Life-cycle personal accounts proposal for Social Security: An evaluation of President Bush's proposal

Abstract

The life-cycle portfolio proposal for personal accounts within a Social Security system would have the government undertake the dynamic portfolio allocation program for individuals. This paper evaluates, using U.S. historical data 1871-2004, several versions of conventional life-cycle portfolios. The results show disappointing performance relative to the rhetoric of the promoters of the proposal. Dynamic portfolio theory suggests that the optimal life-cycle portfolio may look very different from the conventional form. Moreover, behavioral finance suggests that the design of a life-cycle portfolio for Social Security should consider the attitudes and habits of individuals and as well as their diversity.

An Assessment of Life-Cycle Funds

“…This approach models the evolution of returns from historical data, which in principle allows the samples to diverge much more from previous experience, but in a way that reflects the historical structure asset returns. Shiller (2006), which exemplifies the first approach, samples thirty-five year periods from historical data, assessing how various widely-advocated strategies for the allocation of assets would have performed over these intervals. Shiller's objective is not to estimate an optimal allocation but to show that life-cycle portfolios might be dominated by simple strategies.…”

“…The average real rate of return between 1871 and 2004 was 6.8 percent for stocks and 2.7 percent for bonds. Shiller (2006) finds that there in an extremely high probability that an all-stock allocation will yield a higher return than allocations that include bonds. But, Shiller's analysis, which considers only fixed allocations of assets, does not derive an optimal strategy for allocating assets, especially one that allows allocations to change over time.…”

“…Many economists believe that there has recently been a narrowing of the equity and, to a lesser extent, the bond risk premiums. Shiller (2006) reports a survey of the expectations of professional economists. The mean expected equity and bond returns over the 44 years from 2005 are 4.6 and 2.9 percent respectively.…”

Life cycle versus balanced funds: An emerging market perspective

“…Importantly, Estrada (2014) highlights that the debates on the most optimal asset allocation strategy may be nestled in how risk is defined. Some may view a low-risk fund as a stable investment with little adverse shocks while an alternative view may be that a low-risk fund is the fund, which provides the highest mean accumulated ending wealth (Lewis 2008c;Shiller 2006). Should 'risk' be interpreted as a greater range exhibited by the outcomes, the balanced funds would be a riskier choice.…”

Public Pension Reform: A Primer

“…Risk-averse fully rational PRA investors will only be willing to participate in this loan-investment alternative if the expected average return is sufficiently strong to compensate for the extra risk that the person takes with respect to the alternative which is an absence of participation in the scheme. Shiller (2005) addresses this question for various asset portfolios. Using a simulation approach, he shows that there is a substantial risk of obtaining a lower return in the PRA than the interest rate that is used in the offset calculation.…”