PORTFOLIO RISK AND RETIREMENT SAVING

James M. Poterba

MIT

April 2003

PENSION SAVING IS CHANGING

• U.K.: Increasing Importance of Defined Contribution Plans (About One Quarter of Private Plans)

• 1986 Social Security Act: DC Plans and Opt-Out from SERPS

• U.S.: Rising Importance of Self-Directed Retirement Arrangements

DB vs. DC PENSION PLANS

• Defined Benefit Plan: Specifies a Guaranteed Annuity Payout According to a Formula Based on Wages, Years of Service, etc.

• Defined Contribution Plan: Payout at Retirement Depends on Value of Assets, Which Depend on Past Employer and Employee Contributions

SHIFTING LANDSCAPE FOR U.S. PENSION SAVING

• Rapid Rise in Retirement Assets/Wages (0.5 to 2.5, 1975-99)

• 1975: DC Plans Represent About 25% of Participants and Plan Assets

• 1980: 64% of Private Retirement Saving Contributions to DB Plans

• 1999: 85% of Contributions are to “Individual Directed” Plans, > 50% of Assets in DC Plans

GROWING ROLE OF DC PLANS IN U.K.

• 1975: < 2% of Private Sector Occupational Pensions Were DC Plans

• 2001: 22% of Private Plans Are DC

WHY THE SHIFT FROM DB TO DC PLANS?

• U.K.: DC Plans Can Reduce Employer Costs, Allow Greater “Pension Portability” for Workers

• U.S.: Regulatory Changes such as ERISA (1974); Rising Stock Market and Shifting Worker Tastes

COMPARING THE RISKS OF DB AND DC PLANS

• DC Plans: Worker Bears Risk of Asset Price Changes, Must Make Investment & Withdrawal Decisions

• DB Plans: Worker May Lose Large Fraction of Benefits if Changes Jobs Before Benefits Fully Vest

AVERAGE TENURE ON CURRENT JOB, 1983-1998, US

MEN (Friedberg & Owyang)

Potential Experience:

1983 1992 1998

6-15 Years 4.9 4.8 4.4

16-25 Years 9.9 8.1 8.6

26-35 Years 14.2 14.1 13.6

POLICY ISSUES RAISED BY DC PLAN GROWTH

• Accumulation Phase: Should Worker Choice be Restricted? Should There be Guarantees on Returns? What is the Role of Participant Education?

• Payout Phase: Should Annuities be Required? Again, What Role for Education?

CURRENT U.S. POLICY DEBATE ON ACCUMULATION

• High-Profile Collapse of Firms with Company Stock in 401(k) Plans (Enron, Polaroid)

• Weak Stock Market Performance Since 2000 Trimming 401(k) Balances

• Links to Policy Debate on Social Security Privatization

ASSET ALLOCATION IN 401(k) PLANS: STYLIZED FACTS

• Overall Asset Allocation in DC Plans is Similar to Asset Allocation in DB Plans

• About 20% of 401(k) Assets are in Employer Stock

• Many Plans Have High Company Stock Holdings

HOW MUCH EMPLOYER STOCK IN 401(k) PLANS?

• Most Plans Hold None • Large Plans of Publicly Traded Firms Have

Substantial Holdings• Need to Distinguish Employee Allocations vs.

Employer Match• Some Saving Plans Were “ESOPs”

AGGREGATE ASSET ALLOCATION IN 401(k)

PENSION PLANSEquity Funds 51%

Bond Funds & GICs 19

Company Stock 19

Balanced Funds 8

Other 7

ASSET ALLOCATION PATTERNS BY AGE

30s 40s 60s

Company Stock

18.4% 19.7% 16.3%

Equity Funds

60.2 54.8 39.8

GICs 4.6 7.5 19.3

INVESTMENT IN COMPANY STOCK: CHOICE OR

CONSTRAINT? • Some Investment is Worker Directed --

Workers Decide to Hold Company Stock• Some Investment is Driven by Firm

Contributions, Particularly “Matching Contributions”

• Do Workers Think About Correlation with Human Wealth?

INVESTMENT DECISIONS OF 401(k) PARTICIPANTS WHO

CAN INVEST IN OWN STOCK

>30% in Co. Stock 39%

> 50% 28%

> 70% 20%

> 90% 15%

HOW RISKY IS COMPANY STOCK? (Mitchell & Utkus)

• Ten-Year Average Annual Return on Company Stock

(1992-2001): 10.9%• Ten-Year Average Annual Return on S&P 500: 12.9%• Average Standard Deviation of Company Stock

Return: 34.4%• Average Standard Deviation of S&P500 Return:

17.3%

PERCEIVED RISKINESS OF DIFFERENT MUTUAL FUND

TYPES (John Hancock)

• Money Market Funds: 2.4

• Balanced Funds: 2.8

• Company Stock: 3.2

• Stock Funds: 3.6

• International Funds: 4.0

SHARE OF COMPANY STOCK IN FIVE LARGEST DC PLANS

• General Electric: 68% (σ = 33%)

• Verizon: 38% (σ = 33%)

• IBM: 12% (σ = 39%)

• General Motors: 21% (σ = 35%)

• Lockheed-Martin: 36% (σ = 37%)

FIVE LARGE DC PLANS WITH HIGHEST SHARE OF COMPANY STOCK

• Proctor and Gamble: 90% (σ = 37%)

• General Electric: 68% (σ = 33%)

• Chevron-Texaco: 60% (σ = 28%)

• Wells Fargo: 48% (σ = 34%)

• SBC Communication: 44% (σ = 35%)

INVESTMENT STRATEGY FOR SOME WORKERS

FACTORS THAT AFFECT THE COST OF POOR

DIVERSIFICATION

• Volatility of Company Stock

• Time Profile of Contributions

• Other Components of Retirement Income Wealth (SERPS, DB Pension, Private Saving) – Mean and Covariances

• Correlation with Human Capital Risk

LIFECYCLE MODEL, UTILITY-BASED APPROACH TO

EVALUATING COST OF RISK

• Simulate Retirement Wealth for Different Investment Volatilities

• Evaluate Expected Utility of Wealth-at-Retirement

• Compare with Expected Utility Various Investment Strategies

• Translate Into Certainty-Equivalents

EXPECTED UTILITY ALGORITHM

Contribution Profile: .10*(Labor Income)

Utility of Wealth at Retirement:

U(Wret + Wother) = (Wret + Wother)1- /(1-)

E(Utility of Retirement Wealth) =

EUCompany, EUBonds, EU50-50, EUSP500

Wealth Equivalent:

[WESP500]1-/(1-) = EUSP500

SPECIFIC ACCUMULATION ASSUMPTIONS

Working Life: 35 Years Starting at Age 30

Contributions = 10% of Wage Earnings

Five Investment Options: Index Bonds (1.5% Per Year, Real Return); Large Cap Stocks; Individual Company Stock; Two 50/50 Mixes

Calibrate Non-401(k) Wealth at Retirement Based on Health and Retirement Survey

MEDIAN EARNINGS HISTORIES, SINGLE MEN

AGED 66-67

0.0

0.5

1.0

1.5

2.0

2.5

30 35 40 45 50 55 60 65

Less than High SchoolHigh School or Some College

College or Postgraduate

FINAL INCOME, BY EDUCATION GROUP ($2000)

< HS Education

HS + Some College

College or Beyond

Median $23.8 $34.7 $60.7

Mean 27.4 36.9 58.6

MEDIAN WEALTH AT RETIREMENT, HRS SAMPLE OF

SINGLE MEN AGED 66-67 ($2000)< HS Education

HS + Some College

College or Beyond

PDV Social Sec.

$126.3 $147.8 $175.5

DB Pension 15.9 100.6 136.8

Other Financial

16.7 69.0 245.0

SOCIAL SECURITY, DB, & FINANCIAL WEALTH (RELATIVE

TO FINAL EARNINGS)

0

10

20

30

40

50

60

x<10 10<=x<20 20<=x<30 30<=x<40 x>= 40

ratio

perc

ent

of s

ingl

e m

en

Less than HS

HS or Some College

College or Postgraduate

FINANCIAL WEALTH RELATIVE TO FINAL

EARNINGS

0

10

20

30

40

50

60

70

x<0 0<=x<2 2<=x<4 4<=x<6 6<=x<8 8<=x<10 x>10

ratio

per

cen

t o

f si

ng

le m

en

Less than HS

HS or Some College

College or Postgraduate

FINANCIAL WEALTH (EXCLUDING IRAs) RELATIVE

TO FINAL EARNINGS

0

10

20

30

40

50

60

-1<=x<0 0<=x<1 1<=x<2 2<=x<3 3<=x<4 4<=x<5 x>5ratio

per

cen

t o

f si

ng

le m

en

Less than HS

HS or Some College

College or Postgraduate

ASSUMPTIONS ABOUT ASSET RETURNS

Return on Index Bonds: 1.5% Per Year (Real)

Large-Cap Stock Returns: Empirical Distribution, 1926-2001; Mean Real Return = 9.4%, Annual Standard Deviation = 20.2%

Individual Company Stock Return: Mean = 9.4%, Standard Deviation = 40.4%

DISTRIBUTION OF EQUITY RETURNS, LARGE CAP U.S.

STOCKS, 1926-2001

0

2

4

6

8

10

12

14

16

18

20

-40<=x<-30 -30<=x<-20 -20<=x<-10 -10<=x<0 0<=x<10 10<=x<20 20<=x<30 30<=x<40 40<=x<50 50<=x<60

% Equity Return

Nu

mb

er o

f Y

ears

SIMULATION ALGORITHM 1. Draw Sequence of 35 Annual Stock

Returns (and Associated Company Stock Returns) from Empirical Distribution for Actual Returns

2. Calculate Wealth at Retirement for Each Education Group for Each Sequence

3. Evaluate Utility of Retirement Wealth4. Repeat (300,000 times)5. Compute Sample Means as Estimates of

Expected Utility6. Calculate Certainty Equivalents

DISTRIBUTION OF 401(k) WEALTH/FINAL EARNINGS, MEN WITH HS DEGREE AND/OR SOME

COLLEGE

0

5

10

15

20

25

30

35

40

45

50

55

60

65

70

75

80

85

90

95

100% Bonds

50-50 Bonds/S&P

100% S&P500

50-50 Bonds/Company Stock

100% Company Stock

0 20 40 60 80 100 120 140

401(k) WEALTH/FINAL EARNINGS, MEN WITH HS AND/OR SOME COLLEGE,

ONE-STOCK VOLATILITY FACTOR = 1.5

0

5

10

15

20

25

30

35

40

45

50

55

60

65

70

75

80

85

90

95

100% Bonds

50-50 Bonds/S&P

100% S&P500

50-50 Bonds/Company Stock

100% Company Stock

0 20 40 60 80 100 120 140

CERTAINTY EQUIVALENTS, HS GRADUATES, BASELINE CASE

Relative Risk Aversion

Large Cap Stock

Company Stock

= 0 2.87 2.87

= 1 (Log) 2.32 1.42

= 2 1.97 1.08

= 4 1.58 0.88

CERTAINTY EQUIVALENTS, HS GRADUATES, “HALF OTHER

WEALTH” Relative Risk Aversion

Large Cap Stock

Company Stock

= 0 3.64 3.66

= 1 (Log) 2.78 1.47

= 2 2.24 0.97

= 4 1.64 0.72

CERTAINTY EQUIVALENTS, HS GRADUATES,NO OTHER WEALTH

Relative Risk Aversion

Large Cap Stock

Company Stock

= 0 5.48 5.45

= 1 (Log) 3.81 1.09

= 2 2.69 0.12

= 4 1.44 0.003

CERTAINTY EQUIVALENTS, HS GRADUATES, COMPANY STOCK

VOLATILITY = 1.5*MARKET Relative Risk Aversion

Large Cap Stock

Company Stock

= 0 2.85 2.84

= 1 (Log) 2.31 1.86

= 2 1.97 1.46

= 4 1.58 1.14

CERTAINTY EQUIVALENTS, HS GRADUATES, EQUITY PREMIUM

REDUCED BY 200 BASIS POINTS Relative Risk Aversion

Large Cap Stock

Company Stock

= 0 2.02 2.02

= 1 (Log) 1.72 1.19

= 2 1.53 0.98

= 4 1.30 0.83

CONCLUSIONS FROM SIMULATIONS

• Investments Restricted to Company Stock May be Worth Only Half as Much as Diversified Equity Holding

• “Equity Premium Puzzle” Appears: Return to Diversified or Poorly Diversified Equity Portfolio is High

• Costs of Non-Diversification Depend on Other Elements of Household Portfolio

KEY CONSIDERATIONS FOR POLICY DESIGN

• Do Investors Accurately Perceive Risk-Return Tradeoffs?

• Problem of Investor Heterogeneity? Constrain Those Who Make “Plausible” Allocations to Avoid “Risky” Allocations of a Minority?

PUBLIC AND PRIVATE RESPONSES TO LACK OF

DIVERSIFICATION

• Limitations on Investment Options

• Limitations on Asset Allocation – How Frequently “Tested?”

• Participant Education by Government or Firm – Any Liability Issues?