PORTFOLIO RISK AND
RETIREMENT SAVING
James M. Poterba
MIT
April 2003
PENSION SAVING IS
CHANGING
• U.K.: Increasing Importance of
Defined Contribution Plans (About
One Quarter of Private Plans)
• 1986 Social Security Act: DC Plans
and Opt-Out from SERPS
• U.S.: Rising Importance of SelfDirected Retirement Arrangements
DB vs. DC PENSION PLANS
• Defined Benefit Plan: Specifies a
Guaranteed Annuity Payout
According to a Formula Based on
Wages, Years of Service, etc.
• Defined Contribution Plan: Payout at
Retirement Depends on Value of
Assets, Which Depend on Past
Employer and Employee
Contributions
SHIFTING LANDSCAPE FOR
U.S. PENSION SAVING
• Rapid Rise in Retirement
Assets/Wages (0.5 to 2.5, 1975-99)
• 1975: DC Plans Represent About 25%
of Participants and Plan Assets
• 1980: 64% of Private Retirement
Saving Contributions to DB Plans
• 1999: 85% of Contributions are to
“Individual Directed” Plans, > 50% of
Assets in DC Plans
GROWING ROLE OF DC
PLANS IN U.K.
• 1975: < 2% of Private Sector
Occupational Pensions Were DC
Plans
• 2001: 22% of Private Plans Are DC
WHY THE SHIFT FROM DB TO
DC PLANS?
• U.K.: DC Plans Can Reduce
Employer Costs, Allow Greater
“Pension Portability” for Workers
• U.S.: Regulatory Changes such as
ERISA (1974); Rising Stock Market
and Shifting Worker Tastes
COMPARING THE RISKS OF
DB AND DC PLANS
• DC Plans: Worker Bears Risk of
Asset Price Changes, Must Make
Investment & Withdrawal Decisions
• DB Plans: Worker May Lose Large
Fraction of Benefits if Changes Jobs
Before Benefits Fully Vest
AVERAGE TENURE ON
CURRENT JOB, 1983-1998, US
MEN (Friedberg & Owyang)
Potential
1983
Experience:
6-15 Years 4.9
1992
1998
4.8
4.4
16-25 Years 9.9
8.1
8.6
26-35 Years 14.2
14.1
13.6
POLICY ISSUES RAISED BY
DC PLAN GROWTH
• Accumulation Phase: Should Worker
Choice be Restricted? Should There
be Guarantees on Returns? What is
the Role of Participant Education?
• Payout Phase: Should Annuities be
Required? Again, What Role for
Education?
CURRENT U.S. POLICY
DEBATE ON ACCUMULATION
• High-Profile Collapse of Firms with
Company Stock in 401(k) Plans
(Enron, Polaroid)
• Weak Stock Market Performance
Since 2000 Trimming 401(k) Balances
• Links to Policy Debate on Social
Security Privatization
ASSET ALLOCATION IN 401(k)
PLANS: STYLIZED FACTS
• Overall Asset Allocation in DC Plans
is Similar to Asset Allocation in DB
Plans
• About 20% of 401(k) Assets are in
Employer Stock
• Many Plans Have High Company
Stock Holdings
HOW MUCH EMPLOYER
STOCK IN 401(k) PLANS?
• Most Plans Hold None
• Large Plans of Publicly Traded Firms
Have Substantial Holdings
• Need to Distinguish Employee
Allocations vs. Employer Match
• Some Saving Plans Were “ESOPs”
AGGREGATE ASSET
ALLOCATION IN 401(k)
PENSION PLANS
Equity Funds
51%
Bond Funds & GICs
19
Company Stock
19
Balanced Funds
8
Other
7
ASSET ALLOCATION
PATTERNS BY AGE
30s
Company 18.4%
Stock
Equity
60.2
Funds
GICs
4.6
40s
60s
19.7%
16.3%
54.8
39.8
7.5
19.3
INVESTMENT IN COMPANY
STOCK: CHOICE OR
CONSTRAINT?
• Some Investment is Worker Directed
-- Workers Decide to Hold Company
Stock
• Some Investment is Driven by Firm
Contributions, Particularly “Matching
Contributions”
• Do Workers Think About Correlation
with Human Wealth?
INVESTMENT DECISIONS OF
401(k) PARTICIPANTS WHO
CAN INVEST IN OWN STOCK
>30% in Co. Stock 39%
> 50%
28%
> 70%
20%
> 90%
15%
HOW RISKY IS COMPANY
STOCK? (Mitchell & Utkus)
• Ten-Year Average Annual Return on
Company Stock (1992-2001): 10.9%
• Ten-Year Average Annual Return on
S&P 500: 12.9%
• Average Standard Deviation of
Company Stock Return: 34.4%
• Average Standard Deviation of
S&P500 Return: 17.3%
PERCEIVED RISKINESS OF
DIFFERENT MUTUAL FUND
TYPES (John Hancock)
•
•
•
•
•
Money Market Funds: 2.4
Balanced Funds: 2.8
Company Stock: 3.2
Stock Funds: 3.6
International Funds: 4.0
SHARE OF COMPANY STOCK
IN FIVE LARGEST DC PLANS
•
•
•
•
•
General Electric: 68% (σ = 33%)
Verizon: 38% (σ = 33%)
IBM: 12% (σ = 39%)
General Motors: 21% (σ = 35%)
Lockheed-Martin: 36% (σ = 37%)
FIVE LARGE DC PLANS WITH
HIGHEST SHARE OF
COMPANY STOCK
•
•
•
•
•
Proctor and Gamble: 90% (σ = 37%)
General Electric: 68% (σ = 33%)
Chevron-Texaco: 60% (σ = 28%)
Wells Fargo: 48% (σ = 34%)
SBC Communication: 44% (σ = 35%)
INVESTMENT STRATEGY
FOR SOME WORKERS
FACTORS THAT AFFECT THE
COST OF POOR
DIVERSIFICATION
• Volatility of Company Stock
• Time Profile of Contributions
• Other Components of Retirement
Income Wealth (SERPS, DB Pension,
Private Saving) – Mean and
Covariances
• Correlation with Human Capital Risk
LIFECYCLE MODEL, UTILITYBASED APPROACH TO
EVALUATING COST OF RISK
• Simulate Retirement Wealth for
Different Investment Volatilities
• Evaluate Expected Utility of Wealthat-Retirement
• Compare with Expected Utility
Various Investment Strategies
• Translate Into Certainty-Equivalents
EXPECTED UTILITY
ALGORITHM
Contribution Profile: .10*(Labor Income)
Utility of Wealth at Retirement:
U(Wret + Wother) = (Wret + Wother)1- /(1-)
E(Utility of Retirement Wealth) =
EUCompany, EUBonds, EU50-50, EUSP500
Wealth Equivalent:
[WESP500]1-/(1-) = EUSP500
SPECIFIC ACCUMULATION
ASSUMPTIONS
Working Life: 35 Years Starting at Age 30
Contributions = 10% of Wage Earnings
Five Investment Options: Index Bonds (1.5%
Per Year, Real Return); Large Cap Stocks;
Individual Company Stock; Two 50/50
Mixes
Calibrate Non-401(k) Wealth at Retirement
Based on Health and Retirement Survey
MEDIAN EARNINGS
HISTORIES, SINGLE MEN
AGED 66-67
2.5
Less than High School
High School or Some College
College or Postgraduate
2.0
1.5
1.0
0.5
0.0
30
35
40
45
50
55
60
65
FINAL INCOME, BY EDUCATION
GROUP ($2000)
< HS
HS + Some College or
Education College
Beyond
Median
$23.8
$34.7
$60.7
Mean
27.4
36.9
58.6
MEDIAN WEALTH AT
RETIREMENT, HRS SAMPLE OF
SINGLE MEN AGED 66-67 ($2000)
< HS
HS + Some College or
Education College
Beyond
PDV Social $126.3
Sec.
$147.8
$175.5
DB
Pension
15.9
100.6
136.8
Other
Financial
16.7
69.0
245.0
SOCIAL SECURITY, DB, &
FINANCIAL WEALTH (RELATIVE
TO FINAL EARNINGS)
60
Less than HS
HS or Some College
College or Postgraduate
percent of single men
50
40
30
20
10
0
x<10
10<=x<20
20<=x<30
ratio
30<=x<40
x>= 40
70
FINANCIAL WEALTH
RELATIVE TO FINAL
EARNINGS
Less than HS
HS or Some College
College or Postgraduate
percent of single men
60
50
40
30
20
10
0
x<0
0<=x<2
2<=x<4
4<=x<6
ratio
6<=x<8
8<=x<10
x>10
FINANCIAL WEALTH
(EXCLUDING IRAs) RELATIVE
TO FINAL EARNINGS
60
Less than HS
HS or Some College
College or Postgraduate
percent of single men
50
40
30
20
10
0
-1<=x<0
0<=x<1
1<=x<2
2<=x<3
ratio
3<=x<4
4<=x<5
x>5
ASSUMPTIONS ABOUT ASSET
RETURNS
Return on Index Bonds: 1.5% Per Year (Real)
Large-Cap Stock Returns: Empirical
Distribution, 1926-2001; Mean Real Return
= 9.4%, Annual Standard Deviation =
20.2%
Individual Company Stock Return: Mean =
9.4%, Standard Deviation = 40.4%
DISTRIBUTION OF EQUITY
RETURNS, LARGE CAP U.S.
STOCKS, 1926-2001
20
18
16
Number of Years
14
12
10
8
6
4
2
0
-40<=x<-30 -30<=x<-20 -20<=x<-10 -10<=x<0
0<=x<10
10<=x<20
% Equity Return
20<=x<30
30<=x<40
40<=x<50
50<=x<60
SIMULATION ALGORITHM
1. Draw Sequence of 35 Annual Stock
Returns (and Associated Company Stock
Returns) from Empirical Distribution for
Actual Returns
2. Calculate Wealth at Retirement for Each
Education Group for Each Sequence
3. Evaluate Utility of Retirement Wealth
4. Repeat (300,000 times)
5. Compute Sample Means as Estimates of
Expected Utility
6. Calculate Certainty Equivalents
DISTRIBUTION OF 401(k)
WEALTH/FINAL EARNINGS, MEN WITH
HS DEGREE AND/OR SOME COLLEGE
95
90
85
80
75
70
65
60
55
50
45
40
100% Bonds
35
30
50-50 Bonds/S&P
25
100% S&P500
20
50-50 Bonds/Company Stock
15
10
100% Company Stock
5
0
0
20
40
60
80
100
120
140
401(k) WEALTH/FINAL EARNINGS, MEN
WITH HS AND/OR SOME COLLEGE,
ONE-STOCK VOLATILITY FACTOR = 1.5
95
90
85
80
75
70
65
60
55
50
45
40
100% Bonds
35
30
50-50 Bonds/S&P
25
100% S&P500
20
50-50 Bonds/Company Stock
15
10
100% Company Stock
5
0
0
20
40
60
80
100
120
140
CERTAINTY EQUIVALENTS, HS
GRADUATES, BASELINE CASE
Relative Risk Large Cap
Aversion
Stock
2.87
=0
Company
Stock
2.87
 = 1 (Log)
2.32
1.42
=2
1.97
1.08
=4
1.58
0.88
CERTAINTY EQUIVALENTS, HS
GRADUATES, “HALF OTHER
WEALTH”
Relative Risk Large Cap
Aversion
Stock
3.64
=0
Company
Stock
3.66
 = 1 (Log)
2.78
1.47
=2
2.24
0.97
=4
1.64
0.72
CERTAINTY EQUIVALENTS, HS
GRADUATES,NO OTHER WEALTH
Relative Risk Large Cap
Aversion
Stock
5.48
=0
Company
Stock
5.45
 = 1 (Log)
3.81
1.09
=2
2.69
0.12
=4
1.44
0.003
CERTAINTY EQUIVALENTS, HS
GRADUATES, COMPANY STOCK
VOLATILITY = 1.5*MARKET
Relative Risk Large Cap
Aversion
Stock
2.85
=0
Company
Stock
2.84
 = 1 (Log)
2.31
1.86
=2
1.97
1.46
=4
1.58
1.14
CERTAINTY EQUIVALENTS, HS
GRADUATES, EQUITY PREMIUM
REDUCED BY 200 BASIS POINTS
Relative Risk Large Cap
Aversion
Stock
2.02
=0
Company
Stock
2.02
 = 1 (Log)
1.72
1.19
=2
1.53
0.98
=4
1.30
0.83
CONCLUSIONS FROM
SIMULATIONS
• Investments Restricted to Company
Stock May be Worth Only Half as
Much as Diversified Equity Holding
• “Equity Premium Puzzle” Appears:
Return to Diversified or Poorly
Diversified Equity Portfolio is High
• Costs of Non-Diversification Depend
on Other Elements of Household
Portfolio
KEY CONSIDERATIONS FOR
POLICY DESIGN
• Do Investors Accurately Perceive
Risk-Return Tradeoffs?
• Problem of Investor Heterogeneity?
Constrain Those Who Make
“Plausible” Allocations to Avoid
“Risky” Allocations of a Minority?
PUBLIC AND PRIVATE
RESPONSES TO LACK OF
DIVERSIFICATION
• Limitations on Investment Options
• Limitations on Asset Allocation –
How Frequently “Tested?”
• Participant Education by
Government or Firm – Any Liability
Issues?