Reducing Social Security Risk at the PRA Level- Lifecycle Funds and No-Loss Strategies

James Poterba, Joshua Rauh, Steven Venti, and David Wise

Discussion by John Y. Campbell

Pathways to a Secure Retirement Conference

08/10/2006

The Main Points

• Lifecycle strategies reduce risk with age, but this doesn’t help households that are constrained to take less risk than they would prefer

• Expense ratios are important because they lower returns for a given level of risk

Lifecycle Portfolio Choice Theory

• With iid returns, total risk exposure should be independent of age

• Human capital is a relatively safe asset whose value diminishes later in working life

• To compensate, younger households should aggressively take financial risk and older households should cut it back

• Mean reversion in stock returns strengthens this conclusion

How to Take Risk

• Given high historical stock returns and modest risk aversion, households should take plenty of risk

• Even in middle age they may want more risk than can be achieved by 100% equity investment

• PRVW argue for a static 100% equity strategy• But there are alternatives:

– Leverage– High beta stocks– Options

How to Take Risk

• Each of these alternatives has its problems:– Leverage is expensive for ordinary households except

when they hold housing as collateral, and this distorts the asset mix

– High-beta stocks appear to be overpriced, except possibly in an international context (emerging markets)

– Equity index options appear to be overpriced

• Nonetheless they may give households some ability to improve on the PRVW 100% equity strategy

Overpricing of High-Beta Stocks

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

20.00%

0.00 0.50 1.00 1.50 2.00

1927-2001

1927-1963

1963-2001

1927-2001 predicted

1927-1963 predicted

1963-2001 predicted

Overpricing of Equity Index Options

05

101520253035404550

Jan-90 Oct-92 Jul-95 Apr-98 Jan-01 Oct-03

VIX 30-day Historical Volatility

How to Enhance Return

• For given risk, it is important to get the best possible return

• PRVW rightly emphasize the importance of low expenses

• Other things matter too: – Diversification across asset classes (e.g. international

equities, commodities)– Earning an illiquidity premium for retirement savings

(e.g. private equity, timberland)

Harvard Policy Portfolio

Domestic Equities

Domestic Bonds

-5

5

15

25

35

45

55

65

75

85

95

105

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

-5

5

15

25

35

45

55

65

75

85

95

105

Cash Domestic Equities Private Equity Foreign Equities

Emerging Markets Domestic Bonds Foreign Bond High Yield Bonds

Inflation-indexed Bonds Real Estate Commodities Absolute Return

Harvard Investment Beliefs (1)Source: HMC Capital Market Assumptions, 2004

0

1

2

3

4

5

6

7

0 5 10 15 20 25

Standard Deviation

Exp

ecte

d E

xces

s R

etu

rn

Private Equity

Emerging Markets

Timber

Real Estate Foreign Equity

Domestic Equity

CommoditiesDomestic BondsForeign Bonds

High Yield

Absolute Return

Inflation-indexed Bonds

Harvard Investment Beliefs (2)Source: HMC Capital Market Assumptions, 2004

0

1

2

3

4

5

6

7

0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40

Beta with Portfolio of 60% Domestic Equity/40% Domestic Bonds

Exp

ecte

d E

xces

s R

etu

rn

Foreign Equity

Emerging Markets

Private Equity

Absolute Return

High Yield

Timber

Real Estate

Inflation-indexed Bonds

Foreign BondsCommodities

Domestic Bonds

Domestic Equity

What Is Realistic?

• Some ideas are feasible within existing structures: – Low expenses– Diversification

• Other ideas require institutional innovation:– Modest leverage could be accommodated by

structuring a margin account – Illiquid assets require abandoning the assumption that

401(k) or PRA assets can be marked to market daily– This would be an important step to recapturing some

of the benefits of more traditional pension plans.