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WORKING PAPERS 2014
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George Kudrna
December 2014

The Australian government has recently strengthened the age pension means test by raising the income taper and also introduced labour earnings exemptions from the means testing to encourage labour supply of older Australians. This paper assesses economy-wide implications of further hypothetical policy changes to the means testing of the age pension. To this end, we apply an extension of the overlapping generations (OLG) model developed by Kudrna and Woodland (2011a, b), with the capacity to investigate changes in the taper rate and labour earnings exemptions. The simulation results indicate that further increases in the taper combined with lower income tax rates lead to higher per capita labour supply and assets, as well as to welfare gains in the long run, while labour earnings exemptions have largely positive e¤ects on average labour supply at older ages. Further increases in the taper are also shown to generate significant reductions in overall government spending on the age pension and, therefore, could be used as an alternative to increasing the age pension access age.

 

 
Daniel H. Alai, Katja Ignatieva and Michael Sherris
December 2014

Stochastic mortality models have been developed for a range of applications from demographic projections to financial management. Financial risk based models build on methods used for interest rates and apply these to mortality rates. They have the advantage of being applied to financial prising and the management of longevity risk. Oliver and Jeffery (2004) and Smith (2005) proposed a model based on a forward-rate mortality framework with stochastic factors driven by univariate gamma random variables irrespective of age or duration. We assess and further develop this model. We generalise random shocks from a univariate gamma to a univariate Tweedie distribution and allow for the distributions to vary by age. Furthermore, since dependence between ages is an observed characteristic of mortality rate improvements, we formulate a multivariate framework using copulas.We find that dependence increases with age and introduce a suitable covariance structure, one that is related to the notion of a minimum. The resulting model provides a more realistic basis for capturing the risk of mortality improvements and serves to enhance longevity risk management for pension and insurance funds.

 

 

 
Rafal Chomik and John Piggott
December 2014

Australia has an atypical retirement income system: it comprises a flat-rate, non-contributory, affluence-tested age pension, and a mandatory, defined contribution accumulation plan to which employers must contribute 9.25% (moving to 12%) of wages on behalf of their employees. We briefly compare the Australian and US economies and demographies, and then describe the Australian arrangements and assess its economic efficiency and efficacy in delivering retirement support. We focus especially on the means testing of the first pillar in Australia and the mandated membership of pre-funded private pension plans. We conclude by considering insights for the evolution of the US pension reform debate as demographic change unfolds.

 
Rafal Chomik and John Piggott
December 2014

Asian countries are at different stages of demographic transition. While Central and South Asian countries are relatively young and will remain so for some time, East and South-East Asia is expected to age at an unprecedented rate in the next few decades.  Japan has reached the future first. Other nations, such as China, are still young but ageing faster than many advanced economies, including Australia and the United States. This demographic shift has considerable implications for the development of social policy. Here too, countries differ widely.

This chapter sets the context for the rest of the volume. The focus is mostly on countries in East and South-East Asia, but it includes contrasting comparisons to key regional countries such as India and Australia. Firstly, the chapter presents the context: the demographic, urbanisation and social trends facing Asia. Secondly, it tackles the allocation of resources for the elderly, in particular, by summarising approaches to two areas of social policy most pertinent to population ageing: retirement income and healthcare. 

 
Fedor Iskhakov, Susan Thorp and Hazel Bateman
August 2014

We develop and simulate a stochastic lifecycle model to investigate optimal annuity purchases at retirement. Retirees can invest in risky assets, purchase fairly priced immediate or deferred lifetime annuities, and are eligible for a targeted safety net pension. We  match baseline parameters  to current  Australian  settings and conduct scenario analyses over a wide range of individual preferences and financial market outcomes. Except where individuals need to insure a consumption floor, both immediate and deferred annuity purchases are largely crowded out by the means tested public pension. Welfare losses caused by zero annuitisation are small compared with the losses caused by completely annuitising all savings, particularly if wealth at retirement is low. Decumulation policy should ensure individuals are well-informed of the insurance value of annuities and accommodate diverse choices.

 

 
Yang Chang and Erik Schlogl
May 2014

The phenomenon of the frequency basis (i.e. a spread applied to one leg of a swap to exchange one oating interest rate for another of a different tenor in the same currency) contradicts textbook no-arbitrage conditions and has become an important feature of interest rate markets since the beginning of the Global Financial Crisis (GFC) in 2008. Empirically, the basis spread cannot be explained by transaction costs alone, and therefore must be due to a new perception by the market of risks involved in the execution of textbook "arbitrage" strategies. This has led practitioners to adopt a pragmatic "multi-curve" approach to interest rate modelling, which leads to a proliferation of term structures, one for each tenor. We take a more fundamental approach and explicitly model liquidity risk as the driver of basis spreads, reducing the dimensionality of the market for the frequency basis from observed spread term structures for every frequency pair down to term structures of two factors characterising liquidity risk. To this end, we use an intensity model to describe the arrival time of (possibly stochastic) liquidity shocks with a Cox Process. The model parameters are calibrated to quoted market data on basis spreads, and the improving stability of the calibration suggests that the basis swap market has matured since the turmoil of the GFC.

 
Yang Shen and Michael Sherris
April 2014

This paper considers the lifetime asset allocation problem with both idiosyncratic and systematic longevity risks, in which the stochastic mortality model is given by a general diffusion process. A wage earner can invest in a zero-coupon bond, a stock and a longevity bond, consume part of his wealth and purchase life insurance or annuity so as to maximize the expected utility from consumption, terminal wealth and bequest. The problem is solved via the dynamic programming principle and the Hamilton-Jacobi-Bellman equation. General solutions and special solutions are derived for the general diffusion mortality model and the square-root mortality model, respectively. To illustrate our results, numerical examples based on special solutions are provided. It is shown that idiosyncratic mortality risk has significant impacts on the wage earner's investment, consumption, life insurance purchase and bequest decisions regardless of the length of the decision-making horizon, while systematic mortality risk only has significant impacts on the wage earner's investment in the zero-coupon bond and the longevity bond. Since systematic mortality risk can be hedged by trading the longevity bond, its impacts on consumption, purchase of life insurance and bequest are not significant, especially when the decision-making horizon is short.

 
Katja Hanewald and Fanny Kluge
April 2014

Family Structures have changed profoundly in most developed countries in recent decades. Declining fertility and marriage rates and increasing divorce rates, together with longer life expectanies, make financial planning more challenging. Our study analyzes the impact of family structure on individual's attitudes toward risk and on their savings and investment decisions based on data from the German Socio-Economic Panel Study (SOEP) over the period 2004-2010. Using panel data analysis, martial status is found to be a key variable affecting risk attitudes and savings and investment decisions. Compared to people who are single, married individuals report being less willing to take risks, but more likely to invest in risky assets. Our findings indicate that while the recent financial and economic crisis has influenced individual's attitudes, it has not - with the exception of investments in risky assets - affected the savings and investment decisions of individuals.

 

 
Julie Agnew, Hazel Bateman, Christine Eckert, Fedor Iskhakov, Jordan Louviere and Susan Thorp
April 2014

Using an online incentivized discrete choice experiment, we study how well individuals judge financial advice and whether factors other than advice quality influence their evaluations. We find evidence that some individuals rely on extraneous signals to judge advice quality and observe some persistency in adviser choice over time. Our results also explain how some advisers can maintain trustworthy reputations despite giving bad advice. Finally, we explore whether individuals learn throughout the experiment. Our findings have several public policy implications that are discussed in the conclusion.

Appendices A-C

 
Adam Wenqiang Shao, Katja Hanewald and Michael Sherris
February 2014

Reverse mortgages provide an alternative source of funding for retirement income and health care costs. The two main risks that reverse mortgage providers face are house price risk and longevity risk. Recent real estate literature has shown that the idiosyncratic component of house price risk is large. We analyse the combined impact of house price risk and longevity risk on the pricing and risk profile of reverse mortgage loans in a stochastic multi-period model. The model incorporates a new hybrid hedonic-repeat-sales pricing model for houses with specific characteristics, as well as a stochastic mortality model for mortality improvements along the cohort direction (the Wills-Sherris model). Our results show that pricing based on an aggregate house price index does not accurately assess the risks underwritten by reverse mortgage lenders, and that failing to take into account cohort trends in mortality improvements substantially underestimates the longevity risk involved in reverse mortgage loans.