The Hindu Business Line : Equity-linked annuities for pension investors

IF MEDIA reports are to be believed, professional money managers may be able to manage pension funds by end 2005. The Government is likely to have three types of plans to suit investors' risk appetite. The most conservative plan will invest only in fixed-income securities. The aggressive plan will have about 40 per cent exposure in equities.

Investing in just two asset classes — fixed-income and equities — will not help savers. Pension funds' objective must be to help investors hedge their long-term liability.

At present, the market is devoid of such a product. Savers should able to buy inflation-protected annuities if they are to achieve their investment goals.

Hedging vs diversification: Allocating assets between fixed-income securities and equities can help a portfolio strive for mean-variance efficiency. But retirement funds do not need such diversification benefits. The objective of such a fund is to hedge long-term liability. At the minimum, this means protecting a certain standard of living after retirement.

Fixed-income securities and equities are unlikely to help investors meet these goals. Take fixed-income securities. A fund's bond portfolio will be exposed to interest rate risk. Our market does not offer many products to hedge such a risk. And even if OTC products such as exotic swaps are available, hedging costs will be high. Besides, fixed-income securities pay nominal coupons. So, the interest income may not beat inflation.

Next consider equities: There is a notion that stocks are less risky in the long run. Besides, stocks have been empirically proved to outperform other asset classes in the long run. But this is not always true. It is important how stocks in the pension fund portfolio move during the investment horizon of each investor. That is, the likelihood of the pension fund generating the required retirement income for each investor is somewhat path-dependent. Here is why.

Suppose a pension fund investor chooses to allocate Rs 1 lakh every year for the next 20 years. What if the stock market passes through a bad phase in the initial five years?

Or, what if the market tanks in the first year? Attempts will be made primarily to recoup the capital loss through the investment horizon. In that case, stocks may be unable to outperform other asset classes at the horizon.

The point is that stock markets exhibit tail events that are severe in magnitude. Events such as May 17, 2004 when the market crashed nearly 900 points are not outliers.

They happen frequently for a long-term investor's comfort. It is very costly to hedge such tail risk, especially when pension funds have no finite maturity.

Structuring retirement income: Pension investors essentially need a hedge against inflation to protect their consumption pattern. Besides, their investment should carry an upside potential to improve their standard of living and meet contingent liabilities. Yet, the downside risk should be protected.

In effect, this means the investors should be able to buy a product that is inflation-protected and also replicates payoffs on a call option. Fortunately, the market can offer such products in the form of annuities.

At present, all life insurance companies offer annuity products as part of their pension product portfolio. Such annuities do not, however, protect against inflation risk. The unit-linked insurance plans have symmetrical payoffs. That is, the investor is exposed to both the ups and downs in asset prices.

Insurance companies should, hence, offer real equity-linked annuities. The payoff on such a product will be a combination of two factors. The base component will be a fixed-rate annuity, paying real income. This will protect the investor against inflation risk and provide a stable income. The variable component will be linked to an equity index. This payoff will be structured as a call option.

That is, the payoff will be non-linear in that the variable structure will participate in market rallies but will not decline below zero if the market tanks. Of course, the success of this product will depend on the ability to construct an inflation index that replicates the average consumption pattern of retired individuals.

(Feedback can be sent to bvenky@thehindu.co.in)

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