Paolo Volpin (London Business School)
“The Future of Pension Plan Funding”
LSE, 7 June 2007
1

• 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.
2

• 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.
3

• 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.
4

• 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].
5

• 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.
6

• 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.
7

• 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)).
8

• 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.
9

• 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.
10