The Pension Challenge. Risk Transfers and Retirement Income Security

The Pension Challenge. Risk Transfers and Retirement Income Security, edited by Olivia S. Mitchell and Kent Smetters, 2003, New York/Oxford: Oxford Univ. Press, 328 pages. I. This is a very interesting collection of essays mainly concerned with new developments enhancing old-age income security and its costs. Issues such as increasing volatility in capital markets combined with massive global demographic change force academics, financial practitioners, pension participants young and old, and policymakers "to search for innovative and creative responses" (p. 1). After an informative "Overview" by the two editors, there follow thirteen papers organized under two headings: Plan Sponsors and Retirement Income Risk covers six papers by Bodie, Mitchell, and Utkus; Ramaswamy, Doyle, and Piggott; Gold, and Palacios. Global Developments in Retirement Risk Transfers contains seven papers by Lachance and Mitchell, Maurer and Schlag; Forsyth, Vetzal, and Windcliff; Walliser, Turner, and Rajnes, Cummins and Lewis; and Fliegelman, Milevsky, and Robinson. II. In the following review, I shall comment on only a few of these papers, according to my personal interest in evaluating the costs of the implied risk transfer. Increasingly, the traditional defined benefit (DB) model has been substituted with defined contribution (DC) plans. Yet, many of the challenges for DB plans, either centralized public funds or private sector plans, apply also for DC plans (whether public or private). Only a public entity can supervise the funds, and this task requires competence and transparency. Furthermore, government in its role as regulator and supervisor can produce the same distortionary consequences as might have existed in the old public managed system. Additionally, decentralization and competition imply costs that reduce the net investment returns. And these costs result either as pure administration (and selling) costs, or as costs of the risks the plan sponsors transfer to participants. A prominent place here is taken by the investment risk and the hypothesis, that investment risk becomes less important over the long run. As put by Zvi Bodie (in chapter 2), "The apparent reduction in risk is a statistical illusion arising from the fact that the measure of return used is an average compound rate" (p. 21). However, this is not the relevant parameter but "the dispersion of the value of the portfolio in 30 years. The dispersion of long-term holdings does not fall with time" (p. 21). The same is true also with another argument, related to the probability of a shortfall (pos), where this "occurs if the value of a stock portfolio at the horizon date is less than the value an investor would have received by investing in safe bonds (e.g., Treasury bonds) maturing on that same date" (ibid). Now, if the expected average compound return on stocks exceeds the risk-free rate of interest, "it is indeed true that the probability of a shortfall declines with the length of the investment time horizon" (ibid). However, this pos is again "a flawed measure of risk because it completely ignores the severity of the financial loss should a shortfall occur" (ibid). The "right" measure, according to Bodie, is the cost of insurance of the wealth position at the maturity date, and this is a put option: "According to theory, and in actual practice, the put price representing the cost of insuring against a shortfall increases as the investment horizon lengthens" (p. 22). This result is confirmed by Marie-Eve Lachance and Olivia Mitchell (in chapter 8) for Individual Account Guarantees (as part of a social security reform). Without going into details of calculating these IA guarantee costs, the results are astonishing. For an investor with a 40-year investment horizon and a 50/50 stock/bond portfolio, "the cost of guaranteeing the 10-year Treasury bond returns would be 0.65 percent of assets annually," or equivalently $3,406 in present value dollars or 16 percent of total contributions (p. …