Wealth isn't the best measure of personal welfare.
He starts with an example from Robert C. Merton, a Nobel Prize economist and his co-author for "Finance," a college text.
"Would you rather have $5 million or $10 million?" he asks.
"Ten million sounds good to me," I answer.
"That's O.K. for the information you have.
"Now the rest of the story. You've reached retirement and you've got $10 million to invest in an environment of 1 percent yields. Alternatively, you could have $5 million to invest in an environment of 5 percent yields.
"Your $10 million will earn only $100,000 a year. Your $5 million will earn $250,000 a year. So you'd be two and a half times better off with half the wealth!"
Outlined in a recent working paper, "Life-Cycle Finance in Theory and in Practice," Professor Bodie proposes that our common measure of personal welfare--- wealth--- is inadequate. Instead, he suggests we measure personal welfare by our lifetime access to goods, services, and leisure.
This is what some would call a "slow idea," one of those little changes in vocabulary that ends up reshaping our entire view of the world. I asked him to explain more.
"The main thrust of modern finance, post-Merton, is that risk management requires looking at the entity as a whole. In addition, something that is risky for one entity may not be risky for another."
"If a life insurance company insures a life, it is taking a risk. But if I buy a life insurance policy, I am reducing risk.
"Take long term care. If you do well in your portfolio, you don't need long-term care insurance. But firms, when they sell long-term care insurance, have to protect themselves against the fact that more buyers are likely to need LTC than the general population. If (other) risks are integrated, however, costs could be greatly reduced…"
Risk management, in other words, can be used to increase our efficiency in meeting lifetime needs and goals.
"The key contribution of Merton's models was… the life cycle model. When you do that you learn that there is a big difference between wealth and standard of living. In a single period they are much the same. In a lifecycle, they can be quite different."
These are not academic matters. How to cope with chance and risk is what all of us are trying to do when we make decisions about investing, home ownership, personal debt, job changes, etc.
Unmitigated risk--- such as owning a portfolio of common stocks--- regularly works to reduce current welfare by limiting the amount that is safe to withdraw in any year. We can reduce the risk through diversification. But we can only reduce it.
We can eliminate it altogether, Professor Bodie points out, if we go beyond the wealth measure of welfare. We can purchase a conventional life annuity or an inflation indexed life annuity. Similarly, retirees who are holding large investments in reserve to cope with possible long-term care expenses could free wealth for consumption (or inheritance) with the purchase of long term care insurance.
What Professor Bodie envisions, mega trillions of the mutual fund industry not withstanding is a future that contains a new set of financial tools designed explicitly to maximize lifetime consumption. Instead of merely reducing risk through diversification, as mutual funds do, he sees funds being replaced by structured standard of living contracts--- such as Treasury Inflation Protected Securities---and targeted accounts, such as tuition linked certificates of deposit.
An obscure trickle today, these new and little understood tools are just the beginning.
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