The stock market s recent slump and Enron s collapse last year have focused new attention on employee exposure to equity risk, particularly in self-directed 401(k) plans that are gradually displacing traditional defined-benefit pensions.
While many workers continue to view company shares and the stock market as their long-term route to retirement security, that belief was questioned during a conference in April on Risk Transfers and Retirement Income Security sponsored by Wharton s Pension Research Council and The Financial Institutions Center.
The investment industry has a strong stock market bias, said Zvi Bodie, a finance professor at Boston University School of Management, who has studied retirement planning websites and challenges the financial planning notion that a diversified portfolio of stock makes the best investment over a long time horizon.
According to Bodie, hedging over time with fixed income or insurance products, rather than equity diversification, is the best way to manage risk. Diversification works cross-sectionally at a point in time, said Bodie. It does not reduce risk over time. There is no such thing as time diversification.
He said he was angered to find little mention of U.S. Treasury Inflation-Protected Securities (TIPS), which were introduced in 1997, on the financial planning engines he studied. The bonds allow investors to earn an inflation-protected return of 3.4% over the next 30 years, but he said these bonds have not been widely purchased.
There s a lot of talk going on now in policy circles in Congress about how to improve the risk reduction possibilities open to people in the wake of Enron and similar problems, he said. The lack of attention paid to inflation-protected bonds strikes me as an incredible failure of public policy.
Jeremy Siegel, Wharton finance professor and author of Stocks for the Long Run, said his premise that stocks are a better investment over a long period is relative to a random walk scenario. What I found in my analysis, he said, is that relative to a random walk, stocks became safer in the long run. Not that they became absolutely safer.
According to Siegel, an individual s tolerance for risk is tied to labor income. If a person is younger, he or she typically works longer to make up for investments in equities that go bad. Siegel suggested that retirement program managers ask participants directly: If we put you in stocks and stocks do badly, would you be willing to delay your retirement and work harder? If they say yes, that would lead to higher equities. However, Siegel questioned whether people would really be able to answer the question. Often you say one thing, but when it comes to that time 10 or 20 years out, you could change your mind.
He also stressed that the sequencing of equity returns can determine whether an investor has enough money to retire. He took the case of an individual with a life expectancy of 20 years at retirement. Even if stocks outperform bonds in 95% of every 20-year period, if the bad returns come at the beginning of retirement the investor could run out of money.
Siegel, too, likes inflation-adjusted treasury bonds, which he said are beginning to gain a following. Nominal bonds those with set face values are far from risk free, he noted, adding that in 1994, when he did the bulk of the analysis for his book, Treasury s inflation-adjusted bonds were not available. Over 30 years, the real return risk on standard nominal bonds was as high if not higher than the risk on a standard diversified portfolio, he said.
Siegel believes the premium for investment in equities is now about 2 to 3%. With tax adjusted bonds returning 3.5%, Siegel estimated a real return on equities of 5 to 6% going forward. It is far less than what we ve enjoyed in the past, but certainly it is positive, which some people don t seem to think is the case.
According to Siegel, the premium is lower because price-to-earnings ratios are higher and deserve to remain higher due to improvements in business efficiency and technology. He disagreed with some market forecasters who predict a decline in the ratios to around 14. My feeling is stocks should earn 5% or so.
The debate over employee ownership of company stock in 401(k) plans prompted an analysis of the associated risk by Wharton finance professor Krishna Ramaswamy, who pointed out that larger companies are the ones that make their contribution to defined-contribution plans in company stock. He cited research showing that only 3% of plans offer company stock, but 42% of all participants and 59% of all defined-contribution assets are covered by these plans. So actually this is a pretty important issue.
Some distortion, Ramaswamy said, is due to employees who voluntarily choose to buy additional company stock for their retirement portfolio. He said this raises issues of behavioral finance, including the endorsement effect of an employer and extrapolation of past results.
According to Ramaswamy, some plans simply make it easier for participants to designate company stock for their defined-contribution funds. He showed, for example, a complicated defined-contribution sign-up form that had company stock as the top option followed by the appealing phrase: If you entered 100%, stop, and go to the end! You re done! Said Ramaswamy: It turns out there are self-inflicted wounds. Participants actively engage in putting additional money in company stock.
Ramaswamy noted that according to his analysis, employees with 30% of their defined-contribution assets in company stock have an efficiency measure of only 64% when compared against an index of the S&P 500. At a level of 50%, the efficiency measurement drops to 39%.
By comparison, defined-benefit plans are restricted to holding no more than 10% in company stock. At that level, the efficiency measure for average risk is in the 90% range. Ramaswamy s research does not take into account diversification of the individual s entire assets, only the company stock.
Ramaswamy then put a dollar figure on these inefficiency costs by using an exchange-option formula across different time horizons. He found that for every $1,000, it would cost $178, or 17.8%, to purchase insurance against the risk entailed in the company stock versus the index for a period of one year. For three years, he said, the amount would rise to $303, or 30.3%.
It should frighten people to think that to insure $1,000 with an equal $1,000 in the S&P index, they have to give up 17%, he said. That s overpaying for something you don t need to have.
Stephen P. Utkus, a principal at The Vanguard Group who leads the research group in the company s participant education department, said Ramaswamy s work could help investors focus on the risk of volatility, not the potential for appreciation in a single stock. It isolates people from the question of return and gets to a more dispassionate question, which is volatility.
In media discussions, there does seem to be this operating assumption that $1 worth of stock is worth $1 in cash, said Utkus. The academics, of course, don t believe it, but practically everyone else does.
In the debate over company stock limitations on defined-contribution assets, Utkus noted that many assume companies would simply reduce their match, leaving workers worse off. The research response from the academic world is not necessarily. A dollar of stock is worth a lot less, depending on the volatility of the stock, than cash.
However, Utkus said he was not certain about the reliability of the exchange-option model over the long time periods involved in retirement investing. That might work over a short period, but I worry about any theoretical model where there is no active market in 25-year options, he said. If I were going to hedge this, I would want an active, liquid market that s already in existence.
Utkus discussed what he called the Hurricane Andrew Problem which he said can arise when key market makers expose themselves to systemic risk errors. On Florida s Gold Coast, development began in the 1950s and continued through the 1970s with few if any damaging hurricanes. As a result, he said, the probability of a hurricane occurring continued to fall until it occurred.
In December 2000, he continued, market makers would have been happy to make a very low-cost insurance product for the 401(k) investors at Enron. A year later, probably not.
The panel was asked about the double impact on employees, like those at Enron, who lose the value of their company stock at the same time they are losing their jobs. Ramaswamy said that problem may be overstated, because those thrown out of work at Enron still have valuable skills. Human capital doesn t die because Enron died, he said.
Bodie said the greater risk is not necessarily firm specific. The Enron case has raised the issue of lack of diversification in investing in your own company s stock. But let s say you re a stock broker or anyone whose future earnings are tied to financial services. Your future income is very much like an investment in the stock market. You are already heavily invested in the stock market. Do you really want your defined-contribution pension fund to be invested in the stock market also?
Utkus said that when the Employee Retirement Income Security Act (ERISA) was written in 1974 Congress discussed, but rejected, the idea of putting a limit on defined-contribution asset allocations. It did put a 10% limit on defined-contribution plans. Now with 401(k) plans, 20 years later we have high degrees of concentration and it is an interesting policy dilemma, he said.
Michael S. Gordon, a Washington D.C.-based lawyer who helped draft the ERISA laws, said the current debate ignores the political reality of the time ERISA was written. He said there was a proposal to add a 10% limit to defined-contribution plans, but it was rejected because the biggest and best-known profit-sharing plan was that of Sears Roebuck & Co. With no asset-allocation limits, the company was able to retire workers at four times their highest earnings. From a political point of view it became impossible to reverse, he said, adding that you have a similar disconnect today. You have people who are possessed with a quasi-religious belief in company stock.
The current debate over defined-contribution investment in company stock was compared to other investment mechanisms that shifted corporate risk to employees, including Employee Stock Ownership Plans.
Utkus said that for the past 40 years households, in general, have been taking on more responsibility for the management of their financial assets voluntarily and with greater sophistication.
But Bodie said he was concerned about individuals ability to manage
this crucial task. We are now in a very strange situation where government has retreated, and other institutions have retreated, from their active participation in various aspects of the economy. He suggested that government should play a larger role in helping people cope with the complexities of managing the risk in their retirement portfolios.
What do ordinary people know about that? he asked. It s like asking people to perform surgery on themselves as a solution to the problem of medical-cost inflation. It s nuts as far as I m concerned.