PROJECT M
 
PROJECT M
John Y. Campbell

Safer saving

Retirement savers are in dire need of professional help, says Professor John Y. Campbell. Eventually, employers will provide investment advice through funds managed on behalf of their employees

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Safer saving

Retirement savers are in dire need of professional help, says Professor John Y. Campbell. Eventually, employers will provide investment advice through funds managed on behalf of their employees


John Y. Campbell

I believe we need to move towards institutional management of retirement funds on the savers’ behalf, as many people have difficulties managing the options provided. They need some equivalent of the kind of professional investment that defined benefit (DB) plans traditionally provided. It seems important to me to make a distinction between a standard and a supplemental account. The standard one is the initial saving of the employee, up to 10% of annual compensation, plus employer contributions. There should be limitations on the way this is invested since the single worst mistake that people make in DC plans is to invest heavily in their own company’s stock. So, in the standard piece of a DC saving plan, I would rather see well diversified products with moderate fees and no company stock. As people contribute more savings, there can be a broader range of options, but there needs to be more disclosure too.

PROJECT M

What exactly do you mean?

John Y. Campbell

A financial analogy of the nutrition label on a food product seems a good way to present the individual saver with a limited overview of the financial product on offer. But you have to be careful about what actually drives such a ranking because a bad ranking system can be extremely misleading.

PROJECT M

In what way?

John Y. Campbell

Take Morningstar ratings of mutual funds. They heavily emphasize past performance. I think it is more important to present measures of risk.

PROJECT M

What role do fees play in this context?

John Y. Campbell

Most individual investors are likely to lose – at least as much in fees – as they gain in alpha. Individual investors are not well equipped to assess the trade off between fees and alpha, or to bargain for lower fees. The question you have to ask is: why should skilled fund managers leave any money on the table for the capital providers? In the world of retail mutual funds, there is little reason to do so and an individual investor should not expect to benefit from picking an active fund versus an index fund.

PROJECT M

Eventually, we will arrive at an intermediary situation between the two extremes of pure DB and pure DCJohn Y. Campbell

What long-term developments do you expect with regard to DB and DC?

John Y. Campbell

Eventually, we will arrive at an intermediary situation between the two extremes of pure DB and pure DC, where either the employer or the employee bears all the investment risk: an employer sets up a fund on behalf of a group of employees and by doing so provides a certain degree of investment advice. Recent reforms in US pension laws have furnished the legal framework for companies to do so without a major risk of being sued in case the investment performs poorly. This would also give individuals an opportunity to gain access to the potential benefits of active asset management.

PROJECT M

Are there examples of this?

John Y. Campbell

One example is the Australian superannuation industry, which offers a mechanism by which individual retirement savers can pool resources with the help of their employers and benefit from professional asset management.

PROJECT M

How can the financial industry contribute to keeping savings safe?

John Y. Campbell

There are many difficulties in designing an optimal strategy for retirement saving. I think there is an important role for inflation-indexed government bonds to make the portfolio safe in real, not nominal, terms as well as over the long term, not the short term. Risk also needs to be broadly diversified across asset classes. Retirement saving, in my opinion, also ought to earn an illiquidity premium because savers do not need daily access to funds. However, it is a challenge to design a real-world DC pension system so as to earn the illiquidity premium.

PROJECT M

How can we meet this challenge?

John Y. Campbell

You can earn an illiquidity premium in various asset classes. Private equity is one example: corporate bonds, real estate, and agricultural and timberland are others. For example, TIAA-CREF [a fund for teachers and associated professionals in the United States: $398 billion assets under management] gives a DC retirement saver access to commercial real estate and the illiquidity premium it offers. That is unusual.

PROJECT M

How should retirement provisions develop over a person’s career?

John Y. Campbell

Most people take too little equity exposure early in life and too much later in life. Life-cycle funds make adjustments that I think are helpful. One of the reasons why this downturn proved so disastrous for many people close to retirement is that during the boom they had allowed their equity allocations to increase far beyond what they originally intended. And then they lost more in the downturn than they should have done because they failed to rebalance. So I’m in favor of funds that rebalance for you. Even rebalancing to fixed weights is better than nothing, but rebalancing to life-cycle-related weights is desirable.

John Y. Campbell

What do you think the main factors for those weights should be?

PROJECT M

In principle they should be related to the income profile and the risks of income. But a good simple approach is to have a set of funds that offer gradually declining equity exposure over the life cycle.

John Y. Campbell

How do you think saving should change in the retirement phase?

PROJECT M

I think there needs to be equity exposure and some investment risk, even in retirement. But, at the same time, one should recognize that after retirement, you have lost a valuable asset – your human capital. And that asset previously provided an income that for most people is quite stable and more bond-like than stock-like.