It is a little surreal to hear an economics Nobel laureate flag issues and provide solutions to some issues that personal finance writers across the world have been flagging for many years now. The occasion was the RH Patil Memorial Lecture to mark 25 years of the National Stock Exchange. Patil was the first chairman of the exchange that was set up in the aftermath of the 1992 stock market scam. Delivering the lecture was Robert C. Merton, Nobel Prize-winning economist and professor of finance at Massachusetts Institute of Technology.
It was surreal because personal finance writers have flagged issues around trust, asymmetric information, product design, retirement planning being rocket science, to name a few. Surreal because the financial sector, regulators and policymakers have pushed back at ideas around product design and other supply side solutions to focus on disclosure and financial literacy—or the demand side solutions. Inherent in their push back is the tossing of responsibility to consumers of retail finance. I have long believed that it will take product design and supply side solutions to solve this problem.
Merton’s entire talk was about solving some of these issues from the supply side. He was dismissive of financial literacy saying that it is better to design a car that you can just drive rather than teach details of internal combustion to the driver. He says that it is better to design products that an average person can plug and play rather than hold them accountable to learn finance and evaluate products—especially for retirement. This is important because academia informs policy. Policy directs regulation. Regulation constructs markets. Markets design products that you and I buy.
Merton’s latest work is around product design in a government bond that will allow an average person to target her retirement. The solution is called the Standard of Living indexed, Forward-starting, Income-only Securities—or SeLFIES. This is a government bond that begins to pay interest after a certain number of years, for a certain number of years. The buyer targeting her retirement will have to make two assumptions—the year of retirement and how long she will live.
Assume that a 40-year-old in 2018 decides that she will retire in 2038. She currently spends ₹ 12 lakh a year and would like to maintain this standard of living in real terms when she turns 60. She would also like to have a product that looks after inflation during the 30 years she plans to live post retirement. Merton’s solution is to have a deferred interest paying bond that you can buy in 2018, with the payouts beginning at retirement. The payouts will be indexed to a standard of living index so that buyers don’t see a drop in their lifestyle. The payout of these bonds, says Merton, is exactly the cash flows that a typical infra project throws up—a long investment period with no cash returns and then an annuity of returns over the life of the project.
Long term infra projects can be funded by these bonds. What about the hedge for the cost of living? Merton believes that the GST will provide a natural hedge for the product. You can read more about the product here: (SeLFIES for India) and (Time for Retirement ‘SeLFIES’?)
One issue I have with such a product is the proclivity of a government in a pre-election year to use the money to build sub-optimal infra products that don’t generate the returns needed to fund the cash outs in 20 years. Take for instance the pushing forward of bank NPAs by the United Progressive Alliance (UPA) government. Merton says that governments always tend to make good their promises. But I would still worry about a moral hazard of kicking the can down by an irresponsible government.
Another issue flagged at the lecture was of trust. Post 2008, retail investors in the US have lost trust in the financial sector and managed funds. $1 trillion have switched from managed funds to passive funds over the past few years.
Merton believes that the time for fee-only advice is here and that is the only way trust can be re-established. Commissions, whether in cash, kind or any other way, open the adviser to conflicts of interests and it is only the pure fee for adviser that will win the trust of investors.
The Indian market regulator has been grappling with the issue of advice versus incidental advice in distribution for a while now. Inputs from Merton may give more clarity on the way the academic world is looking at the issue now. As I said earlier—the impact of academia is finally on market design.
The next step in this story will be to turn the market from buyer beware to seller beware in retail finance. We wait for that to happen as academia gives us the evidence to something we know from practice.
Monika Halan is consulting editor at Mint and writes on household finance, policy and regulation. To read more expense account columns, click here.