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
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
20.00%
0.00 0.50 1.00 1.50 2.00
1927-2001
1927-1963
1963-2001
1927-2001 predicted
1927-1963 predicted
1963-2001 predicted
Overpricing of Equity Index Options
05
101520253035404550
Jan-90 Oct-92 Jul-95 Apr-98 Jan-01 Oct-03
VIX 30-day Historical Volatility
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
Domestic Equities
Domestic Bonds
-5
5
15
25
35
45
55
65
75
85
95
105
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
-5
5
15
25
35
45
55
65
75
85
95
105
Cash Domestic Equities Private Equity Foreign Equities
Emerging Markets Domestic Bonds Foreign Bond High Yield Bonds
Inflation-indexed Bonds Real Estate Commodities Absolute Return
Harvard Investment Beliefs (1)Source: HMC Capital Market Assumptions, 2004
0
1
2
3
4
5
6
7
0 5 10 15 20 25
Standard Deviation
Exp
ecte
d E
xces
s R
etu
rn
Private Equity
Emerging Markets
Timber
Real Estate Foreign Equity
Domestic Equity
CommoditiesDomestic BondsForeign Bonds
High Yield
Absolute Return
Inflation-indexed Bonds
Harvard Investment Beliefs (2)Source: HMC Capital Market Assumptions, 2004
0
1
2
3
4
5
6
7
0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40
Beta with Portfolio of 60% Domestic Equity/40% Domestic Bonds
Exp
ecte
d E
xces
s R
etu
rn
Foreign Equity
Emerging Markets
Private Equity
Absolute Return
High Yield
Timber
Real Estate
Inflation-indexed Bonds
Foreign BondsCommodities
Domestic Bonds
Domestic Equity
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.