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Impact Investing

IPE special report May 2018

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Redefine DC categories, argues Nobel laureate

GLOBAL - Default categories for defined contribution pensions should be devised according to "prototypes" of employees, Nobel economics laureate Joseph Stiglitz has recommended.

Speaking at Pioneer Investment's European colloquia event in Vienna yeseterday, he also called for greater research into how people make choices and how portfolios can be tailored to individual's needs.

When developing retirement products asset managers should first identify "how people are different from each other" to then form sets of prototypes and create choice within each set, said Stiglitz, the US economist who shared the Nobel Prize in economics in 2001 with two other scientists for their work on information asymmetries between participants in the financial markets.

"Life cycle products may be appropriate for some prototypes," he noted.

He cited homeowners, people with lower educational standards and increasing risk awareness towards retirement as examples of pension fund members who might be most appropriate for these prototypes.

However, he stressed the capital asset pricing model (CAPM) of relationship risk and expected return currently used was "inappropriately describing markets" as it failed to take non-financial assets such as human capital, housing and family structure into account.

"The idea is to create a safer portfolio by decreasing equity exposure towards retirement," he explained.

"However, as human capital matters less at that stage, hence the human capital risk is getting lower, some people might want to compensate by taking higher financial risk."

Stephen Zeldes, professor of finance and economics at Columbia University, noted at the Pioneer conference his research showed certain advantages of decreasing equity exposure with age.

"Left on their own, individuals do not rebalance their portfolio," he pointed out, as his studies showed 65% of active participants to a defined contribution scheme made no or only one change to their portfolio over 10 years.

Zeldes noted the amount of equities in people's portfolios depended very much on the situation on the stock markets in the year they joined the scheme, as well as the behaviour of other members in the cohort.

Life cycle models or target date funds which re-balance the bond/equity ratio to a specific date "are not better in tailoring to individuals' needs but relative to the actual behaviour of people they are much better".

The economist noted customisation of portfolios was difficult as too little is known on the individuals and could only rely on surveys or questionnaires.

"Customisation would be based mostly on noise, leading customised portfolios to be worse than one-size-fits-all models. Furthermore, the complexity of customisation might scare away investors," said Zeldes.


To improve target date funds in the short-term, Zeldes suggests the automatic equity decrease in a portfolio should be altered to get away from the widely used rule of thumb of ‘one hundred minus age' equals the perfect equity ratio.

Zeldes also would like to see more international diversification in US target date funds as domestic equities currently make up 75% of the exposure in this asset class.

Other improvements would be to introduce better benchmarking to facilitate comparison between the funds and introducing more options for the decumulation phase.

Elsewhere, US analyst Phillip Silitischanu from Aite Group, also noted the importance of target date funds to the pension system in the United States.

"In the US, life cycle funds have been finding their way into numerous pension plans, and several plan sponsors have begun utilizing collective investment trusts to build target date and life cycle funds," he said.

"They may be complete nonsense for the APK, but for many investors they are they perfect default fit - if only temporarily," Silitischanu noted in response to comments made by the head of Austrian Pensionskasse Christian Böhm in an interview with IPE. (See earlier IPE story: Life cycle investment is 'utter nonsense', claims IPE winner)

If you have any comments you would like to add to this or any other story, contact Julie Henderson on + 44 (0)20 7261 4602 or email julie.henderson@ipe.com

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