start with Chapter 6, which explains the structure of the Faroese pension system and some Faroese data. Since the system was patterned from the Danish pension system, it is practically a replica of it, with only small variation e.g. pension amount, supplements, or the number of different pension products available to retirees.
Finally, to sum up all the key topics in this paper, Chapter 7 will conclude this paper.
1.3. Delimitation
This paper will mostly concentrate on national pension or old age pension saving. Other related topics i.e. early social pension, early retirement from unemployment insurance, will be mentioned but not be discussed here. Insurance will also be mentioned in the chapter where human capital is explained, but will not be discussed.
For ease, an individual will be referred to as he and him in some instances instead of using he/she or him/her. Individual, investor or client will be used interchangeably. Instead of writing crowns, kr. will be used.
Although there are other frameworks available for advising, the author chose to limit the number of frameworks presented due to time and page constraints. The frameworks will be presented as the author comprehends them. Since Stochastic Present Value (SPV) is a complicated topic, it will not be thoroughly discussed in this paper; rather it will be described briefly.
The alternative framework recommended is a compilation of the different frameworks presented and not by the author’s.
2. Portfolio theory – A life cycle perspective
The portfolio theory, also known as Modern Portfolio theory (MPT) in some literature, is one of the most important and influential economic theories dealing with finance and investment.It is considered by some academics as one of the cornerstones of modern finance theory. This theory was pioneered by Harry Markowitz when his paper "Portfolio Selection," was published in 1952 by the Journal of Finance.In it, he demonstrated that by selecting assets which do not move in exactly the same directions, an investor can reduce the standard deviation of returns (risk) on asset portfolios. It means that by investing in more than one stock or basically by not putting all eggs in one basket, an investor can acquire the benefits of diversification, which primarily reduce the riskiness of the portfolio. In 1990, 18 years after the portfolio theory was introduced, Markowitz, together with William F. Sharpe and Merton H. Miller got the Nobel Prize for their pioneering work in the theory of financial economics.
Likewise, Franco Modigliani was awarded the Nobel Prize in 1985 for his pioneering analyses of saving and financial markets. Bodie (2000) wrotethat the prize was for the construction and development of the life-cycle hypothesis of household saving. The fundamental idea of this theory that people save for their old age is of course not originally Modigliani’s idea but his contribution lies mainly in the rationalization of the idea into a formal model, which he developed in different directions and incorporated within a well-defined and established economic theory. The life-cycle model is today the basis of most dynamic models used in the study of consumption and saving.
Gary Becker also received the Nobel Prize in 1992 forhaving extended the domain of microeconomic analysis to a wide range of human behaviour. His most important contribution is in the area of human capital. The theory of human capital is older than Becker’s work but his accomplishment was to have formulated and formalized the microeconomic foundations of the theory. It has created a uniform analytical framework for studying the return on education and on-the-job training and also helps explain trade patterns across countries[1].The figure below illustrates the development of Life-cycle investing since the concept started with the Portfolio theory in 1952. It shows that the Long term Portfolio choice theory, which belongs under multi-period models, is somewhat in between Markowitz’s and Modigliani’s models.
Figure 2. The Evolution of Life-cycle investing
Source: Grossen, Anders (2007): Lecture: Life and pension education program,
Nordea 11th - 13th .12.2007
2.1. One period portfolio theory – traditional mean variance
Whenever an investor buys a stock, there is a risk that the return will be lower than what is expected. Each stock has its standard deviation from the average return or mean which the theory refer to as risk. In his article, Markowitz (1952) showed how investors should pick assets if they are only interested about the mean and variance - the mean and standard deviation - of portfolio returns over a single period.The risk in a portfolio of different individual stocks will be less than the risk in holding any single one of the individual stocks.
The standard mean-variance (MV) is based upon assumptions that an investor is risk-averse and that either the distribution of the rate of return is multi-variate normal, or the utility of the investor is a quadratic function of the rate of return.Campbell and Viceira (2002) illustrated the results of Markowitz’s analyses on the figure below.
Figure 2.1. Mean – standard deviation diagram
Source: Campbell and Viceira (2002)
Note: for simplicity the figure considers only three assets: stocks, bonds, and cash
The diagram above shows the expected returnon the vertical axis and on the horizontal axis, the risk as measured by standard deviation. Stocks are shown as offering higher expected return and high standard deviation as well while bonds have lower mean and standard deviation. Cash also has lower expected return and riskless over one period. The curved line shows the set of means and standard deviation which could be reached by combining stocks and bonds in a risky portfolio. The maximum level of risk that the investor will take on determines the position of the portfolio on the line.It is clear that for any given value of standard deviation, an investor would like to choose a portfolio that gives the greatest possible rate of return for a given level of risk; therefore, he should always want a portfolio (or a point) that lies up along the efficient frontier (straight line) that is tangent to the curved line, which is called the tangency portfolio (marked best mix of stocks and bonds), rather than lower down, in the interior of the region. Markowitz also emphasized that investment is not just about picking stocks but about selecting the right combination of stocks among which to allocate one’s wealth.He established the significance of diversification of risk and since then, diversification became a key element in portfolio management.
Merton (2006)[2] stated that mean–variance portfolio theory is at the core of what’s done withasset management for personal finance, asset allocation, mutual funds, and so forth.To sum up, there are two main advantages of this theory: first, it simplifies the portfolio selection problem sincethe investor needs only to consider the portfolios on the efficient frontier, rather than a large number of possible portfolios, and second, it quantifies the idea that diversification reduces risks. Portfolios on the left hand of the efficient frontier can have lower risk than any of the constituent assets.
However, according to Michaud (2005) there are limitations to this theory as a practical framework for optimal portfolio choice. MV portfolio theory is estimation error insensitivesincebiases in optimized portfolio weights may be very large and that the out-of sample performance of classically optimized portfolios is generally very poor. In addition, it is very unstable and uncertain that even small changes ininputs can lead to large changes in optimized portfolio weights. The limitations of MV efficiency in practice are essentially the consequenceof portfolios that are overly specific to inputinformation. It assumes 100%certainty in the optimization inputs, a condition never met in practice. Managers do nothave perfect forecast information and find it difficult to use an optimization procedurethat takes their forecasts far too literally.
2.2. Multi-period portfolio theory
Modigliani’s life cycle model of saving is an example of multi-period models as well as long term Portfolio choice theory. Hogan (2007) wrote that life-cycle investing is a multi-period model that uses hedging and insuring as well as precautionary saving and diversification as core strategies for managing wealth. There are many academics who are interested in life-cycle theory of saving and investing and some of them will be discussed in the next section.
2.2.1. Life-Cyle theory of saving
In an article where Bartel (1987) interviewed Modigliani, he wrote that the foundations for Life-cycle hypothesis were laid out in the early 1950s when Modigliani and his student Richard Brumberg collaborated on a research. The theory was illustrated in two papers, in 1953 and 1954. One dealt with individual saving behavior and the other with national saving in the aggregate. Their findings showed that the empirical regularities of saving and consumption behavior could be simplified in terms of a rational, utility-maximizing consumer distributing his resources optimally between consumption and saving over the individual’s life cycle. For example, a consumer can decide how much he wants to spend at each stage of his life and will only be limited by the resources available to him. By building up and running down assets, working people can make provisions for their retirement, and more generally, adapt their consumption patterns to their needs at different ages, independently of their incomes at each age.
The main principle of the economic theory of consumer choice over the life cycle is to reallocate consumption of goods and leisure from those life stages in which they are relatively “high” to stages where they are relatively “low”, a principle known as “consumption smoothing”. According to Kotlikoff (2008), consumption smoothing not only underlies the economic approach to spending and saving, it is central to the field’s analysis of insurance decisions and portfolio choice.