CFA Institute

The Pension Challenge: Risk Transfers and Retirement Income Security by Olivia S. Mitchell;Kent SmettersReview by: Martin S. FridsonFinancial Analysts Journal, Vol. 60, No. 5 (Sep. - Oct., 2004), p. 95Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4480606 .

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Financial Analysts Journal Volume 60 Number 5 j

?2004, CFA Institute .

BOOK REVIEWS

Martin S. Fridson, Editor

The Pension Challenge: Risk Transfers and Retirement Income Security. Edited by Olivia S. Mitchell and Kent Smetters. Oxford University Press, 198 Madison Avenue, New York, NY 10016, 800-451-7556, www.oup.com/us. 338 pages, $79.50.

Reviewed by Martin S. Fridson, CFA.

"While those who oppose augmenting social secu- rity systems with personal savings accounts often point to investment risk as a reason to oppose them, they miss an important point," write Olivia S. Mitchell and Kent Smetters, editors of The Pen- sion Challenge: Risk Transfers and Retirement Income Security. "True advance funding of future pension liabilities always requires an increase in capital holdings, and the risk associated with capital assets must be borne by someone." Unfortunately, "someone" often turns out to be a party other than the recipients of the plan's benefits. In an examina- tion of risk transfer in public pension plans, for example, consultant Jeremy Gold shows that seem- ingly fair actuarial processes systematically favor current plan participants, taxpayers, and politi- cians over future taxpayers.

Mitchell and Smetters, who are professor and assistant professor, respectively, at the Wharton School of the University of Pennsylvania, have pro- duced an excellent international perspective on a vital issue. Among their authors are academics in Australia, Belgium, Canada, Germany, and the United States. Affiliations of the contributing prac- titioners include the International Monetary Fund, Moody's Investors Service, NetRisk, the Public Pol- icy Institute at AARP, the Vanguard Group, and the World Bank.

One point that clearly emerges from the book's well-researched pages is that employees need con- siderable education about their investment choices. Research indicates, for instance, that 401(k) plan participants tend to believe that the stock of their

own companies is not only safer than other stocks but safer than an index of stocks. In aggregate, they clearly must be wrong, just as it is impossible for every child to be above average.

Against this sometimes frightening backdrop, The Pension Challenge provides valuable, practical guidance. For example, the book challenges the blithe assumption that buying stocks for the long run is a safe strategy despite their volatility from year to year. The editors point out that there were 15 years in the 20th century in which the real value of U.S. stocks declined by more than 40 percent over the succeeding decade.

In a similar vein, Zvi Bodie of Boston Univer- sity quotes investment advice offered by a leading financial institution that emphasizes that the range of returns on stocks narrows as the measurement period extends from 1 year to 30 years. Bodie declares the reasoning invalid and perhaps also "dangerously misleading." Dispersion of the aver- age compound rate of return does decline over time, he says, but this rate is not the relevant statistic. To an investor trying to determine how much to invest today to accumulate a stated sum in 30 years, the key is the terminal value of the portfolio. That fig- ure's dispersion does not diminish with time.

As for the book's production quality, Oxford University Press deserves high marks overall. Just a minor criticism is warranted by the erratic handling of names in the index. Certain persons are identified by initial and surname (e.g., Bush, G.W., Clinton, B.) and others by surname only, even when the text supplies the given name (e.g., Bachelier, Scholes). Duen Li Kao is inexplicably listed as Kao, D-I).

In conclusion, the evolution of retirement sys- tems has profound implications for a variety of investment professionals-including private wealth managers, institutional asset allocators, and security analysts concerned with the valuation implications of corporate pension commitments. In The Pension Challenge, all types of practitioners will find comprehensive, up-to-date treatment of the essential issues written in language commendably accessible to the nonspecialist.

-M.S.F. Martin S. Fridson, CFA, is CEO of FridsonVision LLC, New York City.

September/October 2004 www.cfapubs.org 95

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