Yikes! How to Think About Risk?

Alicia Munnell, Steven A. Sass () and Mauricio Soto ()
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Steven A. Sass: Center for Retirement Research at Boston College
Authors registered in the RePEc Author Service: Steven A. Sass () and Steven A. Sass ()

Issues in Brief from Center for Retirement Research

Abstract: The same issue keeps reappearing. How to deal with the risk associated with equity investments when evaluating the financial health of retirement systems? Some experts argue that retirement plans holding equities can make smaller funding contributions than those invested primarily in bonds. After all, stocks yield 7 percent, after inflation, and bonds only 3 percent. Nonsense, say others. The higher expected returns on equities reflect their greater risk. Any serious financial evaluation of retirement arrangements must “risk-adjust” these returns. After accounting for risk, the contribution needed today to fund future pension obligations is the same regardless of whether the fund is invested in equities or bonds. Is it possible to reconcile these two views? How should individuals, governments, and employers account for the expected additional returns from equity investment in pension funds? How should they account for the additional risk? Finally, and perhaps most importantly, how does this relate to the debate about creating private accounts with equity investments for Social Security? To sort out these difficult questions, this brief does three things. First, it describes how equities have performed over the last 75 years. Second, it explains how economists, accountants, and actuaries handle the high returns/high risks associated with equities in the real world. Finally, it explores the implications of the risk discussion for evaluating Social Security reform proposals. The conclusion is that the treatment of the high returns/high risks associated with equity investment depends on the extent to which the entity can manage the risk and the purpose of the calculation. In the case of Social Security reform proposals, evaluations that focus solely on the expected return to equities, without adjusting for risk, overstate the contribution of private accounts to retirement income security.

Keywords: investment; equity; stocks; bonds; retirement; risk (search for similar items in EconPapers)
JEL-codes: E22 D91 H55 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-fmk, nep-mac and nep-pbe
Date: 2005-01
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Working Paper: Yikes! How to Think About Risk? (2005)
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Persistent link: http://EconPapers.repec.org/RePEc:crr:issbrf:ib27

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