SM bonds may improve super system

The recent study from Macquarie University has outlined how an alternative model for saving for retirement might help improve Australia's super system by encouraging people to incrementally buy retirement annuities starting at the age of 30.

The proposal offers a new product for managing longevity risk which will be based on a retirement bond, called a SM bond, and enable an individual to buy a government-guaranteed retirement income stream, without imposing longevity risks onto the government.

Macquarie University finance lecturer and co-author of the study, Shauna Ferris, noticed that the current system was seriously flawed as it focused on balance and the savers were left unsure with "on average" sufficient retirement balance hard to figure out.

The answer to that might be a new public-private partnership, the SM bonds. These bonds are divisible into two components — a survivorship (S) part and a mortality (M) component where the S part must be retained by the originator and M bonds are tradeable. Consequently, the holder of the S part receives the face value of the bond if he or she is alive at maturity and for originators who die prior to the maturity date, the maturity value of the SM bond is assigned to a mortality pool while the holder of the M part of the bond receives the annual bond coupon, and at maturity a pro-rata share of the mortality pool. Additionally, the M market participants will be able to adjust positions and arbitrage between bonds of different ages and times to maturity.

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According to the study, the new solution is in contrast with the longevity securities which are currently available in the market as M bonds will be government-guaranteed standardised contracts and are expected to become more attractive for hedgers and investors.

Also, longevity risks will be priced by market forces which will help create the future market for private sector longevity products, complementary to S bonds.

Each SM bond is associated with a particular age and might be only purchasable by originators of that age while different age bonds are issued every year for ages 30 to 64 each with a 35 year term. As the SM bonds are government-guaranteed, there is minimal default risk for both S and M holders, the study says.

SM bonds can be integrated into the existing retirement savings system, as one component of each individual's retirement savings portfolio.

The other benefits of this model also include:

Individuals' access to government guaranteed defined benefit retirement income streams;

• Governments benefit by reduced exposure to ever increasing demands of the old age pension;
• Society benefits by having access to a vast supply of long term financing; and
• Markets and investors benefit by having a standardised financial instrument making for superior returns and a platform for development, hedging and pricing of further retirement income products.