Inflation-linked bonds still best option for pension savers

From Prof Zvi Bodie and others.

Sir, Jeremy Siegel asserts that “the conservative investor” should avoid inflation-linked bonds and stick with “dividend-paying stocks” (“Inflation-linked bonds face a headwind of many risks”, Market Insight, February 3).

But this misrepresents the nature of inflation-linked bonds – they are the only financial instrument which guarantees a known return, even after inflation, and are crucial for pension savers.

The conservative pension saver, especially those with little or no other capital, should avoid the worst outcomes in retirement by holding inflation-protected bonds, even if it means giving up the possibility of the best outcomes by holding equities.

The higher expected return of equities over inflation-protected bonds is simply a reward for the risk of holding equities; it is not a “free lunch” or a “loyalty bonus” for long-term investors.

But what about the familiar argument that the volatility of past equity returns shows the probability that equities will earn less than the risk-free rate decreases with time, so that long-term pension savers should hold equities, not inflation-protected bonds?

The proper measure of equity risk is the cost of buying insurance against underperformance versus the risk-free return – a “put option” on a stock market index. If risk reduces over time the cost of equity put options against any shortfall should reduce. But the cost increases the longer the option period, reflecting increasing not decreasing risk.

The theoretical price, based on a standard option pricing model and actual prices charged by banks, is about 25 per cent for 10 years and 30 per cent for 20 years.

If holding equities for the long run leads to higher average returns, with negligible risk, why don’t investment banks provide guaranteed equity outperformance, for a modest fee reflecting the (supposedly) modest risk?

The optimal equity/bond split for the pension saver should be driven not by age or time to retirement, but by an individual’s “risk aversion” and the desire to lock in a minimum level of pension, which can only be done by holding inflation-protected bonds. We face many risks in old age which we can do nothing about, why add one we can eliminate?

Zvi Bodie,

Professor of Finance and Economics,

Boston University School of Management, MA, US

Charles Cowling,

Fellow of the Institute of Actuaries,

Bolton, UK

John Ralfe,

John Ralfe Consulting,

Nottingham, UK

Ian Sykes,

Fellow of the Institute of Actuaries,

Dublin, Ireland

Cliff Speed,

Fellow of the Faculty of Actuaries,

St Albans, Herts, UK

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