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Retirement Savings and Efficient Markets

Martin Leibowitz on the impact of retirement investments on the market

William Hester, CFA
April 2004

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In his 1985 book Investment Policy, Charlie Ellis built a case for market efficiency by arguing that active money management, like amateur tennis, is a loser's game. The business had attracted so many bright and hard working people that profits would not be determined by the skill of the participant, but by the errors made by the competition. With so many professionals in the business, there would be too few errors to earn profits.

This theory rests on two assumptions: that all professional investors are in fact, skilled, and that they make up the lions share of stock trading. The skill of professional investors is probably an open question. 1 The second assumption is now also in question because of a trend in the management of retirement assets. The makeup of the 'investing class' is changing as more individual investors are entering the competition.

U.S. retirement assets now make up about half of the $21 trillion dollars held by all US institutions and financial intermediaries, according to the Investment Company Institute.

This roughly $10 trillion in retirement assets breaks down into two parts: defined benefit plans and defined contribution plans. The first promises an employee a series of payments during retirement. Because the states, companies, and universities that offer these plans are on the hook for the benefits, they hire professionals to manage the assets.

Defined contribution plans let employees set money aside each year - mostly tax-deferred - for retirement. The decision of where to allocate these investments is left mainly up to the individuals.

For the first time, the amount of assets in defined contribution plans (including both 401(k)s and Individual Retirement Accounts) is greater than the amount held in plans that promise future benefits.

This lead is sure to grow because both employees and businesses prefer these plans. Investors feel empowered by having money for retirement in their own accounts. Businesses favor them because they are cheaper to run and they transfer essentially all of the shortfall-risk to the employee.

The Habits of Professionals and Individuals

The growing assets in defined contribution plans is a fundamental difference in today's market, says Martin Leibowitz, who has spent a career studying and writing about asset allocation and fixed income strategies. He thinks the trend of self-directed assets could change the trading patterns of stock markets and the way investment managers perform their jobs.

Mr. Leibowitz is uniquely qualified to speak about retirement portfolios. Up until last month he was Chief Investment Officer at TIAA-CREF, which provides investment options for the retirement plans of over 2 million teachers.

Mr. Leibowitz was able to study these portfolios to see how individuals managed their assets. He then compared these results to similar data from professional investors who manage accounts for colleges and universities.

He found that individual investors, in aggregate, rarely rebalance. Instead they let the best performing asset become a bigger part of their portfolio, until a bear market reallocates the assets for them.

From 1994 to the end of 1999, equity allocations in individual investor portfolios soared from 48 percent to about 65 percent of total assets. By the end of the bear market three years later, the equity portion was back down to 48 percent. In aggregate, investors traded very little during this time so the drop in their equity allocation was driven mainly by falling stock prices.

Equity allocations of professional investors were less volatile. Though professional investors did increase their positions from 50 percent in 1994 to 65 percent in 1999, in the four years that followed the pros held their equity positions steady at about 60 percent.

In 2003, this 60 percent equity position left them in a better position when prices rose that year (compared to the 48 percent individual portfolios held).

401(k)s and Market Volatility

When investors ride out market declines, they have little impact on price volatility. Sitting out a slump will neither slow nor speed up a decline. So how does the greater amount of self-directed assets change the trading patterns of stock markets?

The risk, says Mr. Leibowitz, is that individual investors could allow more emotion to direct their investment decisions. An extreme market move could force investors outside of their comfort zone, turning a behavior of holding into one of selling, he says. If so, then this larger pool of individual investors could represent a kind of 'time bomb' that could trigger forced selling and higher volatility.

A drop of 20 percent might do it (without a corresponding run up in bond prices, like the 2000-2003 period). He stressed that this was more of a gut feeling than one based on any quantitative work.

Even if investors believed that markets were efficient, a drop of this amount might skew their perception of risk, he said. "At these levels (of loss), investors would start to feel pain based on short term events, even in light of a long term investment strategy."

Investment Management

How does the greater amount of self-directed assets impact the investment management business? He highlighted three possible changes.

First, there could be more sizeable changes in the equity risk premium (the amount by which stocks are priced to beat risk free investments). Changes in the equity risk premium demanded by investors force stock price changes in the opposite direction. Over long periods of time the equity risk premium has been surprisingly stable. But over shorter periods it fluctuates. Stocks outperformed Treasury bonds by 29 percent in 1999; in 2000 equities trailed debt by 26 percent. This trend toward greater volatility has likely already begun, says Mr. Leibowitz.

Second, the outlook for the equity risk premium may be more discernible as a result of this volatility. Highly valued stock markets would create a poor forward-looking equity risk premium while extremely cheap equity valuations would suggest a positive one.

Third, there may be more opportunities for revisions in asset allocation based on the changing equity risk premium. I took this as the heart of his message. While not promoting market timing, he advised that these periodic changes in the equity risk premium would be discernible and potentially profitable.


Mr. Leibowitz also spoke about the large risks for individuals inherent in these self-directed assets. Based on his experience, the retirement portfolios of many baby boomers are dramatically underfunded. Savings rates need to climb impressively to fix this problem, he said.

Worse, some of those investors might think they are ready to retire. He warned that many soon-to-be retirees could be making two costly errors in judging the amount of their accumulated assets.

First, many are not considering the role of taxes. A large chunk of defined contribution assets will be taxable at retirement. Considering the long-term fiscal outlook of the U.S., tax rates could be higher at retirement.

Second, many investors do not take into account the impact of inflation over a 15 year to 20 year period. One dollar received in 1984 is now worth only 55 cents. Both of these errors would leave retirees with substantially fewer assets then are needed to continue their current lifestyles in retirement.

1 For a view on how it takes professionals, not amateurs, to undermine an efficient market, see ../wmc/wmc040412.htm

(First article in this series on the 2004 AIMR conference )
(Second article in this series on the 2004 AIMR conference )


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