Discussion of “The Optimal Design of Individual Retirements Accounts” by Luciano Greco

1. Discussion of “The Optimal Design of Individual Retirements Accounts” by Luciano Greco Paolo Volpin (London Business School) “The Future of Pension Plan Funding” LSE, 7 June 2007

2. Overview of the Paper • Why is a competitive market for individual pension accounts likely to be expensive? • Assumption 1: Fund managers’ skills are important (and unobservable). • Assumption 2: Fund managers can signal their skills by engaging in costly ‘promotion activity.’ • The (separating) equilibrium fees must cover these costs.

3. Overview of the Paper (cont.) • Can regulation help? • Capping promotion activities or fees would drive high-skilled managers out of the market. • Assumption 3: A public fund manager can act as intermediary and write performance-related contracts with fund managers. • Individual retirement accounts would be less expensive. • This last result is robust to (some degrees of) self-interest by public fund manager and inefficient taxation.

4. Overview of the Discussion • This is an interesting and rich paper that tackles an important topic: How should individual retirements accounts be regulated? • I will focus my discussion on the model’s 3 critical assumptions: • Are they reasonable? • How can they be defended? • The bottom line is that the paper benefits from more critical discussion of the model’s assumptions and more references to the empirical evidence.

5. Assumption 1: Fund Manager’s Skills • Are fund manager’s skills important? Why? • This is a critical assumption in the model and a highly debated issue in finance. A lot more discussion is needed in the paper. Old-school view: Skills are irrelevant because retirement savings should be allocated between a market index and risk free bonds. Modern view: Skills may be relevant for stock picking (market timing) [more on this later] and stock picking is part of a balanced portfolio strategy [more on this later].

6. Assumption 1 (Cont.) • Are there skills in stock picking? • Mutual fund performance is persistent: skill or risk? • (More) direct evidence on the impact of skills on performance: • Chevalier and Ellison (JF, 1999) look at whether SAT scores and MBA degree affect performance and find some results. • Coval and Moskowitz (JPE, 2001) show that local investors earn abnormal returns. • Kacperczyk and Seru (JF, forthcoming): Managers that react less to public information perform better.

7. Assumption 1 (Cont.) • Should retirement savings be invested in individual stocks? What’s the evidence? MIXED: • NO, they do not earn excess return: Wermers (JF, 2000) finds a negative excess return from active fund management (after fees); • YES, they do earn excess return: Cremers and Petajisto (2007) find a positive return (even after fees); • YES (even if they earn no excess return on average): Baks, Metrick and Wachter (JF, 2001), Pastor and Stambaugh (JFE, 2002) use a Bayesian approach to argue that investors should allocate some of their wealth to active managers if they think skill matters.

8. Assumption 2: Costs as a Signal for Quality • Fund managers can signal their skills by engaging in costly ‘promotion activity:’ Is ‘promotion activity’ a signal for quality? • Theoretically, it could well be the opposite (if both stock picking and promotion require time, better quality stock pickers will face a higher opportunity cost for engaging in promotion activities). • Empirically, there is no evidence that fees are positively correlated with performance (see Barber, Odean and Zheng (JB, forthcoming)).

9. Assumption 2 (cont.) • Is costly signalling necessary? Isn’t past performance enough? • Sirri and Tufano (JF, 1998) find that past performance is the single most important predictor of mutual fund flow. • Fees are negatively correlated with flows. • However, they find an interaction effect of performance and fees: The performance-flow relation is stronger for high-fee funds. This is consistent with the idea that fees (=promotional activity) are more valuable for better funds.

10. Assumption 3: Public Agency Writes More Complete Contracts than Private Individuals • It may well be true but it is not clearly justified in the paper. Answer 1: It is because the public agency is better at enforcing contracts. • But then, couldn’t they simply enforce private contracts? That would solve the adverse selection problem without adding an agency problem. Answer 2: It is because the public agency is an intermediary. • If so, you need to explain how.