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TABLE OF CONTENTS

ABSTRACT........................................................................................................................3

1. INTRODUCTION.........................................................................................................4

1.1. PROBLEM STATEMENT..............................................................................................51.2. STRUCTURE OF THE PAPER.......................................................................................51.3. DELIMITATION...........................................................................................................6

2. PORTFOLIO THEORY – A LIFE CYCLE PERSPECTIVE.................................7

2.1. ONE PERIOD PORTFOLIO THEORY – TRADITIONAL MEAN VARIANCE........................92.2. MULTI-PERIOD PORTFOLIO THEORY.......................................................................11

2.2.1. Life-Cyle theory of saving................................................................................112.2.3. Life Cycle model of portfolio choice................................................................172.2.4. Human capital................................................................................................18

3. FRAMEWORKS FOR ADVISING...........................................................................23

3.1. BODIE, TREUSSARD, AND WILLEN..........................................................................233.1.1. Three principles from the life-cycle approach.................................................233.1.2. Five key concepts form the life-cycle model...................................................26

3.2 MALKIEL.................................................................................................................323.2.1. Guidelines to a life-cycle investment plan.......................................................323.2.2. Life-Cycle Investment Guide: Recommended Asset or Saving........................33Allocations.................................................................................................................33

4. RETIREMENT PLANNING......................................................................................37

4.1. ACTIVE (SAVING) PHASE.........................................................................................384.1.1. Investment Policy Statement............................................................................39

4.2 DISSAVING PHASE....................................................................................................43

5. AN ALTERNATIVE FRAMEWORK FOR ADVISING.......................................45

6. THE STRUCTURE OF THE FAROESE PENSION SYSTEM.............................46

6.1. PILLAR 1 – PUBLICLY – FUNDED SCHEME.............................................................476.1.1 National pension (Old age pension).................................................................486.1.2. Special Retirement Savings (Samhaldsfasta)...................................................506.1.3. Civil servants’ pension....................................................................................51

6.2. PILLAR 2 – EMPLOYER - SPONSORED SCHEME......................................................526.3. PILLAR 3 - PRIVATE PENSION SCHEME..................................................................57

6.3.1. Capital Pension...............................................................................................586.3.2. Rate Pension....................................................................................................586.3.3. Life Annuity......................................................................................................59

6.4. SOME OBSERVATIONS FROM THE FAROESE VIEWPOINT.....................................616.4.1. Survey.............................................................................................................616.4.2. Difficulties of saving for retirement.................................................................626.4.3. Framework used by a local savings bank, Nordoya Sparikassi.....................62

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7. CONCLUSION............................................................................................................64

BIBLIOGRAPHY............................................................................................................66

Appendix 1. National pensionist, who is receiving private pension.........................68Appendix 2. The life-cycle model – an Event tree (Original version).....................70

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Abstract

Every investor needs the guiding hands of a reliable and well-informed financial advisor,

who has the knowledge and the appropriate strategies to build the ideal financial portfolio

that could be crucial to the investor’s future retirement income. Being able to convey

essential information, which is comprehensible to an average investor, is perhaps one of

advisor’s main goal. In addition, with the help of an effective framework in advising, he

would be able to identify the investor’s needs and at the same time his limitations.

Therefore, this paper will attempt to develop an alternative framework which Faroese

financial advisors could apply in advising their investors. Finding the best possible

framework that could work for both the investors and the financial institution will not be

simple, but by looking at different frameworks that are presented here and then selecting

the most realistic parts of each framework could be the basis of an alternative framework.

Previously, only few scholars and academics who were interested in the life-cycle theory

but as more and more found out that it made sense, many scholars and academics today

have tried and succeeded in modifying the theory and as a result, millions of people

around the world have started paying attention to life cycle saving and investing,

searching for answers to some fundamental issues they have.

It is any individual’s objective to maximize their utility over the entire life cycle in order

to have a fairly comfortable life even after retirement. This involves saving some stages

in life to be able to consume later in life. Consequently, most academics found out the

significance of human capital to the financial wealth of an individual that they started to

inform everyone how important it is to their total wealth. Human capital is an

individual’s most important asset thus should be taken in consideration when building

their portfolios. How investors chose to allocate their assets is of great importance for the

outcome of their portfolios.

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1. Introduction

Given the uncertainties customers/investors have today concerning future pension

income, there has never been a greater need for well-informed financial advisors, who

have the knowledge and the appropriate strategies to build the ideal financial portfolio.

Being able to convey essential information, which is comprehensible to an average

investor, is one of advisor’s main goal. By being up-to-date with recent developments in

the financial world, a competent advisor would be capable of providing his customers the

best advice possible with regards to developing their financial portfolio. In addition, with

the help of an effective framework in advising, he would be able to identify the investor’s

needs and at the same time his limitations.

Although retirement planning today presents a big, challenging problem, it also offers big

opportunities for banks and other financial institutions to find solutions to address the

problem. Finding the best possible framework that could work for both the investor and

the financial institution will not be simple.

Today, millions of people around the world have started paying attention to life cycle

saving and investing, searching for answers to some fundamental issues they have e.g.

when will they start saving and how much of their current wages they should save for the

future (including retirement), and how they should invest it or whether they should buy or

rent a house and so on. For years, whenever customer’s wealth (total capital) is discussed,

it generally means financial capital e.g. housing, car, stocks and bonds. Nowadays, there

are a growing number of financial planners and advisors who are acknowledging that an

investor’s total capital (TC) consists of two parts: financial capital (FC) and human

capital (HC), and specifically, that risk and return features of human capital should be

considered when building portfolios for individual investors since HC is the biggest asset

an individual have.

However, the bigger question comes right after retiring whether the investor will manage

to efficiently distribute his total wealth throughout his remaining years. Is Life-cycle

theory of saving and investing the answer to all these questions?

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1.1. Problem Statement

The main purpose of this paper is to put together a realistic framework which Faroese

financial advisors can use in advising personal savers and investors. This framework will

be based on theories about modern portfolio, human capital, and life cycle saving and

investing and other frameworks introduced by scholars and academics. Answering some

of the questions below will help in putting up together this framework.

1. Explain the life cycle perspective of the Portfolio theory?

2. What is human capital (HC)? What is its significance to an investor’s decisions?

3. What is Life-Cycle saving and investing theory? How is this theory associated

with human capital?

4. How can Life-Cycle saving and investing theory affect retirement planning?

5. What is the structure of the Faroese pension system?

6. What is the current framework in investing used by financial advisors e.g. from a

local savings bank?

7. How will the alternative framework looks like? Is the local savings bank prepared

to try this framework for advising customers?

However, after the framework is presented, there is still one major question to consider.

Will this alternative framework, which is fundamentally based on Life-Cycle theory, be

realistic to implement in the Faroe Islands?

1.2. Structure of the paper

This paper is divided into two parts, a theoretical part and an empirical part. The

theoretical part starts with chapter 2 up to chapter 4, while the empirical part literary

starts with chapter 5 up to the last chapter. However, in some instances, there are

practical examples in the theoretical part with the intention of clarifying the theories and

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at the same time using data related to the main topic instead of using the original

examples from the source. For example, instead of using dollars, crowns were used.

Chapter 2 will basically explain the portfolio theory in life-cycle perspective wherein

one-period model and multi-period model will be discussed. Human capital will also be

discussed in this chapter since it is an important element in the life-cycle theory.

In Chapter 3, different frameworks introduced by different scholars will be presented. By

looking at these, and with the help of other models, a new framework will be developed,

which hopefully could help financial advisors.

The idea of retirement planning will be presented in Chapter 4 alongside Investment

Policy Statement, which is a framework commonly used in Denmark within the pension

sector. This is also where saving and dissaving phases will be introduced.

After reading and evaluating the different frameworks presented in the previous chapters,

the author will present in Chapter 5, an alternative framework that Faroese financial

advisors can use for advising investors.

The empirical part will start with Chapter 6, which explains the structure of the Faroese

pension system and some Faroese data. Since the system was patterned from the Danish

pension system, it is practically a replica of it, with only small variation e.g. pension

amount, supplements, or the number of different pension products available to retirees.

Finally, to sum up all the key topics in this paper, Chapter 7 will conclude this paper.

1.3. Delimitation

This paper will mostly concentrate on national pension or old age pension saving. Other

related topics i.e. early social pension, early retirement from unemployment insurance,

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will be mentioned but not be discussed here. Insurance will also be mentioned in the

chapter where human capital is explained, but will not be discussed.

For ease, an individual will be referred to as he and him in some instances instead of

using he/she or him/her. Individual, investor or client will be used interchangeably.

Instead of writing crowns, kr. will be used.

Although there are other frameworks available for advising, the author chose to limit the

number of frameworks presented due to time and page constraints. The frameworks will

be presented as the author comprehends them. Since Stochastic Present Value (SPV) is a

complicated topic, it will not be thoroughly discussed in this paper; rather it will be

described briefly.

The alternative framework recommended is a compilation of the different frameworks

presented and not by the author’s.

2. Portfolio theory – A life cycle perspective

The portfolio theory, also known as Modern Portfolio theory (MPT) in some literature, is

one of the most important and influential economic theories dealing with finance and

investment. It is considered by some academics as one of the cornerstones of modern

finance theory. This theory was pioneered by Harry Markowitz when his paper

"Portfolio Selection," was published in 1952 by the Journal of Finance. In it, he

demonstrated that by selecting assets which do not move in exactly the same directions,

an investor can reduce the standard deviation of returns (risk) on asset portfolios. It

means that by investing in more than one stock or basically by not putting all eggs in one

basket, an investor can acquire the benefits of diversification, which primarily reduce the

riskiness of the portfolio. In 1990, 18 years after the portfolio theory was introduced,

Markowitz, together with William F. Sharpe and Merton H. Miller got the Nobel Prize

for their pioneering work in the theory of financial economics.

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Likewise, Franco Modigliani was awarded the Nobel Prize in 1985 for his pioneering

analyses of saving and financial markets. Bodie (2000) wrote that the prize was for the

construction and development of the life-cycle hypothesis of household saving. The

fundamental idea of this theory that people save for their old age is of course not

originally Modigliani’s idea but his contribution lies mainly in the rationalization of the

idea into a formal model, which he developed in different directions and incorporated

within a well-defined and established economic theory. The life-cycle model is today the

basis of most dynamic models used in the study of consumption and saving.

Gary Becker also received the Nobel Prize in 1992 for having extended the domain of

microeconomic analysis to a wide range of human behaviour. His most important

contribution is in the area of human capital. The theory of human capital is older than

Becker’s work but his accomplishment was to have formulated and formalized the

microeconomic foundations of the theory. It has created a uniform analytical framework

for studying the return on education and on-the-job training and also helps explain trade

patterns across countries1. The figure below illustrates the development of Life-cycle

investing since the concept started with the Portfolio theory in 1952. It shows that the

Long term Portfolio choice theory, which belongs under multi-period models, is

somewhat in between Markowitz’s and Modigliani’s models.

Figure 2. The Evolution of Life-cycle investing

Source: Grossen, Anders (2007): Lecture: Life and pension education program, Nordea 11th - 13th .12.2007

1 Information here came from Bodie’s and Merton’s book Finance (2000.

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2.1. One period portfolio theory – traditional mean variance

Whenever an investor buys a stock, there is a risk that the return will be lower than what

is expected. Each stock has its standard deviation from the average return or mean which

the theory refer to as risk. In his article, Markowitz (1952) showed how investors should

pick assets if they are only interested about the mean and variance - the mean and

standard deviation - of portfolio returns over a single period. The risk in a portfolio of

different individual stocks will be less than the risk in holding any single one of the

individual stocks.

The standard mean-variance (MV) is based upon assumptions that an investor is risk-

averse and that either the distribution of the rate of return is multi-variate normal, or the

utility of the investor is a quadratic function of the rate of return. Campbell and Viceira

(2002) illustrated the results of Markowitz’s analyses on the figure below.

Figure 2.1. Mean – standard deviation diagram

Source: Campbell and Viceira (2002)

Note: for simplicity the figure considers only three assets: stocks, bonds, and cash

The diagram above shows the expected return on the vertical axis and on the horizontal

axis, the risk as measured by standard deviation. Stocks are shown as offering higher

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expected return and high standard deviation as well while bonds have lower mean and

standard deviation. Cash also has lower expected return and riskless over one period. The

curved line shows the set of means and standard deviation which could be reached by

combining stocks and bonds in a risky portfolio. The maximum level of risk that the

investor will take on determines the position of the portfolio on the line. It is clear that for

any given value of standard deviation, an investor would like to choose a portfolio that

gives the greatest possible rate of return for a given level of risk; therefore, he should

always want a portfolio (or a point) that lies up along the efficient frontier (straight line)

that is tangent to the curved line, which is called the tangency portfolio (marked best mix

of stocks and bonds), rather than lower down, in the interior of the region. Markowitz

also emphasized that investment is not just about picking stocks but about selecting the

right combination of stocks among which to allocate one’s wealth. He established the

significance of diversification of risk and since then, diversification became a key

element in portfolio management.

Merton (2006)2 stated that mean–variance portfolio theory is at the core of what’s done

with asset management for personal finance, asset allocation, mutual funds, and so forth.

To sum up, there are two main advantages of this theory: first, it simplifies the portfolio

selection problem since the investor needs only to consider the portfolios on the efficient

frontier, rather than a large number of possible portfolios, and second, it quantifies the

idea that diversification reduces risks. Portfolios on the left hand of the efficient frontier

can have lower risk than any of the constituent assets.

However, according to Michaud (2005) there are limitations to this theory as a practical

framework for optimal portfolio choice. MV portfolio theory is estimation error

insensitive since biases in optimized portfolio weights may be very large and that the out-

of sample performance of classically optimized portfolios is generally very poor. In

addition, it is very unstable and uncertain that even small changes in inputs can lead to

large changes in optimized portfolio weights. The limitations of MV efficiency in

practice are essentially the consequence of portfolios that are overly specific to input

information. It assumes 100% certainty in the optimization inputs, a condition never met 2 Remark is included in the book “Future of Life Cyle saving and investing” published in 2007

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in practice. Managers do not have perfect forecast information and find it difficult to use

an optimization procedure that takes their forecasts far too literally.

2.2. Multi-period portfolio theory

Modigliani’s life cycle model of saving is an example of multi-period models as well as

long term Portfolio choice theory. Hogan (2007) wrote that life-cycle investing is a multi-

period model that uses hedging and insuring as well as precautionary saving and

diversification as core strategies for managing wealth. There are many academics who

are interested in life-cycle theory of saving and investing and some of them will be

discussed in the next section.

2.2.1. Life-Cyle theory of saving

In an article where Bartel (1987) interviewed Modigliani, he wrote that the foundations

for Life-cycle hypothesis were laid out in the early 1950s when Modigliani and his

student Richard Brumberg collaborated on a research. The theory was illustrated in two

papers, in 1953 and 1954. One dealt with individual saving behavior and the other with

national saving in the aggregate. Their findings showed that the empirical regularities of

saving and consumption behavior could be simplified in terms of a rational, utility-

maximizing consumer distributing his resources optimally between consumption and

saving over the individual’s life cycle. For example, a consumer can decide how much he

wants to spend at each stage of his life and will only be limited by the resources available

to him. By building up and running down assets, working people can make provisions for

their retirement, and more generally, adapt their consumption patterns to their needs at

different ages, independently of their incomes at each age.

The main principle of the economic theory of consumer choice over the life cycle is to

reallocate consumption of goods and leisure from those life stages in which they are

relatively “high” to stages where they are relatively “low”, a principle known as

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“consumption smoothing”. According to Kotlikoff (2008), consumption smoothing not

only underlies the economic approach to spending and saving, it is central to the field’s

analysis of insurance decisions and portfolio choice.

,

2.2.2. Life cycle model of saving

According to Bodie (2000), there are two approaches an investor could do to compute

how much he should save for retirement: (1) Aim for a target replacement rate of pre-

retirement income, and (2) Aim for maintaining the same level of consumption spending

before and after retirement. For example3, an investor is 35 years old, expect to retire at

67 and live for 13 years until age 80 and have no assets. To simplify, the assumptions are:

no taxes, real income labor adjusted for inflation is 250,000 kr. per year until age 67, and

the real interest rate is 3%.

1. Target replacement rate of pre-retirement income

When making a savings plan, it is recommended by experts to aim for a replacement rate

equal to 75% of pre-retirement income, which in this case is 0.75 x 250,000 kr. or

187,500 kr. per year. There are two steps in computing how much saving is needed to

achieve the preferred target:

1. First, compute the amount needed to have accumulated in the personal retirement

account when the retirement age is reached.

2. Then compute the annual amount of saving needed to reach that future value.

First, compute the amount an investor/saver need to have in the retirement fund at age 67

to be able to withdraw 187,500 kr. per year for 13 years.

3 Example taken from the book Finance by Bodie & Merton. Only the real income before retirement per year was adjusted to the Faroese situation and intentionally set at a lower end wages.

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N I PV FV PMT Result

13 3 ? 0 -187,500 kr. PV= 1,994,054 kr.

Next, compute how much is needed to save each year to have 1,994,054 kr. accumulated

32 years from now:

N I PV FV PMT Result

32 3 0 1,994,054 kr. ? PMT = 37,980 kr.

Therefore the conclusion from this procedure is that in order to be able to take out a

retirement benefit of 187,500 kr. per year for 13 years, one need to save 37,980 kr. per

year (3,165 kr. per month) in each of the next 32 years.

Given that the consumption during the working years will be 212,020 kr.(250,000 –

37,980) and the money available for consumption in retirement is only 187,500 kr., then

we need to find the right replacement rate (RR) higher than 75% until the right RR is

determined. After trying different RR, the suitable RR was established at 83% (pre-

retirement income of 207,500 kr.), which gives a PV of 2,206,753 kr. and a PMT of

42,031 kr.. Now the consumption before and after retirement are almost equal: 207,500

kr. ≈ 207,969 kr.(250,000 – 42,031). Therefore, the investor needs to save 42,031 kr.

each year for the next 32 years.

The second approach, which addresses the problem directly without trial and error search

will be described below.

2. Maintain the same level of consumption spending

In order to know how much to save if the goal is to spend the same amount on

consumption before and after retirement, one needs to take the real income before

retirement, 250,000 kr. minus the same amount in each of the next 47 years, denoted by

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C. At age 67, the total accumulation will be 52.503 kr. x (250,000 – C)4. The amount

withdrawn from the retirement account each year after 67 will be C. Its present value at

age 65 is 10.635C5.

To find C, set the two amounts equal to each other:

52.503 (250,000 – C) = 10.635C

C = 207,890 kr.

Therefore, consumption spending is 207,890 kr. per year. Annual savings during the

working years must, consequently, be 42,110 kr. per year (250,000 – 207,890). The

total accumulation of savings at age 67 will be 2,21,891 kr.6.

The table below will show the time profiles of income, consumption and saving assuming

that the income will be constant at 250,000 kr. until age 67 and then drops to zero

afterwards while consumption be at 207,890 kr. from age 35 to 80.

Table 2.2. Salary, Consumption, and Saving over the Life cyle (in kr.)

Age Salary Consumption Saving Human Capital

Retirement Fund

35 250,000 207,890 42,110 5,097,191 0

45 250,000 207,890 42,110 3,984,229 482,744

55 250,000 207,890 42,110 2,488,501 1,131,511

67 250,000 207,890 42,110 0 2,210,891

68 0 207,890 - 207,890 0 2,069,3287

70 0 207,890 - 207,890 0 1,773,333

75 0 207,890 - 207,890 0 952,063

80 0 207,890 - 207,890 0 14

Source: derived from the example in Bodie’s (2000) book but corresponding salary in kr..

4 N=32, i=3, PV=0, FV=?, PMT=1……FV= 52.503 kr.5 N=13, i=3, PV=?, FV=0, PMT=1……PV= 10.635 kr.6 N=32, i=3, PV=0, FV=?, PMT=42,110……..FV= 2,210,891 kr.7 N=1, i=3, PV=2,210,891, FV=?, PMT=-207,890…..FV= 2,069,328

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According to the table, given the labor income of 250,000 kr. per year for 32 years, the

human capital at age 35 will be 5,097,191 kr.8. On the other hand, the retirement fund is 0

at the age of 35 and accumulates until it reaches the maximum amount at age 67 and then

slowly decreases and be totally gone at age 80. Therefore, if the individual in this

example will live longer than 80 years (which is very common these days), he needs to

either lessen his consumption or increase his contribution to his retirement fund in order

to have enough money during retirement. As mentioned, the amount given on the table is

based on the assumption that the interest rate is constant at 3%. However, it is important

to acknowledge that interest rate has a great impact to the value of human capital,

permanent income and saving of an individual. The higher the interest rate, the higher the

level of permanent income will be and on the contrary, the lower the value of human

capital. Yet, even though the value of human capital is lower, it is still an advantage

having a higher real interest rate since the saving period occurred during the working

years. The table below shows this connection.

Table 2.3. Human Capital and Permanent Income as a function of the Real Interest

Rate

Real Interest Rate Human Capital9 Permanent Income10 Saving11

0 7,500,000 166,667 83,333

1 6,451,927 178,751 71249

2 5,599,114 189,864 60,136

3 4,900,110 199,852 50,148

4 4,323,008 208,639 41,361

5 3,843,113 216,220 33,780

6 3,441,208 222,648 27,352

10 2,356,728 238,951 11,049

Assumptions: The individual is currently 35 years old, expect to retire in 30 years at age 65 and then to live for 15 more years until age 80. The real salary is 250,000 kr. per year and does not have any assets.Source: Bodie (2000)

8 N=32, i=3, PV=?, FV=0, PMT=250,000……PV=DKK 5,097,191 9 N=30, i=0, PV=0, FV=?, PMT=250,000……FV= 7,500,000 kr.10 N=45, i=0, PV=7,500,000, FV=0, PMT=?....PMT= 166,667 kr. (change the corresponding PV and real interest rate)11 250,000 kr.– 166,667 = 83,333 kr.

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The table shows that interest rate is negatively correlated with human capital, positively

correlated with permanent income, and negatively correlated with saving.

Assuming that all assumptions mentioned above hold, how will a 100,000 kr. in a savings

account affect the individual’s future consumption? It means that he could increase his

consumption spending for the next 45 years by 4,079 kr. or maintain his consumption and

increase his savings thus bequest money for his beneficiaries.

In contrast, if an individual dies at 80 and wants to leave a bequest/inheritance of 100,000

kr. to his children, he needs to reduce his consumption by 1,079 kr. in each of the next 45

years to be able to leave inheritance.

But how will the consumption and saving be affected by the old-age pension from the

government and the work related pension? As of January 2008, a Faroese single retiree

gets basic and supplementary pension, 50,028 kr.and 37,712 kr. respectively, plus 26,760

kr. from the labor market pension fund (Samhaldsfasta), a total of 114,500 kr. per

annum12. Of this amount, 56,400 kr. is deductible; therefore, only 58,100 kr. is taxable

and assuming that income tax is at 40%, then a single individual will receive 91,260 kr.

(56,400 + 34,860) after tax income from the government. Additionally, if the individual

was employed prior to retirement, he will also receive the amount that he saved plus

interests and he can decide whether it will paid out as a lump sum (in cash) or in monthly

instalments. As a result, the retiree does not have to save the full amount recommended

but simply around half of 207,500 kr. annually.

To sum up, the two approaches are very similar but the second approach is without doubt

easier to calculate. Retirees who are entitled to old-age pension and other sources of

pension do not have to save as much for their retirement during their working years

therefore can increase their consumption or save up for something that they are dreaming

about for a long time.

12 More on the Faroese pension system in the following chapter.

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Critique of the Bodie’s two approaches

There is no doubt that the assumptions mentioned in his book are made for simplicity and

easy calculation but it is also very clear to all of us, that an individual’s consumption

varies depending on what stage of the life-cycle he is in. Consumption of individuals in

their 30’s and 40’s are generally higher than those in their 50’s and 60’s, therefore

assuming that consumption will be the same for many years is very unrealistic. It is often

assumed that individuals who are close to retirement usually own their homes and are

finished supporting their children through school and for that reason, have lower

consumption than before. Furthermore, the recommended savings per month seems to

high for an ordinary employee and even for a single person. Nevertheless, these

approaches are not totally useless, at least the readers got an idea on how much they will

need to save each year in order to enjoy the same lifestyle after retirement, and thus, it is

up to them how they will adjust their saving, depending on what stage of the life-cycle

they are in.

2.2.3. Life Cycle model of portfolio choice

Campbell and Viciera (2003) introduced the formula for the optimal share of stocks in

financial wealth as

α' = α + ( H t + F t ) = 1 + Ht μ - r f + σ 2 / 2

Ft Ft γσ2

where α’ indicates the optimal share of stocks with regards to human capital; H is the

human capital in kroner; F is the financial capital in kroner; μ is the expected log-return

on stocks; rf is the riskless rate; σ is the volatility on the stock market and γ is the

investor’s risk aversion. The optimal amount invested in stocks will be, α' F t , while the

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optimal amount invested in bonds will be (1 - α') Ft - Ht . When the income is like a risk-

free bond, the optimal share of stocks increases concurrently that the human capital

increases compared to the financial capital. Further explanation of human capital will be

in the next section.

2.2.4. Human capital

Human capital (HC) according to Campbell and Viceira (2002) is the expected present

value of their future labor earnings over the human life cycle. HC is composed of factors

that are fixed (inborn ability), which is basically fixed after a certain point (formal

schooling), and that vary with time (experience). Even though HC is a determinant of the

present value of lifetime earnings, it is not the only factor since individuals have the

choice whether to work and how much to work. Merton (2003) pointed out HCs

importance, its volatility and its correlation with other assets in asset allocation decisions.

In order to understand HC and its role in portfolio selection; we must imagine an

individual investor/consumer as a small private company, similar to the table below.

Figure 2.2. Extended household balance sheet

Assets Liabilities

Human capital

Financial capital Ordinary savings - Direct investments - Indirect Investments Pension savings

- Direct investments - Indirect savings

House Investment

Tax on future income

Deferred tax On ordinary savings Pension savings

House financing

Own capital (Net capital)


The balance sheet above looks like a traditional statement except for human capital.

Inclusion of human capital on the balance sheet will certainly ensure that it will be an

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integrated part of the overall advice. For the average investor, HC is the largest

component of his assets and it is dominant/ maximum for younger persons (as can be

seen in figure 2.3 ). Financial capital accumulates as the individual gets older and

increase his income or get returns from his investments.

Figure 2.3. Relationship between Human capital and Financial capital


The figure shows how human capital is connected to financial capital. They come from

the opposite direction and as an investor grows older; his human capital gets depleted and

converted to consumption and savings and at the same time, his financial capital gets

larger. As mentioned in the introduction part, total wealth is the combination of human

capital and financial capital.

An investor’s human capital comes from income from work. He can increase his HC by

obtaining higher education or specializing in whatever he is doing since it will have a

positive effect on his income. The risk of HC depends on how stable the income is, which

will also depends on the investor’s profession and employment situation. In one of his

articles, Larsen (2007) wrote that an individual’s human capital can be compared to being

“stock-like” or “bond-like” type. If the income is relatively uncertain and market

dependent, then HC resembles more of a “stock”. This means that financial assets should

be allocated more in bonds, when a part of the total wealth is already placed in stocks in

19

form of “stock-like” human capital. On the other hand, if the income is relatively certain

and in uncorrelated with the market then HC resemble most of a “bond”. Again, this

means that a bigger share of the financial assets should be allocated to stocks. The table

below will illustrate this:

Table 2.4. Optimal positioning of the Total Wealth classified as HC and FC with

regards to Stocks and Obligations.

Independent Stocks Bonds

Amount Share Amount Share

Human Capital 3 million 100 % 0 million 0 %

Financial Capital 0 million 0 % 3 million 100 %

Total Wealth 3 million 50 % 3 million 50 %

Public Sector Stocks Bonds

Amount Share Amount Share

Human Capital 0 million 0 % 3 million 100 %

Financial Capital 3 million 100 % 0 million 0 %

Total Wealth 3 million 50 % 3 million 50 %

Source: Larsen, Anders Lund, 2007: Lønindkomstens betydning for porteføljevalget – Er du en aktie eller en obligation?, Finans Invest, Marts, nr. 2

As table 2.4 illustrates, income’s risk profile plays a critical role in allocating financial

assets. Individuals with market-sensitive income and correlated with the stock market

should allocate a smaller portion of their financial wealth in stocks. On the contrary,

those with steady income and not correlated with the stock market can place a larger

portion of their financial wealth in stocks.

It is important to remember though that when a wage earner dies, HC will immediately

drop to zero and in turn will affect the total wealth. Thus, it is necessary that the wage

earner hedges this mortality risk by getting a life insurance. According to Chen et al

(2006), life insurance is the perfect hedge for HC in the event of death because term life

20

insurance and HC have a negative 100% correlation with each other in the “alive” state

versus “dead” state. To demonstrate the types of decisions the investor faces, together

with the variables that affect the decisions, see figure 2.4.

Figure 2.4. Relationships among Human Capital, Asset Allocation, and Life

Insurance

Source: Chen, Peng et al (2006)

The figure clearly shows the connection between the variables and any decision by the

investor regarding e.g. human capital will definitely affect his financial capital and the

other two variables. The altering combination of financial capital and human capital over

an individual’s life-cycle affects the allocation of his financial assets. It can be said that

most favorable asset allocation depends on the risk-return characteristics of assets and the

flexibility of the individual’s labor income.

Through the years, many scholars and academics introduced different frameworks and

models to help investors to manage their financial portfolios and as years go by, the

difference between them is getting clearer. Therefore, in one of his article, Bodie (2003)

summarized the distinction between the old and new paradigm for personal financial

management which emphasized that welfare is measured by lifetime consumption, not by

wealth.

21

Table 2.5. Summary of Old and New Paradigm for Personal Financial Management

Feature Old paradigm New paradigm

Measure of welfare Wealth Lifetime consumption

Time frame Single period (stocks seem

safe in the long run)

Many periods (stocks are risky

in short and long run)

Risk management techniques Precautionary saving

Diversification

Precautionary saving

Diversification

Hedging

Insuring

Retail financial products Cash

Insurance policies

Mutual funds

Targeted savings accounts

(e.g. tuition-linked certificates

of deposits)

Structured standard-of-living

contracts

Quantitative model Mean-variance efficiency

and Monte Carlo simulation

Dynamic programming and

contingent analysis

Capital market expectations Estimated from historical

statistics

Inferred from the current

prices of financial

instruments

Source: Bodie, Z. (2003): Life Cycle Investing in theory and in Practice, Financial Analysts Journal,

Jan/Feb 2003

Furthermore, Bodie (2003) illustrated in table 2.4 that the risk management techniques of

the new paradigm are very different from the old paradigm approach of saving and it is

due mainly to diversification strategies, expecting that the portfolio will last for the whole

of retirement regardless of trends in personal spending, longevity, inflation, and

investment volatility. It does not mean that the old paradigm was wrong in the first place;

rather something better always turns up and the process continuous. It is the investors

who are benefitting from these new models since advisors are using the newer models in

advising.

22

3. Frameworks for advising

Today, there are many frameworks or models for advising investors available in the

market, which is highly recommended by different academics and scholars. A few of

them will be described below:

3.1. Bodie, Treussard, and Willen

Since life-cycle saving and investing are today a subject matter which could be of

assistance to millions of people globally, the authors chose to develop this framework

using uncomplicated models, avoiding mathematical equations and focus on several key

concepts. The crucial role of consumption in life-cycle planning was emphasized here as

well as the use of financial assets as way to transfer consumption through various phases

in life-cycle. This framework could be a valuable guide to financial institutions in helping

them to develop and explain products that ordinary people can understand.

3.1.1. Three principles from the life-cycle approach13

Principle 1: The focus should be on the consumption profile instead of the financial plan

itself. As shown in figure 3.1, consumption is calculated by deducting savings from the

income during the working years, and withdrawals less health expenses in retirement.

Principle 2: Financial assets should be viewed as means of transportation for moving

consumption from one location in the life-cycle to another. For example, if the investor

wanted to increase consumption in youth then he could reduce his saving in youth and

leave the amount saved unchanged in his prime earning years, as a result, he could

transfer consumption from retirement to youth. Furthermore, if he reduced his saving in

youth but raise his saving in middle age, he then could transfer consumption from prime

earning years to youth14.

13 Source: The theory of Life-cycle Saving and Investing by Bodie et al (2007)14 Moving consumption over the life cycle is at the heart of life-cycle planning.

23

Principle 3: A dollar is more valuable to an investor in situations where consumption is

low than in situations where consumption is high. For example, an additional kroner is

much more valuable to a recent college graduate, when his consumption is lowest, than to

a middle-age executive, when his consumption is high.

Looking at the suggested consumption over the life-cycle in the figure below, it is

apparent that there is huge difference. Employing the third principle, it is possible to

improve the situation by trying ton move consumption form situations with high

consumption to situations with low e.g. consumption in youth (85,000 kr.) is much lower

(and consequently more valuable) than it is on average in prime earning years (250,250

kr.), assuming that the high- and low-income paths are likely. By saving less in youth and

more in prime earning years, the investor could transfer consumption from a low-value

situation to a high-value situation and make himself better off.

24

Figure 3.1. The life-cycle model – an Event tree

Expenses: 22,700 kr. Advice: Withdraw 227,000 kr a year

Consumption: 204,300 kr. Income: 455,000 kr. a year a year

Advice: Save 91,000 kr. a year Consumption: 364,000 kr.

a year

Expenses: 68,100 kr. a year Advice: Withdraw 227,000 kr a year

Consumption: 158,900 kr. a year

Income: 130,000 kr. a yearAdvice: Save 45,000 kr. a yearConsumption: 85,000 kr. a year Expenses: 22,700 kr. a year

Advice: Withdraw 227,000 kr. a year


Income: 227,500 kr. a year Advice: Save 91,000 kr. a year Consumption: 136,500 kr.

a year Expenses: 68,100 kr. a year

Advice: Withdraw 227,000 kr. a year


Source: Bodie, Z. et al (2007): The Theory of Life-Cycle Saving and InvestingNote: The original amount in the article is in US$ but to best fit the target group, amounts used were in Danish kroner. The income is after-tax income (35% tax) and the proportion of the amounts i.e. income, saving and consumption were the same as the example in the article. See Appendix ????

3.1.2. Five key concepts form the life-cycle model15

15 Taken from the article “ The theory of life-cycle saving and investing” by Bodie et al (2007)

25

(1) Youth (21-35)

(2)Prime Earning Years (36-65)

(3) Retirement

(66-80)

(HG) Good Health

(H) High Income

(HB) Bad Health

Start

(LG) Good Health

(L) Low Income

(LB) Bad Health

There are five concepts directly significant to the practice of life-cycle planning and these

are: (1) the concept of a lifetime budget constraint, (2) the relevance of contingent claims

in life-cycle planning, (3) the trade-off imposed by varying costs of consumption over

one’s lifetime, (4) the role of risky assets, and (5) asset allocation over the life- cycle.

Insight 1: The lifetime budget constraint

This follows directly from Principle 2 above, which imply that under certain conditions,

household consumption over the life-cycle depends entirely on the present discounted

value of lifetime income and not on the evolution of the income itself. According to the

life-cycle model, if there are two investors with the same total wealth, under certain

conditions, then their consumption decisions over the life cycle will be the same, in spite

of the shape of their actual income profiles. It does not matter whether that one investor

inherited 3 million kr. and decided to stop working afterwards and the other one who’s 35

years old college graduate and has a financial wealth of 400,000 kr. plus human wealth of

about 2.6 million kr.. Even though these two investors look very different, according to a

simple version of life-cycle theory they are similar.

Insight 2: The importance of constructing “contingent claims”

In Insight 1 it is mentioned that investors can use financial assets to transform their

income and expense stream equal to their financial wealth/capital but it is not specified

how. This concept will focus on how to accomplish this. First, if future income and

expenses are definite, then investors can convert them into additions and subtractions

from current wealth by simply borrowing and/or saving the appropriate amounts. For

example, he knows that he will earn 455,000 kr. five years from now and if interest rate is

fixed at 5 %, then he has the possibility of increasing his current liquid wealth by

borrowing as much as 356,504 kr. and pay back the money (plus interest) from future

earnings. But in reality, things are not that easy since random outcomes exist. Using

figure ?? (event tree) again, along (H) High Income path, he earns 455,000 kr. a year and

assuming that there is zero interest rate, he could borrow that amount and be able to pay it

when he is 45. But what if he earns (L) Low Income instead, then he does not have

enough to pay the loan as his salary will only be 227,500 kr. Therefore, he could convert

26

his future income along the low-income path into current income by shorting 227,500 kr.

of the low-income asset, and likewise, his income along the high-income path using high-

income asset. Furthermore, contingent claims also help if there is any problem with

inflation. An investor is certain that he will earn 300,000 kr. next year but he is uncertain

about inflation, it could either be 0 or 10%. Then the investor’s real income along one

path would be 300,000 kr. in real spending power and on the other path, 270,000 kr. if

contingent claims are created then the investor can follow Principle 2, to shift

consumption from the low-inflation event o the high-inflation event. However, there are

limits to contingent claims. It works well if both parties can confirm the event in question

and neither party can affect or has better information about the chance of the event’s

occurring. Also, the creation of contingent claims requires that the investor clearly

understand the risks involved.

Insight 3: The Prices of securities matter

Contingent claims were discussed above but nothing was mentioned about the price of

this. To demonstrate some of the issues on how it is priced, let’s say an investor will have

two equally possible incomes in the future: H and L.

Table 3.2. Understanding the role of the prices of contingent claims.

Scenario

H L

Probability 50 % 50 %

Initial consumption 100,000 kr. 50,000 kr.

Expected consumption 75,000 kr. 75,000 kr.

Certainty equivalent 70,710 kr. 70,710 kr.

Baseline Prices

H L

Price of contingent 50 øre 50 øre

Strategy Sell 25,000 kr. Buy 25,000 kr.

27

Cost -12,500 kr. 12,500 kr.

New consumption 75,000 kr. 75,000 kr.



Alternative Prices

H L

Price of contingent claim 40 øre 60 øre

Strategy 1 Sell 25,000 kr. Buy 25,000 kr.

Cost -10,000 kr. 15,000 kr.





Cost -12,000 kr. 12,000 kr.





Cost -5,000 kr. 5,000 kr.




Source: Bodie Z. et al (2007)Note : this is a replica of the table in the article by Bodie except for the currency, it was originally in US$

The above example illustrates an investor who has two equally probable outcomes in the

future: consumes 100,000 kr. in the high-income outcome (H) and consumes 50,000 kr.

in the low-income outcome (L). The expected consumption is just the average of the H

and L outcomes. The certainty equivalent is the level of certain consumption that would

make him happy. If a financial planner will help him out by offering a set of contingent

claims, paying 1 kr. in both outcomes. In the baseline case, the contingent claims cost 50

øre, then the planner recommended to the investor to short 25,000 kr. of H outcome

income by shorting the contingent claim and long 25,000 kr. of L outcome income by

longing the L outcome contingent claim. Now, the investor consumes 75,000 kr. in both

28

outcomes, shifting from the high income to the low income. In the alternative cases, the

price of contingent claim is slightly different, and the investor is asked to short three

different amounts at different costs. Consumption differs in every alternative but the

process is the same as the baseline case. Overall, the table demonstrates that the most

favorable plan depends on the price of the contingent claims. It shows that only one of

the cases that it was possible to get rid of variability from consumption. In the baseline

scenario, there was no risk premium and therefore no incentive for the investor to take on

risk, while it was the opposite in the alternative scenario since risks are involved.

Insight 4: Risky assets in the life-cycle model

The benefit of the risky assets is one of the most important insights of the life-cycle

model. In this model, risky assets are viewed as a way to move money across different

outcomes at a given time and not as a way to transfer resources across time. For example,

an investor who lives for two years, this year and next year wherein there are two

possible outcomes, good times and bad times. He can invest in a bond that pays 5% on

both outcomes and a stock that increases 30% in good time and falls by 5% in bad times.

The figure below will illustrate this event tree:

29

Figure 3.2. The role of risky assets in the life-cycle model

THIS YEAR NEXT YEAR

“Good Times”

Bond + 5 % - 105 kr.

Stock + 30 % +130 kr.

Payoff = + 25 kr.

Start

Bond - 100 kr. “1” “2”

Stock + 100 kr.

Investment = 0 “Bad Times”

Bond + 5 % - 105 kr.

Stock - 5 % + 95 kr.

Payoff = - 10 kr.

Source: Bodie et al (2007)

The figure shows that the investor’s portfolio is composed of 100 kr. of stock, financed

by a short position in the bond. The portfolio costs zero today and next year, pays 25 kr.

in good times and – 10 kr. in bad times. In short, it is possible to convert 10 kr. in bad

times into 25 kr. in good times (“2”). To transfer money across time, the investor can use

the bond, which allows him to exchange e.g. 100 kr. today for 105 kr. in both times in the

future (“1”). Let us say that the results are equally probable, but it is vital to remember

that the purpose of financial planning is to smooth consumption across outcomes so we

need to be sure that this what the investor wants. Actually, he probably would like to

transfer income jus the opposite way, that is, if “good times” meant employment and

“bad times” meant joblessness.

Insight 5: Asset allocation over the life-cycle

Some practitioners and even academics argue that investors should reduce the proportion

of their portfolio in risky assets as they age. Depending on the situation, this

recommendation can be right or wrong. First, compare a young retired investor

30

(expecting to live another 21 years) with an old retired investor (expecting to live only

another 11 years), both living entirely on their financial wealth.

Table 3.1. Understanding the role of age on portfolio choice in a life-cycle model

Young Retiree Old Retiree

This Year

# of years remaining in life 21 11

Consumption / Wealth 1 / 21 1 / 11

Wealth 2.1 m kr. 1.1 m kr.

Consumption 100,000 kr. 100,000 kr.

Investment 2 m kr. 1 mkr.

Next Year

# of years remaining in life 20 10

Consumption / Wealth 1 / 20 1 / 10

L H L H

Bond Return 0 % 0 % 0 % 0 %

Stock Return - 50 % 100 % - 50 % 100 %

Strategy 1: All Bonds

Wealth 2 m kr. 2 m kr. 1 m kr. 1 m kr.

Consumption 100,000 kr. 100,000 kr. 100,000 kr. 100,000 kr.

Strategy 2: All Stocks

Wealth 1 m .kr. 4 m kr. 500,000 kr. 2 m kr.


Strategy 3: 50 / 50

Wealth 1.5 m kr. 3 m kr. 750,000 kr. 1.5 m kr.


Source: Bodie et al (2007)

The table shows that if one expects to live 21 years (including this year) then one should

consume one-twentieth of one’s wealth. For simplicity, it is assumed that both retirees

have sufficient wealth to guarantee consumption of 100,000 kr. this year, which means

that the young retiree has almost double the wealth of the old retiree. We noticed that the

young retiree is consuming only half of what the old retiree does which implies that the

young retiree can absorb a loss more easily but the consumption for the two investors

31

under two different allocation strategies is identical. It also shows that a 50 % reduction

in wealth leads to a 50 % reduction in consumption for both investors and even though

the young retiree’s wealth falls more but that level effect was offset by consuming a

smaller fraction of his wealth. This could give the impression that the life-cycle theory

has little advice to offer on asset allocation but the fact is because of the labor income

contribution, the percentage of financial wealth/capital invested in risky assets can vary

significantly over the life-cycle.

3.2 Malkiel

According to Malkiel (2003), there are some general rules that could be useful to most

individuals at different stages of their lives. However, it is important to keep in mind that

no guide will exactly fit every individual case; therefore any plan would require some

adjustments to fit the individual’s situation.

3.2.1. Guidelines to a life-cycle investment plan16

There are three broad guidelines which could help in constructing an investment plan to

an individual’s situation.

1. Specific Needs Require Dedicated Specific Assets

It is important to remember that any specific need must be funded with specific assets set

aside for that need. For example, if a young couple planning to build a retirement nest-

egg expects to need 200,000 DKK for house down payment in one year’s time then to

meet that need, the amount should be invested in a safe security, maturing when the

money is required i.e. one-year certificate of deposit. In the same way if college tuitions

will be needed in three, four, five, and six years, then funds can be invested in zero-

coupon bond securities with the corresponding maturity or in intermediate-term bond

mutual funds. This is to ensure that the money needed will be secure and will be available

when needed.

16 From the book “A Random Walk Down Wall Street” by Burton G. Malkiel

32

2. Recognize the Individual’s Tolerance for Risk

Risk tolerance is the level of uncertainty that an individual/investor can handle in regards

to a negative change in the value of their portfolio. It is a major determinant of portfolio

choices and could be influenced by e.g. age, family status, wealth, income requirements

or financial goals. For example, a 70 year old widow would generally have lower risk

tolerance than a 30 year old director. Therefore, it is crucial for the advisor to ask the

investor his risk tolerance before recommending any asset allocation/financial plan.

There are several financial experts e.g. William E. Donoghue, who developed

questionnaires for determining risk tolerance level, which could be useful for advisors.

3. Constant Saving in Regular Amounts, No Matter How Small, Pays off

Many people especially those in their 30’s, who are just starting their family believe that

it is impossible to build up a sizable nest egg since they do not have any money left after

the house mortgage, car payments and all other bills are paid. And to a certain extent,

they are right that it is hard to save when there is nothing to save but no matter how small

the amount of money is save every month, can in time produce considerable sum of

money. The possibility of accumulating a large retirement fund is easily attainable if

there is still many working years in the future or if the remaining working years are not

that many, then the only option is to save more to reach the target amount.

3.2.2. Life-Cycle Investment Guide: Recommended Asset or Saving

Allocations17

1. Age Mid-twenties

Lifestyle: Fast, aggressive. With a steady stream of earnings, capacity for risk is fairly

high. Need discipline of payroll savings to build nest egg.

17 Lifted from the book ”A Random Walk Down Wall Street”

33

Age: Mid-Twenties

Stocks (65%)

Bonds (20%)

Real Estate (10%)

Cash (5%)

CASH (5 %): money-market fund or short-term-bond fund (average maturity 1 to

1½ years).

BONDS (20 %): zero-coupon Treasury bonds, no load high-grade bond fund,

some Treasury inflation protection securities (5% of portfolio).*

STOCKS (65 %): two-thirds in stocks with good representation of smaller growth

companies; one-third international stocks, including emerging markets.

REAL ESTATE (10 %): portfolio of real estate fund

2. Late Thirties to Early Forties

Lifestyle: Midlife Crisis. For childless career couples, capacity for risk is still

quite high. Risk options vanishing for those with college tuitions looming.

CASH (5%): money-market fund or short-term-bond fund (average maturity 1 to

Age: Late Thirties to Early Forties

Stocks ; 55%Bonds ; 30%

Real Estate; 10%

Cash ; 5%

34

1½ years).

BONDS (30%): zero-coupon Treasury bonds, no load high-grade bond fund,


STOCKS (55%): two-thirds in stocks with good representation of smaller growth

companies; one-third international stocks, including emerging markets.

REAL ESTATE (10%): portfolio of real estate fund.

3. Age: Mid-Fifties

Lifestyle: Many still reeling from college tuitions. No matter what the lifestyle,

this age group must start thinking about retirement and the need for income protection.


1½ years.

BONDS (37½%): zero-coupon Treasury bonds, no load high-grade bond fund,


STOCKS (45%): three-quarters in stocks with good representation of smaller

growth companies; one-quarter international stocks, including emerging markets.

REAL ESTATE (12½%): portfolio of real estate fund.

Age: Mid-Fifties

Stocks ; 45%

Bonds ; 37½%

Real Estate; 12½%

Cash; 5%

35

4. Age: Late Sixties and Beyond

Lifestyle: Enjoying leisure activities but also guarding against major health costs.

Little or no capacity for risk.

Age: Late Sixties and Beyond

Stocks ; 25%

Bonds ; 50%

Real Estate; 15%

Cash ; 10%


1½ years).

BONDS (50%): zero-coupon Treasury bonds, no-load high-grade bond fund,


STOCKS (25%): primarily high-quality stocks with some representation of

smaller growth companies.

REAL ESTATE (15%): portfolio of real estate fund.

* If bonds are to be held outside of tax-favored retirement plans, tax-exempt bonds

should be used.

To sum up the guide above, for those in their twenties, it is recommended to have an

aggressive portfolio since at this age, there are a lot of times to survive the ups and downs

of the investment cycles and their human capital is at its peak and definitely larger than

financial capital. Aside from domestic stocks, it is advisable to diversify internationally

since it is believed that economic activities in different countries are not perfectly

correlated thus producing a more stable returns from year to year than one invested only

in domestic stocks. Furthermore, international diversification allows an investor to

achieve exposure to other growth areas in the world. As investors get older, they should

start cutting back on riskier investments since its attractiveness diminishes as human

capital declines and financial capital accumulates. It is a good idea to start increasing the

36

proportion of bonds and stocks that pay generous dividends. By the age fifty-five,

investors should begin thinking about the transition to retirement and changing the

proportion of bonds and stocks in their portfolio. In retirement, Malkiel (2003) mentioned

a rule of thumb to make the proportion of bonds almost equal to one’s age while the rest

divided between regular stocks and real estate.

As stated earlier, this guide will not suit everybody’s situation therefore some

adjustments could be made to fit the situation of the investor.

4. Retirement planning

Franco Modigliani received a Nobel price in 1985 for his work of being the creator of the

Life-cycle hypothesis, which aims to describe the level of saving in the economy. He

recommends that consumers should aim for a stable level of income throughout their

lifetime e.g. by saving during their working years and spending during their retirement as

can be seen if figure 4.1. It is divided into two phases, the active or saving phase and the

retirement or dissaving phase.

Figure 4.1. Life – cycle Theory


37

The figure above simply illustrates that the saving phase typically starts at age 25, when

an individual starts to earn money and be able to save for the future, until age 65, when

an individual usually retires. Naturally, the age differs from individual to individual and

which country we are talking about. In contrast, dissaving phase starts after retirement

where the individual will start receiving monthly pension from the government, insurance

companies, financial institutions (where he saved) and so on.

4.1. Active (saving) phase

Human capital, as mentioned in the previous chapter, is the main mechanism that could

initiate this phase whether individuals are paying for the mortgage of their homes, saving

for pension or investing on stocks or bonds. As long as the individual can work and get

paid for it then saving is possible. The saving phase in the figure above is equivalent to

financial capital illustrated in figure 2.3 and the upward movement of the saving phase is

feasible from the time an individual starts working and gets paid for it until he stops

working and retire for good since his saving accumulates in the long run. In some

instances, retirees continue to work part-time even after retirement but their income (not

including pensions), however it does not add to the upward movement, rather it only

compensates for the loss income during their working years.

Supposedly, the active phase or saving phase commences when an individual has residual

income after paying the necessities, mortgage, pension savings and other expenditures,

more often than not, invest their money on something e.g. stocks, bonds, real estate (aside

from their homes), fixed capitals and so on, which can be used for saving or other

purposes. Indirectly, paying a mortgage and owning a home is a kind of saving through

the equity of the house once it is sold or when it is sold in the market. Additionally,

saving for pension, whether it is involuntary or voluntary are included in this phase18.

If investors believe that they are familiar with the basics of investing, then they can

manage their own portfolio, otherwise, they need to avail themselves of good financial

18 Pension will be thoroughly discussed in the next chapter

38

advisors who can help them in developing their portfolios successfully. If their portfolio

is well-managed, the investments could provide them with extra income which may

possibly increase their saving or financial wealth.

For example, in Denmark, there is one framework which is now generally used when

advising called Investment Policy Statement (IPS). At present, it is only applied in the

pension’s sector; perhaps in the near future it will also be applied in advising private

individuals and companies, just like in the USA and England. The next section will

present this framework.

4.1.1. Investment Policy Statement

It is a fact that excellent financial advising is difficult to put in writing and many

experienced advisors rely mostly on their knowledge from past experiences and then

combine it with their intuitions. Some of them will most probably agree that they do not

need a framework in advising their clients. However, time and again some financial

advisors have not made an effort to identify the real needs and preferences of their

clients. For that reason, a framework in advising which focuses on investors’ real needs

and risk tolerance was introduced to resolve the problem. This framework is called

Investment Policy Statement (IPS), a popular framework used today in financial advising

all over the world and the most significant phase in portfolio advising process. Although

following the framework will not guarantee a perfect advising, it would serve as a good

starting point19.

19 Source: Michael Andersen’s article, Investment Policy Statements (2006)

39

Figure 4.2. Portfolio Advising Process

Planning Phase Implementation- & Feed Back Phase

Source: Andersen, Michael (2006)

The figure above shows the different phases involved in the advising process, which is

divided into three phases namely: a planning and analyzing phase, an implementation

phase, and a feed back phase.

- Planning phase is the most important phase and consists of two major elements:

a thorough customer analysis, wherein IPS is executed, and a capital market

analysis.

- Implementation phase consists of the concrete portfolio construction and changes

herein i.e. strategic allocation, portfolio optimization, and securities selection

- Feed back phase consists of a continuous monitoring of client’s and capital

market’s conditions besides performance assessment and evaluation of the

portfolio with regards to the client’s investing objectives.

Investopedia defined Investment Policy Statement (IPS) as a document drafted between a

portfolio manager and a client that outlines general rules for the manager. This statement

provides the general investment goals and objectives of a client and describes the

40

Investment Policy Statement: Investor’s Objective,limitationspreferences

Portfolio Strategies

Capital Market’s expectations

Monitoring of investor-related Conditions

Portfolio Construction, - revision & - implementation - Strategic asset allocation - Portfolio Optimization- Securities Selection

Monitoring of Economic, Political and Market related Conditions

Performance Measurement & Evaluation

Relevant Economic, Political& Market related Considerations and Expectations

strategies that the manager should employ to meet these objectives. Specific information

on matters such as asset allocation, risk tolerance, and liquidity requirements would also

be included in an IPS20. According to Andersen (2006), IPS clearly specifies

client’s/investor’s returns on investment objectives and risk tolerance. Every IPS is

principally unique and tailored to the client’s overall economic situation. There are five

investment-related limitations that are generally very diverse by nature but not

independent from each other.

- Liquidity requirements: it is of great importance to the portfolio particularly that

different asset classes have different liquidity properties. Not only with regards to

the disposal time but also with regards to the amount of transaction costs. As a

minimum requirement, all significant known future liquidity needs should be

specified precisely with regards to time and amount.

- Investment horizon: most theorists and practicians are convinced that the longer

the investment horizon is, the bigger investment risks an investor can take. This is

mostly based on the human capital argumentation Campbell and Viceira (2003)

introduced in the previous chapter. Many investors and some financial advisors

still overlook the fact that risk is investor-dependent since some are risk averse

and others are tolerant to risk. The most secure asset for long-term investors are

state issued index obligations that matches the investment horizon, otherwise long

nominal fixed state obligations will do if they are convinced of the Central Bank’s

prophecy of low-inflation regime. Unfortunately, some investors do not know

their exact investment horizon and for this reason unable to be specific. In

contrast, most investors are quite sure of their investment horizon. Age and life’s

phase are common indicators on how long the horizon will be.

- Tax consideration in financial advising is definitely essential competency for

financial advisors since returns will be calculated after all expenses including

different company and investor’s tax are deducted. Tax advising comes in

different levels and is generally investor-dependent. Institution’s pension

investors’ tax conditions are very different from private individual’s savings.

20 Lifted from www.investopedia.com/terms/i/ips.asp

41

http://www.investopedia.com/terms/i/ips.asp

- Legal and Regulation-related conditions (external conditions): the outside world

can usually restrict investment opportunities drastically by stipulating

requirements i.e. which asset-classes is allowed to invest in; fluctuation

boundaries for portfolio-share in the individual asset-classes; spread requirement

for all or for chosen asset-classes.

- Unique Circumstances ( internal conditions): all other circumstances other than

the four mentioned before, which restrict investment opportunities e.g. asset-class

limitations, land limitations, sector limitations, Specific asset consideration, ethics

consideration, inheritance consideration.

Scott Frush (2004) emphasized the importance of Investment Policy Statement (IPS) in

his book, Optimal Investing and compared it to a blueprint of a house. IPS serves as the

blueprint for building an individual’s optimal portfolio and is fundamental to the long-

term success of some financial goals. Mainly, an IPS assists an investor to learn more

about what his needs and priorities are and how to best address them, and the risks

involved with investing. Secondly, this policy allows both the investor and his portfolio

manager (if there is one) to get a better understanding of the goals and limitations, and

how to best manage the portfolio to accomplish the specific financial goals. An IPS will

not alone guarantee success in protecting and growth of the optimal portfolio, it will also

shelter the portfolio from ad hoc revisions (made by either you or your portfolio

manager) as well, from a sound long-term asset allocation policy. Taken as a whole, an

IPS will ensure that individual clients gets sufficiently high degree of information and the

necessary advising to be able to make a decision based on well-informed foundation.

There are many other schemes to enhance an individual’s saving besides the one

discussed above, it depends on what scheme he is interested in and is capable of.

42

However, there is probably just one way of dissaving, that is by using or taking out the

accumulated savings.

4.2 Dissaving phase

After many years of taking advantage of human capital and at the same time

accumulating financial capital, comes the time for an individual to retire and benefit from

whatever form of saving he made during his working years or the saving phase. This

would be the start of the dissaving phase.

Retirement age varies around the world, nevertheless whether it is 60 or 67 years old,

retirees need a source of income in order to survive. The big challenge now is how to get

most out of the total amount of assets accumulated, for the rest of the retirees’ life,

whether their saving is in form of pension savings, equity from their homes or free funds

in securities etc. Most Europeans are lucky since old-age pension plus other forms of

pension funds are available to eligible retirees, therefore the minimum amount of

retirement income will enable retirees to manage going on with their lives though with

some constraints. Furthermore, retirees who were active in the labor market will also

receive employer-sponsored pension and those who invested in some securities, real

estates or other kinds of investments, will also get additional income, which could allow

them to continue living almost the same or better lifestyle than they had pre-retirement

time and enjoy life as they have plenty of free time now. But the big question is, whether

their savings will be enough during their remaining years.

In 2005, Milevsky and Robinson came up with an instinctive and reliable planning model

by deriving an analytic relationship between spending, aging, and sustainability in a

random portfolio environment. They are basing their analysis on the Stochastic Present

Value (SPV) and a continuous-time approximation under lognormal returns and

exponential lifetimes. The figure below can illustrate the analytic relationship between

the three:

43

Figure 4.3. Retirement Finances Triangle

Spending and Consumption

Health, Age, Asset Allocation And Mortality and Investments Source: Milevsky, M.A. and Robinson, C. (2005)

According to Milevsky and Robinson (2005), the triangle gives a graphical illustration of

the connection between the three most important factor n retirement planning: spending

rates, investment allocation, and mortality (determined by gender and age). The link

between these three factors is referred to as the probability of retirement ruin, where ruin

means outliving one’s resources or retirement savings. Increasing the age of retiree at

retirement, reducing the spending rate, or increasing the portfolio return will each shift

the mass of SPV closer to zero (which means reducing the area inside the triangle) and as

a result generate a higher probability that the initial nest egg will be enough to sustain the

plan. On the other hand, the opposite will increase the probability of ruin.

In contrast to the deterministic case wherein both the horizon and the investment return

are definite, SPV is a random case since both variables are stochastic and it is defined as:

Ť i

SPV = Σ Π (1 + Řj )-1

i=1 j=1

where the new variable Ť denotes the random time of death (in years) and the new

variable Řj denotes the random investment return during year j. (For the infinitely lived

endowment or foundation, Ť = ∞.) The perception for this equation is that, the retiree

must sum up a random number of terms, in which each denominator is also random. The

44

Probability of Retirement Ruin

first item discounts the first year of consumption at the first year’s random investment

return. The second item discounts the second year’s consumption (if the individual is still

alive) at the product (the compounded rate) of the first and second years’ random

investment return. And so on.

5. An alternative framework for advising

After analyzing the different frameworks presented in the previous chapters, it can be

concluded that all of them are usable, although some parts are unrealistic. Therefore, the

author will attempt to develop an alternative framework which is based on these

frameworks. Selecting the best parts of each framework and put it all together in such a

way that it would comprehensible to both the investor and the financial advisor.

Since IPS serves as a foundation for all future investment decisions to be made by an

investor, it should be the first step an advisor should make. Although IPS is normally

used by large investors, it could also be useful to individual investors. Creating a simpler

questionnaire for the investor which will reveal his:

- financial situation i.e. assets, liabilities, income, any business and how much money

he is intending to invest

- purpose of investing e.g. pension saving, private saving or for business

- experience and knowledge about different types of securities

- time horizon: when is he going to need the money

- risk tolerance: risk averse, somewhere in the middle, or risk taker

Being able to identify all these facts will provide the advisor all the necessary information

about the investor so that he could advise him appropriately according to his needs, goals,

risk tolerance and limitations. This could be the standard questionnaire the advisor could

give to the investor to fill out when he comes into the bank/institution for advice. The

advisor could guide them in answering the questions if he is in doubt. In Denmark, most

banks/financial institutions have this questionnaire available online for their customers,

who are advised to fill this prior to the meeting with the financial advisor. It is an

45

advantage for the customers to be able to fill out the questionnaire at home and wait

answering the difficult questions when the advisor is present.

Figure 4.2 in page 39 is a very important diagram since it shows the whole process in

portfolio advising, from IPS to strategy development and afterwards, to the actual

portfolio construction with all the elements. If the purpose of the investor is to save for

his pension, then the advisor can look at Bodie’s Three principles from the life-cycle

approach in page 22 and the Five key concepts from the life-cycle model starting from

page 2521. If the investor wishes to invest his money in securities, the advisor can refer to

the Life-cycle investment guide of Malkiel starting from page 32. Although, the author

commented that Bodie’s two approaches in computing how much and individual needs to

save for retirement (starting from page 11) is a bit unrealistic to save more than 3,000 kr.

a month, it could still be helpful in estimating how much he needs to save to have good

retirement years later in life. Adjustments can also be calculated for different

circumstances e.g. if he has savings prior to his decision to save for retirement or if he is

getting pension from the government or other pension funds. These adjustments could

lower the suggested savings every month and thereby making the amount more

reasonable. In the midst of all these guidelines, there is one that stands out: Constant

saving in regular amounts, no matter how small, pays off. There is no guarantee that this

alternative guideline based on life-cycle theory will work out but the only way to find out

is to give it a try in the Faroe Islands.

6. The Structure of the Faroese Pension System

The Faroese pension system is approximately the same as the Danish pension system,

with a few minute distinctions. It is based on three pillars principle where the first pillar

is publicly-funded scheme (tax-funded) or social security scheme on a pay-as-you-go

basis, the second pillar is employer-sponsored scheme or private mandatory scheme, and

the third pillar in the system is voluntary payment arrangement by the individual. These

21 It is the author’s intention from this part to only refer (not re-write again) to the frameworks and page number to avoid duplication.

46

payments will serve as a supplement to the tax-funded and the employer-sponsored

schemes, with the purpose of maintaining a given coverage/compensation/income after

retirement from the job market. Although the term “pillar” is widely used today, I

supposed that the word “tier” fits better to the pension system rather than pillar since the

three pillars are placed above or below the other. There are many individuals who do not

have or cannot afford the third pillar for various reasons.

6.1. Pillar 1 – Publicly – funded Scheme

The public tax – financed pension system is composed of the national pension or old-age

pension and the special retirement savings, which is called Solidariske Arbejdsmarkeds-

pensionsfond (Joint Labor Market Pension Fund) or Samhaldsfasta in faroese. Both of

these schemes are required by law and will be briefly describe below. As the public

servant pension scheme is also tax-financed, it will also be describe in this chapter.

Historically, there is a close connection between the Faroese and the Danish legislations

within the social security, among these old-age pensions. It is often that once legislation

is passed in Denmark, it will also be presented to the Faroese legislature for reading and

approval and after some time will be amended and later on passed to be implemented in

the Faroe Islands. For instance, the first “poorman’s” act/law from 1891 was introduced

in the islands and when the old-age pension was introduced in Denmark in 1922, it

marked the early development of a Faroese social security system. A couple of years

later, the old-age pension’s act/law was finally introduced in the Faroe Islands in 1933. It

means that all individuals over the age of 60 have the right to old-age pension, which is

half of the amount Danes get. The social security system consists of national pension,

which is the primary source of income for many, together with early social pension and

diverse income-related supplement. Common for these schemes are that, they are

publicly regulated and serve as a security net with a sociopolitical prospect. The scheme

ensures a given minimum living standard for everybody regardless of earlier affiliation to

the labor market.

47

6.1.1 National pension (Old age pension)

The national pension or old age pension (folkepensionen) forms part of a publicly-funded

scheme, which provides uniform pensions for persons of Faroese nationality living in the

Faroe Islands. There is no direct link between the national pension and the professional

activity exercised by the pension applicant. Expenses for the old age pension are entirely

financed by the state and therefore funded by taxes.

The right to old age pension requires that the applicant must

has Faroese/Danish nationality or is married to or at the latest married to a person with

Faroese/Danish nationality.

has a permanent residency in the Faroe Islands or is employed on a ship registered to

the Faroe Islands.

has a permanent residency in the Faroe Islands (Denmark) for at least 3 years between

the age of 15 and 67 years.

However, authorities can make special exemptions from these major conditions about

nationality and residency.

Apart from the conditions above, the right to a full old age pension is subject to the

condition that the pension applicant has retained his or her resident status in the Faroe

Islands (Denmark) during the 40 years. If this condition is not fulfilled, the pension

applicant is entitled to 1/40 of the full pension for each year of residence completed in the

Faroe Islands (Denmark) between the age of 15 and 67 years.

48

Table 6.1. Old age pension for 2008 in the Faroe Islands (FO) and in Denmark (DK) (in kr.)

Single (FO) Single (DK) Married (FO) Married (DK)

Basic sum per year

50,028 61,152 39,756 61,152

Supplement per year

35,712 61,560 27,648 28,752

Basic sum per month

4,169 5,096 3,313 5,906

Supplement per month

2,976 5,130 2,304 2,396

Source: www.almannastovan.fo and www.aarhus.dk

In both countries, the old age pension consists of a basic sum and a pension supplement.

In the Faroe Islands, the basic sum is tax-free and is paid out regardless of the

individual’s income and is not regulated every year. The pension supplement, on the

other hand, is taxable as any other income, and is regulated and increases constantly at

4 % every first of January every year. Ordinary income and other income, e.g. bank

interests and private pensions, which is higher than 56,400 kr. annually, will be deducted

from the supplement. In other words, any income lower than 56,400 kr. will not affect the

pension supplement whereas any amounts higher will affect the supplement by deducting

60 kr. for every 100 kr. increases of any amount exceeding 56,400 DKK. For further

illustration of these, please refer to appendix 1. The administration of the pension

schemes is managed by Almannastovan, the Faroese Social Office.

Based on the table, the basic sum and particularly the supplement is much higher in

Denmark than in the Faroe Islands but it is important to take into consideration that in

Denmark, the basic sum and the pension supplement are both taxable. Therefore, the after

taxed pension amount in the Faroe Islands22 will almost be at the same level compared to

Denmark

22 Including Samhaldsfasta pension – will be discussed later

49

http://www.aarhus.dk/

http://www.almannastovan.fo/

In addition to the monthly benefits mentioned above, a pensioner can also apply for extra

help, e.g. for medicines, prescription glasses, dentures or dental works etc., provided that

he/she does not have any savings or fortune in the bank.

According the Faroese Statistics Office, in 2007 approximately 60 % of all persons who

are 67 years or older received old age pension’s full supplement plus the basic sum.

About 17 % received the reduced supplement, which mean that retirees’ incomes exceed

the limit, 56,400 kr., while 19 % received only the basic pension sum, which indicates

that some retirees are still active in the labor market. In 2007, there are 6,150 persons

receiving national pension, slightly up from 6,142 in 2006.

6.1.2. Special Retirement Savings (Samhaldsfasta)23

The law concerning labor market pension fund or Samhaldsfasta (in Faroese), an

obligatory savings scheme, was introduced in 1991, with the purpose of guaranteeing all

Faroese nationals a labor market pension benefits. All residents who live permanently in

the Faroe Islands and are registered at the Faroese National Registration Office and who

are 67 years old have the right to receive pension from “Samhaldsfasta”. All Faroese

citizens who are taxpayers contribute a 1.5 % of their income and employers contribute

1.75 % of total A-income paid out to employees24. Persons, who are 67 years old and

older are exempted from contributing to the scheme, however, employers, who are 67

years old and older and have employees in their businesses must contribute the

mentioned percentage of total A-income. Persons with higher income contribute more to

the scheme than persons with lower income but every one receive the same amount

regardless of how much they contributed or how long they have been active in the labor

market before they reach the age of 67 years old. In April 1997, the Fund started paying

out pensions with 500 kr. a month. Today, after 10 years, the monthly pension more than

quadrupled at 2,230 kr. or 26,760 kr. annually and is universal for everybody. This

pension is taxable but will not be deducted from the supplement to the old age pensioners

or early social pensioners. Although the scheme is financed by contributions from

employees and employers, it is actually a tax-funded scheme, which is under the

23 Information here is from the courtesy of Atli Rasmussen, Føroya Lívstrygging24 A-Income is income earned

50

supervision of the Faroese National Bank. The administration of the scheme is managed

by the Faroese Tax Authorities.

6.1.3. Civil servants’ pension

Civil servant’s pension is an obligation pension which is created in association with

working in the public sector. The highest pension is 60 % of a monthly salary is obtained

after 37 years of employment as civil servants. If this is not attained, then the pension will

be reduced according to the rules of this law/act.

At the moment there are about 1,200 civil servants in the Faroe Islands25. Half of these

figures are teachers while 160 civil servants work within the health sector. The rest are

employed in other sectors i.e. post office, fish inspection, tax office and the different

ministries. Aside from them, the prime minister and parliament members are also entitled

to civil servants’ pension. When the Faroese government took over some ministries under

the Danish government, they automatically took over Danish civil servants, which today

are considered Faroese civil servants. Since there is no specific fund that finances this

scheme, it is basically tax-funded like the old age pension scheme. According to the

Ministry of Finance website, expenses for the year 2007 were 17.6 million kr. and are

expected to be 18.05 million kr. in 2008.

Table 6.2 . Faroese Civil servants’ pension expenses (million kr.)26

2003 2004 2005 2006 2007 2008 (proposed)

2009 (expected)

Expenses 12.677 14.800 15.570 17.050 17.550 18.050 18.500

Source: Ministry of Finance homepage: www.fmr.fo

It is apparent from the table above that the expenses for the civil servants’ pension

scheme increased 38 % from year 2003 to 2007. One of the reasons for the increase on

the expenses is due to the fact that many of civil servants going on pension, particularly

teachers and post office employees who used to be Danish civil servants, in an increasing

25 Figures and info are taken from www.hagstova.fo and www.fmr.fo (Ministry of Finance) 26 http://www.fmr.fo/Data/Register/94D5BAF6-1FD2-4193-B610-8D08F2762E1D/98886A77-69F2-41CB-B2BB-9A3A87F6DEBD/019A80CE-CE90-4028-BE90-016DBE02695E.pdf

51

http://www.fmr.fo/

http://www.fmr.fo/Data/Register/94D5BAF6-1FD2-4193-B610-8D08F2762E1D/98886A77-69F2-41CB-B2BB-9A3A87F6DEBD/019A80CE-CE90-4028-BE90-016DBE02695E.pdf

http://www.fmr.fo/Data/Register/94D5BAF6-1FD2-4193-B610-8D08F2762E1D/98886A77-69F2-41CB-B2BB-9A3A87F6DEBD/019A80CE-CE90-4028-BE90-016DBE02695E.pdf

http://www.fmr.fo/

http://www.hagstova.fo/

pace have reached the age of 67 years old. Therefore, it is vital for the government to

continue on keeping the number of civil servants under control. Previously teachers were

hired as civil servants but since 1998, all teachers were appointed on a group contract

basis. Given that teachers today make up half of the Faroese civil servants, this

modification will greatly reduce the number of civil servants in the future. In the long

run, civil servants’ pension will only be significant to a declining fraction of pensioners.

6.2. Pillar 2 – Employer - Sponsored Scheme

Employer-sponsored pension is defined here as the pension scheme that was established

in correlation with employment27. A pension scheme can be based on the general

agreement, on occupation, on education, or on particular business. Through the years,

there are more and more groups of the Faroese labor market are covered by the pension

scheme.

In 2002, an agreement between fishermen and their shipping company to established an

individual pension scheme. According to the Faroese Fisherman’s Association, when it

started, it was agreed that the shipping company will contribute to each fisherman 15 kr.

per working day and fishermen will contribute 10 kr. to the pension scheme, a total of 25

kr. per working day. As of Jan. 2008, both parties contribute an equal amount, 35 DKK,

to the scheme, totaling 70 DKK per day. This fishermen’s scheme, which is in form of

capital pension, offers the contributors payment during old-age, sickness, or in case of

death, offers their beneficiaries benefits. Even though there are a growing number of

fishermen, blue collar workers, workmen, engineers and navigators28 have started to save

for their pension, they are still in the starting phase while a large group of workers in the

public sector i.e. white collar employees, teachers, health workers/services and academics

already have a pension scheme for quite some time. The table below will show the

27 Although civil servants’ pension scheme is also connected with employment but due to the fact that it is financed by taxes and not by personal or employers’ savings, so I decided not to include it here in the second pillar. 28 Except those engineers and navigators sailing for the Danish fleet

52

pension contribution of some chosen groups of workers both in the public sector and the

private sector.

Table 6.3. Pension contribution for chosen labor groups (per Jan. 1, 2008)

Profession Group % of wage Profession Group % of wage

BLF 15.0

Teachers 16.0

White Collar jobs* 13.5

Nurses** 13.5

Blue Collar jobs*** 11.0

Workers**** 7.1

Fishermen***** 70 DKK

Engineers****** 6.0 - 12.5

Sources: www.blf.fo (Faroese Economists’ and Lawyers’ Union), www.lararafelag.fo (Faroese Teachers’ Union), www.starvsmf.fo (Faroese White Collar Workers’ Union), www.ssf.fo (Faroese Nurses’ Union), www.fhf.fo (Faroese Blue Collar Workers’ Union), www.fafelag.fo (Faroese Workers Union), www.fiskimannafelag.fo (Faroese Fishermen’s Union), www.mf.fo (Faroese Engineers Union) NOTE: * from 01.10.07 = 13.5% (workers 11.5%+employers 2%, from 01.10.08 = 14% (w.12%+e.2%), ** from 01.05.08 =13.5%, from 01.10.08 = 14.5%, *** Klaksvík = 11%, Tórshavn = 13% , **** from 01.05.08 = 8.1 %, **** also 1.5 % of salary is contributed to life insurance, Lívstrygging, ***** depends on the employers, for full details please visit www.mf/00004/00031 For economists, lawyers, teachers, white collar workers and workers, employers contribute the full amount to the pension fund.

As table shows, some groups in the Faroese labor market are contributing a large part of

their wages to a pension scheme but there are also a few groups who contribute very little

part to the pension scheme, e.g. workers and fishermen. Since 1998, 3 % of salaries paid

out to members of the Faroese Workers’ Union are paid partly to a pension scheme and

partly to an insurance scheme. The original amount was equally divided between the

workers and the employers. Today, the employers contribute 8.1 % of the members’

salary to the scheme. The union is the Faroese counterpart of LO29 and comprises almost

all the workers’ union in the Faroe Islands except Havnar Workers’ Union (Tórshavn, the

Islands capital) and Klaksvikar Workers’ Union. Most of the Faroese unions’ pension

funds are saved in the Faroe Islands but the Faroese Workers’ Union is saving their

pension through ALKA, a Danish insurance company.

29 LO (Landsorganisation) = nationwide organisation

53

http://www.mf/00004/00031

http://www.mf.fo/

http://www.fiskimannafelag.fo/

http://www.fafelag.fo/

http://www.fhf.fo/

http://www.ssf.fo/

http://www.starvsmf.fo/

http://www.lararafelag.fo/

http://www.blf.fo/

It is easily noticeable that fishermen’s contribution to the pension scheme is very low

since it is stated in kroner rather than in percentage as the other unions. Especially that

their salaries depend much on what kind of fish and how much they catch, their income is

very unstable. Sometimes their income is above the average salary and sometimes it is

below, nevertheless contribute the same amount.

As mentioned earlier, some labor market pension schemes depend much on the contract,

occupation and education but there are also some schemes based on the business’

activities. After the Faroese Employers’ Union and the insurance company, Føroya

Lívstrygging established an agreement regarding a company’s pension fund; there are an

increasing number of companies that are establishing pension funds for their employees30.

These companies could range from a company with few employees to a company with

more than 50 employees. Pension contributions, which is paid by the employers and

employees was at 12 % of the income during the starting point. It is up to the company

and the employee if the contribution should be lower or higher than 12 %. Capital

pension is the most popular scheme used by companies and unions and being able to set

up a capital pension account in banks since in the middle of the 1980’s besides insurance

companies or pension fund, also resulted to tougher competition in the industry and to

higher number of pension schemes providers available in the market.

Búskapar- og Løgfrødingafelag Føroya (BLF) members also have a pension scheme but

contrary to DJØF31 members in Denmark, the Faroese economists and lawyers do not

have a collective pension fund like JØP32, but have an individual pension scheme. There

are only a few examples of collective pension fund in the Faroe Islands. They are pension

funds for Faroese Workers’ Union ( Føroya Arbeidarafelag), Havnar Blue Collar

Workers’ Union ( Havnar Handverkarafelag) and Havnar Workers’ (Men) Union

( Havnar Arbeidsmannafelag). Since 1997, Havnar Workers’ (Men) Union arranged that

pensioners who are members of the mentioned pension funds got 2,700 DKK per month

from the collective pension fund. It was in 1983 that members started contributing to this

30 Companies pension , see www.liv.fo and www.industry.fo 31 Danmarks Jurist- og Økonomforbund32 Juristernes of Økonomernes Pensionskasse

54

http://www.industry.fo/

http://www.liv.fo/

collective pension fund. But in 2000, workers started to contribute to an individual

pension account (capital pension)33.

One of the major reasons why capital pension is widespread in the Faroe Islands is due to

lack of senior posts’ initiative from the public sector, and also from the labor market’s

part to initiate a collective pension scheme and the fact that taxation on interest income

until late 1990’s was only 0.5 %. With establishing capital pension, an individual can

look forward that the pension will be taxed 35 % at the time of payment. Afterwards, the

rest of the amount will continue to earn interests and only pay 0.5 % in taxes of the

interest income. However, since 1999, interest income has been taxed with 35 %. In

contrast, payments from rate pension or life annuity will be taxed as ordinary income.

Different labor unions have different regulations and sometimes different benefits. For

example, Klaksvíkar Workers’ (Men) Union ( Klaksvíkar Arbeidsmannafelag) started in

2004 to provide active paying members at the time of their retirement (67 years old),

100,000 DKK in cash, (tax-free) provided that their salary went through the Union for the

last 10 years 34. The women’s union also provides the same benefit to its members. In

addition, it is possible for members to retire at age 65 and if they sign a contract stating

that they will not go back to the labor market, they are also entitled to 100,000 DKK in

cash. Those members who wait until 67 to retire will get the cash plus they can still chose

to work part-time after retirement35. Both unions are taking a percentage of its members’

salaries while employers contribute the same amount, to set up a capital pension accounts

for each members. The only difference is where the unions placed these savings: the

men’s union placed it at Nørdoya Sparikassi and the women’s union placed it at Føroya

Lívstrygging.

Many Faroese people have pension funds, which are saved in Danish pension funds e.g.

nurses contribute their pension contribution to Pension fund for Nurses and doctors

contribute to Pension fund for Doctors. Another large group of workers, who contribute

to a Danish pension fund, are Faroese citizens, who are employed by the Danish

33 Information from Havnar Arbeidsmannafelag, www.haf.fo 34 A short interview with Arthur Gudjonsson, chairman of Klaksvíkar Arbeidsmannafelag35 A short interview with Vónbjørt Gudjonsson, board member of Klaksvíkar Arbeidskvinnafelag

55

http://www.haf.fo/

merchant navy e.g. navigators and machine engineers. The table below will show an

overview of the Faroese pension saving from 2000 to 2006.

Table 6.4. Overview of the Faroese Pension Savings (million kr.)

31.12.2006 31.12.2005 31.12.2004 2000

Total 4,826.7 4,544.0 4,074.8 2,255.0

Faroese Banks 942.5 913.9 744.1 375

Lív + AMG +

HA + FA + HH

2,805.0 2,531.7 2,261.6 1,150.0

Pension in

Danish pension

funds

1,131.5 1,098.5 1,069.2 730.0

Source: Sigurd Poulsen, Director, Faroese National Bank Note: Lív = Føroya Lívstrygging; AMG = Arbeiðsmarknaðareftirlønargrunnurin; HA=Eftirlønargrunnur Havnar Arbeiðsmannafelags; FA=Eftirlønargrunnur Føroya Arbeiðarafelags; HH= Eftirlønargrunnur Havnar Handverkarafelags

The table shows the development of the Faroese pension savings from year 2000 to 2006,

which are placed in financial institutions and pension funds in the Faroe Islands, and in

Danish pension companies and pension funds.

The largest part (58 %) of pension savings in the Faroe Islands is placed at Føroya

Lívstrygging and others. The amount has more than doubled, from 1,150 million kr. in

year 2000 to 2,805 million kr. at the end of 2006. Almost 20 % of pension savings are

placed at Faroese banks and savings banks. The growth here is also extraordinary, from a

mere 375 million kr. in year 2000 to 942.5 million kr. at the end of 2006. The Faroese

pension savings placed in Denmark in 1997 was 730 million kr. and it grew to 1,131.5

million kr. at the end of 2006. This means that the total Faroese pension savings amount

to 4,826.7 million kr. in different pension funds plus the equities on people’s homes. The

Faroese pension funds are supervised by Tryggingareftirlitid (Insurance Inspector), a

Faroese inspection’s authority.

56

6.3. Pillar 3 - Private Pension Scheme

Individual’s private pension scheme is a saving scheme that is set up by an individual

with the purpose of supplementing the publicly financed pension payments and

compulsory labor market pension schemes. The scheme is independent of employment

terms or conditions but in principle the same pension taxation rules as the labor market

pension schemes. Similar to the labor market scheme, the payments could be paid out as

lump sum or as installments for a number of years and they are either saved through

pension funds or financial institutions with or without additional insurance coverage.

Despite of the fact that private pension schemes were originally conceived as a

counterpart to the publicly financed scheme, this is also sponsored by tax legislations.

It was not so long ago when private pension scheme was introduced in the Faroe Islands.

In 1967, life insurance company, Føroya Lívstrygging was founded as a division of a

bigger insurance company, Tryggingarfelagid Føroya (Faroese Insurance Company)36. In

the beginning, it was mostly private individuals who started pension savings but as time

went by, labor unions and companies also started pension savings for their members and

employees. A big part of Faroese pension savings is managed by Føroya Lívstrygging but

since in the middle of 1980’s, banks and savings banks also started managing pension

savings for private individuals and labor unions.

The private pension scheme is regulated by law37 and as of today, composed of capital

pension, rate pension and life annuity. Other pension products available in Denmark have

not yet reach the Faroese market. Of these three, capital pension occupy take up the

biggest share monetary wise.

6.3.1. Capital Pension

Individuals between the age of 18 and 60 can contribute to capital pension scheme and

the individual can decide what amount will be automatically transferred from his/her

account to the pension fund before his income is taxed. One of the advantages of this

scheme is that, contributions to capital pension are tax-deductible from the taxable

36 www.liv.fo 37 Parliamentary law nr.51 from 29.december 1971

57

http://www.liv.fo/

income. This year, 2008, the highest allowed tax-deductible amount is 47,500 DKK and

this amount is regulated every year. Nørdoya Sparikassi38 and other banks offer 4.75 %

interest for capital pension. When the individual turns 60 years old, he has the possibility

of cashing in the fund as lump sum (cash) or as monthly payments and it will only be

taxed 35 %. If unfortunately, the contributor dies before he turns 60 years old; his

beneficiary will get the entire amount and be taxed as if the beneficiary is the contributor.

If the contributor dies after he turned 60 and after a portion of the fund is taken out, the

remaining amount in the fund will be handed to the beneficiary.

As mentioned before, some labor unions are also saving through capital pension,

therefore, there are individuals who are saving capital pension both through their unions

and saving personally, in order to ensure that they will have sufficient income after

retirement.

6.3.2. Rate Pension

The rate pension scheme is very similar to the capital pension scheme. Any investor from

18 to 60 years old can start this scheme; however, payment could only be paid out 5 years

after the starting year. It is also a tax deductible pension savings form that guarantees a

continuous payment, with the purpose to some extent of partially replacing earlier income

of the retiree. Those individuals who are capable of saving higher amount than 47,500

DKK can save their money in this scheme. There is no limit on the amount that could be

contributed to this scheme. The conditions for cashing in of this fund are the same as

capital pension; however, the fund is payable over a ten year period and will be taxed as

ordinary income when the payment start. Since the payment is considered as ordinary

income, it will affect old age pension payment. As explained in the old age pension part

of this report, the pension supplement will be affected by this “ordinary income”.

6.3.3. Life Annuity

Life annuity can also be called “pension scheme with a continuous payment”, and very

different from the other two schemes mentioned earlier since anybody can start the

38 A Faroese Savings Bank

58

scheme regardless of age, even those older than 60 years old. Life annuity can be the

opposite of the other schemes for the reason that its payment will be lifetime. When an

individual cashed in his capital pension or after selling a business or a property, he has

the possibility of purchasing life annuity. Life annuity is paid out a fixed amount monthly

from the retirement time. Payment can either be lifetime or limited to a determined

amount of time, though minimum of 10 years. Like rate pension, payments in this scheme

are also taxed as ordinary income. A major disadvantage of this scheme is that, if the

individual dies, the annuity payment discontinues at the same time and the beneficiary

will not get anything from the fund and any money left on the scheme will fall back to the

pension company. There are only two companies offering life annuity in the Faroe

Islands: they are Føroya Lívstrygging and Betri Pensjón, another division of

Tryggingarfelagid Føroya.

6.3.4. Voluntary pension scheme

Even though that more and more groups in the Faroese labor market are now part of a

pension scheme, there are still a large group in the market that do not belong to a pension

scheme. Some of these groups have just started contributing to a scheme and

contributing with a small amount compared to their salaries. Moreover, there are many

who do not or in some way very limited connection to the labor market. As mentioned

previously, many fishermen can sometimes earn a very high salary39. With a pension

contribution of a mere 70 DKK per “official” working day, it is apparent to say that it is a

very low pension contribution in comparison to their income. Therefore, it is common

these days that these men contribute to a private voluntary pension scheme i.e. capital

pension to ensure that they will have sufficient amount of income when they retire.

However, there are no published statistics available thus it is not easy to confirm how

many of these 2,196 fishermen contribute to a voluntary pension scheme40. A large group

of fishermen, who are not covered by any agreement, are fishermen who are members of

Meginfelag Útródrarmanna, a small boat’s fisherman’s union. This union tried to avail of

39 Depending on their fish catch and the season (prices vary), www.fiskimannafelag.fo 40 Number of workers under “fishing” category of industry in 2007, www.hagstova.fo

59

http://www.hagstova.fo/


a pension scheme, which also includes insurance for their members but it turned out to be

too expensive for the union since many of its members are old41. The Engineers’ Union

also encourage their members, specially those members who haven’t save much for their

pension, to save more voluntarily but the reaction to this plea was not yet visible42. On the

other hand, according to the Navigators’ Union’s chairman, Eydstein Djurhuus, many of

their members are saving privately through capital pension scheme.

One important labor group who are not covered by arranged pension scheme, are the self-

employed businessmen. There is no official statistics on how many of these businessmen

are saving for their pension but according to banks and Føroya Lívstrygging, there were

self-employed businessmen who started pension schemes with them.

Another group, who do not nor have a limited association with the labor market, are a

large group of women, who are stay-at-home mothers. Some of these women probably

have some kind of private pension saving scheme before they stopped working and it is

likely that most of these women will only receive old-age pension and pension from

Samhaldsfasta when they retire. For this group, the only form of saving will be in the

equity of their homes. Most of Faroese retirees still live in their homes since it is still not

a tradition in the Faroe Islands to sell their homes and move into nursing homes or

smaller apartments, in order to benefit from the equity of their homes. But this trend of

moving to smaller apartments or nursing homes has already started and the government

has plans in the future of building more old people’s apartment to encourage them in

moving.

6.4. Some observations from the Faroese viewpoint

6.4.1. Survey

A small survey was made in the author’s hometown, Klaksvík. It is the second largest

town in the Faroe Islands with approximately 4,800 inhabitants. According to the local

Statistic’s office, there are around 2,300 people between the age of 20 to 65 years old. 41 According to the chairman for Meginfelag Útródrarmanna, Audunn Konradson..42 According to Sjúrdur Heinesen, Engineers’ Union

60

Therefore, I asked 250 individuals, ages ranging from 20 to 65 years old and with

different occupation, whether they are contributing to a voluntary pension saving scheme.

The questionnaire was very simple, it simply asked their age, occupation and whether

they are voluntarily pension saving. It was intentional that half of the respondents are

“stock”- like individuals i.e. fishermen, fish factory workers and other blue collar

workers and the other half are “bond”- like individuals i.e. teachers, nurses, white collar

workers and other civil servants.

The results showed that only 45 individuals (18 %) out of 250 are voluntarily

contributing to a private pension scheme, specifically capital pension, and they all belong

to the “stock” – like group. Some of them have heard of it, and are aware of this private

voluntary pension scheme from financial institutions and insurance companies but most

of them do not have enough information to be convinced and to conclude that this is a

great idea and actually decide to be a part of it. To think that only 36 % of the “stock”-

like group are saving to supplement their retirement income proves that there’s a need for

institutions offering the pension schemes to increase their marketing campaign to their

customers. On the other hand, it is not surprising that 205 individuals or 82 % of 250

questioned not to have any extra pension savings since they are expecting to receive a

sufficient amount of money when they retire from the first pillar, Samhaldsfasta and the

second pillar. Most of them said that their unions have an excellent pension scheme

therefore there is no need for them to think of supplementing their retirement income.

Moreover, for some who are on their 30’s and 40’s, particularly those with children,

commented that their expenses almost equal their salaries so the chance of saving for

their retirement is out of the question. If ever they will save, it will be for a down

payment for new home, new car, a summer home or a holiday for the whole family. They

just want to enjoy life today and chose to wait thinking about their retirement. Luckily,

like most Europeans, Faroese people do not need to think of health-related expenses or

school-related expenses since the government is providing them with many social

benefits.

6.4.2. Difficulties of saving for retirement

61

Regardless of the fact that voluntary saving gives tax deductible amount up to 47,500

DKK from the income and taken automatically from the salary before paying taxes, thus

making it more attractive to save voluntarily for pension, it still shows that it is quite

difficult for many Faroese people to start saving for pension on a voluntary basis for

various reasons. Bodie’s idea of the life cycle theory to save the same amount yearly for

pension seems too unrealistic since consumption of younger people in their 20’s, 30’s and

even 40’s is mostly focused on paying down the mortgages of their houses, started having

children and sometimes, paying off large study loans. It is also the time when they want

to enjoy their life at the same time given that they are working so hard to keep the ends

meet.

Given that the Faroese people have a social safety net after retirement, they feel that they

do not need to save as much as stated in the examples in the previous chapters. Yet, if

they manage to voluntary save some amount regularly during their working years then

they could be confident that they do not need to change their lifestyle that much and they

could enjoy their retirement without worries and maybe leave their family a bequest. A

wish a family-oriented and traditional Faroese individual has.

6.4.3. Framework used by a local savings bank, Nordoya Sparikassi

Today, the changing needs of customers and the competition between financial

institutions are tougher than it was a few years ago, therefore it is up to the competing

institutions to be ahead of the competition. Introducing new products with the help of

sending out eye-catching and easy to understand brochures about their new products to

households all over the islands, is one way of ensuring that Nordoya Sparikassi’s both

loyal customers and potential customers are informed of their new products/services. In

addition, they are also offering personal advice on varieties of subject matters regarding

their accounts and on how to efficiently build their financial portfolios. They have

professional advisors prepared to give their customers the best advice possible. At the

moment, they are not using any official framework in advising their customers but they

are working on developing a framework that could help in improving their services. As

62

expected, customers seeking advice are usually asked the purpose of saving and the time

horizon, their risk tolerance and their financial situation. Most of them have heard of the

life-cycle theory, they have never actually use the model in advising customers.

According to the assistant manager, Eydun Kjølbro and investment advisor, Marja

Lamhauge, it is often that customers who already have loans are the ones who regularly

come in and get the chance to learn more about these new products e.g. capital pension

or investing in stocks or bonds in general. It is very often that after giving customers

more information about the products, they will be convinced that the products will be

beneficial to them and decide to buy the products immediately. When asked if they

perform unsolicited marketing just to follow-up the possible effect of the marketing

campaign regarding new products and they both said definitely not since it is illegal to do

that. However, they are both positive that customers today are more aware of the different

products/services that they are offering and they are more interested on learning new

information. The bank needs to find the best strategy to effectively reach and convince

their customers of their products/services. It will take some time and probably more

perseverance from the financial institutions’ part to change customers’ traditional way of

thinking regarding saving and especially investing but it will definitely change in the

future.

63

7. Conclusion

Life-cycle theory of saving and investing may not be the perfect answer but it is probably

the most rational method available for both advisors and investors. Frameworks presented

in this paper are also not flawless but usable and mostly understandable to ordinary

investors. However, the most important element in this paper is the fact that human

capital has a very important role in an individual’s total wealth since it is the most

important asset an investor has. Therefore, it is necessary to hedge it by taking a life

insurance. When this is taken care of, then one can start thinking of saving and investing

and all the frameworks available starting by creating an Investment Policy Statement

(IPS), which basically serves as a foundation for all future investment decisions to be

made by an investor. This will provide the advisor all the necessary information about the

investor so that he could advise him appropriately according to his needs, goals and

limitations.

The conventional approach to life-cycle investing is too simplistic or unrealistic. With

new developments in the financial markets and products today, let investors to benefit

from modern techniques which use multi-period hedging, to identify more optimal

portfolios to deliver consistent returns and build financial wealth more reliably over the

life-cycle. Investors have learned that relying on equities, even when young, involves

risks and a broader spread of assets is required at all phases of the life-cycle.

Diversification, together with regular monitoring and rebalancing of assets are keys to

long term investment success for most investors. A broad spread of holdings and a

variety of assets – including equities, fixed income, property and alternative assets e.g.

hedge funds and private equity – is usually best at all stages of the lifecycle. With the

help of financial advisors, investors in their 30’s and 40’s are now able to use

sophisticated techniques to construct portfolios which will be expected to generate capital

growth over time, with less volatility than the standard traditional approaches of relying

on equities when young and then moving to fixed income assets in later life.

64

The Faroese pension system is built up on the three pillar system, which is a combination

public-financed old-age pension scheme, employer-sponsored scheme and private

pension scheme. Given the problems the pension system has today regarding longevity

and increasing number of retirees (no fertility problems yet in the Faroe Islands)

compared to the working group, it is clear that the need for the labor market pension

scheme and the individual’s pension scheme will increase in the future. It is obvious that

an individual cannot influence the first pillar, to a degree influence the labor market

pension scheme (up to him how much he works) but he can absolutely control his own

pension scheme. By referring to the life-cycle theory of saving and investing and the

alternative framework presented here, the investor could estimate his future consumption

and he has the option to develop the ideal amount to save (according to his needs and

goals) every year to supplement the pension payment he will receive from the first and

second pillars, in order to be able to live comfortably and enjoy life during retirement

years. By putting the theory into practice, there is a great chance that a Faroese retiree

will manage to have enough money throughout his remaining years provided that there

are no drastic changes in the future regarding pension regulations and the longevity of the

longevity of the Faroese people.

65

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Faroese Fishermens’ Association website: www.fiskimannafelag.fo

Faroese Insurance Commission website: www.tryggingareftirlit.gov.fo

Faroese Life Insurance Company website: www.liv.fo

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Faroese National Bank website: www.landsbank.fo

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http://www.landsbank.fo/

http://www.fafelag.fo/

http://www.liv.fo/

http://www.tryggingareftirlit.gov.fo/


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67

http://www.ns.fo/

http://www.norden.org/pub/ovrigt/statistik/sk/ANP2007732.pdf

http://www.fmr.fo/

http://www.hagstova.fo/portal/page/portal/HAGSTOVAN/Hagstova_Foroya

Appendix 1. National pensionist, who is receiving private pension

Example 1 : Married pensionist, who’s getting private pension (DKK)

Income, e.g. private pension(taxable)

Basic sum

(tax-free)

PensionSupplement(taxable)

Total taxable amount

Difference for every 10,000

0 39,756 27,648 67,404 -

10,000 39,756 27,648 77,404 10,000

20,000 39,756 27,648 87,404 10,000

30,000 39,756 27,648 97,404 10,000

40,000 39,756 27,648 107,404 10,000

50,000 39,756 27,648 117,404 10,000

56,400 39,756 27,648 123,804 -

60,000 39,756 25,488 125,244 7,840

70,000 39,756 19,488 129,244 4,000

80,000 39,756 13,488 133,244 4,000

90,000 39,756 7,488 137,244 4,000

100,000 39,756 1,488 141,244 4,000

102,480 39,756 0 142,236 -

110,000 39,756 0 149,756 8,512

120,000 39,756 0 159,756 10,000

If the annual income is 56,400 DKK or lower then a married pensionist will get the entire

pension supplement. If the income is between 56,400 and 102,480 DKKthen supplement

will be reduced by 60 DKK for every 100 DKK exceeding 56,400 DKK. The entire

pension supplement will be removed if the income exceeds 102,480 DKK. The last

column shows how the total income increases for every 10,000 DKK in private pension.

68

Example 2 : Single national pensionist, who is receiving private pension (DKK)

Income, e.g. private pension(taxable)

Basic sum

(tax-free)

PensionSupplement(taxable)

Total taxable amount

Difference for every 10,000

0 50,028 35,712 85,740 -

10,000 50,028 35,712 95,740 10,000

20,000 50,028 35,712 105,740 10,000

30,000 50,028 35,712 115,740 10,000

40,000 50,028 35,712 125,740 10,000

50,000 50,028 35,712 135,740 10,000

56,400 50,028 35,712 142,140 -

60,000 50,028 33,552 143,580 7,840

70,000 50,028 27,552 147,580 4,000

80,000 50,028 21,552 151,580 4,000

90,000 50,028 15,552 155,580 4,000

100,000 50,028 9,552 159,580 4,000

110,000 50,028 3,552 163,580 4,000

115,920 50,028 0 165,948 -

120,000 50,028 0 170,028 6,448

130,000 50,028 0 180,028 10,000

If the annual income is 56,400 DKK or lower then a single pensionist will get the entire

pension supplement. If the income is between 56,400 and 102,480 DKKthen supplement

will be reduced by 60 DKK for every 100 DKK exceeding 56,400 DKK. The entire

pension supplement will be eliminated if the income exceeds 115,920 DKK. The last

column shows how the total income increases for every 10,000 DKK in private pension.

69

Appendix 2. The life-cycle model – an Event tree (Original version)

Expenses: $5,000 a year Advice: Withdraw $50,000 a year

Consumption: $45,000 Income: $100,000 a year a year

Advice: Save $20,000 a year Consumption: $80,000 a year

Expenses: $15,000 a year Advice: Withdraw $50,000 a year

Consumption: $35,000 a year

Income: $30,000 a yearAdvice: Save $10,000 a yearConsumption: $20,000 a year Expenses: $5,000 a year

Advice: Withdraw $50,000 a year


Income: $50,000 a year Advice: Save $20,000 a year Consumption: $30,000

a year Expenses: $15,000 a year

Advice: Withdraw $50,000 a year


Source: Bodie, Z. et al (2007): The Theory of Life-Cycle Saving and Investing

70

(1) Youth (21-35)

(2)Prime Earning Years (36-65)

(3) Retirement

(66-80)

(HG) Good Health

(H) High Income

(HB) Bad Health

Start

(LG) Good Health

(L) Low Income

(LB) Bad Health

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