Joao F. Cocco

Longevity Risk, Retirement Savings, and Financial Innovation

Over the last couple of decades unprecedented increases in life expectancy have raised important concerns for retirement savings. We solve a life-cycle model with longevity risk, which can be hedged through endogenous saving and retirement decisions. We investigate the benefits of financial assets designed to hedge the shocks to survival probabilities. When longevity risk is calibrated to match forward-looking projections, those benefits are substantial. This lends support to the idea that such hedging should be pursued by defined benefit pension plans on behalf of their beneficiaries. Finally, we draw implications for optimal security design.

Stock Market Mean Reversion and the Optimal Equity Allocation of a Long-Lived Investor

This paper solves numerically the intertemporal consumption and portfolio choice problem of an infinitely-lived investor who faces a time-varying equity premium. The solutions we obtain are very similar to the approximate analytical solutions of Campbell and Viceira (1999), except at the upper extreme of the state space where both the numerical consumption and portfolio rules flatten out. We also consider a constrained version of the problem in which the investor faces borrowing and short-sales restrictions. These constraints bind when the equity premium moves away from its mean in either direction, and are particularly severe for risk-tolerant investors. The constraints have substantial effects on optimal consumption, but much more modest effects on optimal portfolio choice in the region of the state space where they are not binding.

Corporate Governance of Pension Plans: The U.K. Evidence

For this study of the governance of defined-benefit pension plans in the United Kingdom, the governance measure was equal to the proportion of trustees of the pension plan in 2002 who were also executive directors of the sponsoring company. The findings indicate that pension plans of indebted companies with a higher proportion of insider than independent trustees invest a higher proportion of pension plan assets in equities and that the sponsors contribute less to the plan and have a larger dividend payout ratio. This evidence supports the agency view that insider trustees act in the interests of shareholders of the sponsor, not necessarily in the interests of pension plan members. Many companies have promised their employees defined-benefit (DB) pensions. The large increases in life expectancy that have occurred since the 1970s and the decline in interest rates that are used to calculate the present value of pension liabilities have led to significant increases in corporate pension liabilities. As a result, many DB corporate pension plans now show substantial deficits. In the United Kingdom, which is the focus of this article, DB pension plans are set up in trusts with trustees responsible for the trust assets and management. More precisely, the trustees must decide how to invest the assets of the pension plan and must put in place a schedule of contributions for the sponsoring companies. These powers, combined with the size and deficit of the pension plans, mean that the actions of pension plan trustees have important implications not only for pension plan members (or beneficiaries) but also for the value and behavior of sponsors. The law specifies that the trustees of the pension plan may be directors of sponsoring companies, which may lead to conflicts of interest between the executive and trustee roles. In this article, we study such conflicts of interest. We focus on two alternative hypotheses. The first is that the presence of insiders is a source of agency problems because it allows insider trustees to favor shareholders of the company over members of the pension plan. A company with a DB pension plan can be considered to own a put option: If the assets (the company and DB assets) fall short of the pension fund liabilities, the company has the option of giving those assets to the DB beneficiaries as payment. Because the value of a put option increases with the risk of the underlying assets, insider trustees may have an incentive to increase the riskiness of the assets (the company and the DB plan assets) beyond what is optimal for the members of the pension plan by, for example, investing the pension plan assets in equities. Agency problems may also be reflected in the contributions paid into the pension plan. Pension plan liabilities are similar to long-term debt, and pension plan members are debtholders of the company. Insider trustees who favor shareholders of the company over debtholders (i.e., pension plan members), however, may have an incentive to reduce company contributions to the plan. The second hypothesis is that insider trustees facilitate an efficient management of tax liabilities, which may be positive for both shareholdersand pension plan members. More precisely, companies may be able to generate tax savings if they integrate their financial and pension investment policies: If a company increases leverage, uses the proceeds to fund the pension plan, and invests those funds in bonds, it may generate tax savings without affecting financial risk. The reason is that the increase in leverage generates a debt tax shield while the return on bonds held in the pension plan is tax exempt. To test these hypotheses, we collected information for 2002 and 2003 on U.K. companies that had DB pension plans. We found evidence that supports the agency hypothesis that insider trustees act in the interests of shareholders of the sponsoring company, not necessarily in the interests of pension plan members. More precisely, we found that pension plans of the more-leveraged companies with a higher proportion of insider trustees invest a higher proportion of the pension plan assets in equities than do other plans and, in this way, make riskier investments. Also, we provide evidence, consistent with the risk-shifting effect, that the presence of insider trustees allows companies to reduce contributions to the plan.

Evidence on the Benefits of Alternative Mortgage Products

Alternative mortgage products were identified by many as culprits in the financial crisis. However, because of their lower initial mortgage payments relative to loan amount, they may be a valuable tool for households who expect higher and more certain future labor income, and who wish to smooth consumption over the life-cycle. This paper uses United Kingdom household level panel data to show evidence in support of this hypothesis and on other important benefits of alternative mortgages, including portfolio diversification, tax benefits, and a reduction in the transaction costs incurred in housing transactions.

Corporate Pension Plans as Takeover Deterrents

We use UK data to show that firms that sponsor a defined-benefit pension plan are less likely to be targeted in an acquisition and, conditional on an attempted takeover, they are less likely to be acquired. Our explanation is that the uncertainty in the value of pension liabilities is a source of risk for acquirers of the firms shares, which works as a takeover deterrent. In support of this explanation we find that these same firms are more likely to use cash when acquiring other firms, and that the announcement of a cash acquisition is associated with positive announcement effects.

Defined Benefit or Defined Contribution? A Study of Pension Choices

We solve an empirically parameterized life‐cycle model of consumption and pension choices to show how expected earnings growth and risk affect the benefits of final‐salary defined benefit (DB) pension plans, relative to pension plans that are defined contribution (DC) in nature. We use micro data on the pension choices of individuals to provide evidence consistent with the model predictions: (1) individuals who expect a higher growth rate of earnings are more likely to choose DB final‐salary schemes, and (2) individuals who face a higher variance of persistent income shocks are less likely to choose DB final‐salary schemes. We control for cohort and age fixed effects in the empirical analysis.

Understanding the Trade-Offs of Alternative Mortgage Products

Alternative mortgage products are commonly characterized by initial lower mortgage payments, followed by larger payments later on. As a consequence they may be a valuable tool for households who expect higher future labor income, and wish to smooth consumption over the life-cycle. I propose a test, based on the permanent income hypothesis, of whether this is the case. I use United Kingdom panel data, a country where alternative mortgage products have been widely available for many years, to implement this test. I find evidence, for part of the sample period, supportive of this hypothesis. In addition, I investigate what makes it more or less likely that households have difficulty meeting mortgage payments.

Structuring Mortgages for Macroeconomic Stability

We study mortgage design features aimed at stabilizing the macroeconomy. We model overlapping generations of mortgage borrowers and an infinitely lived risk-averse representative mortgage lender. Mortgages are priced using an equilibrium pricing kernel derived from the lenders endogenous consumption. We consider an adjustable-rate mortgage (ARM) with an option that during recessions allows borrowers to pay only interest on their loan and extend its maturity. We find that this maturity extension option stabilizes consumption growth over the business cycle, shifts defaults to expansions, and is welfare enhancing. The cyclical properties of the maturity extension ARM are attractive to a risk-averse lender so the mortgage can be provided at a relatively low cost.