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

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.

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

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  1. 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

  2. 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

  3. 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

  4. 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

  5. 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

  6. Overpricing of High-Beta Stocks

  7. Overpricing of Equity Index Options

  8. 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)

  9. Harvard Policy Portfolio

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

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

  12. 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.

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