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
20.00%
1927-2001
18.00%
1927-1963
16.00%
1963-2001
14.00%
12.00%
1927-2001 predicted
1927-1963 predicted
1963-2001 predicted
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
0.00
0.50
1.00
1.50
2.00
Overpricing of Equity Index Options
50
45
40
35
30
25
20
15
10
5
0
Jan-90
Oct-92
Jul-95
VIX
Apr-98
Jan-01
30-day Historical Volatility
Oct-03
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
105
105
95
95
85
85
75
Domestic Bonds
75
65
65
55
55
45
45
35
35
25
25
15
Domestic Equities
15
5
-5
1992
5
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Cash
Domestic Equities
Private Equity
Foreign Equities
Emerging Markets
Domestic Bonds
Foreign Bond
High Yield Bonds
Inflation-indexed Bonds
Real Estate
Commodities
Absolute Return
2003
-5
2004
Harvard Investment Beliefs (1)
Source: HMC Capital Market Assumptions, 2004
7
Timber
Expected Excess Return
6
Private Equity
5
Emerging Markets
4
Real Estate
Domestic
Equity
Foreign
Equity
High Yield
3
Absolute Return
2
1
Inflation-indexed Bonds
Domestic Bonds
Foreign Bonds
Commodities
0
0
5
10
15
Standard Deviation
20
25
Harvard Investment Beliefs (2)
Source: HMC Capital Market Assumptions, 2004
7
Timber
Expected Excess Return
6
Private Equity
Emerging Markets
5
Real Estate
4
Foreign Equity
Domestic Equity
High Yield
3
Absolute Return
2
Commodities
Foreign Bonds
1
Domestic Bonds
Inflation-indexed Bonds
0
0.00
0.20
0.40
0.60
0.80
1.00
1.20
Beta with Portfolio of 60% Domestic Equity/40% Domestic Bonds
1.40
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.