Title: Reducing Social Security PRA Risk at the Individual Level
1Reducing Social Security PRA Risk at the
Individual Level Lifecycle Funds and No-Loss
Strategies
Pathways to a Secure Retirement
Conference,August 2006, Washington, DC
Joshua Rauh University of Chicago and NBER
David Wise Harvard and NBER
James Poterba MIT and NBER
Steven Venti Dartmouth and NBER
2Motivation
- Lifecycle funds charge investors to rebalance
away from stocks and towards bonds as retirement
draws near - Market for these funds has grown exponentially in
recent years - Could these products mitigate risk in a Social
Security system with private investment accounts
(PRA)? - This paper uses simulations to examine expected
utility of wealth at retirement under different
PRA asset allocation strategies - Particular attention to lifecycle funds versus
age-invariant strategies - Simulation framework developed in PRVW (2005) to
calculate and compare certainty equivalent
measures of the different strategies
3Preview of Results
- Expected utility associated with different 401(k)
asset allocation strategies, and the ranking of
these strategies, sensitive to - the expected return on corporate stock
- the relative risk aversion of the investing
household - the amount of non-PRA wealth that the household
will have available at retirement - expenses associated with given strategy
- There often exists a fixed-proportions portfolio
of stocks and inflation-indexed government bonds
that yields expected utility at retirement at
least as high as that from lifecycle strategies - When asset allocation is reasonably close,
variation in expense ratios is more important
than variation in asset allocation
4Market for Target-Year Lifecycle Funds
50
billions
45
40
35
30
25
20
15
10
5
0
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Data source Morningstar
5Asset Allocation in Target-Year Lifecycle Funds
by Retirement Year
6Simulating DC Account Balances Related Literature
- Empirical Literature
- PRVW (2005)
- Samwick and Skinner (2004)
- Shiller (2005)
- Theoretical Literature
- Merton (1969), Samuelson (1969), Bodie, Merton
and Samuelson (1988), - Gollier (2001), Gollier and Zeckhauser (2002)
- Campbell and Viceira (2002), Cocco, Gomes and
Maenhout (2005)
7Simulation Model
- 401(k) Accumulation Profile for a Given Household
(i)
return net of investing expenses
- Contribution for a Given Household (i)
assuming this is all earnings, not just Social
Security covered earnings
- Information on household earnings and wealth from
the Health and Retirement Study (HRS) - Focus on the 1400 couples with male aged 63-72
for which Social Security earnings histories
available for secure restricted use
8Simulation Technique
- Evaluate household utility at retirement using a
standard constant relative risk aversion utility
function -
- Find certainty equivalents accounting for the
fact that households have non-PRA wealth, given
by non-pension annuities and other financial
wealth
9Asset Allocation Strategies
- 100 TIPS
- 100 Government Bonds
- 100 Large Cap Corporate Equity
- (110 - Age) Stocks, (Age10) TIPS
- (110 - Age) Stocks, (Age10) Government Bonds
- Empirical Lifecycle, Stocks and TIPS
- Empirical Lifecycle, Stocks and Bonds
- Feldstein No Lose Plan
- Optimal Fixed Proportions (5 Grid)
- Optimal Linear Lifecycle (5 Grid)
10Simulating Equity Returns
- All portfolio strategies are simulated under two
distributions for equity - historical empirical distribution of simple
annual returns, with replacement - same but with equity returns reduced by 300 basis
points
11Expense Ratio Assumptions
- 1. Baseline assumptions
- 32 basis points for equity mutual funds and
government bond funds (weighted mean of SP 500
index funds from Hortaçsu and Syverson (2004)) - 40 basis points for TIPS
- 40 basis points for lifecycle funds
- 2. Actual average expense ratios for lifecycle
funds, 74 basis points - 3.High expense ratios for everything
- 100 basis points for stocks, bonds and TIPS
- 120 basis points for lifecycle funds
12Baseline Expense Ratios, No Other Wealth
13Various Expense Ratios, No Other Wealth
14Optimal Fixed Proportion and Linear Lifecycle
Strategies
15Lifecycle vs. Optimal Strategies
16Effects of Other Wealth
- Optimal fixed proportions does slightly better
than the empirical lifecycle portfolio for the
higher two education categories under baseline
expense ratios and historical equity returns - A 100 stocks strategy dominates for these
education groups under the high expense ratio
scenario - their background wealth makes them effectively
less risk averse - the lifecycle funds cost 120 basis points
compared to the equity funds 100 basis points.
17Conclusions
- Higher risk aversion, lower expected stock
returns, lower non-PRA wealth are the factors
that reduce the attractiveness of a 100 stocks
strategy - Avoiding high expense ratios is critical for
households saving for retirement in PRAs - Many of the available lifecycle products have
higher expense ratios than could be achieved by
the household - Households who are unable to do this on their own
will not do terribly in lifecycle funds but they
will lose money relative to what they could get
if they executed very simple investing strategies
on their own