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Reducing Social Security PRA Risk at the Individual Level

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... to rebalance away from stocks and towards bonds as retirement ... 100 basis points for stocks, bonds and TIPS. 120 basis points for lifecycle funds ... – PowerPoint PPT presentation

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Title: Reducing Social Security PRA Risk at the Individual Level


1
Reducing 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
2
Motivation
  • 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

3
Preview 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

4
Market 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
5
Asset Allocation in Target-Year Lifecycle Funds
by Retirement Year
6
Simulating 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)

7
Simulation 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

8
Simulation 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

9
Asset Allocation Strategies
  1. 100 TIPS
  2. 100 Government Bonds
  3. 100 Large Cap Corporate Equity
  4. (110 - Age) Stocks, (Age10) TIPS
  5. (110 - Age) Stocks, (Age10) Government Bonds
  6. Empirical Lifecycle, Stocks and TIPS
  7. Empirical Lifecycle, Stocks and Bonds
  8. Feldstein No Lose Plan
  9. Optimal Fixed Proportions (5 Grid)
  10. Optimal Linear Lifecycle (5 Grid)

10
Simulating 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

11
Expense 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

12
Baseline Expense Ratios, No Other Wealth
13
Various Expense Ratios, No Other Wealth
14
Optimal Fixed Proportion and Linear Lifecycle
Strategies
15
Lifecycle vs. Optimal Strategies
16
Effects 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.

17
Conclusions
  • 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
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