The Finance of Retirement & Pensions

Welcome, everyone, to the finance of retirement and pensions, my online course. I'm very excited to have you all here. great turnout for the class, and really looking forward to this journey through the finance of retirement and pensions with you. I wanna invite you to please start watching the video lectures. The video segments for lecture one are now posted under the lecture section of the website. And I also wanted to point you towards the assignments section of the website, where you can see a couple things. First of all, there you'll be able to find the lecture exercises, which you have to complete if you want to achieve a certificate of accomplishment for the course. Also there, you're gonna find some questions for discussion. These are questions that I use with my students here at Stanford in class. And for those, what I'd like you to do is do them and discuss them in the discussion forums, I invite you to do that. There'll be designated areas of the discussion forums, so that you can discuss these questions for a class discussion. Those are not mandatory for receiving a certificate of accomplishment and there won't be answers posted to those either, those are just for, for your for your discussion. So, as you know, this is an eight week course. And I'm going to be checking in with you weekly, through these video casts. And, also, you should watch the NovoEd website here for any announcements I might have about the, about the class. I'll be posing announcements under the announcements section. I'd also like to invite you to follow me on Twitter. @JoshRauh, that's my Twitter handle. @j-o-s-h-r-a-u-h, @JoshRauh. And I'll sometimes be posting ideas on twitter and things that might be relevant for the, for the course. Well, it's been a big week in financial markets, particularly in bond markets. Bond markets are important if you're a saver, because they basically are very related to the interest rates that you're going to receive on your savings. If you're an investor in bonds, or if you're a borrower, if you've got a mortgage, an adjustable rate mortgage, or if you're thinking about taking out a new mortgage for a property you're thinking about buying. Those rates that you're either are earning or paying are all affected by what's going on in, in bond markets. So this week, of course, we've been reading a lot about the government shutdown, about the debate over the debt limit. People have thought that US government bonds are the safest asset out there, but now there is this kind of constant concern in the background that well, would the US government really default on its debt? The markets seem to think that, of course, the US government will probably get its act together and will not default on its, its, its obligations, but it's causing some consternation in Washington. We also have a new Chief of the Federal Reserve announced today, Janet Yellen. And the big question that she's gonna face is when to stop the Federal Reserve stimulus. The Federal Reserve has been buying bonds to the tune of $85,000,000,000 a month, and that's been keeping interest rates in the economy down and stimulating the economy. The big question is how long the Federal Reserve is going to keep doing that. if you're thinking about buying a home or you're thinking about taking out a new loan, you're hoping that they keep doing that long enough for you to get that loan through because you like the fact that interest rates are low. If you're a saver and you've been saving in, relatively risk, risk-free or relatively safe assets, you're

actually, may not, you may, may not like the Federal Reserve policies now because they're keeping interest rates really, really low. So very big week in financial markets, particularly with regards to bond markets. And in this course we'll be talking about bond markets, starting in week two, in the second week of the course. this week we're gonna be talking about two things. There are gonna be two lectures you're gonna watch for this week. The first one is going to be on saving for retirement. The saving phase. And the second is going to be on various strategies that you can take if you are retired, if you are already retired, or if you're going to retire on a particular day, a particular year. What strategies are you going to follow then to manage your retirement balances and to spend them down. So, in terms of saving for retirement, I think you'll see in the video lectures that there's a big element here, a big question is, how much do you have to save as a portion of your income to give yourself any kind of reasonable retirement. And, I think one of the, one of the things that people usually observe when they look at the spreadsheet models, that accompany the lectures that I've done are that, you have to save more and probably work longer than you might have otherwise thought. A very common retirement age these days in the US is 62 years old. Well, people are living longer than they ever have before. And interest rates of safe securities are low. So, saving more and working longer end up being prescriptions that one might have to follow if you want to if you want to have a retirement that is, you know this is, gonna fund your reasonable standard of living. And of course, you're gonna have to make a plan as to what that standard of living is gonna be, and what percentage of your expenditures during a normal working year do you wanna try to replace in retirement. Do you wanna really cut back and scale down your spending by half. Say or do you wanna actually not cut back at all and try to keep spending as much in retirement as you, as you do when you're, when you're working. So I think, you know those are some of the key questions you're gonna ask in the, ask yourself in the saving for retirement section of this course. I'm looking forward to reading a lot of discussion in the discussion forums about that. And in general, I think, also, you'll probably see in the saving for retirement section that one of the things that people are having to do is, you know, they're having to, first of all you've gotta start now if you haven't started yet. You know, starting now is something you could always do. And also just basically, you know, plan for the fact that well right now interest rates are low and you might live for a long time, so that means that you're gonna have to have a pretty aggressive savings strategy now. if you wanna have a comfortable retirement. So the second video lecture which is not yet posted but which will be later on in the week is about what to do with those retirement balances when you reach retirement. And most people tend to, in the US tend to try to follow spending rules. So, for example, a very common spending rule, other people followed for a long time was the idea that you might spend 4% of your retirement balance every year. That was a very common rule. I sent around a link to an article that suggested that the times for that rule are probably over. Why are they over? Well, they're over for the same reasons I was discussing before about why you might need to save more and work longer during your working life. The 4% rule's probably over because,

well, people are living for a longer period of time. And interest rates, macroeconomic interest rates, the returns you can get on your savings are just very low. So if you're following spending rules to try spend down your retirement balances, it's gonna be important to evaluate whether those are going to be robust so you're living a long life, possibly, hopefully, living a long life. And also robust to you know, potentially returns in financial markets that aren't quite as good as what they've been in the past. Also, in video lecture two, I'm gonna be talking about the market for life annuities. These are products that many of you may know about, many of you may not. They're products sold by insurance companies that basically provide insurance against living a long life. You give the insurance company a lump sum amount of money when you're 60 or 65 or whenever you want to retire, when you want this to begin, and then the insurance company pays you a pension, basically an annuity, for your entire life. And they do that as long as you're alive. You can also buy versions of these products where you can buy them so that they'll pay out as long as either you or your spouse is alive. You can also buy them with with guarantees. as I talk about it in that video lecture, you're going to see that a lot of people look at the prices of those annuities. The prices of these products. The amounts of money they can get from an insurance company for for, for forking over a, a, a big lump sum of money today. And they often find that it seems like it's a small amount of money. Well, that's because I think a lot of people are underestimating just how long you're likely to live today, just given you know, advances in medical technology. And if you look at the life tables from the Social Security Administration and other places. You'll see that even there, some people think that these tables, even understate the situation. Even there, you're likely to live for a pretty long time. And that means that in order to finance a secure retirement, yeah, you got to have a lot of savings. You might also think about buying some buying, using some of your assets to buy some longevity insurance against living a long life. So that's the material for this week, and really looking forward to hearing your thoughts about the material in the discussion forums, and very much looking forward to getting started with the class. Thanks, everybody. 1. Will There Be Enough? Welcome to this lecture on saving for retirement. This lecture is about a question many of you might be asking. Will there be enough? An increasing number of Americans are concerned about having enough money in retirement. Here is some evidence from a survey by the employee benefit research institute. In 2013 only 13% of workers were very confident about having enough money to live comfortably in retirement. And only 38% were somewhat confident way down from previous years. And there's only slightly greater confidence among people who are actually retired. Only 18% are very confident. Down from 41% in 2007. Perceptions are one thing. But are the worries about retirement justified? In fact, another study by the same organization looked at how long retirement funds would cover the expenses of the early baby boomers, or people born between 1948 and 1954. The study found

that 47.2% of these individuals were in fact at risk of not having sufficient retirement income. And that's just to meet minimum retirement living expenditures, plus uncovered health and nursing home costs. There are many ways to achieve a secure retirement, but I would argue that the strongest tool you can have, is an understanding of the joint roles of saving and investing. The principles of finance have a lot to tell us about what can be achieved, what are reasonable goals, and how to think about trading off risk and return. So suppose you are one of the many people who worry about having enough assets for retirement. Will these tools make you less worried about retirement finances? Well on the one hand, analyzing retirement saving strategies with these tools may initially make you more worried. One of the main points we will see is that you cannot hope to achieve returns that are higher than those on say bank accounts or other risk-free securities without taking on greater risk. And one mistake many people make is to overlook those risks in their retirement planning. On the other hand, understanding what is realistically achievable without risk as well as the distribution of outcomes to which risky assets give exposure will give you the power to make more informed decisions. You may have to recalibrate your expectations, but understanding the trade off between risk and return should allow you to prepare better for your retirement, and to decrease your worries. 2. Saving for Retirement Saving for retirement. In economics, we like to start with the simplest possible model of reality, and then build complexities necessary. So, let's begin by just considering a single individual who's going to retire at age sixty-seven. Since polls suggest that 67 is now the average age at which Americans expect to retire. Let's suppose this person is gonna start working at age 25. And to keep it as simple as possible, imagine that this is a world where there is no Social Security system. Or even a government. He will then retire on his 67 birthday which means he would have worked for 42 years.Then he will subsist in retirement for 20 years, and die at age 87. Image yourself in the shoes of this person. This of course is a simplified setting and there are lots of complications that we could add. We can still learn a lot from the basic frame work. To attach some numbers, suppose this person starts their working career earning a salary of $50,000 during the year that he is 25. Now, I need to assume something about how that salary is gonna grow ove rtime. So, let's assume it grows with inflation, plus one percent real growth in purchasing power. Consumer price inflation was 1.7% in the year 2012, so to use a round number, I'm gonna start out by assuming that inflation will be two percent per year. So that total annual salary growth will be three percent per year. By age 66, this individual was earning around $168,000, and after his 67th birthday, there are no more earnings. There are many savings rules you can put into this set up, and you can play around with them, and see how your investments would grow. For example, here's what happens if you contribute a fixed amount of $2,000 per year At the end of the first year you have $2,000 in your account. At the end of the second year you

have the 2,000 you set aside in 2013 plus the $20 in interest earned on that money, plus the additional $2,000 you contribute in the second year. Continuing on like this and earning compound interest, you would end up with around $104,000 in your account at the end of the year you're age 66, that is on you 67th birthday. It could certainly be tough to make that money last for the 20 years of your retirement. Or here's when happens if you contribute 10% of your salary each year, you'd end up with around $485,000 in your account on your 67th birthday. That's much better. But if you think about it, that still might be hard to make last for 20 years. In the last year of your career, you just enjoyed spending around $151,000. And you can calculate that under our modest two percent inflation assumption, stuff would cost two and a quarter times, in 42 years, what it does today. With only $485,000, you'll clearly have to cut back on your spending in retirement rather substantially. Now, what if you increase the share of income that you have saved? That will proportionally increase your balance at retirement. So doubling your contribution rate to 20% of income will leave you with $971,000 at age 67. Perhaps now we are getting close to a balance you can imagine working with. But at the same time goods and services at that point cost two and a quarter times what they do today. And you need to make your money last for 20 years. When you consider that you were spending $134,000 in the year before retirement, you'll almost certainly have to cut back. So what have we learned about saving for retirement? First, it sounds obvious, but holding other things fixed. The more you save the more you have in retirement. Second when your income is growing, strategies in which you contribute a fixed share of your income, as opposed to a fixed amount will allow your contributions to grow as you get close to retirement. Third with a working life of around 40 years, and low interest rates, you have to take on a fairly aggressive savings strategy to get up to an account balance that might provide a reasonable foundation for retirement. Even then your ultimate purchasing power depends a lot on how much inflation has eaten away the value of your savings. 3. Investing in Default-Free Securities Investing in default-free securities. Before we start to model, your options take risks. What is actually the best that can be achieved with essentially RISK-FREE SECURITIES? If you want to reach the retirement date with a certain guarantee account balance, you could invest each year in US government securities called treasury bonds. Le's have a look at what is called the Treasury Yield Curve. The treasury yield curve is a series of annual lines interest rates on US government bonds of different maturities. An investor can earn these rates or close to them by buying these bonds and holding them until they mature. You can look this up on websites like the wallstreetjournal.com or bloomberg or the U.S Treasury website. So as of January 13, 2013, if you bought a one year security, you could only earn a certain return of 0.15%. Or $1,50 per $1000.00 invested and you get your $1000.00 back

as well, at the end of the year. You actually would have done better in the bank account that was paying 1%. However, if you bought a 10 year security, you could earn a certain return of 2.03% or $2.03 per year. Per $1000 invested, and you'll get your $1000 principal back at the end of the ten years, as well. If you buy a 30 year security, you can earn a certain return of 3.19%, or $3.19 per year, per thousand dollars invested. And, once again, you'll get your $1000 principal back, this time, at the end of 30 years. Now, I said a certain return, but aren't treasuries risky as well? Isn't it possible that the US Government will default on its debt? Recent fiscal problems faced by the government have raised the notion that US Government bonds are not risk less. Furthermore, the debt of many other countries that have experienced crisis and defaulted on debt such as Argentina and Greece was once viewed as very safe. That said, it is still the case that, in outright default, where the US government permanently abrigates its obligation to pay debts, is quite unlikely. Much more likely than default will be that the government will create inflation to pay of its debts. So that the dollars you're receiving will not be worth as much over time. Inflation is a form of default. We'll pay you back, but we'll do so in currency that is not worth as much. And that risk is one possible reason that in normal times the yield curve tends to slope upwards. We'll proceed viewing the payments specified by U.S. treasury bonds as nominally risk less. That is to say if the bond promises to repay our $1000 plus interest of $3.19 per year for 30 years then the government will do exactly what it promised. But without any guarantee of what those interest payments or what the final $1000 will allow you to buy when that money comes back to you. Maybe only a candy bar or a stick of chewing gum. If what you cared about then was arriving at age 67 with a guaranteed nominal amount of money, you could achieve that by buying government bonds of different maturities. Ideally, when you turned 26, you take your new savings and buy a bond with a 41 year maturity. At age 27, a 40 year maturity. At age 28, a 39 year maturity. And so on. Let's consider what happens if each year you could buy a standard treasury bond that would mature at your retirement date. The US government doesn't issue securities that are longer than 30 years to maturity. While some other countries do. So here I'm just gonna assume that the yields on those bonds would be the same as the yield on the thirty year bond. The advantage of this over the 1% bank account is that in most normal time periods, you get the benefit of higher risk-free returns when you lock up your money in the government bonds for longer periods of time. When I say lock up, it's not as though you can't access the money at all. You can sell the bond if you want to. But the point is that, you might get to do that at a gain, or you might have to do it at a loss. Now I'm simplifying something here by assuming that all the interest payments you'd receive from each bond can be re-invested at the same rate as the initial bond you bought. Let's go through how the asset accumulation works. By thinking about your annual

contributions, and how each contribution grows over time. To take one of the years as an example, think about the money you contribute when you have 30 years to retirement. In this year, you contribute around $6,900 and you can invest in riskless treasury bonds. So should those contributions will grow at 3.19% per year. Giving you around $18,000 when you retire. Next, think about the money you contribute when you have 20 year to retirement. In that year, you contribute around $9,300 and you can invest in risk less treasury bonds. Such that those contributions will grow at 2.8% per year. Giving you around $16,000 from that contribution when you retire. Finally, think about the money you contribute when you have 10 years to retirement. In that year, you contribute around $12,500. You're gonna invest them in riskless treasury bonds. That will grow at 2.03 % per year giving you $15000 per year when you retire. And so on. So if you do this for every contribution, add up the balance at the end, you'll find that the total in your account, at the end of all this is around $691,000. That's much better than saving in the bank account that earned 1% per year, that only got you to around $485,000 at the end of your working life. Now, you might be able to do a bit better. If on horizons where treasury bonds yield less than bank deposit accounts, use the bank deposit account. But, this won't affect the results much. There are important details to this calculation. Particularly, how I treat contributions that are more than 30 years to retirement. That I assume interest payments on the bond can be reinvested at the bond's initial yield to maturity when you bought it. And, the way that I interpolate between points on the yield curve. But these are not that material to the main calculation. Now you might hope for higher interest rates in the future, on risk less securities. You might hope that in, say, 30 years, when you're 55, you'll be able to get a better than 2.03% rate on risk-free savings in the remaining 10 years. But in financial markets, the best forecast of tomorrow's long-term rates, are today's long-term rates. Rates on safe securities, might be higher in 30 years than they are today. But they might be lower. So, what have we learned about investing in securities with guaranteed nominal returns? The most important observation, is that in most normal times, the longer the horizon over which you do not need to touch your money, the higher return, you can get on guaranteed securities or at least. Nominally guaranteed securities. Your spending power with those dollars is not guaranteed. In the language of economics, we say that the term structure of default free interest rates is usually upward sloping. And while you might hope for higher interest rates in the future, that is not a certain proposition. The only thing that is certain is today's rates for securities held to maturity. What we haven't considered yet is your ability to take risk, which introduces a distribution of possible outcomes. Some of these outcomes are better than risk free rates, but some of those outcomes will be worse than risk free rates. 4. Risk

Risk. Let's go back to the situation where you are saving for retirement. We discover that if you saved in a bank account that earns 1% interest and you contributed 10% of your income every year. You'd end up with around $485,000 when you retire. If you invest in the safest types of government securities, which yield up to around 3.2% at long maturities, you would end up with around $691,000. Since it could be difficult to make such amounts of money last for your entire lifetime, it is tempting to wanna just increase the interest rate here with the hope you might be able to earn higher returns by investing in risky assets. For example if you put in a 5% interest rate still at a 10% contribution rate you get over $1,000,000 at retirement. $1,075,000 that's even better then if you doubled through a 20 % contribution rate and still had a 1% interest rate. But if you're tempted to do this, the key question's gonna be where is the risk? When safe securities yield 1%, you cannot target a return of 5% without taking risk. Which means that you accept the possibility that the returns might be much worse than the 5%. And that is gonna be a key point that we'll come back to repeatedly. It is impossible to generate the possibility of higher returns than the risk-free rate without taking risk. And it wouldn't be a good idea to just raise the interest rate here to some return that we can only get by taking risk without explicitly accounting for that risk. What are some risk strategies that might allow an investor to target a 5% return. One simple example is U.S banks issue bonds that represent debt claims on their assets. The yield on a Mixed Maturity Portfolio of these bonds is around 5%. Now, that does not mean that they will return 5% for sure. The most fundamental principle of finance is that the only reason a security might generate a return higher than a risk-free rate is because there is some risk that they will generate worse returns than the risk-free rate. Here's a very simple model of this. Suppose there are two possible outcomes. The good outcome, and the bad outcome. Under the good outcome, the US banking sector solves enough of its problems to meet all of its obligations. The bonds mature, and earn their yields to maturity of 5%. Under the bad outcome the US banking sector delivers the 5% returns until 2045, at which point it has a major crisis where you lose 90% of your money, after which time it resumes it's 5% yields. It turns out that that's equivalent to realizing an annualized loss over the entire time period of around 3% per year. In finance, we call these outcomes, the good outcome and the bad outcome, states of the world. Not to be confused with states of the United States, states of the world are possible outcomes. The simple model above assumed only two states of the world, but of course there is a continuum of states of the world from best to worst. So going back to the bank bonds, we already saw that you'll end up with over a million dollars. $1,075,000. If the good states of the world, the constant 5% return is realized. But if you do the calculation, you'll see that in the bad state of the world, you'll end up with only $265,000. That's if we have this major banking crisis. The example is meant to illustrate the following point. The yield to maturity on risky bonds reflects the best possible

outcome. If the bond is held to maturity, in that the yield is only earned, if the bonds do not default. In the background there is a possibility of bad outcomes where the bonds will earn much less than this. If they weren't then 5% would be a risk free rate and clearly it is not. How willing should you be to take this risk? Well, that depends on three main factors. First the probabilities of the good and bad outcome. Obviously, the larger the probability the good outcome and the smaller the probability the bad outcome, the more attractive this investment will be to any economic agent. Second, your risk adversion. The less you like risk, the less attractive the risky bond will be to you. A useful baseline is to compare yourself to someone who is risk neutral. Someone who is risk neutral will consider only the average, or mean outcome, which we call the expected outcome or the outcome in expectation. For example, suppose there were a 70% chance of the $1,000,000 plus outcome, and a 30% chance of the $265,000 outcome. Then the so called expected outcome or mean outcome is 70% times 1,075,000 plus 30% times $265,000 or around $832,000. Calling this the expected outcome is a bit of a misnomer, because the expected outcome never actually happens. You either get the good outcome or you get the bad outcome, but nonetheless it's common to call this the average or expected outcome, or expected future value of the savings strategy. Now, risk neutral individual would compare this 832,000 to the 691,000 she could get in her treasury bonds and to her it would look like a good deal. Well, this is a good example. Most people are not risk neutral. Remember, you have no other assets here and no social security. Would you really trade a virtually sure thing, $691,000 in exchange for a 70% chance that you'll retire with over a $1,000.000, but a 30% chance you would retire with only $265,000? Some of you might, but many people would not. The third consideration in whether you take the risk or not is a concept we call state pricing. We hold a lot of things fixed in the model today But in practice, you also have to consider what else is going on in the state of the world in which the bank bonds perform badly. If you do have other investments, they will probably be doing less well, also. The economy is more likely to be in the tank and you might have lost your job in the state of the world, too, or have had to accept lower wages from your current job. So, having money in this bad state of the world, when you're otherwise down and out would be quite valuable. In economics we say that the shadow cost of a dollar in the bad state of the world is high and in finance we call this general issue state pricing. The bank bonds are in a sense, extra risky, because they kick you while you are down. We'll come back to state pricing later and in fact, the study of financial economics makes it hard to escape. We've now introduced the concept of financial risk. What are the key points? It's impossible to generate higher returns than the risk free rate without taking risk. Conversely, the only reason the security might generate a return that's higher than the risk free rate is because there's some risk that security will generate worse returns than the risk free rate.

And the desirability to you of a risky strategy is a function of three things. First, the probabilities of the various outcomes. Second, your risk aversion. And third, the issue of state pricing. What else is going on with your financial life in the state of the world when the bond defaults. 5. Overall Recap So, to recap this lecture, we started out asking how the financial tools of saving and investment can jointly allow an individual to plan for retirement. In this lecture, we've seen that the amount of assets you can accumulate, using safe securities, will depend on how much you earn, and how much you save. Furthermore the real purchasing power of your savings will depend on how much inflation happened in the mean time, we assumed an annual rate of 2%, it could be higher, or it could be lower. Now you might hope to achieve investments, that are greater than the risk free rate by investing in risky securities. But one must view that as a risky proposition. One that is possible only if you accept the possibility of much worse returns. If it were easy to obtain high and safe returns on risky assets, their value would have been bid up already. So, one of the big things I want you to take away here, is that you should never put the hoped for returns on risky assets, into these kinds of models. Without also considering and modeling some down side scenarios. It's the possibility of those losses which allows for their to also be the possibility good outcomes. Along these lines we introduce the important concept of states of the world, and the three important considerations in weighing the extent to which you should take risk. The probabilities of the actual outcomes, your risk aversion and state pricing. The fact that bad outcomes may happen in states of the world where you might otherwise be down on your luck. Now, the tools I presented here are useful for understanding the outcomes you can expect from either riskless assets, or assets whose risks are quite easy t specify. But, there are a number of issues we did not address. First, the financial instruments that you would likely invest in, do not come with a pre-specified list of outcomes with associated probabilities. So, a natural place to go from herei is to understand what role stocks, bonds and other financial securities, play in the accumulation of retirement wealth, by gaining a better understanding of their risk and return properties. Second, your need to accumulate wealth for retirement, depends on the other resources that you think you will have when you're retired. Most american retirees will receive social security, which consists of periodic payments from the US government. Other countries also have these basic national pension systems. The degree to which social security will support your spending goals in retirement will inform the amount of saving that you should be undertaking on your own. Third, once you've accumulated assets during your working life, we'll need to determine the best way to manage and spend down those assets. That means that once you've saved and arrived at retirement with a nest egg, you'll immediately be confronted with a new question, how do I make the money last?

Strategies for managing money in retirement and spending down the assets are just as important for your financial well-being as strategies for accumulating the assets. So wrapping up, the ability to model how retirement accounts will grow, assuming various prespecified rates of return, is a critical first step. But there's much more to learn about the risk and return trade off in real world investment opportunities, as well as the government programs that may assist you in retirement. And the best way to spend down the assets once you've reached retirement.

Week 2: Spending Down Retirement Assets: the Decumulation Phase 1. Making the Money Last through Retirement Welcome to this lecture on spending down retirement assets. This lecture is about making the money last through retirement. Once you've saved some money and are retired, a major question is how to make the money last through retirement. According to the Pew Research Center 38% of Americans worry that they will not have enough income and assets to last through the retirement years. And a recent working paper from the National Bureau of Economic research showed that 46% of senior citizens in the US has less than $10,000 in financial assets when they die. Having relied in their later years almost completely on social security payments as their formal support. Well those who have no desire to pass money on to their children as inheritance, might view this as evidence of excellent financial planning in retirement. The reality is that, many retirees found themselves scaling back consumption, so as to avoid being left with no assets at all. Now, by definition, many of the troubles faced by the individuals in this study were presumably due to not having saved enough. But, some of their woes may also have been related to having spent too much early in their retirement under the expectation that their money would last longer than it actually did. On a more optimistic note, the same study also shows that some retirees have done better. Over 1993 through 2008, the median total wealth, broadly defined, was more than $600,000 one year before they died. But again, was that good financial planning, or bad? If these people don't care about leaving wealth to their heirs, they could have spent more money. In this lecture, we're gonna consider what determines whether a person outlives his or her savings. And we'll learn about the insurance products that exist for people who want to ensure against this outcome. These products are called life annuities which make a guaranteed stream of payments until the purchaser dies. These financial securities have prices which will help us understand the true cost of longevity insurance that is the cost of insuring against out living ones resources. 2. Outliving Your Savings and the Role of Life Annuities Outliving your savings and the role of life annuities. Suppose that you have arrived at retirement with an account balance of $1 million. One way to accomplish this, would have been to have a starting income of $50,000 at age 25. A 2% inflation rate, a 1% real salary growth above

and beyond inflation, a 2% interest rate investing in safe securities, such as Treasury bonds, and a savings rate of around 17.2% of your income. Until you retire at age 67 on your birthday. Now, a person who's just turned 67 and has retired with a million dollar balance now faces the problem of how to make the money last. Many people take a rather adhoc approach drawing down the retirement assets as they are needed or as they want to spend them or which is a bit better according to some kind of plan. For example, consider your $1 million balance, if you knew you would live for 20 years, then you could spend $50,000 dollars per year even if you earned no interest. Not bad, although it's worth keeping in mind there is inflation, so this would give you a declining stream of real purchasing power. A better question is, what can you spend in the first year, so that if your spending grows with inflation you can just exhaust the last dollar of your balance at the end of life? And I also want to account for the fact that you can earn interest in retirement supposing for the time being, that this interest will be in the same low risk free rates that you got in the safe securities when you were saving, are 2% per year in this example. By trial and error, or using a goal seek function in a spreadsheet, you'll find that in the first year of retirement, you can spend $51,000, and you'll be able to let this amount grow with inflation. This is roughly consistent with a Rule of Thumb sometimes referred to as the Rule of 20. You would need a retirement fund balance that is around 20 times the pension you will want to pay yourself. But remember, in this example, if you live day over 87, you'll have no assets at all. As is the case when you're saving for retirement, a temptation here is to wanna ask, what happens if I can earn more than that low risk free rate on savings accounts or Treasury bonds? Well, you have to keep in mind it is impossible to generate the possibility of higher returns than the risk free rate without taking risk. And it wouldn't be a good idea to just raise the interest rate here, to some return that you can only get by taking risk without explicitly accounting for that risk. In other words, you can easily modify this example to model how much you could spend if you could earn something higher then a one or 2% return. But it would be very misleading to do that, without also modelling some scenarios where you earn something less than that. Now I want to make this example a bit more realistic, by introducing one very important source of uncertainty, you do not know how long you will live. The strategy we just went through allows you to keep control over your assets, but you run the risk of outliving them. Ideally, you would run down your assets so that you exhausted all of your wealth on the day that you die, minus anything you wanted to leave to your heirs, of course. But since we don't know how long we're gonna live, this can be tricky, spend too little early on and you die with a larger amount of wealth than you intended, spend too much early on and you outlive your assets. An alternative approach to retirement is where by the individual purchases of a product called a Life Annuity. This is an arrangement where by an individual turns a fixed amount of money upfront to an insurance company. Then the insurance company pays the individual in monthly installments until

the individual dies. The rules governing the amount of the monthly installment are agreed when the contract is signed. There are many variations on annuity products, for now, I'm only talking about the simplest kind, fixed annuities, that guarantee a fixed monthly payment. There are also variable annuities whose payouts might vary with the stock market, those are much more complex products. And I'm also only talking about what is called a Single Premium Annuity, which refers to the fact that the payment for the annuity is made all at once and not over time. Another variation, is that the payments from a Life Annuity can start either immediately, in which case it's called an immediate annuity or later in which case it's called a Deferred Annuity. So, observed with the benefit of hindsight, someone who buys an annuity and leaves for another 40 years, say from age 60 to age 100, will have gotten a far better deal from the annuity than someone who buys an annuity and dies the following year. What annuities provide, however, is longevity insurance, the individual who lives to age 100 would have been very likely to outlive his or her savings, had he not bought an annuity. If an annuity is just taken out by one person, it is called a Single Life Annuity, but a life annuity can if desired, be specified so that it pays out if either member of a couple is still alive. Such a product is called a Joint and Survivor Annuity and is more expensive than a Single Life Annuity, of course. There are some different kinds of Joint and Survivor Annuities. The standard arrangement with a Joint and Survivor Annuity is for a 100% continuation percentage, which is to say that the amount of the annuity is the same regardless of whether one person is still alive or two. But these products can have different continuation percentages for example, in some cases, the contract specifies that the amount of the monthly payment will fall by 25% or 50% when the first member of the couple dies. Why? Well, the second member mainly needs to support him or herself, not both members of the couple. Now, is there any reason you would have to annuitize your whole retirement wealth? In the U.S., it's totally optional whether you wanna buy an annuity at all and most people choose not to. Furthermore, even if you decide to buy an annuity, you don't have to spend 100% of your retirement savings on it. For example, you could choose a retirement to annuitize half of your retirement savings, and retain the rest, spending it down as you choose. Something to keep in mind is that, assuming you have social security, or if you're one of the relatively few people these days that still receive a defined benefit pension from your employer. A life annuity would not be your only source of annuitized income. As such, as long as those other programs are around, you will not literally end up having zero resources on which to survive. But, if you live a long time, and you outlive your other savings, you will certainly have to scale back on your consumption. If, that is, you have not also purchased some longevity insurance through a life annuity. Now, the annuity products that we've considered so far do not protect retirees from all risks. One major risk that purchasers of life annuities are still exposed to, is the possibility that inflation could erode the value of their savings.

For that you would need an inflation protected or inflation indexed annuity which promises to increase your monthly payments along with consumer price inflation. Those products are also available, but they're less common and perhaps that through the lack of the willingness of the insurance companies to promise such a payment stream. To fund such a promise an insurance company needs to buy CPI Inflation Indexed bonds for which there's still a relatively modest market compared to nominal bonds. So to recap, we began the segment with an example of how you might draw down your assets in retirement, if you knew how long you were gonna live but of course, your actual lifespan is unknown. So we discussed life annuities, which are products that exist with this longevity risk, and provide insurance against outliving one's savings. The more spending needs you can take care of with other sources of annuitized income that will pay you income until death. Such as social security and defined benefit pensions, the less demand for life annuities you would have, other things equal. But keep in mind that most private sector workers today do not have access to defined benefit pensions. And depending on your income, social security by itself is not likely to be sufficient to maintain your standard of living. 3. The Market for Annuities The Market for Annuities. Economists and non economists tend to view annuities quite differently. Economists have for a long time wondered about why annuities aren't more popular in countries such as the US where they're not required. After all, we buy insurance against our health deteriorating or against damage to our houses and cars. So, why do more people not buy annuities to insure against outliving their assets? To try to understand this question, let's look at some prices for annuities. According to the website immediateannuities.com. For a 60 year old man $100,000.00 in March 2013 as a lump sum, bought a payment of $ 479.00 per month for the rest of his life. That price is an average price over what many insurance companies are offering. For a 60 year old woman it will buy you a payment of $450.00 for the rest of your life. Why the difference? Well women typically live longer than men and the insurance companies selling these products know that and construct their products accordingly. Another observation is that the older you are, the greater the monthly payment the insurance company will offer you for your money today. Why? Well, because the older you are, the shorter your remaining period of life expectancy. Think about it, suppose the insurance company is at least breaking even on the annuities it is selling to 60 year olds. The company would then make out sized profits if it promised the same payments to someone who bought the annuity at age 75. In exchange for the same amount of money, say $100,000 since in expectation, the insurance company will be making fewer payments to the person who buys annuity at age 75. Since the industry is somewhat competitive, an insurance company that tried to offer the same payment to someone who is aged 75 as someone who is age 60 would not have many age 75 buyers. Now many people do not have a positive first reaction to these prices. It seems to entail

giving up an awfully large amount of money up front in exchange for relatively small monthly payments. Besides, what if I buy one of these and I get hit by a bus tomorrow? You might say it doesn't matter because I'll be dead anyway but. Many people would like to think that if that happened, their children could receive a windfall of the unspent retirement money. Not so if you bought annuity. And, in fact, that's one reason to suspect people might not like annuities. But if you're worried about dying tomorrow, a related product many insurance companies offer is a life annuity with a certain number of years payment guaranteed to you or your heirs even if you die. For example, here I've added prices from March 2013 for a life annuity with a guarantee that at least you or your beneficiaries will receive ten years of payments. These products have lower monthly payouts of course and despite the ten year guarantee and the fact that many economists believe that people should buy more annuities. Most people still don't find these annuities very enticing at these prices. Another complication for life annuities these days is the fact that in an environment where interest rates are low, it is expensive for the insurance company to provide these payments. That's because the insurance company is largely trying to buy bonds that will match these promised cash flows. Since bond yields are so low, the insurance companies offer lower pay outs for a given amount of money say $100,000 than they did when bond yields and interest rates were higher. To see this, here are single premium annuity rates from immediateannuities.com going back to January 2003. You can see that $100,000 today will get a 65-year-old men $522 per month for life. Or a 65-year-old woman $491 per month for life with at least ten years guaranteed. But back in 2003 it bought 575 to 625 per month for the woman and 600 to 650 per month for the man depending on what month the annuity was bought in. What is the other line in this graph? That is the yield that you can get on very safe corporate bonds. Those are bonds that are not quite as safe as US treasuries, but close. And you can see that there is a tight relationship here between the bond yields and the annuity prices. So in looking at these prices you also have to ask, what is the alternative if you want a safe return, which these annuities definitely offer? The alternative is saving your money in safe bonds and these also offer much less attractive yields then they used to. So relative to bonds it's not at all clear that annuities offer worse payouts then they used to. Setting aside the fact that interest rates are lower than they used to be and therefore, that many financial assets look expensive. It would still be nice to understand why more people in the U.S don't buy annuities. Economists have many hypotheses for why people often have a negative reaction to annuity prices. Here are some of them. Perhaps consumers have some aversion to annuities because there are markups in prices. In other words, consumers may believe that insurers are earning economic profits off of them. And indeed some recent academic research suggests that outside of the financial crisis, insurers have been receiving markups of perhaps 5% to 10% on their life annuity products.

Alternatively perhaps people don't like annuities because they bequest motives. That is, they wanna leave inheritances to their children which an annuity precludes. Or perhaps people wanna have liquid funds in case of an emergency so that there is a precautionary liquidity motive. Yet another explanation is that there is adverse selection in annuity markets. And that the only people who buy annuities are ones who will have some good reason to believe that they will live for a long time. Everyone else then stays far away from the annuity market because they know it'll be a bad deal for them. Another possible reason annuities are unpopular is that perhaps people just undervalue the longevity insurance. They believe they will not live as long as they're likely to. And a final reason is that it's difficult to feel comfortable about writing a big check to an insurance company. You might fear what happens if the insurance company itself runs into financial difficulty. Some of these fears are irrational as there are state protection funds for insurance companies and for these products. But nonetheless worries about this so called counter party risk will persist. The bottom line is that life annuities provide longevity insurance which economists generally view as valuable. But people don't usually have a positive reaction to annuity prices. The reasons for that are an active topic of academic research. Suffice to say, most economists believe individuals should be buying more annuities than they are. 4. Annuity Pricing and Mortality Tables Annuities pricing and mortality tables. What determines the price of a life annuity? That is what determines how much monthly income an insurance company will give you in exchange for say $100,000. As we address this question, keep in mind that insurance companies are trying to charge a price that compensates them for their costs and also to leave some cushion of profit. Of course, if one company prices the product with a high profit, another can undercut it, so it as least a somewhat competitive market. An insurance company that needs to price an annuity has a similar problem to an individual who is trying to set up a stream of lifetime income for him or herself. Imagine that you wanted to pay yourself $500 per month for life out of your savings. Suppose for the sake of argument that you knew how long you would live. Say, 30 years. And, instead of each year consisting of 12 monthly payments starting next month, let's suppose you were just gonna get $6,000 per year, starting a year from now. So, 500 per month times 12 is 6,000. If you were doing this in 2013, your first payment would be in 2014, and your last in 2043. Well then, there are safe securities you could buy to replicate this stream of cash flows. Those would be government bonds that look like this. To meet the 2014 cash flow, you would buy a zero coupon bond that will pay $6,000 one year from now. To meet the 2015 cash flow, you would buy a bond that will pay $6,000 two years from now. To meet the 2016 cash flow You would buy a bond that will pay $60,000 three years from now, all zero coupon bonds and so on through 2043.

These government bonds each have a price. And if you learn something about bond pricing, it is not hard to determine what these prices would be. To replicate the cash flows, you basically need to buy 30 bonds with different maturities. And the cost of buying those bonds would be the cost of paying yourself. A riskless benefit. Now, some might look at this and think, gee, it seems expensive to do this with riskless securities. Can't I just set aside less money and take some risk? Well, that's all well and good if you are willing to receive less from your investments than you've planned in case the stock market or other risky asset you invest in does not perform well. But when an insurance company writes a contract with you, they're gonna have to make that specified payment no matter what, an insurance company that promises riskless benefits and funds them with risky securities, exposes itself to a risk of insolvency. As a result, insurance companies are regulated, they are allowed to take some risk in their portfolios but under a law, their rights to take that risk are limited. Otherwise, people could buy annuities from the insurance companies and find that the insurance companies become insolvent before they can make all the payments. What about uncertain life expectancies? Insurance companies are selling annuity products not just to one person but to a pool of individuals. If that pool of individuals is large it has the same longevity and mortality characteristics as the rest of the population then the company can make a pretty good forecast of the bonds it would need to set aside to make the payments. Let's consider an extension of this example. Imagine a hypothetical population that lives on a planet called Snorf. Now, instead of having human mortality patterns, each member of this species, call them Snorfs, either dies at age 80 or at age 95. That is, if a Snorf lives beyond 80, he will surely live to be 95. So, half of the Snorf will live to 80, and half will live to 95. Suppose further that the Snorfs in this population do not know of which type they are, and there is no medical test that would reveal that type. Finally, let's suppose that there are 100,000 Snorfs in every age cohort, which is to say that every year 100,000 Snorfs are born and therefore every year 100,000 Snorfs reach any given age up to 80. In this case, if every Snorf were required to buy an annuity from an insurance company on the planet Snorf when he reached age 65. Then the insurance company on the planet Snorf could pretty well buy bonds that would cover. The entire liability. For every new cohort of Snorf reaching age 65, the insurance company would just buy, well, 100,000 of each of the zero coupon bonds that matured in years one through 15, plus 50,000 of each of the zero coupon bonds that matured in years 16 to 30. Note that we don't know today which exact Snorfs in this population, are gonna be the ones to live 15 years from age 65 versus 30 years from age 65, we just know that half of them are. And that is sufficient for the insurance company, who is pooling these risks to buy the necessary securities. We can also define for this population a mortality rate, also known as a death probability. For this population, mortality is zero until the age of 80, at which point it spikes up to 50% during the year the population turns 81. After which it returns to zero for a while and then finally spikes up to 100% at age 95.

Now, let's return to earth. The population I just described is of course a rather unusual kind of population, but of course actuaries who work for insurance companies and the government calculate death probabilities for humans as well. These actuaries produce statistical tables which depending on whether you're a glass half full or glass half empty kind of person Are called either mortality tables or life tables. Here is some data based on the life table for 2007 produced by the Social Security Administration. This is based on a particular kind of mortality table called a period life table, or period mortality table. It shows the death probabilities by age that are actually being experienced by people today. Or in the case of this table, around 2007. For essentially every one in the U.S., and U.S. territories, so covering currently around 320 million people, I've put the plot on a logarithmic scale, so that even small differences are apparent at all ages. A period life table does not account for the fact that life expectancies are changing over time. So, for example, today's 75 year old men Have a mortality rate of 4% in the year that they are 75, which is really not bad. But if you are 25 today, it may well be that when you turn 75, your mortality rate will be a lot lower than 4%. And conversely if today's 75 year old man had opened up a social security period mortality table in 1960, when he was a young man of 22. You would've seen that a 75 year old in that period mortality table had an approximately 7% mortality rate and you might have mistakenly concluded that his life was likely to be much shorter than it is in fact likely to be. Death rates across the age distribution were in fact a good deal higher for men in 1960 than today. And here's some similar data for women. In the 2007 period life table 75-year-old women face mortality rates of just under 3% in a year. In 1960, the 75-year-old woman faced an almost 5% likelihood of death in that year. And as was the case for men, death rates across the entire age distribution were a good deal higher for women in 1960 than they are today. So the bottom line so far is this while today's period mortality tables present the experience of people of a given age today, they do not present the experience that you can expect to have at any age that is different from your age today. This raises the question of whether it is possible to construct a mortality table that projects mortality rates for someone who is born in a given year, for example someone born in 1980. That is what a cohort mortality table does. Here, demographers and actuaries are employing their best possible projections of how long people will live given improvements in mortality that are likely to occur. So, you can compare, for example, the projected mortality experience for someone born in 1980 who turns 34 years old in 2014. With today's period mortality tables. You'll see that the people born in 1980 had higher mortality rates when they were young kids than today's young kids but they will have lower mortality rates beyond around their current ages, which is in the early 30s. Now, a really tantalizing calculation you can do with cohort mortality tables is to see the cumulative survival probabilities of people of different ages. So, here's the entire cumulative probability that males and females born in 1980 make it to any given age. For this cohort, again

these are people who are in their early 30s today, There is around a 75% chance that a man will live to be 70. There's a 54% chance they'll live to be 80, and a 21% chance that he will live to be 90. And there's around an 83% chance that a woman will live to be 70, a 65% chance she'll live to be 80, and a 33% chance she will live to be 90. We can also ask the question of survival probabilities conditional on attaining a given age. For example, assuming a person born in 1980 eventually reaches age 65, what would be the remaining median number of years he or she will live and what will be a 10th percentile outcome and what will be a 90th percentile outcome? Well, if you're a man born in 1980, and you make it to age 65, actuaries believe you have a 90% chance of living beyond age 70. A 50 50 chance of living beyond age 84. And a 10% chance of living beyond age 95. If you're a woman born in 1980 and you make it to age 65, actuaries believe that you'll have a 90% chance of living beyond age 72. A 50 50 chance of living beyond 87, and a 10% chance of living beyond age 98. Perhaps living to such advanced ages seems to you as though it would constitute good fortune. But it won't be such good fortune if you have no assets on which to live. Finally, we can look at how these cumulative survival probabilities have changed over time. Let's start with a cohort born in 1950 who will turn 65 in 2015. These are data that an insurance company will wanna use if pricing an annuity product for someone who was buying an annuity at age 65 in 2015. At most points of the distribution, it's about two years shorter than in the people born in 1980. And now looking forward in time for the kids born in 2010, it's about two years longer. Again, indeed, a girl born in 2010, if she lives to be 65, has about a 10% chance of living to be 100 years old and these odds are projected to keep rising for future generations. Now, of course, in a population as diverse as the population of all U.S. citizens, there is substantial heterogeneity in longevity. Life expectancy appears to vary by income. It also appears to vary by race. And while healthy people can of course die suddenly and unhealthy people can live a long time. Your doctor could probably give you a reasonable sense, or estimate, of whether you're likely to live longer or shorter than the average for your age and sex. So, this means that annuities are gonna be a better deal for some people than for others in the population. The longer you think you'll live, the better deal an annuity will be. For the insurance companies on the other hand, the only thing that matters is whether the mortality tables they are using for their pools of customers are correct on average. If they're not, then insurance companies will have unexpected variation in their profits for selling annuities. If the population ends up living longer than expected, say because cancer is cured, some insurance companies may experience large losses on the annuity products they sell. On the other hand, if the population ends up living shorter than expected, then the insurance companies would experience gains on the annuity products. And, a related concern that insurance companies surely have, is whether the population of customers arriving at their door is really the average in the population.

That is why they will use life tables specific to the assumed distribution of their customers in pricing their annuity products. So in this segment we examined why the price of annuities depends in part on the mortality patterns in the population. A single life annuity can be thought of as a bond that makes interest payments only if the individual is still alive with a principle ultimately forfeited upon the purchaser's death. In a poll population then, a life annuity is a bond whose expected payouts depends on overall longevity. The value of such product can therefore be pinned down by the factors that determines two things, one bond prices and two the distribution of longevity in the population 2.5 - Deferred Annuities Deferred annuities. So far we've dealt with immediate annuities. Where a retiree makes a large upfront payment to an insurance company. Which then begins monthly payments right away. And now I want to talk about the idea of a deferred annuity. Which is an annuity where you pay today. Or possibly pay in over a period of time and then receive a life annuity at a certain date. So suppose for example a 55 year old entered a deferred annuity contract with an insurance company, where the payments do not start for ten years. The cash flows would look like this, in 2013 the premium would be paid, that's minus P. Then from 2014 to 2022 there would no payments. Starting in 2023 the individual would receive a benefit, B each month he or she was still alive, otherwise, there would be no benefit. Or if there were more gradual pay in, the cash flows would look like this. In 2013, starting in 2013, we'd have these monthly premiums of minus aP, each month the individual was still alive. If they weren't alive there wouldn't be anymore premium to be paid. And then starting in 2023, the benefits would begin. Each month the individual was still alive, the benefit B would be paid each month, unless the individual had died, in which case, there would be no benefit. So here, a is a constant, such that the present value of all the gradual premium payments to the insurance company, equals the lump sum premium payment, P. Note that there are 120 months between the payment of the premium and the start of the benefit. That's ten years. But this constant a, would actually not be 1 over 120, it would be more than that because the seller of the product is gonna charge you for the fact that they're not getting your entire premium today. A dollar today is worth more then a dollar tomorrow to the insurer, and all the more so because the purchaser might die before the premium is fully paid. This contract looks not unlike a defined benefit pension. Employers and employees pay contributions into a fund over a period of time, and the fund then pays an annuity out to the employee when the employee retires. That's a typical defined benefit pension contract. So, the contributions to the DB pension could be thought of as premium payments spread out over time that allow the purchaser or worker to build up rights to an annuity that will begin in the future, when the worker retires. So, if we want to get a sense of the cost of providing a guaranteed lifetime pension to somebody, the cost of providing a deferred annuity would not be a bad place to start. Another type of deferred annuity that has received some attention lately, is the advanced life deferred annuity or ALDA. An ALDA is nothing but a deferred annuity that you might purchase at retirement, but that doesn't start paying out until some advanced age, such as 85. So it has the same cash flows as what

I've just showed for the deferred annuity but the purchaser is say, age 65 and buying an annuity that starts at age 85. ALDAs are not currently widely available due to a large part of regulatory impediments. But an attractive feature of them is that they'll be substantially less expensive since they're only going to start paying out 20 years from the time of purchase and even then, they pay out only if individual lives to 85, and even then, only for the remaining duration of the individual's life. By some estimates, the cost of this product, if competitively provided, would be around 1 10th the cost of an immediate annuity. So instead of the immediate annuity, we saw in the earlier segment, which costs $100,000 in exchange for payments of around $500 per month for life starting at age 65. The cost of the ALDA would be maybe only $10,000 in exchange for payments of $500 per month, but those payment wouldn't start until age 85. And that $10,000 premium payment could even be broken up into monthly payments, with some interest of course, over the 20 years between ages 65 and 85. Another advantage of this is that the individual would know that he or she could in the meantime, spend down the remaining assets freely as long as they were covering their premiums. So to go back to our example at the beginning of the lecture, suppose you arrived your retirement at age 67 with a balance of $1 million. One option, an option that few would take, would be to spend the whole thing on an immediate life annuity which would generate income of around $60,000 per year. Since it costs $100,000 for $500 per month or $6,000 per year. For $1 million, you get $60,000 per year. But if each $6,000 per year for life after age 85, really only costed you $10,000, you could comfortably part with say, $80,000 of your nest egg when your 67 to buy this ALDA. And that would ensure that you would get $48,000 per year in resources from the ALDA longevity insurance, after age 85, if you live that long. In the mean time, you'd then be free to spend down the remaining $920,000 during the time that you were ages 67 through age 84, knowing that it would be perfectly fine, to exhaust these resources. Under the assumptions we made, in the first segment, you can comfortably spend around $52,000 per year from age 67 to 84. You could grow that with inflation without taking investment risks. Compare that to spending $51,000 per year, and planning to run out of assets for sure on your 87th birthday, and the ALDA looks like a pretty good option. In sum, deferred annuities allow the buyer to purchase longevity insurance that begins at some point in the future. There's been some recent excitement about advanced life deferred annuities or ALDAs, because they could provide longevity insurance while also allowing the retiree to regain control over most of his or her capital. 2.6 Overall Recap So, to recap this lecture I started out asking you how worried you are that you will outlive your savings. Worries about outliving your savings are in part related to how much saving you think you will accumulate. But we've now seen that once you have accumulated assets. There are financial products you can use to guarantee you'll not run out of assets. These products, life annuities have a feature that is attractive to many economists. They provide insurance against the risk that you might not think about as a financial risk but really is one. The risk

that you will have a longer than expected life. Despite the relatively wide spread availability of life annuities however, many people have viewed these products as expensive. Annuities require relinquishing control of a large amount of resources in a lump sum. In exchange for the guaranteed monthly benefits. You should now have a general idea of what annuities can and cannot do. But there are many additional considerations that we taken into account in deciding how much of your retirement wealth you might want to convert into annuity. First and most importantly we need to examine the financial instruments that you would use to invest the wealth that is not annuitized. If this wealth is really for generating a secure stream of income for consumption. Those assets are gonna be mostly bonds and perhaps some real estate or other fixed income asset. But if you have a large safety buffer or are willing to potentially scale back expenditures quite a bit if need be equities may have a place in the portfolio for retirees. A full consideration of spending rules for retirees requires us to consider the possibility of risky investment strategies. Second, we didn't discuss planning for leaving bequests to heirs, should you wanna do that. Annuitizing one's entire wealth will maximize the longevity insurance, but will leave nothing for your heirs. And third, we mention that the existence of social security gives you some pre-annuitized income as would any pension plans in which you participate, but we have not analyzed those programs in detail. Finally, consumers of annuities must be able to trust that the insurance companies will be solvent and delivering on their promises far into the future. History has given no reason to doubt that this will be the case, but given the large, idiosyncratic exposure. An individual has, if she or she gives over their entire life savings to an insurance firm. This seems like an important area for careful investigation. Lecture 3 - The Bond Market and Bond Pricing Weekly Announcement - Week 2 Hi, everybody. Hope you're having a good week and have been digging into the video lectures and assignments. this week I wanna talk about a few things. First, I'm gonna talk about some questions that have come up about the course material. I'm also gonna talk about some of the general ideas from the first couple of lectures, we'll review those, talk a little about some things that have happened in the news and then a bit of a preview for what you can expect in the coming week. So, some questions that have come up, so some people have experienced some tech issues. the team assures me that they are working on them and that all of your questions about tech, tech issues in the discussion forums are being read and are being heard. so rest assured that the team is trying to correct any issues the people are, are having. regarding the assignments, so initially, on the initial assignments we're doing something with the feedback where you're going to have feedback on these assignments, meaning the answers to the questions on Friday. That's on the, on the 25th. And, that means you have until Friday to do your final submissions. Now, in the mean time the team at NovaRed, NovaEd is working on making it so that you will have immediate responses immediate feedback on the quiz questions. So, the way it will be is you'll have a

first opportunity to fill out the quiz questions, then you'll get some immediate feedback with which ones you got right, which ones you got wrong. Then, you'll be able to try the question a second time, and you'll get feedback again on which ones you got right, which ones you got wrong. You'll have an opportunity to try it a third time. So, that's how it's gonna work going forward. the NovaEd team is still working on implementing this feature and,uh, it should be implemented sometime during the coming week. For the time being, the lecture videos three, four, and five, for those we will start out posting the questions as PDFs, so you can get a head start on those and then, when this new feature is implemented you'll have the instant feedback quiz feature there. So, that's how we're going to do that. so some questions that people asked about the quiz questions, about the assignment questions. some people thought the assignment questions were kind of hard. Well, I think that's good. This is based on a real Stanford course that I teach and it's not always going to be easy. so I want you, really do your best to try to, dig in, you know, you might have to poke around and figure out for some of these, which spreadsheet you have to use. that's the way I want, I want it to be, and I want you to have to figure out which spreadsheet to use. I don't want it to just be obvious what to do or what the, what the answer is. And of course, feel free to discuss in the discussion forums. another example of one thing that came up, people told me, well Professor I think that in question two of the first video lecture assignment, there's a mistake because they were getting the same answer when they did the two scenarios that are there. Well, I'll tell you, this is not a mistake. This is one where you have to think about the question a little bit more deeply. my students at Stanford, got that question and I know you can, as well. other questions that came up question six through eight on the first set of assignment questions. for those, for some people it wasn't clear what spreadsheet you should be using. You know, again, I want you to poke around a little bit, but I do tell you in that question now that you should be using the spreadsheet called, Six Risk. And actually answering the ques, those questions is now just gonna be a matter of changing a couple of the rates of return assumptions that are in that in that spreadsheet, in that workbook. so I want to encourage you to, you know, keep trying with the quizzes. It's important to do them. Do your best with them. And you know, we'll be getting you the feedback soon and you'll know the correct answers. And just keep just keep going at it, you know, if keep trying these and keep looking at them over and over again, thinking about them, leaving them alone for awhile, come back to them I know you'll do great. So you know I think the general idea from the first lecture was that, you know, you're gonna have to probably save a lot if you expect to have a a reasonable retirement. You know, people during this transition we've been experiencing from sort of reliance on traditional defined benefit pension plans, more to 401(k)s and individual retirement accounts. I think we're kind of discovering that in this experiment a lot of people, didn't really save enough so what's gonna happen? What is the, what is the solution? Well, you know, one solution is for people to try to work more and save more, so you could save more of your paycheck, you could work longer.

others might hope for more in the way of government programs that will support them in retirement like expansions of Social Security or of of some other kind of government program that would, that would come in. I think the hopes for that have to be somewhat limited given the current state of affairs in in government finances. So, I think probably, there's gonna be no real other solution than saving more and working more. Although, of course, we can pay attention to those government programs and see if we can, we can make them work better for people. so the big news in the past couple days has obviously been the the budget deal and the United States is not going to default on its debt. it was quite interesting to see during the days leading up to the deal that for a time, the yield on very, very short term treasury bonds, so one month Treasury bonds. The yield on those bonds was actually higher then the yields on three month Treasury bonds, on longer term things. And, it's very unusual to have that's called, that's called a inverted yield curve at the very front end of the curve. It's very unusual to have an inverted yield curve at the very front end of the curve and if you think about the reason why that, why that is. Well, that's because markets were thinking, you know, gee there's really some possibility that the US government might not be able to get its act together here, and that they might, you know, sort of just, just drop the ball on making the payments on the debt that's coming due in the really, really short term. And the markets thought that the government would get its act together on longer term debt but that possibly very, very short term debt could have been affected. And, I mean, these yield differences were not that great. But, it's still very interesting that at that very, very front end of the curve that one month yield was higher than, than the three month yield for a day or two. So, some interesting news in the pensions and retirement world, this week. the world that I follow a great deal in regards to public sector pensions or pensions for public sector employees. this is big news in California. The Mayor of the city of San Jose, which is actually the second largest city in California by number of residents, and around the 10th largest city in the US. The mayor of San Jose, his name is Chuck Reed Democrat, and other mayors, proposed a a state-wide ballot initiative that would would say that in California that it would be possible to change the pension deal for government workers prospectively, so going forward. And, this is partly in response to the fact that in San Jose, California, the, the city was in something of a, of a crisis. It had reached the point where about 20 percent of its revenues were going to fund the pensions for public sector employees. And, as a result, the mayor of the city introduced a ballot measure there in the city to try to change the pension package a little bit. He introduced a a new tier for new workers, so a kind of a less generous pension plan for new workers. And, he said, that existing workers going forward you know, if they wanted to keep their existing benefits, they would have to pay more into the pension fund themselves out of their own pay or their other choice would have been to go on the somewhat reduced benefit structure that the new employees had. so this was a very interesting case for those of us who follow state and local pension systems around the US because the city was clearly struggling under the burden of pension payments. And, in fact, in a lot of cities around the US, the pension payments are now taking up contributions to the funds are taking up a lot more of government revenues than they ever have before.

and, of course, nobody in this case, or really in any cases really, is talking about rolling back benefits that people have already earned. The debate is really about whether you can change perspective benefits. So, a lot of the ways these, these are traditional defined benefit pension plans and the way they typically work is that employees told that they will receive a certain percentage of their salary times the number of years that they have worked. They receive what's called a benefit formula. so these changes that are being proposed in San Jose, in, in places around the country, they almost never would consider taking back benefits that have been earned already, but they are about perspective benefits. So, if you've worked for ten years and based on your formula, you would've been able to retire with a pension of say, $15,000. what the, these new changes would do is it would allow state and local governments to say, okay, that $15,000 dollars, that is safe, that's not going anywhere, but the rate at which you accrue new pension benefits going forward would be different. So, the rate at which a public employee would earn new credits and have that $15,000 dollars grow would be, would be slower. this has been quite a contriversial thing in California. many of the public employee groups have said, you know, we're entitled to the formula we've had from the beginning. there's a body of case law that is generally in the past, supported that view, but the mayors are now pushing back against that view. They feel that their budgets are crunched, that the money liked to be spending on other things, libraries and parks and things like that are getting now crowded out by these pension payments. some mayors, you know have tried to, you know, raise more revenue in various ways but they're also looking, taking a hard look at these, at these benefit structures and and asking, you know, whether there's any changes that has to be made to them. So, we're going to be talking about that issue as the course goes on and I think I'm previewing it, now. What I really want to do, before we get deeply into that issue, is I really want to make sure that we've all got a very fundamental understanding of the principals of finance. And, so that's why in the coming week, I'm going to be going over a lot about bonds, we got bond markets, how they work. We'll be talking about the following weeks stock markets, how they work. Because, really, in order to understand the cost of providing these kind of, kind of state and local and these, these defined benefit pension promises, to understand the cost of those, you really have to have an understanding of, of, of basic finance. And, a really great place to be starting with that is the second lecture from last week lecture, lecture two, on the annuities market and on annuities. Because, really a defined benefit pension is nothing other than a deferred annuities. Essentially employees that are in these systems where they're promised traditional pensions when they retire. What those employees are getting is they're recieveing credits for basically annuities in the future. They're really being given deferred annuities. They're being, they're earning the right to have annuities payed to them when they retire. And so, in that sense, what we're looking at in lecture two, what we've looked at in lecture two, the lecture about annuities is very relevant for measuring defined benefit pension liabilities which is the, this topic we're gonna come back to. Because, really, defined pension liabilities are nothing other than annuities. They're, they're deferred annuities that workers, typically they work for state and local governments, but also, you know, workers

of very traditional, older companies like General Motors or some of the airlines are still are still accruing, are still earning. And so, to understand what the costs are of providing these benefits, we need to get an understanding of what are the, what are the costs, what is the value of, of deferred annuities? And so, in that sense, the lecture two material should be very useful to us going forward. So, for the video lectures this week it's basically, mostly about bonds, bonds, bonds, and more bonds. and you're going to be understanding, learning about how bond markets work and what really, and what determines the value of a bond. What is a bond? many of you may invest in bond funds if you have a 401(k) so that may be a place that you come in contact with bonds. many of you may just have mutual funds where you're investing in bonds. And, also, as I'm going to emphasize in the video lectures for this week you know, the concept of bonds and where they derive their value, that concept is useful far beyond just, you know, understanding bonds themselves. The, the concepts really go far beyond that and, and for example, define benefit pension promises and annuities also, their, their value is very much bond-like and they're really deriving their value, from some of the same basic ideas as bonds are. And, bonds are really just, you know, anytime you have a, a stream of payments that is contractually specified up front, that's what a bond is. And so the real question is, you know, what, where is, where is the value derived from that? Well, it derives from this contract of the stream of payments. And then, and then, what are the, what are the risks of investing in bonds? You know, those risks may involve inflation, you know, the, the money that you're promised back may not be worth as much when you get it as as it, as it was at the time that it was promised. There are also risks of default possibly okay, so hopefully the U.S. Government has averted default for some time, but there are other entities that issues bonds. So say corporations that issue bonds that may, may not be as safe. There are companies that have defaulted on their bonds. Any company that has gone into a bankruptcy proceeding has defaulted on their bonds, so there's, there's default risk. And, there are other risks, as well, like what happens if you have to sell the bond, if you have to sell the promise before that stream of cash flows is over? You can probably get some other market participant to pay you for the rest of those those cash flows, but the question is what price they're gonna offer you and that would depend upon market conditions. So, we call that interest rate risk. So, those risks of investing in bonds are gonna be, well, one of the major topics of the lectures coming up, and you'll see that kinda the greater those risks, the higher the yield that one is gonna, has observed on, on these bonds, on these, on these fixed-income instruments. And, that also ties into the concept of risk that we saw last week. You know, you only can expect or can target a return that is higher than a risk-free rate if you're also taking on risk. So, if a bond has a yield that is well above the yield on very, very safe securities like treasury bonds or short term treasury bonds, then it must be that there's some risk associated with that. and that's really this financed view that there's, you know, there's no free lunch, there's a risk associated with it. And if it's offering a higher yield that means there must be some, some risks, as well. So, that's, that's some of the key issues that you'll be dealing with and you'll be learning about in these lectures that are coming up this week.

keep in mind that the assignments for these lectures will initially be posted as PDFs, so have a look at them as soon as you can. And then they will later be converted into online, online quizzes just like weeks one and two except this time, now, you'll be able to get that immediate feedback which I know a lot of you have been wanting to wanting to have. So, I hope everybody has been having a good time, having fun in the discussion forums having fun watching the lectures and working on the assignments and looking forward to talking to you more. Take care everybody. 3.1 - What is a bond and why should we care? Welcome to this lecture about the bond market and bond pricing. First of all, what is a bond and why should we care? A bond is an IOU issued from a borrower to a creditor or lender, is a piece of paper, or these days an electronic document, that specifies the payments the borrower will pay to the creditor to pay off the obligation. The bond is formally created when the creditor, transfers funds to the borrower and in exchange receives the IOU. Why is it important to learn about bonds? Several reasons. First of all as a personal investor, there are good reasons to have some bonds in your portfolio. Bonds generally provide fixed or at least mostly predictable income streams. So, they can be a useful tool to save for specific expenditures like, college for your kids or for your retirement or after you've retired to generate income for yourself. Second, many large long term investors. Such as insurance companies and pension funds that cover public employees, invest in bonds. If you wanna understand those entities, you need to understand the role of bonds in their portfolios. Third, much government borrowing takes place through bond markets. So, from the perspective of understanding public finances. Which affect you through the taxes that you pay. It is important to understand bonds. Finally, we cannot hope to understand the value of many financial products or guarantees such as pension and annuities. Until we understand bonds. That is because these arrangements are basically the same thing as a bond. They just are less likely to trade on a financial market. An annuity is like a bond that makes regular payments, until the purchaser dies. And a traditional pension arrangement, in which an employee, in the U.S. now it is usually a government employee. Receives a monthly check from their employer, is also just like a bond. The IOU is simply from the government to a current or former employee. Like an annuity, a pension ceases upon the death of the individual, as opposed to having a repayment of principle to an investor. So, the bottom line so far is that the concept of a bond and what a bond is worth, is useful far beyond just pricing a bond. It will allow you to understand how much other streams of income are worth, including annuities and pensions. 3.2 - Who are the borrowers in bond markets? Who are the borrowers in bond markets? Here are some statistics. The US Treasury is the largest, with around $11 trillion of outstanding treasury bonds, as of the end of 2012. A treasury bond is an IOU from the Federal Government, it is a security entitling the holder to specified payments from the US Treasury.

Next are U.S corporations with around $8.5 trillion of traded bonds outstanding. Then there's a large dollar amount of bonds related to home mortgages around 8.2 trillion. If you buy a home and take out a mortgage, you must make periodic payments to the bank to pay off that obligation. So, in fact, when you take out the mortgage you are selling a bond to the bank. The bank holds on to some of these individual bonds, until they mature and the loan is paid off. But other mortgages are packaged together into mortgage backed securities and sold to investors. The last category I'll mention are municipal bonds. These are bonds issued by state and local governments. There're about $3.7 trillion of these bonds outstanding. Combining these top four with several other categories, U.S. borrowers have issued $37.7 trillion of bonds. That compares to annual U.S. GDP Of around 15.7 trillion. GDP is the value, the total value, of all goods and services produced in the economy. So the bond market is around 2.4 times our GDP. Do these statistics on the bond market represent all debts outstanding the U.S borrowers owe to creditors? Definately not. First of all, when I was talking about mortgages, I mentioned that some are sold to investors but others are not. Those that are not, remain on the balance sheet of the bank as loans. Banks, credit card companies and the financing arms of many other companies, also provide large amounts of business and consumer credit. This credit is to finance the purchase of consumer goods, capital goods or general spending. Second, the federal government collects contributions from your paycheck for Social Security and Medicare, called Payroll taxes. In exchange they have pledged to provide an annuitized stream of income for you or health insurance benefits when you retire. Those are also dead arrangements as well. Where you have given money to the Government through payroll taxes and the Government has pledged to pay you an annuity when you retire. Similarly, State and Local Governments and some firms have also promised payments to retirees through defined benefit pension arrangements And promises for retiree health insurance. These are not technically bonds, but Social Security, pensions and Medicare are a large category of government debt. And, just like if we were analysing a bond or another type of debt, we'll have to consider whether there's a risk of partial default on these obligations. Finally, an annuity, the promise an insurance company has made to pay people streams of payments for the rest of their lives. Is also a kind of private bond. The purchaser gave the insurance company cash when he or she retired and the insurance company now owes the individual a stream of payments. So these other categories of debt, which we typically call loans and pensions instead of bonds. Are really just like bonds other than the fact that they are not quite as readily trade-able. But the difference is not as great as you might think, banks actually can syndicate loans and repackage them for investors. Insurance companies trade bond like securities that provide many different types of streams of income. And as long as we know what the promised stream of payments looks like and what the risk profile is of those payments, we can price these promises as though they were bonds and get a sense of how much that promise is worth. 3.3 - Coupon Bonds Coupon bonds. Let's consider traditional bonds. A bond promises to repay an amount upon maturity. Maturity means the end of the life of the loan. The promised repayment amount is called the face value,

or par value. Most commonly, the bond also promises to pay the holder periodic interest payments, which are specified as a percentage of the face value. These payments are called coupons or coupon payments. A bond that promises to pay periodic interest payments plus repayment of principal is called a coupon bond, or power bond. Let's see how this generally works for U.S. treasury bonds. The Wall Street Journal website provides regular information about the yields on recently issued U.S. treasury bonds that mature at different dates. Here are some numbers from their screen on March 6th, 2013. Each row of their table represents one bond issue with a different maturity date. So, let's consider the line for a bond that matures on February 15th, 2023. Given that these are recently issued bonds, I can tell you that this bond was issued on February 15th, 2013 with a maturity of ten years. These bonds typically have a face value of $1,000. This one has a coupon of 2%, which means that the annual payments the bond makes will be $20 per year. But actually, since U.S treasury bonds pay interest semi-annually, that means twice-per-year, the holder gets $10 every six months. Here is the timeline of scheduled cash payments for this bond. On the issue date, the buyer pays some money to the government. Then every six months, the buyer gets a coupon payment of $10. That continues until the day of the 20th coupon payment ten years from now, when he gets that last $10 coupon payment plus $1000. Remember that the 2% rate, which implies these $10 coupons twice a year, as well as the $1000 at the end, is written into the Treasury Bond contract. These things are for all practical purposes written in stone. They cannot be changed. The buyer of a treasury bond always knows what she is getting, at least in nominal dollars, though not purchasing power. And of course, assuming that the U.S. federal government does not become as financially distressed as Argentina or Greece, these are the closest thing we have to non defaulting nominal promises. What actually happened at the auction when the bond was sold? You can find out on the U.S Treasury direct website that it sold for $99.5859 per hundred dollars of face value, which is around $995.86 per $1,000 of face value. That means that bond buyers on February 15th were a little less enthusiastic than the government thought they would be when the government set the coupon rate. So, what have we learned about coupon bonds? These are the most standard types of bonds. We took an example of a treasury bond issued by the U.S. government and looked at its price at issuance, and several weeks after it was issued. At the time of issue, investors discounted the future payments a little more than the treasury department expected, paying a little less for the bond than the $1,000 face value. 3.4 - The Prices and Yields of Coupon Bonds The prices and yields of coupon bonds. How would you determine the amount you would pay for a coupon bond? Recall the pattern of cash flows that this bond promises. A very naive approach would be to just add up each of the cash flows. The 19 payments of $10 each, and the final payment of the last $10 coupon plus the face value for a total of $1200. But of course, that would be wrong. Why would it be wrong? Well, first and foremost, it ignores the time value of money. The fact that a dollar today is worth more than a dollar received tomorrow. Second, while we consider treasury bonds to be very safe. For any risky security, you would have to consider that a risky dollar is worth less than a safe dollar.

In the case of a treasury bond, the willingness of investors to buy a fixed stream of payments will likely be lower if the perceived risk of inflation is higher. So inflation would be the main risk here. For a bond issued by a corporation or a municipal government, investors may also need compensation for the risk. The issuer might default on the obligation and actually not make the promised coupon payments or the repayment of principal. That is why we have to discount the payments and instead, find a present value of the cash flows. Since the coupon rate on this bond was set at 1% every six months, it should not be surprising that if we discount the payments of the bond at a 1% semi annual yield to maturity or a 2% bond equivalent annual yield, then the price will be 1,000 dollars. Presumably what the treasury had in mind when they issued this bond. The yield to maturity is the interest rate that makes the present value of the bond's cash flows equal to its price. Let's see how this works. If we examine the coupon payments and compare the promised coupon payments to their discounted value, we could see that each payment in the future is discounted more and more. And the final payment, which includes the last coupon and the principle repayment is actually discounted the most. Why? Well, the 1% semiannual rate is being applied over 20 periods. The sum of the present value of each payment is the price of the bond $1000. Which of course is less than the sum of the undiscounted payments, $1200. To be clear about the terminology, we call the 2% number the bond equivalent annual yield. Invest in a security that has a six month yield to maturity of 1%, leads to more than a 2% return at the end of of the year if you've reinvested the proceeds. You would in fact have a return of 1.01 times 1.01 minus 1 equals 2.01% not 2%. So, while traders, market participants and the financial press quote bond yields using the convenient bond equivalent annual yield. Which is just two times the semi-annual yield. These players would all understand the true equivalent annual yield is a little more than 2% in this example, and you should understand that too. If you go back to the cash flows for this bond and use trial and error or a goal seek function, you will find that the actual price at which the bond sold on the first day, $995.86, reflects a semi-annual yield of 1.023%. This is a bond equivalent annual yield of two times 1.023% or 2.046%. The discounting reflects the fact that due to time and risk, the present value of these payments is lower than the contractually specified amounts. Remember that the investors in these newly issued bonds had ample other opportunities that day to invest in bonds. And it was those other bonds and other investment opportunities that ultimately led traders to pay $995.86, pricing it at a 2.046% annual yield to maturity. The law of one price tells us that the new securities should not trade at a premium or discount to other securities in the market with identical properties. The yield to maturity that priced this bond will be the yield to maturity on an alternative investment opportunity with equivalent risk. From this discussion, it should be clear that a higher discount rate or yield means a lower price. Price moves inversely with yield to maturity for bonds since higher discount rates reduce the present value. This is one of the key principles of bond pricing. If you own a bond and the yield to maturity falls, that is good news if you were thinking about selling this bond because it means that the price of the bond has risen.

The future cash flows are not being discounted as heavily by the market as they were previously. Now, suppose that an investor actually bought this bond at issue, at the price of $995.86 which is equivalent to a yield to maturity of 2.046%. Doesn't that mean that the investor will actually realize an annualized return of 2.046%? Well, the first point you have to keep in mind is that he gets 1.023% compounded every six months, which works out to something closer to 2.06% per year. But getting that is actually not a sure thing. Why? Two reasons. First, the investor has to hold the bond to maturity to realize the yield to maturity. I mentioned before that the price of this bond increased to $1005.50 by March 6th, from February 15th. So, if you sold this bond right away when that happened, you would realize a profit. And if the price rose enough, you could realize much more of a profit than 2.06%. And that in just a very short amount of time. The bond price could also fall, if you had to sell the bond, you would realize the loss. We call this risk interest rate risk. Because it reflects the possibility that the market might decide to discount the bonds cash flows at a different rate. If you hold it to maturity though, interest rate risk is not a factor. You know exactly what you're gonna get assuming the bond does not default, which is our assumption about U.S. treasuries. The second reason you don't exactly get the yield to maturity for sure, is that the coupons must be able to be reinvested at the yields to maturity for the lifetime of the bond, not at whatever other rate prevails at the time. And particularly for the payments that are closer to the maturity of the bond, such reinvestment prospects are not as favorable. For example, the last coupon coming off the bond, can only be invested at the one year rate that prevails at the time. Which in normal times is far less than the ten year rate. So, what have we learned about pricing coupon bonds? The payments that you get from a standard default free coupon bond are completely known ahead of time. But the amount that investors are willing to pay for that stream of payments is much less certain. Investors are asking themselves, how much do we have to be compensated for the the time value of money, and also for the risks that we are taking? So what are these risks? Well, for issuers whose prospects are not totally certain, such as corporations and cities, yields are likely to be higher to reflect the fact that is a possibility of actual default, or nonpayment of coupons and principal. Those yields are what you get if the bond matures without defaulting. They are not a sure thing. Now in the case of U.S government bonds, the risks involved with holding the bond to maturity, are really limited to inflation risks. The possibility that your $1000 at maturity will not even buy you a piece of chewing gum. But if you think you might wanna sell the bond before it matures, even a treasury bond then you are also subject to interest rate risks. Investors demand for owing he bond, could be up or it could be down, on the date that you wanna sell it. We've also now covered some basics of bond math. When bond yields rise, their prices fall and vice versa. This is because bond prices and bond yields are two sides of the same coin. The higher the yield, the more investors are discounting feature payments. That means the less weight they are putting on payment out in the future. Investors prefer current payments to future payments because of the time value of money. And they are concerned about the risks of inflation, non-payment, or the ability to sale their bond before maturity without realizing a loss. 3.5 - Clean Prices and Dirty Prices

Clean prices and dirty prices. The coupon bond in the previous section was issued at a price of $995.86, which implied a semi-annual yield to maturity of 1.023%, or a bond equivalent annual yield of twice that, 2.046%. The full formula used to calculate the present value was the following. Ten over one plus r, that's the first coupon, plus ten over one plus r squared, that's the next one, plus ten over one plus r cubed, and so on, up until the very last payment, which is $1,010 divided by one plus r to the t, that's the principal repayment plus the last coupon. And if we plug in a r of 1.023%, we get a price of $995.86. I mentioned that by March 6th, this bond was trading at more than that, at a price of $1,005.50. That was the price quote on thewallstreetjournal.com alongside a yield quote of 1.939%. Recall again that it's standard to quote these in units of $100. So you'd actually see $100.55 is the quoted price, but the actual bond price is ten times that or $1,005.50. So, let's check whether we can square the price that the Wall Street Journal quoted for this bond with the yield that they quoted for this bond. On March 6th, we were 19 days closer to the date of the first coupon payment than when the bond was issued. So we were 10.5% of the way through the first six month period. 10.5% is 19 divided by 181, which is the total number of days in the six month period. So that means that discounting that first cash flow back to March 6th, we have to use an exponent, not of one period, but of 0.895 periods. And discounting the second term, we wanna use not two periods, but 1.895 periods, and so on. So, doing our discounting, ten over one plus r to the 0.895 plus ten over one plus r to the 1.895, and so on, where the last payment is 1,010 divided by one plus r to the 19.895. If we plug in the semi-annual yield, which is the 1.939% divided by two, that's 0.969%, we find a price of $1,006.55. But wait a second, that price is not consistent with the quoted price of $100.55 per $100 of face value or $1,005.50 for a $1,000 bond even though the $1,005.50 was quoted on the website alongside the yield to maturity of 1.939%. So, what gives? The apparent discrepancy has to do with the way that prices are quoted when bonds are between coupons. Trust your math. If you wanted to buy this bond on March 6th, you would actually pay $1006.55 as you calculated from your formula, as an invoice price. Sometimes also called a dirty price. But bond prices are quoted online and in newspapers, and on many trading systems using clean prices, which typically do not include the accrued interest. Remember that in this example on March 6th, you were already 10.5% of the way to the first coupon payment. That is worth 10.5% times $10, or $1.05. That's the difference between the dirty price you actually pay, $1,006.55, and the clean price that is quoted, $1,005.50. The difference is that $1.05 of accrued interest. So, the relation we have is as follows. The dirty, invoice or present value or actual, price is equal to the clean or quoted price, plus accrued interest. Why quote a price that's not actually paid? Let's try graphing out the present value, that is the dirty, true or invoice price of a bond over time, starting from a point where the yield to maturity is the coupon rates, the bond is trading at par. You will see it's value fluctuating in a sort of jagged pattern just because the timing of interest payments. Changes in clean prices on the other hand, actually reflect some change in the economics of investors' desire to hold the bond. When the yield to maturity in a bond equals the coupon rate, the bond is

referred to as trading at par. But recall that on March 6th, 2013, this bond was actually trading at a yield to maturity that was lower than the coupon rate, so it was trading at a price that was above par. How do the clean and dirty prices change as this type of bond matures? The clean price is still a straight line and the dirty price is still jagged, but now we have the price of the bond declining down to the $100 face value principal repayment as the bond approaches maturity. This is because the advantage the bond has of paying a coupon rate that is higher than the market interest rate, diminishes as the date of maturity approaches. So if the price of a premium bond declines as the bond approaches maturity, do I lose money by investing in such a bond? No, despite the capital loss that will occur, you don't lose money by investing in this bond, because you're getting those above market coupons from the outset. So, to recap. The prices and yields you see online for US bonds will not exactly match up, unless it happens to be the exact day after a coupon was just paid, or if you do a correction for accrued interest. The price you see in the Wall Street Journal or on the wallstreetjournal.com, or Bloomberg, or Routers, is usually the clean price, if we're talking about a U.S. bond. That clean price is not the price you actually pay to buy the bond or the price you receive to sell the bond. You actually pay the dirty or invoice price, which will be the clean price plus any accrued interest. It's important to pay attention to whether you're looking at a clean or dirty price quote. While in US markets we typically quote the clean price, in some European markets, quoting the dirty or true invoice price is more common. So, if you invest in bonds, make sure know what kind of price you're being quoted. In the U.S, if you think you are buying at the quoted clean price, you are not. The actual price you'll pay will be higher. And in Europe, if you're selling a bond and think you're gonna get additional accrued interest beyond the price you were quoted, you will be disappointed when your sale goes through to find out that, in fact, you were quoted the actual dirty market price. 3.6 - Pricing a Coupon Bond as a Sum of Zero-Coupon Bonds Pricing a coupon bond as a sum of zero coupon bonds. Now we're gonna consider bonds that pay no coupons and simply mature in a certain number of years by repaying the face value of say $1000. This kind of bond is a one shot payment called a Zero Coupon Bond. How much would it cost? Well the first thing to note, is that anyone issuing such a bond even the U.S government would have to sell the bond for less than $1000. As long as interest rates on longer term safe securities are positive which they almost always are. The present value of a zero coupon bond maturing in T periods is C sub T the cash flow at time T, divided by 1 plus r sub T to the power of T. I wrote the subscript capital T in the discount rate r sub capital T to specify that this is the appropriate discount rate for a zero coupon bond maturing in capital T periods. If the equivalent annual discount rate had been 2% which would be a one percent semi-annual yield to maturity. When the bond was issued then this bond would cost $819.54. If the annual discount rate were 2.04% or 1.02% semi-annual yield to maturity, then this bond would cost $816.31. Now, let's go back to the coupon bond. This coupon bond paid 20 annual coupons of $10 each and then the last period also repaid $1000 in principal.

And each of these also had a present value based on the bond's overall yield to maturity. But here's the key insight. This coupon bond is just like a series of 20 zero coupon bonds. 19 of them pay off $10 and one pays off $1010. It's as though the investor has bought 20 zero coupon bonds maturing every month. Or you can think of it as 21 zero coupon bonds. 20 little ones paying off the $10 coupons and one paying off $1000 at the same time period as the very last coupon. It turns out that if each of those little bonds traded separately, they would not have the same yield to maturity as one another. In fact, their present values would be different from the present values we calculated at the coupon bonds overall yield to maturity. This phenomenon is called the term structure of interest rates. The fact that a yield on a pure one year payment is different from and usually less than a yield on a pure two year payment. Which is different from and usually less than the yield on a pure three year payment and so on. Bond triggers have carved up treasury bonds like this for a long time. The procedure of breaking down a coupon bond into it's components is called coupon stripping. This coupon bond would actually be broken down into 21 pieces. 20 little coupons each paying $10 and one principal repayment paying $1,000. Those securities can then be sold separately and in doing so, one learns how much the market would be willing to pay for promises at each different time horizon. The treasury itself does not issue these bonds but it does allow the Federal Reserve to hold these securities under the Strips program. Strips stands for ''Separate Trading of Registered Interests and Securities" a convenient acronym that evokes the stripping of the coupon bonds that takes place. The Wall Street Journal website provides prices of strips. This information tells us exactly what the prices and yields are of the different cash flows that comprise a coupon bond. 20 coupon cash flows and one repayment of principle at the end. Now this interesting. You might wonder why there is a different yield to maturity for the February 15th, 2023 coupon payment versus the February 15th, 2023 principle. Well that's related to differential tax treatment of these two pieces. For individuals the coupons are taxed as ordinary income. While on the principle only capital gains tax would be owed. Since a coupon bond can be thought of as a series of zero coupon bonds. We can just add up the prices of the strips here, multiplied by the appropriate payment size to get the total present value of the coupon bond in the example. That is, these prices are per $100 of face value. But for the coupon bond, we really have 20 coupon bonds with face value of $10 plus one principal repayment with face value of $1000. So for each coupon, we need 1 10th of the quoted strips price at the relevant horizon. The near term ones will then be worth close to $10.00 each and the long term ones will be worth more like $8.00 each. And for the big principle repayment in 2023, we need ten times the quoted strips price, so $820 instead of $82. By the way, since these instruments are traded in markets. There is both a bid price which is what dealers are offering to pay for the securities. And an ask price which is the price at which they're willing to sell security. I'm gonna use the bid prices here. And if we add up all of the appropriately scaled bid prices, we find that the total at which bond dealers would buy this stream of cash flows equals $1006.53.

That's very close to, just a shade below the coded price for the coupon bond of $1006.55. This set of zero coupon bonds can be taught of a synthetic version of the coupon bond. Observe that the earlier payments are actually worth more. They are discounted less when we use this term structure of interest rates than when we use the bond's flat overall yield to maturity of 1.939%. And the last few payments including the big repayment of principal at the end are actually worth less, they are discounted more. When we use this term structure of interest rates then when we use the overall yield to maturity of 1.939%. So we can rewrite the bond present value formula as follows. The present value equals the first coupon payment divided by 1 plus r sub 1. Which is the annualized yield on a one year zero coupon treasury bond. Plus the second coupon payment divided by 1 plus r sub 2 which is the annualized yield on a two year zero coupon payment. And so on for the cash flows of the bond. Now those sub-scripted numbers in the interest rates in the denominator have deep meaning. Markets supply different annualized interest rates to payments that are made at different horizons. In normal times, generally r(sub1) is less than r(sub2) which is less than r(sub3) and so on. So we've seen in these zero coupon or one shot securities, that the yield to maturity rises with the time horizon. The yield on a ten year bond is higher than the yield on a five year bond which is higher than the yield on a one year bond. This is not always the case but is more often the case than not. There's some debate as to exactly why this is but the consensus is that it has to do with risk and the liquidity premium. Investing in longer term bonds exposes you to a greater degree of inflation risk. If you bought shorter term bonds and there was a lot of inflation those bonds will at least mature sooner and you can invest in higher yield in security when they do. Other things equal you also prefer instruments that you are less likely to have sell at a loss. That liquidity preference would push investors towards shorter term bonds over longer term bonds. Pushing up the relative yields of the longer term bonds and pushing down their prices. The greater these risks and liquidity concerns, the lower the price of the bond and the higher the yield. And it's generally the case that these risks and liquidity concerns are stronger for very long term promises. 3.7 - Overall Recap So let's recap this lecture. Bonds, which are simply tradable IOUs are important instruments in financial markets. Governments, banks and non financial corporations are the big issuers of these bonds, which is to say. They are the primary entities that use bonds to borrow in financial markets. Households, pension funds, and foreign governments are major categories of owners of the bonds. Serving as the creditors to the entities whose bonds they own. A bond promises to repay in amount upon maturity at the end of the life of the loan. The promised repayment amount is called the face value, or par value. Most commonly, the bond also promises to pay the holder, periodic interest payments, or coupons. Which are specified as a percentage of the face value of the bond. In most cases, when the issuer first sells the bond, the bond's price is close to the face value of the bond. Reflecting a yield to maturity that is close to the coupon rate on the bond.

The payments that you're promised from a standard coupon bond are completely known ahead of time. So if you hold a bond to maturity, the only risks are those of inflation and default. As long as the bond hasn't defaulted by the maturity date, the face value will be returned to the investor. But the price the market puts on the bond's future payments, or alternatively, the yield at which it discounts them, can change over time. So, investors who think they wanna sell bonds before the bonds mature have to consider the possibility the value of the bond could be higher or lower when they wanna sell. We saw that prices and yields of bond move in opposite directions. if the yield to maturity rises, that means that the market is discounting future payments more. And the bond has gotten cheaper. If the yield to maturity falls that means that the discounting future payments less and the bond has gotten more expensive. Finally, we saw how coupon bonds can be carved up into zero coupon bonds and priced accordingly. As bond traders have done for many years with US treasury strips. The prices of the strips reveal that the use of a single yield to maturity to price a bond. Hides the fact that the market usually discounts more distant payments at a higher periodic rate then nearer term payments. So what have we not yet covered about bonds. First, we haven't gone into the reasons that prices and yields might change over time for essentially default-free bonds, like treasury bonds. And how sensitive such bonds are to changes in discount rates. Nor have we looked at how corporate and municipal bonds that might default, are priced. And what drives changes in their prices in their time, both absolutely and relative to treasury bonds? We've also really only considered vanilla bonds. There are a range of other flavors and twists on the theme, including inflation index bonds And floating rate bonds. Finally, it's important to consider the implications of this analysis for investing in bond mutual funds or bond exchange traded funds or ETF's. Which is the way that many individual investors will invest in bonds. Those funds are allowing bonds to mature and automatically rolling over the proceeds into new bonds. So that the cash flow timing you incur is different relative to buying individual bonds if your plan is to consume the proceeds. Lecture 4 - Interest Rates and the Valuation of Treasury Bonds 4.1 Overview: The Risks and Returns of Bond Investing Welcome to this lecture about interest rates and the valuation of bonds. Lots of people invest in bonds or bond funds in their retirement accounts. Investors and bonds need to understand what factors determines changes in bond prices. For example, if you decide to invest your money in US Treasury Bonds, you face a corset of bond risks, if you're holding the bonds to maturity the risks faced are mostly about inflation. The likelihood that the promised repayments on the bond won't buy you as much consumption in the future as it does today. Here's how inflation has affected the value of $1 over 30 year periods beginning in each year. As a bond investor, you might get lucky and experience the 30 year period following 1966. That is from 1966 to 1996. When inflation only eroded the value of fixed payments by around 20%. But you might get unlucky and experience a period like 1920 to 1950 where in addition to many other serious problems in the world, there was lots of inflation and the spending power of promised nominal dollars declined by 80%.

Bond yields in a market setting will compensate for expected inflation, but the risk is that inflation might be greater than expected. And the luckiest state of the world, for bond investors, is one where there is deflation an increase in the purchasing power of a dollar. Now if you aren't holding bonds to maturity you also face interest rate risk, the possibility that the market will discount the bonds promised payments at higher rates at the very time when you want to sell the bond. So suppose you buy a zero coupon bond with ten years to maturity. If a year goes by and the yield on the bond has fallen, its price will be higher than it was to start. Suppose another year goes by. And that by this time the yield has risen beyond its original level. That means the price will be lower than its original level. And the price might continue to fluctuate. So if you wanna sell the bond during this time, you face this interest rate risk. As the bond gets close to maturity, the price will converge to the face value. And the interest rate risk is reduced. So if you wanna consume the, the proceeds of the bond after holding it to maturity, then the interest rates do not matter to you. But what if at maturity you were planning to reinvest the funds, not spend them. If you want to reinvest the funds, having low interest rates at that point is actually bad for you, and having high rates is good. That rate risk at the reinvestment horizon is reinvestment risk. And is actually the opposite of the interst rate risk you experience if you want to sell before maturity. So if your consumption horizon is shorter than the bond's maturity, you'd be worried about rates possibly going higher. If your consumption horizon is longer than the bond's maturity you'd be worried about rates possibly going lower. In some, with government bonds, investors can usually get better returns than just cash. But as with every other instrument that enables the possibility of a return higher than a risk-free rate, there are risks involved. In this lecture we'll aim to understand the risk and return trade-offs to investing in government bonds. 4.2 - Why do Treasury Bond Yields Vary? Why do treasury bond yields vary? The pricing of bonds is all about how much the market discounts future cash flows. Let's consider a standard coupon bond with a face value of $1000 and an annual coupon rate of 2% paid semi annually or $10 for every six month period. If markets discount the cash flows at a 2% bond equivalent annual yield or a 1% semi annual yield, then the bond will cost $1000. But as market conditions change, the discounts the buyers and sellers of the bonds may apply to these cash flows can either increase or decrease. For example. If the market only discounts the cash flows at a 1% bond equivalent annual yield, right 0.5% semi annual yield, the bond will be worth $1,094. So this drop in the yield by one percentage point raised the value by $94 or by 9.4%. If, in contrast, the market discounts the cash flows at a 3% bond equivalent annual yield or a 1.5% semiannual yield, it'll be worth $914. So this increase in the yield by 1% point lowered the value by $86 or by 8.6%. But why would a bond trade at different yields as time passes. Why would buyers and sellers of bonds agree on larger or smaller discounts of future cash flows? And why do some bonds carry higher yields to maturity than others.

That is, why is it that the market is discounting the cash flows on some bonds at a higher rate than the cash flows on other bonds? To answer those questions, you have to return to the reasons why buyers and sellers in the bond market discount cash flows in the first place. Why would you not pay the undiscounted sum of the cash flows, or twelve hundred dollars for this bond. You, as a bond investor, need to be compensated for, one, the time value of your money. The fact that a dollar today is worth more than a dollar tomorrow. And, two, any risk that you might be taking on. The fact that a safe dollar is worth more than a risky dollar. So changes in the discount rate or bond yield over time reflect either changes in the compensation the market demands for time or changes in the compensation the market demands for risk. Time is straight forward, but what exactly are the risks we're talking about here? Since these are default free treasury bonds it is not about default, what is it about? Well, there are two kinds of risks, the risks you will experience even if you hold the bond to maturity, and the risks you experience if you might sell the bond before maturity. So regarding the first, if you are sure to hold the treasury bond to maturity, and plan to spend the money at that point. The only risk you're taking on is inflation risk. When you buy the bond, its price is determined in part by investors' expectation of what inflation will be. If inflation turns out to be higher than expected, your payments will not buy as much, in the way of good and services, as you and the rest of the market had been expecting. For investors who are planning for a specific time horizon, say, ten years, the extent to which they're concerned about inflation being higher than expected. Will inform whether or not they invest in a sequential series of shorter term bonds, say ten one year bonds or five two year bonds, or alternatively a single ten year bond. If you think the ten year bond has adequate compensation. For the inflation you're likely to experience, then you prefer that. If you're very worried though, that the long bond does not adequately compensate for inflation, then you'll prefer short term bonds. If inflation picks up but you've been investing in short term bonds, you'll at least be able to reinvest your proceeds in the new short term bonds at higher yields. Had you invested in the long term bonds, you're stuck with the low rates that don't compensate for the newly higher levels of inflation. That was all assuming you were holding the bonds to maturity and planning to spend the money at that point. If you are not holding the bond to maturity, you also face the risk that bond prices will change between now and the time you want to sell the bond, for any one of a number of reasons. This is broadly called interest rate risk. Since the risk that investors will discount the payments more during the time period after you bought the bond and before you sell it is related to changes in interest rates. To understand these reasons we can very roughly decompose the yields on US treasury bonds which are nominal in that they guarantee you a specified number of dollars, but provide no guarantee as to how much consumption those dollars will provide. We can decompose these yields into the following pieces. The nominal yield equals the real yield plus expected inflation plus an inflation risk premium. The nominal yield is what you actually see. It's what actually quoted when you look at a treasury yield and what you actually receive in dollars.

The real yield is what that yield would be in a world with no inflation. The expected inflation piece is the market's central forecast for inflation. And the inflation risk premium is additional compensation that investors might demand for bearing the risk that the inflation forecast is wrong. That last piece is in there, that Inflation Risk Premium, because there is risk surrounding the forecast of how much inflation will be. The more uncertain that forecast is, the greater the risk premium that exists to compensate investors for the possibility that inflation could be much larger than expected. This means that if the yield on Treasury bonds changes, for example from 2% to 3%t, that generally boils down to one of, or combination of, three things. One, the real discount rate is changed. Market participants suddenly require more consumption tomorrow to forgo a unit of consumption today. Or, two, expected inflation has changed. Market participants, investors, believe there will be more inflation than they believed yesterday. Or three, the risk premium for inflation has increased. Markets demand more compensation for the possibility that their inflation forecasts are wrong. The exact decomposition of the nominal treasury yield on any given day into these three components is not a trivial exercise, now at least because we think there might be some additional factors. Related to the fact that treasuries are extremely liquid. We actually do know what the real yield is from some special inflation index bonds, called treasury inflation-protected securities, or TIPS. The payments promised in these TIPS bonds are real cash flows, meaning that the payments are guaranteed to rise with inflation. For much of 2012 and 2013 this real yield was negative. And there was a difference of around 2 to 2.5% points between the real yield and the nominal yield. But it's not easy to back out how much of that difference is due to inflation expectations versus an inflation risk premium. Some estimates suggest that around 0.5% points, which we also call 50 basis points, comes from the inflation risk premium, that means that the expected inflation priced into today's ten year treasury yield is about 2% per year. So market prices generally imply that investors believe that inflation going forward will be consistent with today's inflation levels which are, historically, rather low. The preceding analysis does not quite get to why these three factors might change. The inflation pieces would generally change because there was some news or change in beliefs about inflation. It must also be recognized that the Federal Reserve, the US central bank, has a big influence on the market for bonds. The Federal Reserve does not have direct control over long term interest rates, although it does have control over short term interest rates. Through it's open market operations and there should be a tight relationship between the yields on a longer term bond and the current and expected future yields on shorter term bond. For example, under an idea called expectations hypothesis, the yield on a two year bond reflects the market's expectation of what return could be achieved if instead of investing in the two year bond, an investor invested in a series of two one year bonds. In this notation E sub 2013 of r sub one 2014 is the market's expectation as of 2013, of the yields that will prevail on a one year Treasury Bond that will be issued in 2014. So, suppose for example that the one year yield were 1% in 2013, and the two year yield were 3% in 2013. They're actually much lower. But suppose were the rates. The expectations hypothesis suggests that investors in 2013 expect that the one-year deals that will prevail in 2014 will be 1.98%.

That's because 1.03 equals 1.01 times 1 plus this expectation of what one-year yields the investors think will prevail in 20, in 2014. And that equals 1.98%. A similar relationship holds for a ten year bond. A ten bond yield reflects today's one year yield as well as market's expectation of the one year yield will prevail between 2014 and 2015, as well as the market's expectations of the one year yields. Will prevail between 2015 and 2016, and so on. So the yield on the ten year bonds could change because the Federal Reserve changes short term interest rates or it could change because markets change their expectations of the extent which the Federal Reserve will change rates in the future. For investors who hold the bond to maturity, they will still get the same cash flows as they otherwise would have. But investors who might sell the bond early would be doing so at a higher price if yields rise, due to the expectation that the Fed will raise rates, and a lower price if yields fall, due to the expectation that the Fed will cut rates. Now, many people invest in bonds through bond mutual funds, such as those provided by large mutual fund companies like Vanguard and Fidelity. These funds buy lots of bonds and pool them together. The bonds in the funds have an average maturity that stays relatively constant since, as each bond matures, it is replaced by a new bond in what is called a rolling ladder. If you're planning on liquidating the bond fund in order to spend the money or if you need to meet a fixed liability then this fund or rolling ladder subjects you to the interest rate risks inherent in buying individual bonds. You'll be selling the fund at a point when the prices of the bonds in the fund might be higher or lower than they are today. So, for those who are using bonds to fund fixed spending plans, it's much better to buy individual bonds in a non-rolling ladder, that mature when you need them. For example, if you need to spend, say $50,000 per year over each of the next ten years, you can do so by buying ten zero coupon bonds. Each with a face value of 50,000, and with maturities of one, two, three, etc. Up to 10 years. Such bonds can be purchased through brokerage accounts, although one has to watch that the fees don't add up. On the other hand, if you would be reinvesting the principle from the bonds anyway, and not spending it or trying to meet some fixed liability, then there's no real benefit to receiving the principal back at maturity. And bond funds would be more appropriate for your purpose. And one also has to consider that bond mutual funds or exchange traded funds, ETF's, are generally the most cost-effective way in terms of low fees, to get exposure to the bond market. So, why do prices move around, even on what is probably the safest kind of bond, the Treasury bond? The simplest answer is that the market decides that future cash flow promises from the US treasury are either worth more or less to them than those promises were in the past. These changes might happen because investors require a real or purchasing power adjusted compensation for holding the bond, or because investors become more concerned about inflation. Both the real return that investors require and their views about inflation are likely influenced quite strongly by the monetary policy of the Federal Reserve. 4.3 - Sensitivity of Bond Prices to Interest Rates

Sensitivity of bond prices to interest rates. Investors in bonds think a lot about what other investor in the market for bonds are doing. Indeed the extent to which other investors in the market for bonds discount future payments, impacts the price of your investments. But how can we figure out how much a bond's price will fall in value for say, a 1% change in the bond's yield to maturity. Suppose we have a standard coupon bond with a face value of $1,000, and an annual coupon rate of 8% paid semi annually. Or $20 for every six month period. So 4% is the semi-annual rate. If markets discount the cash flows, an 8% bond equivalent annual yield, or a 4% semi-annual yield, then the bond will cost exactly $1,000. Now if you were doing this in 2013, you could say that this was clearly not a treasury bond. The last time the ten year treasury yield was over 8%, it was 1991. But this could be a bond issued by a corporation or other riskier entity and investors require some compensation for investing in these securities instead of treasuries, which is why the yield would be higher. So the bond starts out trading at par or at a 8% yield maturity for a price of $1,000. Now, for a 1% increase in the yield to maturity you will find that this bond's price falls by 6.5%. For a 2% change in the yield to maturity it falls by 12.4%, which is less than two times the impact of the 1% change. And for a 3% increase in the yield to maturity. It falls by 17.9% which is quite a bit less than three times the impact of a 1% change. So each additional percentage point increase in the discount rate continues to impact the bond price adversely, but does so with the decreasing strength. On the other side, a 1% decrease in the yield to maturity increases the price of the bond by 7.1% which is more than the decline experienced if the yield to maturity rose by 1%. For a 2% decrease in the yields maturity the price rises by 14.9% and for a 3% change it rises by 23.4%, so here the change in price for each additional decline in interest rates is actually more than linearly proportional. That is, the 14.9% is greater than two times the one year change of 7.1%. And 23.4% is more than three times the one year change of 7.1%. Let's add the comparable analysis for a zero coupon bond, also with a ten year maturity. This one is more sensitive to changes in price and here I'm also gonna add in both coupon and zero coupon bonds. With a much longer maturity, 30 years, to examine their sensitivity to prices. The 30 year bond prices are much more sensitive to yields than the ten year bond prices and the 30 year zero coupon price is much more sensitive to yields. So the bottom line so far that we've observed is that, for a given maturity, a coupon bond is less sensitive in price than a zero coupon bond and a long maturity bond is more sensitive in price than a short maturity bond. Now, despite the curvature in the lines or convexity that we see here in these graphs, it turns out that we can write a pretty good linear approximation as follows. The percent change in price equals negative the duration times delta 1 plus r over 1 plus r where r is the initial yield to maturity on the bond. And duration is a constant that I'll explain in detail in a minute, formerly known as the Macaulay duration. So the formula says that the percent change in price can be approximated by multiplying a constant, its duration, by the percent change in the gross interest rate. This object on the right, delta 1 plus r over 1 plus r. Or the rate of change in the gross interest rate, is quite close to the level change in the discount rate in percent, so just delta r, just slightly smaller. Now, what is the duration. Duration, it turns out, is the

weighted average maturity of the cash flows. For a zero coupon bond, duration equals maturity because there's only one cash flow. For a coupon bond the duration is less than the maturity since lots of cash flows are being returned to the investors before the maturity of the bond. For example take the ten year coupon bond we've been discussing. To find it's duration, we need the weighted average maturity of the bond's payments. The weights are the proportion of the present value of each payment. In the bond's total value. So, taking a weighted average of the maturity of each payment, we find that the duration is 7.07 years or 14.13 half years. Now, let's look at the payments of the 30 year bond with the same coupon. The duration here is, once again, the weighted average maturity of the payments, which turns out to be 11.76 years. Or 23.53 semi annual periods, note that this is a lot less than 30 years. A big piece of this bond's present value is returned to the investor long before 30 years have passed. So all things, all other things equal, longer maturity bonds can typically be thought of as having higher duration, that's not true in every case but is in most cases. And bonds with higher coupons, other things equal, can be thought of as having lower duration. How does the duration approximation perform relative to the actual percent change in price that we can expect from changes in interest rates? Well as you can see from the formula. The duration approximation is a linear approximation. Here is a graph of the actual percent changes in the prices of the four bonds, relative to the change in rates as measured in the duration formula. The curvature in these lines is called convexity. Convexity is the fact that the bond gains more in value for a 1% drop in interest rates than it loses for a 1% rise in interest rates. The duration formula approximates this convex relation with a linear relation. As we can see most clearly if we look at the present change in the price of the thirty year zero coupon bond. Other things equal, zero coupon bonds display the most convexity. Consider the ten year coupon bond, where convexity is lower than for the thirty year and the approximation is better. We found above that this bond has a duration of 14.13 half years. The approximation tells us that, for a 1% change in yield, we'll have a 14.13% change in price. And, indeed, when the yield falls by 1%, the price increase is, well, a little more than 14.13%, it's 15.5%. And when the yield rises by 1%, the negative effect on price is, well, a little less than 14.13%. It's 12.9%. But this 14.1% is not too bad an approximation, and it's very simple to implement. Now, instead of working with a somewhat complex object, that is, the rate of change in the gross rate, this delta 1 plus r over 1 plus r, we can instead work with this simple change in the interest rate in percentage points if we define modified duration as the following. Modified duration equals duration over 1 plus r, where r is the initial yield to maturity of the bond. This is a nice trick, because if we use this modified duration. Then the percent change in price simply equals negative the modified duration times delta r, whe, where delta r is just a level change in the yield in percentage points. The modified duration of the ten year coupon bond is 14.13 divided by 1.04, which equals 13.59 semiannual periods. Or around 6.8 years. So 1% point change in the annual yield is estimated to have a 6.8% effect on the prices. In fact such a yield drop increases the price by 7.1%.

And a similar yield increase drops the price by 6.5%. Again 6.8% turns out to be not a bad approximation and very easy to implement. To recap, in this section we've learned about the tool of duration as a useful way of measuring the sensitivity of a bond's price to the interest rate. This is useful in many contexts, including bond investing, and also understanding the sensitivity of pension liabilities to discount rates. What is the duration of the stream of cash flows? It is really just the weighted average maturity of these cash flows. And if we divide that by 1 plus the yield to maturity we get the very convenient` object called modified duration. A 1% point change in a bonds yield to maturity generates a price change in the bond that's approximately equal to this modified duration. This is a highly useful tool for understanding the price risks in owning bonds. 4.4 - Inflation Indexed Bonds Inflation indexed bonds. Some governments, including the United States, issue inflation-linked bonds. In the U.S., these bonds are called TIPS, which stands for Treasury Inflation Protected Securities. There are around $850 billion of TIPS outstanding, at a total of $11.3 trillion in marketable US government securities most of which are just regular nominal Treasury bonds. The payments promised in TIPs are real cash flows. That means that the payments the will rise with inflation and to some extent they may fall with deflation. This is in contrast with bonds that are not indexed to inflation for which the promised payments are nominal. The way TIPS work is that whenever there is inflation, the face value and the coupon payments of the bond increase. For example, suppose you bought a ten year bond with a 1 1/2% coupon rate and that over the next ten years we have inflation of 3% per year. Here we have the coupon payments if it were just a plain nominal bond. The payments would be constant at $15 per year. And now here are the additional payments if it were an inflation-linked bond. So now the coupons rise to as much as $20 in the final year. And what about the repayment of principal or face value? After ten years, you'd get only $1,000 if it were a nominal bond. But you would get around $1,344 if it were a TIPS or inflation-linked bond. Another way to see this is to look at the same figures expressed in real dollars or in actual purchasing power. If you bought the nominal bond, you'd see your spending power eroded. But if you bought the TIPS bond, the purchasing power of these coupons would remain constant. And the repayment of principal would give you the same spending power as $1,000 today. As opposed to less than $750 of spending power if you had been investing in nominal bonds during this time. The higher inflation is, the greater the benefit ex post. For example, inflation was running at around 3% per year in 1972, but it was running at around 12% by 1974. Let's imagine we had a repeat of this experience today. Suppose that you own a ten year nominal treasury bond yielding 1.5% per year. Then, under this inflationary scenario, the purchasing power of your coup, of your coupon payments, would sharply decline. And the value of repaid principal would also be greatly eroded. But if you buy TIPS, your coupon payments will continue to support the same purchasing power. Remember, these are today's dollars, so they represent purchasing power. And your principal repayment would also have the same purchasing power as it does today. Now, because of the inflation protection,

there is no chance that you're going to be able to buy a TIPs bond for the same price as a nominal bond that offers the same basic coupon. Inflation protection is valuable as it is insurance against an event in financial markets that can erode your spending power. So the US Treasury typically issues TIPs with much lower coupons than their nominal bonds and tries to sell these TIPs at par. Recall again the relationship. The nominal yield equals the real yield plus expected inflation plus the inflation risk premium. The TIPs bonds are quoted at the real yield. They're expected to deliver the real yield plus expected inflation. Another way to rearrange this equation is, the real yield equals the nominal yield minus the sum of expected inflation and the inflation risk premium. So the yield on TIPS, the real yield will be the nominal yield minus expected inflation and an inflation risk premium. At what yield to maturity do TIPS bonds typically trade? Well on the 28th of March 2013 the bonds that were maturing in January 2023, around ten years later, had a coupon of only 0.125% and a price of around $108. That implies a yield to maturity of -0.68%. In fact, as of March 2013, you had to look out to around 20 years maturity for TIPs, before the TIPS yield to maturity, as quoted, is positive. The fact that there are negative yield quotes on TIPS has led some commentators to say that TIPS are bad investments, because they have a negative yield. Well, there are a couple of problems with that statement. First, remember the yields shown in that -0.68% that I just mentioned is not the yield you will ultimately get. You will get that yield plus realized inflation. So on that date, you could have chosen to either buy a ten year nominal bond with a yield of 1.855% or a TIPS bond for not -0.68% but -0.68% plus realized inflation. So which is a better deal, well ex post, that will depend on whether inflation will be more than around 2 1/2% per year over the next ten years. Second, the TIPS also provide insurance against inflation going up even more, and that insurance is valuable. Saying that TIPS are a bad investment because their yields are negative, is like saying that fire insurance is a bad investment if your house doesn't burn down. Even more so because the insurance element of TIPS, the inflation indexation, is actually activated every month that there is inflation in the U.S. economy. Many academics have actually wondered why TIPS yields aren't even lower, given where nominal bond yields and surveyed inflation expectations are today. What happens if there's not inflation, but deflation? Deflation is the opposite of inflation. We haven't had prolonged deflation in the U.S. here since the late 1920s and early 1930s. If you buy a regular nominal bond, so not a TIPS bond and there's deflation then your bond payments will actually buy your more than they do when you buy the bond. So, deflation is good for owners of nominal bonds. What about for inflation-linked bonds? Well, that depends on the details and U.S. TIPs have some important contractual features. The coupon payments would fall, but TIPs have a special feature that protects them against deflation to some extent. Namely that at maturity the purchaser is guaranteed not to get back less than the face value, the 1,000th in nominal dollars. One caveat is that the prices of the tips trading in markets today are quite far over $1,000.

For this bond it's $1,080 or $108 per $100 of face value. That means that if there's deflation, the face value of the TIPS bonds would actually have a pretty long way to fall, 8% before they hit the floor. So, the deflation protection is not as valuable when you have bonds that have large embedded capital gains. Let's have a look at the historical data on TIPS yields. The constant maturity TIPS yield is available from the Federal Reserve since 2003, even though these bonds have been around in the U.S. since 1997, in some individual issues. The lower line is the ten year TIPS yield and again, this is the real yield. And the upper line is just the regular nominal ten year treasury bond. The ten year TIPS real yield has been negative since around late 2011. If we look at the spread between the nominal treasury bond and the TIPS, we can see that, with the exception of the financial crisis in late 2008 the spread has been around 2 to 2 1/2% for most of the time that the TIPS have been in existence. During the financial crisis, there was an extreme flight to the safety of nominal treasury bonds. And, perhaps, fears of deflation that drove the spread down as far as 25 basis points or only 0.25%. So to recap. Inflation index bonds are a useful security for investing in fixed income without the inflation risk. The way TIPS work is that whenever there is inflation, the face value and the coupon payments of the bonds increase. The yield on a TIPS bond at any given time is a real yield, and that the buyer of the bond will get that yield plus realized inflation. The higher inflation turns out to be, the greater the benefit to the investor, ex post. Now, you can't quite think of the difference between the nominal bond yield and the TIPS yield as the market implied expected inflation. It's actually an upper bound of the market implied expected inflation because there's also an inflation risk premium. TIPS are protected against deflation to some extent, as well. But when there are lots of embedded capital gains, for example, because interest rates have fallen since the TIPS were issued, then this deflation protection won't kick in unless there were a prolonged period of deflation 4.5 - Overall Recap What have we learned overall in this lecture? We examined what determines yields on government bonds, and why they change. We decomposed treasury yields into real yields. Expected inflation and inflation risk premium. At the most basic level, treasury yields change because one or more of these components changes. That is to say that either the real discount rate has changed because market participant require more consumption tomorrow to forego unit of consumption today or expected inflation has changed. Market participants believe there will be more of it, or the risk premium for inflation has increased. Perhaps market demands more compensation. For the possibility that their inflation forecasts might be wrong. If you're planning on holding the bond until maturity and using the proceed to fund your consumption, then the only risk you're really face is pure inflation risk. If your horizon for consumption is longer or shorter than the maturity of the bond, then an investor cares about all of these risk components: real interest rates, expected inflation and the inflation risk premium. If you wan to consume before the bond matures you have to sell the bond, and the price you get at that time.

Will depend on all of these three factors. If you want to consume after the bond matures, you have to reinvest the proceeds and the yield at which you do that will also depend on all three of these factors. These issues also come up in deciding on whether to buy a bond fund or individual bonds. If you plan to liquidate a bond fund, a mutual fund, or ATF in order to spend the money, or if you need to meet a fixed liability, and are trying to do it with a bond fund, then the fund which is a rolling ladder, subjects you to the interest rate risks inherent in buying individual bonds. If you would have built the ladder anyway Perhaps because you are constantly reinvesting the money then the bond fund provides good diversification and liquidity at low cost. Finally we study tips which are one of the main instruments for investing in bonds without taking on the risk of inflation. Tips are a very useful tool for retirement planning because they guarantee a real stream of purchasing power but their market is still somewhat small. And it maybe that governments are reluctant to issue too much in the way of tips. If government debt roll in tips, it would remove the government's option to inflate away its debts. What key issues remain to be understood after this lecture about bonds? Really, the main thing is that we have not yet studied bonds issued by other entities. Such as corporations, or state and local governments. These bonds carry some of the same risks as investing in treasuries, but also an important additional risk, the risk that the issuer will default. Not through inflation, since these issuers don't control their own currency. By just by not making the promised payments. How that possibility of true payment default affects bond yields? And how sensitive bond yields are to news about issuers of defaultable bonds is an important further topic for bond investors to understand. Lecture 5 - Corporate Bonds and Municipal Bonds 5.1 - Risks and Returns to Investing in Bonds NOT Issued by the US Government Welcome to this lecture on Corporate bonds and municipal bonds. Today we're talking about the risks and returns to investing in bonds that are not issued by the US Government. Investors in these bonds face the same core risks as they face in government bonds, but they also face additional risks. Accordingly, bonds that are not treasuries offer higher yields to maturity than treasuries, but those additional yields are only achieved if the bonds actually make the payments that they promise to. There are two main types of non-treasury bonds that I want to discuss, corporate bonds and municipal bonds. Corporate bonds are bonds issued by corporations who wanna borrow money from investors instead of, or addition to borrowing from a bank. If you own corporate bonds you face an additional risk relative to investing in treasuries. The risk that the issuer might simply not make the payments that the bond contract is promising. If a coupon payment or principal repayment on a bond is not made in full, that is called a default or default event. Defaults on corporate bonds happen in the context of a corporate bankruptcy, the legal proceedings that happen when a firm's management determines that the firm cannot meet its debt obligations. Think of General Motors, Enron, Chrysler, United Airlines, American Airlines, Delta Airlines and so on. Bankruptcy often happens under pressure from the creditors, the banks and bondholders who have loaned the firm money, and want the firm to stop losing money.

In bankruptcy, these creditors take over. They go to Court to sort out who is owed what and who is first in line to get paid. For the large firms who issue corporate bonds, the goal is usually to keep operating the firm under a new financial structure. That's what Chapter 11 of the U.S. Bankruptcy Code allows. Less common for big firms, but more common for small firms is the liquidation of the company under Chapter 7. It is rare for either of these processes to result in all creditors, all banks and bondholders getting repaid in full. If they could be repaid in full, well, there'd be no reason to go into this bankruptcy proceeding. On the other hand, the bondholders usually do not lose 100% of their money. So, investors in corporate bonds are constantly trying to judge two things. First, how likely is it that the firm will default on these obligations through bankruptcy? And second, if they do default on me how many cents on the dollar am I likely to get back in court? The more likely the default and the lower the likely recovery in default, the higher will be the yields on the bonds. Furthermore, relative to treasury bonds, corporate bonds are likely to be harder to sell at a time when you really need to liquidate them. That is they are less liquid than treasury bonds and that contributes to the existence of a spread even of very, very safe corporate bonds over US government bonds. In the second part of the lecture, we will look at municipal bonds or munies. Municipal bonds are bonds issued by state and local governments. They have historically had very low default rates, but there has been much controversy recently as to whether or not we're likely to see more defaults on municipal bonds going forward. Cities, in some states, are allowed to enter into bankruptcy under Chapter Nine of the Federal Bankruptcy Code. This happened recently in a number of California cities, including Vallejo, Stockton and San Bernardino. Like a Chapter Eleven, or Chapter Seven for corporations, a Chapter Nine for municipalities means that creditors may see the value of their claims reduced. So, while municipal defaults are still rare, it can't be denied that defaults happen. That said, muni investors do have some additional protections relative to investors in corporate bonds whose companies enter bankruptcy. Overall, there are some higher grade and some lower grade municipal bonds, so investors view the debt of some cities and states as riskier than that of others and that is presumably in part due to concerns about possible default. 5.2 - Corporate Bonds and Default Risk Corporate bonds and default risk. Corporate bonds are bonds issued by corporations. In US markets there are about $9 trillion of these bonds outstanding at the end of 2012. Investing in these bonds involves some of the same risks as investing in treasury bonds. But also an important additional risk, that the issuer will go bankrupt and default on it's debt. If that happens, you may be able to recover some of your claims if your creditor class is well represented in the bankruptcy proceedings. You'll certainly face a substantial loss relative to the face value of the debt and the coupon payments that you were promised. Compare for example investing in a treasury bond to investing in a corporate bond. If you buy a treasury bond, you're buying a promise of nominal repayment, there's essentially no state of the world where your nominal repayment will be different from what is promised. But when you buy a

corporate bond, you're buying a security that will have different nominal payouts in different states of the world. If the bond does not default, it will make nominal payments as promised. If the bond does default, then you will get something less than those nominal payments. To understand what you will get in these different states of the world, you should first understand that the debt issued by a corporation is a claim to the same underlying assets, as the equity issued by the corporation. It's just that the debt has a pre-specified and senior stream of promised cash flows. A company is bound by contract to service it's debt if it is solvent. It must pay the principal and coupon payments on it's bonds and bank debt. Once it has done so, shareholders are the residual claimants. If the firm cannot service the debt, then it can file for bankruptcy in order to restructure it's promises. Where restructure here implies some renigging and some postponing of these promises. Now, I wanna think about the market value balance sheet of the simplest possible company, it looks like this. On the left hand side, we have assets. On the right hand side, we have liabilities that consist of debt and equity as the residual claimant. Think of this as a balance sheet with everything marked to market. That's quite different than the balance sheet that accountants use, since accountants tend to carry around a lot of assets at their original cost. The way to think about this is that the value of the firm's assets a is moving around some randomness on a frequent basis. And it is that randomness that is determining changes in value in the firm's debt. And changes in the value of the firm's equity. The firm's debt D is some fixed claim on the value of the assets. And the value of the equity, E, is what is leftover after the debt has been paid. So, if you have shocks to the value of the firm's assets, those will effect the value of both debt and equity. To take an example, suppose Solid Corp has an outstanding borrowing of $100. So bonds with a face value of $100 that are coming due in, say, three months time. Solid Corp has a triple a bond rating. It is a high quality investment grade firm. It has $1,000 in assets, and it's market value balance sheet looks like this. Assets of $1,000 on the left-hand side. Liabilities here, D equals 100, and equity of the residual claimant at 900. In this case, D, the market value of the bonds as well as the face value, is 100. D is almost surely gonna get paid, as the debt is coming due very soon. And we're in a very low interest rate environment, too. So, the market for bonds should be willing to pay almost $100 for this debt. Maybe $99.99. Now what happens if we have a $100 fluctuation in the value of the assets on the Solid Corp balance sheet? For Solid corp, a $100 fluctuation in the value of assets will be reflected almost completely in changes in the value of equity. What do I mean by fluctuation in the value of assets? Well, if the value of the firm's assets has a sudden big move. Due to some unexpected news and these assets rise by 10% in value or rise by $100, then we will have E, the market value of equity rising in value from 900 to $1000 with D basically unaffected. And if the assets instead fall by 10% or $100 then we'll have E being worth $800. Again with D basically unaffected. D is almost sure to get paid either way. So it's value is hardly sensitive at all to changes in

assets. Now consider Flimsy Corp. Flimsy corp also have outstanding borrowing of $100, so bonds with a face value of $100 and suppose again that these are coming due in three months time. Flimsy Corp has a triple C bond rating, it's a speculative grade firm. The traded debts of speculative grade firms are sometimes called junk bonds. Flimsy's balance sheet starts out looking like this. Unlike Solid Corp, its assets are only worth $100. On the liability side, its debt is worth $95, and equity, the residual claimant, is five. The first question we should discuss here is why would D not be worth 100, with E being worth zero? Well, if the firm were shut down today. D would get 100, and E would get zero. But the firm is not shutting down today. It is continuing to operate for three months. So equity is worth some nonzero amount, because there's a chance that A will rise. And D is worth less than 100, because there's a chance that assets will fall before the debt is due. Keep in mind that equity has limited liability. Even if the debts are not paid in full, the value of shares in a company can't go negative. Consider now what happens if the market decides that Flimsy Corp's assets are worth 10% less than they were previously. Well, the exact market value. Of D and E depends on how volatile the assets are, which determines how likely the value of the assets are to recover to be more than $100. I have't given you enough information to figure out exactly how much the value will change, but we might well see something like this: assets going down to 90 and then the value of debt going down to 87 with equity being worth three. So $2 came off of equity, which fell from $5 to $3, but most of the dollar value of the $10 decline in assets was borne by debt, which fell in value by $8 from 95 to 87. Note that this is not an actual default event yet, this is just the bond holder's reacting to the fact that default risk has risen. It now seems less likely that in three months time, they will get their entire principal of $100 back. So, if you are an owner of the Flimsy Corp bonds, you would see a substantial fall in the value of your bonds To reflect the greatly increased risk that the face value of the bonds will not be repaid. And unlike treasury bonds, those bonds are not necesarrily going to recover to be equal to their face value of 100 when they mature, which in this example will happen in three months time. For example, if the value of the assets is the same in three months as it is today, $90, then your bonds will end up being worth $90 at maturity and you would see a 10% loss. Relative to face value, equity will be worthless. Your bonds will not be worth $100 at maturity. The assets aren't there in the firm to pay for them. A riskless bond would be guaranteed to be worth $100 at maturity. Where a corporate bond is not. So that is default risk. The closer to the default boundary the firm is operating, the more that changes in the asset values will be reflected in the price of the debt. We've seen that the debt issued by a corporation is a claim to the same underlying assets as the equity in the corporation. A corporate bond can't mature at a value that is above it's face value, but unlike a treasury bond it can default ending it's life at a value that is below it's face value. Defaults happen when the firm cannot or does not service the debt, that means meet the coupon payments or principal repayments specified in the bond contract.

The sensitivity of the value of a corporate bond to matter specific to the particular issuing firm is gonna be much greater when the firm relies more heavily on debt financing, like Flimsy Corp. In contrast, the debt of firms that are highly rated will only use a small or moderate amount of debt, tends to behave a bit more like a treasury bond. 5.3 - Comparing Corporate Bonds to Treasury Bonds Comparing Corporate Bonds To Treasury Bonds. How does investing in corporate bonds compare to investing in treasury bonds? As you might expect, corporate bonds carry higher yields than treasury bonds of comparable maturity. Why? Well by now you're getting used to thinking that if a fixed income security. Seems to be promising a higher yield, it must also carry some higher risk. Clearly one major risk you know about is default risk. If market prices start reflecting higher discount rates, that is if the yields on corporate bonds rise, one potential explanation is that default risk has risen. Corporate bonds can be broadly divided into investment grade and speculative grade according to their risk as perceived by rating agencies such as Moody's, S&P and Fitch. You could think of the investment grade firms as companies without much debt on their balance sheet who are very unlikely to default, like Solid Corp. And speculative grade firms as companies with a lot of debt on their balance sheets that are much riskier, like Flimsy Corp. Their debt is sometimes called Junk Bonds or more euphemistically High Yield. Consider the history of defaults on these two categories of corporate bonds. History shows that investment grade corporates are quite safe, but still not default free, particularly in the worst recessions. As for speculative grade bonds, in expansions, they too have a pretty low probability of default, perhaps a couple of percentage points per year. But in recessions, the default rates on speculative grade bonds really spikes up. In the past few recessions, they have risen to over 10% per year during the down turns. When a firm defaults, that does not mean the creditors necessarily experience a 100% loss. They might, but on the other hand, they might only experience the partial loss of a coupon payment or two, depending on where their rights fall relative to other creditors. Focusing on 1982 to 2012 for which we have good data on the loss rates, it becomes clear that the actual loss rates or percentage of principal loss are less than 100%. So for example in 2009 over 13% of speculative grade debt went into some kind of default. But only 8% of actual bond value was lost, because creditors did recover something in the legal bankruptcy proceedings. How much you recover also depends on the type of bond you have, a firm's capital structure might consist of first and second lien bank loans. As well as senior secured bonds, senior unsecured bonds, senior subordinated bonds and junior subordinated bonds. Firms that have issued bonds that are secured have pledged collateral against those bonds and there typically, the recovery rates are very high. The designation subordinated means that the holders of those bonds will be in line behind at least some other creditors in a bankruptcy. If you own junior subordinate bonds, then you're likely last in line among creditors. Although, at least you'll be ahead of equity owners or shareholders who are mostly wiped out in a typical bankruptcy. Corporate bond yields depend on the factors that influence treasury bond pricing as well as the default risk and some other factors that we will discuss. So, corporate bond prices are more volatile than those

of treasury bonds. On the Wall Street Journal webpage. You can see big movers in corporate credit in both the investment grade and high-yield or speculative grade or junk bond categories. The difference between a corporate bond yield and treasury yield of comparable duration is called the bond spread. If a company's bond yield falls to be closer to treasuries we say that the spreads have tightened, that means that the company's bonds have become more valuable relative to treasuries. If a company's bond yield rises to be farther above treasuries, we say that the spreads have widened, that means the company's bonds have become less valuable relative to treasuries. It is often the case that companies whose bond spreads tighten the most are also seeing abnormally positive returns on their stock. And companies whose bond spreads widen the most are seeing abnormally negative returns on their stock. This is because the market's in essence revaluing the company's assets and as you now know, debt and equity are claims on those same assets. The other difference between US Government debt and other types of bonds is that US Government debt is extremely liquid. There are many different definitions of liquidity. One is related to the depth of the market. If you wanted to sell or buy a large quantity of these assets, how much would placing that order move the price? If not very much, then the market is seen as very liquid. Another measure of liquidity is how quickly you can execute a big transaction. So, how much additional yield can one get by investing in corporate bonds over treasury bonds. When asking that question, you have to of course, keep in mind that corporate bonds are risky and they might default. Here are some historical credit spreads. Again, these are the yield differences between corporate bonds and treasury bonds. First consider the changes over time in the spreads of triple-A bonds over ten-year treasuries. These are the highest-quality bonds. And also the changes over time in the spreads of what Moody's calls BAA bonds over ten year Treasury. The other large rating agency would call these triple B bonds. These are not junk bonds but they are the lowest investment grade bonds. One thing to notice is that the spreads tend to be the highest during recessions, particularly the most recent recession but also 2002 and 1982 to 1983. The exact drivers of these spreads is still a topic of active research. But perhaps the most obvious explanation is that companies are more likely to default during recessions when Treasuries are especially safe. But there's still an awful lot of movement in the spread of AAA corporates to Treasuries, these are very safe bonds, so it's a bit puzzling. And by the way, despite the bad reputation that AAA ratings on mortgage backed securities received. In the financial crisis, the ratings of corporations are generally considered a more straightforward endeavor. So what is going on here? Why are the triple-A spreads moving around so much? Well, much of the spread between triple-A bonds and the ten-year treasury is probably not due to default risk, but rather, other factors. Such as liquidity, and changes in the spread may be due to the market's demand for liquidity, which gets very high in recessions and volatile environments. There are also differences in state level tax treatments of treasuries and corporate bonds that play a role in the triple A to treasury spread. Now BAA bonds, the lowest grade investment grade bonds, are more risky, particularly in recessions. In bad years for corporate debt, like 2002 and 2009, around 10% of the total outstanding debt rated below

BAA went into default, with investors realizing substantial losses. So, we can also look at the spread between BAA, somewhat risky and AAA, safe corporate bonds. Since the 1980s, excluding the financial crisis, the BAA, triple A spread has been relatively stable in the 0.05% to 1.5% range, though it is generally higher in recessions. Keep in mind that in order to realize these yield differences as investments, you actually have to hold the bond to maturity, be able to reinvest the coupons at that yield. And have the bond not default. Compare that to investing in a treasury bond. To realize the yield to maturity on a treasury bond. You just have to hold the bond to maturity, and be able to reinvest the coupons at the yield to maturity. To realize the yield to maturity on a corporate bond. You have to be able to do those things, and not experience a default. This raises the point that in talking about corporate bonds, there's a very important distinction between two concepts; the yield to maturity on the bond, and the expected return on the bond. Because corporate bonds can default, the expected return on the bond or the mean return over the different states of the world, is actually lower than the yield to maturity. Take an example, consider a zero-coupon corporate bond with the following features. It matures in one year. It has a yield to maturity of 8%, and it has a 10% probability of default in which case you will only recover 60% of your investment in bankruptcy court. The distribution of outcomes then, looks like this. There is 10% chance that you'll lose 40% of your money. And there's a 90% chance that you'll get an 8% positive return. In this case, the expected return is 90% times 8% plus 10% times minus 40% equals 3.2%, which is far less than the yield to maturity of 8%. This is another example of how, when dealing with risky securities, you really have to think in terms of probability distributions and states of the world. The term expected return refers to the mean outcome and of course the mean outcome is not ever actually realized here which is a problem when thinking in terms of expected returns. Instead of probability distributions. It's more useful here to talk about points in the distribution. For example, the median outcome, or median return, here, is 8%. The median is actually greater than the mean, or expected return, here. That's something that's generally not true for the stock market. Usually it's less. The twentieth, thirtieth, fortieth, fiftieth, sixtieth, seventieth, eightieth, ninetieth, ninety-ninth percentile outcomes are also all 8%. There is in fact a 90% chance that you'll get an 8% return, but the tenth percentile outcome is that you'll lose 40% of your money. A final caveat has to do with compounding default probabilities. It may seem taht a bond, which you estimate has a say 3% annual default probability does not carry much risk. 3% per year is not far from the historical annualized default probability of junk bonds, averaging over both good and bad periods, but over ten years, the compounded default probabilty of such a bond would be around 26%. The compounded default probability is 1 minus the probability that it defaults sometime over that ten years. So we have 1 minus, 1 minus 3% to the power of 10, or 26%. So it's important to take that cumulative nature of default probabilities into account. So, how does investing in corporate bonds compare to investing in treasuries?

Well when you invest in corporate bonds you take on the regular risks of investing in treasury bonds, but you also take on default risk. And unlike treasury bonds, corporate bonds are not guaranteed to return their face value when they mature. So, even if you hold corporate bonds to maturity, you have much more to worry about than simply inflation risk, you also have to worry about default risk. The yield to maturity on a corporate bond can not be thought of as the expected return on the bond, due to the fact that there are states of the world where the bond might default. But because these bonds tend to vary bimodel outcomes. Bimodal means there are two of them, either the bond defaults or it doesn't. It makes the most sense when dealign with corporate bonds to consider the distribution of possible outcomes. If the bond matures, you get the yield to maturity. If it doesn't, you lose your principle, up to whatever can be recovered on your behalf in a bankrupcy proceedign. 5.4 - Municipal Bonds Municipal bonds. Municipal bonds or muni bonds are the debt securities issued by state and local governments as well as other public sector entities such as counties, school districts, public transportation authorities, and also some non-profit organizations. This market is around $3.7 trillion in size. Interestingly, around 45% of the muni bond market is owned directly by primarily US households. And an additional 29% is owned by mutual funds and exchange traded funds, ETF's, many of which themselves are owned by households. This is a huge contrast to Treasury bonds, almost half of which are owned by foreign entities and only 9% are owned by US households with another 8% owned in mutual funds. Even in absolute terms, households own more muni bonds than Treasuries, they own 1.6 trillion in muni bonds compared to 1 trillion in Treasuries. And if you assume households own all the mutual funds as well, then it's 2.7 trillion for muni bonds versus 2 trillion for Treasury bonds in the accounts of US households. The likely reasons for this extent of household ownership in munis, has to do with the fact that when the individual or household owns a muni bond they, with some exceptions, do not have to pay federal income taxes on the interest paid by that bond. That makes individuals in high tax brackets a very natural investor clientele for owning muni bonds. That tax break does not occur when households own Treasury bonds or when they own corporate bonds. And as a result muni bonds trade at lower yields, higher prices than corporate and Treasury bonds of similar quality. For example, here's some yields on 10-year bonds at the beginning of April 2013. The US Treasury 10-year yield was 1.69%. Triple A rated muni bonds with 10 years to maturity were trading at, very close, 1.68% and triple A rated corporate bonds that also mature in 10 years were trading at 2.22%. So the 10-year triple A rated muni bond, the safest category among munis, yield about the same as the US Treasury bond despite not being as liquid, or quite as safe. And that's because of this tax advantage. These munis trade at negative spread to 10-year triple A rated corporate bonds, not because they're necessarily safer, in fact since 2010 the munis and corporates should be roughly on the same rating scale. But because of this municipal bond tax advantage. Tax exempt entities, such as pension funds or university endowments are not a natural clientele for muni bonds, since they don't pay tax anyway.

Why should they own these bonds that pay lower yields, with the same level of risk, as a result of the tax advantage? They shouldn't. These institutions that are already tax exempt can get a higher yielding bond for the same level of risk and not have to pay tax in any case. Similarly, there's not much of an argument for a household to own a municipal bond in a retirement or other tax deferred savings account like a 401k or a 403b, or IRA. Instead they could own some other security in the retirement account, such as Treasury or corporate bond, that would carry a higher tax burden if it were held outside the account. And then outside the account the household could own the muni bond. Let's talk about the types of muni bonds that exist. There are two major categories of muni bonds. One, general obligation bonds or GO bonds and two, revenue bonds. General obligation bonds, GO bonds make up around 1 3rd of the total dollar value of the muni bond market. There are more directly analogous to US Treasury bonds and are most commonly issued by states, cities, towns, and school districts. In this arrangement the issuing government, the state or the city or town, or school district, pledges that it will make contractual payments. The bonds are then secured by the full faith credit and taxing power of the issuer. Some major GO bond issuers include State of California, State of Illinois and New York City. The key economic difference between a GO municipal bond and a Treasury bond, is these GO issuers cannot mint their own currency if necessary to meet their obligations. Though California did make some required payments in 2009 and 2010 in the form of IOU's. Revenue bonds make up the other 2 3rds of the muni bond market. They do not pledge the full faith and taxing power of the issuer. But rather, specify that the bond promises will be paid from a specifically identified source of revenue, such as the proceeds from a toll road or a municipal transportation system or an airport or water treatment facilities, to name a few. So, for example, the New York MTA, Metropolitan Transportation Authority has issued revenue bonds to make capital improvements to its system. And in doing so it guarantees that these bonds will make their promised repayments out of the specific revenue stream from ticket sales on the MTA. In buying revenue bonds, investors take some comfort in the fact that public transportation systems, in a city like New York, have a monopoly on the provision of these services. So if they have to raise ticket prices, demand will probably be not as elastic as in a truly competitive market for the provision of a service. If in contrast, a hair-cutter in a salon tried to issue a bond, now we're talking about a non-municipal bond, secured against the revenue from his future haircuts, investors would be a lot more concerned. If he had to raise prices a lot, would his customers go elsewhere? Probably. Cities and states often purchase protection for both types of bonds, GO and revenue bonds, from what are called monoline bond insurers. These firms promise to make any payments if the issuer defaults, in essence taking over some or much of the credit risk from individual creditors, as long as the insurer remains solvent, of course. The creditworthiness of both the issuer and the insurer are therefore important to investors in municipal bonds. The Federal Government does not explicitly or implicitly back any muni bonds. That said, there is some discussion today as to whether if some state and local governments got into very deep financial trouble, they might prove too big to fail, like some large banks in 2008.

Because the bonds of these cities and states are own by households, muni bond defaults would probably not have the same systemic impact on the financial system as the failure of a large bank. But if a state or local government could not continue to operate and meet its debt obligations, it's worth wondering whether the political process would lead to some support by the Federal Government. Either through direct fiscal support or through the Federal Reserve. What is the historical record on muni bond defaults? In the market for rated municipal debt, such defaults have been rare, particularly for general obligation bonds. And particularly relative to corporate bonds. Researchers at the New York Fed reported that over 1986 to 2011, there are only either 47 or 71 defaults of muni debt, depending on which rating agency data you take, out of over 54,000 issues. Whereas for corporate bonds, there were closer to 2,000 defaults over a 5,656 issuers. Defaults on GO bonds are thus far, quite rare. Although, there have been some recent default experiences with bond holder or insurer losses in Jefferson County, Alabama, Harrisburg, Pennsylvania, Vallejo, California and now possibly Stockton, California. These GO defaults have taken the form of a Chapter 9 bankruptcy. Chapter 9 is a legal proceeding under the Federal Bankruptcy Code, that allows municipal governments, but not state governments, to default and restructure their debts. Furthermore, there are 22 states whose laws do not even allow cities in the states to access Chapter 9 bankruptcy at all. That means that a large share of the outstanding float of muni ibond debt may not even be subject to the possibility of a Chapter 9 bankruptcy proceeding. Some analysts have argued for the creation of alternative legal structures for the restructuring of state debt such as bankruptcy codes for state governments. If that happened, it would raise the possibility for legal defaults on a larger portion of the total amount of the outstanding state and local government debt, than is legally allowable under current law. Finally, I'll mention that the ability for state and local governments to meet their obligations and avoid default, is closely related to their ability and will to increase tax revenues and or cut government spending, if the need arises. If a city, county, or state raises tax rates, business and individuals have the option to move themselves and or their activities to another city, county, or state. Such movement would be costly to the individuals and businesses, but is less costly than say off-shoring a business out of the US entirely or moving to a tax shelter country. As a result, municipalities whose tax base is very elastic, may have a harder time raising revenues than those whose tax bases are very inelastic. There's unfortunately thus far a dearth of studies on just how elastic local tax bases are. To recap, muni debt is in a large part owned by households, who are a natural clientele for owning them, due to the tax treatment. About one third of the muni bonds outstanding are GO bonds, general obligation bonds, backed by the full faith and credit of the state or local government entity issuing the bond. GO bonds are conceptually similar to Treasury bonds, although cities and states cannot print their own currency to pay their debts, that is, they cannot inflate their debts away. The remainder of the muni space consists of revenue bonds, secured by a stream of payments from a specific activity. Default rates on muni bonds have historically been very low, but there is a vigorous debate as to whether or not they are likely to be higher in the future.

5.5 - Understanding Municipal Bond Yields Understanding Municipal Bond yields. There are some important differences between uni bonds and treasury bonds. Uni bonds are riskier than treasuries. They're also less liquid, meaning that an investor's ability to sell them at any given time at a market price, without a big price impact, is not as great as for treasuries. Finally, Munis have an important tax advantage for taxable investors. The interest income received from Munis is exempt from federal taxation. In most states, the interest on Munis issued by governmental entities within the state is also exempt from state taxation. This additional state level exemption is why some providers of municipal bond mutual funds, like Vanguard, offer state specific community bond funds. Like a California only fund. From a diversification stand point, state specific funds would be worse than funds that pool Muni bonds across all states, California, New York, Florida, etcetera. But for residents of a state like California which has a relatively high income tax there can be substantial tax advantages to keeping ones Muni Bond investments within the state. For decades, from at least the 1950s through the early 2000s, high grade Muni Bonds traded yields that were below those of treasury bonds. The average difference in yield or the spread of the well known bond buyer index of 20 year Munis, relative to treasuries, between 1953 and 2007 was negative 1.01%. Muni Bonds yielded less than the treasuries. But from 2008 to 2013, the average spread was positive 0.9, 0.69%. Muni Bonds yielded more than the treasuries. And as of March 2013, the spread was as high as plus 1.21%. That means that Muni bonds traded a yield that was 1.21% higher than Treasury Bonds. So the question I want to consider here is, why did Muni Bonds use to trade at yields below those of Treasury bonds? And why do they now trade at yields above those of Treasury bonds. The three key candid factors are number one, default risk differences, number two, differences in the liquidity premium, and number three, taxation. Let's take these on by one. First, market perceptions of default risk may be somewhat higher today than they were in the past, that might in part explain the change in Muni Spreads. Today, there is clearly some default risk priced into Muni Bonds. And there are yield differences among Muni Bonds, that likely reflect differences in perceived default likelihood. For example, State General Obligation Bonds, State GO Bonds, generally trade at lower yields than local bonds, reflecting the additional revenue sources that states have access to. And even among states, we also have some differences in perceived default risk with Illinois Bonds in particular trading at substantial spreads, the bonds of most other states. Why else might Muni spreads to treasuries be higher than in 2007 and before? The second explanation is that the convenience factor of the extreme safety and liquidity of treasuries may have become more important since the financial crisis. That would also explain why Muni bonds spread have increased so much. But neither these factors, neither the safety and liquidity factor nor default risk, explains why Muni yields used to be below treasuries and were that way for so long. To explain that we have to understand the tax treatment of Muni Bonds versus Treasury Bonds and Corporate Bonds. Let's start out by considering a fully taxable Corporate Bond.

And use that as a point of comparison. For example, consider a ten year Corporate Bond with a coupon rate of 8% paid semi annually. If this bond has a price of $1000 then the semi annual yield to maturity will be 4%. But taxable investors and this Corporate Bond, do not get to keep all of those cash flows. If you, as an individual, own such a Corporate Bond, outside of a retirement account, you must pay income tax on each coupon payment at your tax rate on interest income. That tax rate is usually the same as your ordinary marginal income tax rate. Which I will abbreviate here as the Greek letter tau. This is simply your tax bracket, or to be more precise, the tax rate you will pay on an additional dollar of earned income. Here are the marginal tax rates for a married household doing a joint filing for 2013. So if your household earns up to $72,500 in that year, the rate is 15%. If it earns 72,500 to 146,400 it is 25% and so on. The top brackets are 35% for households earning around $398,000 to around $450,000 and 39.6% for households earning above $450,000. Don't confuse this with your average tax rate which is your total taxes paid divided by your total income. These are marginal tax rates, the rate on an additional dollar of earned income, say if you worked some extra hours or took a side job. We can now define the after tax yield on a bond as the regular observed yield to maturity at which the bond trades, which is r, times 1 minus tao, 1 minus the tax rate. This after tax yield is the yield that prices the bonds, taking account of the fact that the investor in the bond pays a tax rate of tao. So if the investor pays, say, a 35% federal tax rate. Then the after-tax yield to maturity on the bond is 4% times 1 minus 35%, equals 2.60% semiannually, versus 4% pre-tax semiannually. In annual terms that is 5.2% after tax versus 8% pre tax. Of course, if you're also one of the 40 or so states that also tax income you would have to consider the taxes paid to that state. For example many people in California pay income tax at a 9.3% rate. One could approximate the combined federal plus state tax rate in this case as 35% plus 9.3% equals 44.3%. But since state taxes are deductible when you file your federal taxes, you can instead think of your native tax take home rate as 1 minus the federal rate times 1 minus the state rate or here 1 minus 35% times 1 minus 9.3% equals 59%. That is the share of every dollar in interest income, that you get to keep, 59%. In this case, the after tax yield on the Corporate Bond in the example for the investor in question is r, the pre-tax yield, times 1 minus the federal rate, times 1 minus the state rate, which is equal to 4% times 59%, or 2.36% semiannually. Again, compare to 4% pre-tax. So the after tax yield is even lower now once we've considered state income taxation as well. What does this have to do with Muni Bonds? Well, suppose that the above bond were a Municipal Bond instead of a Corporate Bond, and were issued in a state whose income tax code allows the deductability of interest. From instate unibond issue against State income taxes. In this case, no Federal tax would be owed on the bond, and no State tax would be owed on the bond. So, the before tax and after tax yield on the Muni Bond would be 4% every six months, semi-annually. This would be a much better deal for a taxable investor than a 2.36% semi-annual yield. In fact we can define something called the equivalent taxable yield or taxable equivalent yield for the Muni Bond. The equivalent taxable yield is defined as follows. It's the rate that a fully taxable bond of

the same credit quality would have to provide to the investor in order for the investor to be indifferent between the taxable bond and the Muni bond. In this case, that equivalent taxable yield could be sold for as follows. The equivalent taxable rate times 1 minus federal times 1 minus state. That's the percentage of a dollar that you get to keep equals the tax free Muni rate. Plugging in the numbers, we have the equivalent taxable rate, times 59% equals 4%. So the equivalent taxable rate is equal to 4% divided by 59% or 6.8%. What does that mean? Well, that means a taxable investor, so an individual, or household buying this Muni Bond outside of their retirement account, a taxable investor would be indifferent between a bond that is yielding 4% and is a Muni bond and is not taxable. And a taxable corporate bond that is yielding 6.8%. That is if she faces a 35% federal tax rate and a 9.3% state tax rate. Also, remember that if you want annual bond equivalent yields, you have to multiply all these yields by 2. One can easily assemble a taxable equivalent table using this calculation. That table gives the taxable-equivalent yield for investors in different tax brackets investing in bonds with different yields. These calculations make it clear that the higher the tax bracket, and the higher the yield, the more valuable the Muni Bond tax exemption. Why did I choose to compare a Muni Bonds to Corporate Bonds here to get these taxable equivalent yields? Why not compare Muni Bonds to Treasury Bonds? There are two reasons, first, as I mentioned before, Treasury Bonds are both less risky and more liquid that either Muni Bonds or Corporate Bonds. This almost certainly affects Treasury Bond yields. On both liquidity and risk, high grade munis are more similar to high grade Corporate Bonds, than to Treasury Bonds. Second, Treasury Bond interest actually also has a tax exemption feature. Not at the federal level, but at the state level. That is, if you own a Treasury Bond, in a taxable account, you must pay tax on the interest to the Federal Government. However, you do not have to pay tax on the interest to your state government even if the state government charges income tax on earnings and investment income. So the equivalent tax will yield for tax exempt munis would be a bit lower if we were comparing them to Treasury Bonds. But again because of the extreme degree of safety and liquidity of Treasury Bonds the comparison between treasuries and munis, is just not as apt as the comparison between treasuries and corporates. So to recap, the tax treatment of Muni Bonds lowers the yields relative to what they would otherwise be. For many decades, high grade Muni Bonds traded at yields that were below the yields of Treasury Bonds. But since 2007 some combination of liquidity and default considerations have led to positive spreads of 20 year Muni bonds over 20 year treasuries. 5.6 - Overall Recap >> So to recap this lecture, we considered corporate bonds and muni bonds. The key difference between these bonds and treasury bonds are three things. First, liquidity. Second, the possibility of default. And third, the tax treatment. Essentially all of the important price and yield differences among different types of bonds boil down to these three considerations. Bonds are of course only one kind of financial instrument and while the corks of their contracts can create complexities they're actually the most straightforward financial instrument to value because

they entail contractually prespecified payments. In contrast, if you consider, say, a share of stock in a company that stock does not have contractually promised payments. It entitles you to dividends that the firm may or may not pay and also the voting rights in the company. So the tool kit of bond valuation is useful as it highlights the fact that the price of all financial securities boils down to the present value of the stream of cash flows. The investors in the market discount those streams of cash flows using discount rates that reflect both the time value of money and the risk of the cash flows. But the fact that a security such as stock in a company does not have contractually prespecified payments means that their actually, usually priced based on their expected or mean cash flows. Not on any promised cash flows. And for that reason the discount rates used in pricing securities such as stocks will have to be appropriate for discounting expected, or a mean cash flows, where the mean has taken over different states of the world as opposed to the discount rates we use for bonds which are yields to maturity or best case returns the bond does not default. Lecture 6 - Fundamentals of the Stock Market Weekly Announcement - Week 3 Hi everybody. Hope you've been having a good week two of the MOOC, The Finance of Retirement and Pensions. This week was all about bond markets. One thing you might have realized as you went through the videos is if you keep up with bond markets today, that the yields on government bonds are a little bit, little bit higher today than they were when I recorded the videos a few months ago. just so you all know, you know, there's some great sources online for being able to see exactly what the US treasury yield curve looks like on any given day. One of those is, the Daily Treasury Yield Curve website, by the by the, the US, put out by the US Treasury. here you can see the daily treasury yield curve rates for maturities of as short as one month, and as long as 30 years. 0.02 here at this very short end, this is for treasury bills, this is the one month one month treasury bills, the shortest maturity. I have also the three month treasury bills here, 0.04. And this is, this is 0.02%, and 0.04%, these are already in percentage points, so this is a this a, a, a, a very, a very tiny yield. We call this two, two basis points, is what we, what we would call that, the basis points are the hundredths of a, of a percentage point. so if you look at the yield curve today, it sort of begins at you know, almost zero at the very short end, this is as of October 25th, when I'm looking at this. And then at the, at the ten year horizon it's a yield of 2.5, 3% and at the 30 year it's a three point, 3.60%. And you can see that in the last month some interesting things happened, those of you who are following the the, the debt ceiling debate and the government shutdown. You know, these treasury bills, these short-term bills, are actually yielding a little bit more here, 32 basis points as of October 15th, so, so we talked about that before. you can, you can see that here. and compared to where say the ten year yield was when I recorded the video lectures, you know, these are about 80 basis points higher. So we can also look here at something very useful, which are the real the real yield curve rates.

So, the real yield curve, these are the yields on TIPS, on the treasury inflation protected securities. And here, if we wait for this to come up, so here, we can see the yields on the treasury inflation protected securities. These are the inflation linked bonds that are issued by the US Treasury. The five year has a negative yield of 0.47, but remember these are real yields, these are you get this, this, plus you also get inflation, because the principle of these bonds is increased with inflation. for the seven year bond there is zero real interest, nearly zero real interest, basically three basis points, but remember you also get inflation. So, if inflation is running at 1.7% per year, then you actually, you actually get 1.73% on your, on your investment, you don't just get the yield that's quoted. ten year is 34 basis points, and the 20 year is about, is about one percentage point. So the, with a 20 year TIPS bond you would get one percentage point plus whatever inflation is. And keep in mind, again, these are, these are the real yields, these are the yields that you get, you get these, plus you also get inflation. Some people look at these yields, and they say, well these look terrible. These are very low, these seem to be very low yields. But you have to remember, that you also get inflation on top of this. And, if you look at the yields on the ten year treasury bonds, if we compare this 0.34 here, for example, to the to the two point, 2.5 or 2.6%, we saw on the, on the ten year treasury bond, you know, the, the question that you wanna ask yourself, is, is inflation gonna be enough over this ten year horizon to you know, to compensate for that difference. So, so the yield on the ten year treasury was 2.53%, the yield on the ten year TIPS is 0.34%. So what that means is that if inflation ends up being more than about 2.2% over a ten year horizon, you will have done better investing in the TIPS bond than you will have investing in the regular treasury bond. Now of course there's another reason that you may have seen in the lectures that you want to invest in TIPS, and that's because the TIPS also give you this inflation protection, this, this insurance protection. So whatever inflation is, whatever inflation is, you know, if you're investing the TIPS, you at least know that your investment will you know, will, will, will, will keep up with inflation if you're investing at one of these maturities where where the, the yield is, is greater than zero, the real yield is greater than zero. also, you know, one thing I wanted to discuss, it came up in the discussion forums, very interesting regarding that point about insurance and products that have insurance. there was some great discussion in the forums about annuities people have some very strong opinions about, about annuities. Some people seem to think they're a very good thing, some people seem to think they're a very dangerous thing, and it's, it's, it's quite interesting, annuities is a, really, really a lot of passionate viewpoints about, about annuities out there. And the viewpoints that I've seen tend to focus around the following things. You know, in the lectures, I emphasize the fact that annuities have this longevity insurance component. So they're, they're an insurance product in that if you live a long time you will make sure that you don't outlive your savings, that was kind of the, the basic idea of the lecture at the end of, at the end of week one. but the the sort of points that people have been making about the risks of investing in annuities are the following. First of all, you know, there may be risks in the, in the carriers, in the insurance companies themselves. you basically, you have to hope that the insurance company or the guarantee fund that guarantees the insurance company, and states have these guarantee funds, that those will you know, will outlive you.

And there hasn't been reason in, in history to think they, they won't although, you know, we did see, you know, blowups in some major insurance companies in the financial crisis. They were bailed out by the US government but you know, certainly I think it'd be interesting to see more analysis of how secure the state guarantee funds are for these insurance companies. and another point that came up a little bit in the discussion forum, some people said, well they, they think that insurance companies have big margins and make a lot of money off of annuities, and therefore, they don't want to buy an annuity for that reason, because the insurance company's going to make a lot of money. That's a little bit less of a compelling reason to me. you know, insurance companies make a lot of money off of a lot of products, they make money off of car insurance, they make money off of health insurance. They're not in this business of providing insurance unless they're, they're making some money. And that can still be a valuable product for you in the same way that, you know, if you have a smartphone, I mean, the manufacturer of the smartphone Apple or Samsung, is probably making a lot of money off of you, but you're, you're deriving something from that. And with the insurance companies and their products, you know, you're deriving actual insurance. another reason that people sometimes get fired up about annuities is there is as I mentioned a real range of annuity products that are out there. It's not just the simple fixed life annuities that I talk about in the lecture, there are things called variable annuities, where you have the value of the product is gonna vary with that, that of a market index, which in principle is, is fine. But sometimes these products get very complicated. They have death benefits in them. And sometimes people, it's hard to really understand them, I find it difficult to understand some of the products and I'm a finance professor. So, so I think that that complexity combined with high fees makes people wonder, are these good products or not. And I, I'm very interested to hear more discussion about that and, and debate in the in the discussion forums. so coming up this week, we have the individual assignment that is coming up. So that's gonna be during our week, our next week coming up about about stocks, about equity markets. And the individual assignment is gonna ask you to you're gonna individually collect data. Each person's going to collect data on one mutual fund or exchange traded fund. If you have a work place provided 401K or 403B, a defined contribution kind of plan at work, I'm asking you to pick one of the funds that you you could invest in, that you have the option to invest at your, at your workplace. And you're gonna collect some information about some historical performance about that fund, and some information about the fees of that fund. And you're going to do a little analysis as to whether the fund has outperformed its benchmarks. And how much fees have been collected by the fund and how that compares to, you know, the fees that would have been paid if you had had the opportunity to invest in the fund at a, at a lower expense ratio. so the idea is to kind of get you thinking about performance evaluation of mutual funds and ETFs, trying to understand what the expense ratios really mean. And looking at the performance number, seeing seeing if you can analyze those. And what I'm really looking forward to doing is kind of compiling all the information that you all send in as part of this assignment, in these in the spreadsheets.

And hopefully, we'll be able to put together some interesting statistics about the mutual funds and the exchange traded funds that you've analyzed. So for the coming week, as I said, we have the stock market lectures that are coming up in lectures six and seven. And a few things I wanna highlight to you about the, about the stock market, just to sort of preface some of the things that you'll be watching. This is a graph here of the Dow Jones Industrial Index, this is the the average Dow Jones Indus, Industrial Average, a very well known index of industrial companies in the US. And you can see how this is done from the year 1900 to the present. This is on a logarithmic scale here. So you can see that there has been huge growth in the in, in the, in the index. you know, it went from in the year 1900, from about 60, to all the way up to, you know, over 15,000 today. So, so there's been a huge growth in the index. And, that's kinda the starting point for the discussion about the stock market. You know, the stock market has done this well historically, what if anything can we conclude about how we'll do going forward. What can we learn from history at all about the, about the future, and that's kind of one of the big debates that happens in, in finance. The general principal that I'm going to emphasize to you, is one that you're already surely familiar with, and that is that, you know, past performance is no guarantee of future performance. And the basic fundamental idea of finance, as you kind of gotten a sense of up til now, is that if a security, you know, is providing you with some possibility of a return that's higher than a risk-free rate of return, then it must have, must carry some risks with it. And so you know, similarly when we think about the US stock market, it wasn't risklessly that the US stock market grew this way, there were a lot of risks that could have materialized that did not. And so it's in thinking about that, that we'll be through the lens of that we'll be looking at the stock market this week. One of the key principles also that I'll bring up, that I bring up again and again, is this idea of a distribution of outcomes. Whenever you invest in any security, there's a distribution of possible outcomes over future states of the world. When we talked about the bond markets, this past week you saw that, you know, the states of the world were generally, if you're investing at the same horizon as the bond matures, and then generally there's two states of the world, either the bond matures and pays all its coupons or the bond defaults. Those were kinda the, the key states of the world. There was also another dimension, the idea that there were different differential inflation environments that could prevail, so that the nominal dollars that you got repaid by the bond could be worth a lot when you when the bond matures or it could be worth, could be worth less. And those were sort of the states of the world when thinking about bonds. the stock market is sort of a broader continuum of possible states of the world when you think about it. I mean the, the stock market has a you know, has returns that it's going to generate. We talk about the idea this week of the so called expected return on the stock market, which is a bit of a misnomer. In the same way that it's a bit of a misnomer for the bond market, it's a bit of a misnomer for the stock market. Expected return is really just the mean return over the possible states of the world that could prevail.

And we're going to see this week, that often that mean return can be quite different from say the median return, especially when you have asset prices, stocks behaving the way that most finance people think that they behave. it really is the case that actually the mean or the expected return over a, a long horizon is actually less than 50% likely to come true. It's, it's actually the expected return, that mean return is above the median return. And that way the, the word expected return, I think, is something of a, of a misnomer. So I'm hoping that through the lectures this week, you'll get a bit of an understanding of what I mean when I talk about a distribution of outcomes and, and means over states of the world for the stock markets. So that's one of my, one of my goals for you for, for this week. I'll also preface one other thing before I close, which is something called the price earnings ratio in the stock market. This is the ratio of the price of a share to earnings per share. So the price of a, sort of share of stock in you know, you can think of this as being a composite company of all of the companies in the US divided by their earnings. And today that value, this is the Shiller price earnings ratio after Robert Shiller who thought of it, he just he just won the Nobel prize last week, is right now around 25. So what that says is that for every dollar of reported corporate earnings these days, investors are willing to pay around $25 in terms of the price of a share of that company today. So they're paying about $25 today for $1 of, of earnings in, in today's terms. Of course, why are they paying, why are they paying that much? Well, they're thinking that that dollar of earnings is going to continue, and that eventually they're gonna get payouts from the company in terms of dividends or that the money will be reinvested in the company and they'll be able to sell the shares back into the market at a, at a higher price tomorrow. So for every current dollar of reported earnings they're willing to pay around $25. You can see from this very interesting website here that that number is somewhat high relative to history. It's not as high as it got in 1999 when, when the market was willing to pay over $40 for a, a dollar of a dollar of earnings. but it's, you know, it's sort of up there. I mean it's if you compare it to you know, some of these other peaks here, it's really it's, it's really somewhat high in the context of history. So we'll talk a little bit in the lectures coming up this week about what that means, whether there's any predictability in the stock market. Whether we should be considering something like that all in, in terms of the question of you know, how much you should be investing in the stock market. So thanks very much everybody for participating in the discussion forums. I'm really liking what I'm seeing. Everybody's being very active and respectful in the discussion forums, which I very much appreciate. And I'm, looking forward to reading more, and to doing our week on the stock market with you. Take care, everybody. 6.1 - Understanding the Stock Market Welcome to this lecture on the fundamentals of the stock market. Today, we're talking about understanding the risks and potential returns of investing in the stock market. Suppose you had just turned 67 at the end of 2012 and had just retired. You had saved for retirement, starting at the age of

40, until you retired on your 67th birthday, having invested all of your contributions into the stock market and reinvested all the dividends. How well would you have done? If you began this saving with your first contributions to your retirement account in 1986, at the end of your first year of work, under the retirement plan, assuming starting income of $50,000, an inflation rate of two percent per year, a real salary growth rate of one percent, and a contribution each year of ten percent of your income, you would have ended up with $592,000 in your account at the end of 2012. Not bad for having not started to save until age 40. What if instead, you'd been a few years older and had started this with your first contribution again in age 40 in 1983, instead of 1986. Your 67th birthday would have occurred at the trough of the stock market in February 2009. If you retired at that point, you would have ended up with around $429,000, or around 28% less than if you had started three years later. Now with the benefit of hindsight, it is clear that people who hung in there with the stock market in February 2009 saw their balances recover. But at the time there was great concern about the stock market. When you really get into the situation of having just seen a little less than half your retirement wealth evaporate in the span of a year, it's difficult to know what to do. If there really is mean reversion in the stock market, meaning that extreme increases and extreme decreases will level out over time, then won't you just hang in there through the downturns, and sell off your positions slowly during big booms. Well, this is a very difficult path to force yourself to follow. Specifically, when everyone is making money in the stock market it's hard to force yourself to sell out of it, and when everyone is losing money, it's hard to stick with it or buy more stocks. And importantly, we don't really know if the stock market really mean reverts. We don't know that in all cases after the market falls that it will rebound. We only have one history of the stock market in the U.S. If we look around the globe, we can find examples of countries whose stock markets never recovered or took a very, very long time to recover. Here, for example, is a graph of a Japanese Stock Market, the Nikkei 225. It got almost to 40,000 points in 1989. It then fell to below 10,000 points. That's a 75% decline. By April 2013, it's recovered to around 13,000. Well, this is very far from the high of almost 40,000 at the end of 1989. In this lecture, we'll make some progress towards understanding the stock market. Many individuals invest in stocks, deciding that they like the risk return trade-off they percieve in the stock market. For example, consider 401k plans, the leading retirement saving vehicle for private sector workers in the U.S. with over $3 trillion of assets in them as of today. At least 44% of 401k assets owned by participants in their twenties is invested in stocks. And 41% of the assets for participants in their sixties is invested in stocks. Those figures don't even include other types of retirement account investments, such as target date funds and balanced funds, which also include some equities. And then, there are the large pension funds that manage trillions of dollars of money to provide pensions to government employees and also the older employees of firms in more traditional industries. These pension funds have also chosen to invest in the stock market. At the end of 2012, state and local governments had around $3 trillion in US based pension funds as well, with around $1.8 trillion in corporate stocks.

The stock market consists of the traded equity stakes in all publically traded companies. In this lecture, I won't be talking too much about individual stocks but more about the stock market as a whole. One of the major principles that you learn if you study individual stocks is that there are substantial benefits to diversification. Diversification is the combination of the stocks of many different companies into a portfolio. What we are covering in this lecture is how financial economists generally think about valuations in the stock market. Financial economics views the stock market as it views any other asset. There are many different states of the world. The economy is good or bad. Whether natural resources are cheap or expensive. Whether inflation is high or low. And an asset is characterized by its performance in each of those different states of the world. Historically, stocks have had a higher return than risk-free assets, but that higher return is not guaranteed. And lack of the guarantee, the fact that the stock market can generate much lower returns in the risk free asset in some states of the world, is what makes it possible that the stock market can potentially deliver higher returns than the risk free rate in other states of the world. 6.2 - Risk and Return Risk and return. The first most basic return measure for any risky asset. Is just the return over a certain time period from holding the asset. This is called the simple holding period return. To illustrate how the simple holding period return is calculated for an individual stock. Consider the stock of the company Exxon Mobile Corp. I chose this company because it's one of the largest companies by equity market capitalization in the U.S. and because it pays dividends. Here's the price of a share of the stock XOM at the end of each month between 2005 and 2012. You can see that the stock is traded between $50 and $100 per share. But this doesn't tell us the actual percentage return on an investment in the stock of a given amount over a period of time, say a month. To do that, you might calculate the return as follows. Take the price at the end of the month, P sub t, subtract the price at the end of the previous month, P sub t-1. And divide that whole thing by the price at the end of the previous month. P sub t minus 1. For example, at the end of October 2012, a share of the stock, traded at price of $91.17. One month later, at the end of November 2012, it traded at the price of $88.14. So by this calculation, the return on this month would have been $88.14, the November price minus 91.17, the October price. Divided by $91.17, for a return of negative 3.3%. This graph shows us these price-based returns for each month between 2005 and 2012. The first month of this time period involved an unusually strong return for this stock, exceeding 20% in the month. But in most other months during this time-period, the stock's performance was between negative 10% and plus 10% on the month. But this analysis so far ignores the fact that XOM, Exxon Mobile, pays dividends, and does so once per quarter. So, including dividends, the returns in those dividend paying quarters are a bit larger.

The formula for the overall holding period return including dividends is as follows. Take the price at the end of the month, P sub t. Add the dividend paid during the month Div sub t. Subtract the price at the end of the previous month, P sub t minus 1 and divide the whole thing by P sub t minus 1. So to continue the Exxon Mobil example, in November, 2012, a share of Exxon Mobil paid a dividend of $0.57. making the total holding period return for the month of November 2012 equal to $88.14, the ending price. Plus $0.57, the dividend you got. Minus 91.17, the price at the end of the previous month, all divided by 91.17 for a negative return of 2.7%. Negative 2.7%. Not as bad as if the investors hadn't received the dividend, in which case it would have been negative 3.3%. Next we can look at the average or mean monthly return. This is simply the average of the monthly returns. We just add up the returns and then we divide by capital T, where capital T is the number of time periods or months. In this case we have seven years and 11 months of returns. That is, 7 years times 12 months is 84 months, plus another 11 months makes 95 months, 1 month short of 8 years. Summing up all the returns in the chart, and dividing by 95 months, we get a mean, really an arithmetic mean, return of 0.88% per month. Ignoring compounding, that's equivalent to 12 times 0.88% or 10.5% per year. So, that's the average return of this stock over this time period. 10.5% per year. What about risk? In this histogram, you can see the overall distribution of the monthly returns over this time period. The first and most basic measure of risk here would be the standard deviation of monthly returns. Standard deviation you will recall, is a summary measure of dispersion around the mean. It is based summing up of the square deviations from the mean. In this example, the center of the deviation multi returns is 5.54%. It's common practice, though not precisely correct, to annualize that by multiplying it by the square root of 12. You get an annualized standard deviation for monthly data of 19.2%. This is approximately the standard deviation of annual returns on the stock, 19.2%. The word volatility describes this kind of variation in the price of a stock. Now, if you wanna get into the technicalities. Volatility is typically calculated a bit differently from an annualized standard deviation of monthly simple returns. The most standard calculation of volatility begins with daily returns as opposed to monthly returns. And instead of the simple return above, it uses the continuously compounded version of the return, which is, we write it as little r sub t. And we calculate that as the natural logarithm of one plus the simple return, big R's of T. So for example, if the price of the stock is $53 today, and it was $50 in the previous day. And no dividend was paid, then the simple return is 6%, 53 divided by 50 minus one. And the continuously compounded return is the natural logarithm of 1.06, or 5.08%. The continuously compounded version is slightly smaller. Because it treats the compounding that's happening at every instant. When quantitative finance people or quants, talk about volatility. They're talking about the annualized standard deviation of the continuously compounded calculation using daily data. But for practical purposes, I'm gonna consider the standard deviation of monthly returns as synonymous with volatility. It turns out that much of the volatility that one experiences by owning individual stocks can be diversified away by combining those stocks together. To illustrate this, consider again the period 2005

to 2012. Using monthly data, we can calculate that the returns on the stock market as a whole had an annualized standard deviation of 16.6%. This is the volatility of a portfolio that holds all the stocks traded on the major U.S. exchanges in proportion to each ones market value. But the returns on many individual stocks are much more volatile than that. For example, we saw that Exxon Mobile, XOM had an annual standard deviation of 19.2%. The other two largest companies by stock market capitalization in the US markets are Apple and Google. The individual stocks of these companies had annualized standard deviations of their returns of 36.1% and 34.5% respectively. Much higher than the 16.6% volatility of the market as a whole. And while some stocks, including some large stocks, which is that of WalMart, Inc., Had a lower standard deviation than the market as a whole. The fact that the volatility of the market as a whole is only 16.6% is not because of those companies. That's because when you combine stocks into a portfolio, you eliminate essentially all of the firm-specific, or idiosyncratic risk. You're left with only the systematic or market, risk that can not be diversified away. The idea is that while unexpected things can happen to individual firms. Like the new iPhone could have unexpectedly awesome or unexpectedly terrible sales relative to the rest of the industry. When you put all of these stocks together you diversify away that risk. So if you own stock not just in Apple but also in the firms Samsung and HTC. These companies make a lot of smart phones running Android that compete with Apple. Then, you don't care about the next iPhone as much. What you do care about are corporate profitability as a whole and investors perceptions of that, and their willingness to pay for it. And that's the risk that you bear when you invest in a diversified portfolio of stocks. So, a second and from an economists perspective, true measure of risk, is the extent to which a security exposes one to systematic risk. Or risk that cannot be mitigated through diversification. Risk that is firm specific, idiosyncratic to a specific company, is not a risk that you have to bear in very large portion. Risk that is systematic or about the entire market is risk that cannot be avoided even with a diversified portfolio of stocks. What is a diversify portfolio of stocks. Well, I'm think here in particular of a broad stock index mutual fund or a broad stock index ETF. Some very common iterations of this are the vanguard 500 index fund, or the fidelity 500 spartan index fund. Those do not hold every stock, but rather the top 500 largest stocks, that comprise the S and P 500 index. And as a result, their performance tracks that of the S and P 500 index very closely. These index funds are some of the cheapest funds you can buy in terms of their expense ratios. And they give exposure to most of the domestic stock market. You could also get total market index funds such as the Vanguard total stock market index fund. Which really tries to track the performance of evaluated portfolio of the entire stock market. In the post-war period, that portfolio has been a bit more volatile than just the top 500 largest companies in the market. But it is a broader portfolio. You can also buy international stock market index funds or international exchange trade funds. Those usually aim to give you exposure to the entire global stock market in proportion to the size of each country's market. When investing in international funds, also means taking on currency risk.

The risk that the US dollar or home currency will depreciate relative to the foreign currencies by the time you wanna sell the fund. Important point about a diversified portfolio, is that it holds stocks in proportion to their market values. That is, it's a valuated portfolio, where value here is the total equity market capitalization of the stock, or it's market value. Calculated as the number of shares outstanding for the stock times the price per share. So if a company has 10 million shares outstanding at a price of $100 per share. Then it has a market cap or market value of $1 billion, that's 10 million times $100 per share. The weight of each stock i in a valuated portfolio, is then the market value of that stock i, divided by the total value of the stock market. So a stock like the one we were just talking about, with a market capitalization of $1 billion. In a total stock market with a capitalization of $18.7 trillion, that was the market cap of the entire US stock market at the end of 2012. Well, that stock would have a weight in the market portfolio of 1 times 10 to the 9. That's the 1 billion market cap of the individual stock, divided by 18.7 times 10 to the 12. That's the 18.7 trillion market cap of the entire US stock market for a percentage of 0.0053%. That would be the weight of this one stock in the valuated market portfolio. From this point on, I'm gonna refer to the stock market as the broad market index of all US stocks. Otherwise known as the market portfolio. To a first approximation, you can think of the market portfolio as the S&P 500. But technically, I'm referring to the broad portfolio of all publicly traded firms in proportion to their market value weights. I'm intentionally excluding private equity, non traded ownership stakes in firms when I refer to the stock market. When I'm referring to the stock market, I'm just talking about tradable equity. So to recap, in this segment we looked at simple return measures. I emphasize the importance of including dividends in measuring returns. You can't just take changes in price levels and think of that as a return. We went over the calculation of the average and standard deviations of monthly returns. And we reviewed why it is that when you put individual stocks together in a broad portfolio, you reduce your risk. The key idea there is that there is firm specific risk that can be diversified away in a broad portfolio. But the risks of the overall economy or investors' overall desire to own stocks. Or the extent to which they discount the cash flows they expect to get from stocks, that's not diversifiable. And, that non-diversifiable risk is called systematic risk. Finally, I explain that a diversified portfolio stocks consist of a valuated stock market index. Such a product is readily available in the market for mutual funds or ETFs. And if you buy the right one, it should have a very low expense ratio. From this point on, we'll think mostly about the value of the stock market as a whole, not the value of individual stocks. 6.3 - Why Does the Stock Market Have Value? Why does the stock market have value? A share of a common stock is a slice of ownership in firm. Suppose there is a firm with 100 million shares outstanding. And, you own 100,000 of them. That means you owned 1 1000th of the firm's equity. This essentially gives you three things that may be of value. First, you receive 1 1000th of any dividends that the firm pays to common shareholders as long as you own the shares. Second, you have the right to sell the 100,000 shares at anytime to another investor at

a market price. Third, you have voting rights in all matters that management puts to common shareholders for a vote. If there's only one class of shares, then your voting rights are proportional to your ownership share. In this case, you would have one-one thousandth of the total vote. I'm going to focus on the first two of these as the main source of value, dividends, and the right to sell the shares. Now, we're going to see that, in fact, that it's really only the first one, the dividends, that matter. What does the present value intuition say that the value of these shares should be at any given time? Well a key point is that in this context there are no contractrually promised cash flows. The firm may or may not pay dividends and its shares may or may not be worth anything at all to the investors at some point in the future. Another key feature of these equity securities is that they are perpetual. They exist as long as the firm exists. Now, if equity did have prespecified or contracturally promised cash flows it could be priced like an infinitely lived bond, called a consol or perpetual bond. There aren't many consol bonds these days. The UK government last issued some in 1923. But when they have traded, their yields have been rather close to the yields on very long term bonds. So such an instrument would not be hard to price. Specifically, the present value of a bond where there are contractually pre-specified cash flows is usually defined relative to those contractually pre-specified cash flows. So, consider a bond that promised to pay a fixed amount each year forever, in perpetuity. Then its value would be the present value of all future cash flows, an infinite sum of discounted cash flows. Conveniently by the perpetuity formula, this value can be expressed very simply as the present value of this consol bond, being equal to c divided by r long. Where here, c is the promised annual cash flow, and r long is the yield-to-maturity on a long term government bond. So for example if the consol bond promised to pay $100 per year forever. And, government bond yeilds with a similar duration, had yield to matuirty of 3%. It's the yeild to maturity on long term US government bonds at the end of 2012. Then the infinitely live bond would have the value of 100 divided by 0.03, or $3,333. Now, let's compare this to a stock. Suppose you plan to own a stock forever, then the cash flows you would get from that security would be simply the future stream of dividends that the stock pays. If you plan never to sell the stock then its price today can be thought of as a present value of that infinite stream of expected future dividends. We can write this as the price of the stock at time zero equals the sum from time 1 to infinity of expected dividends at each time t, divided by 1 plus r to the power of t, at some rate r. But critically, this r is not gonna be the discount rate on long term government bonds. That would be far too low a rate to use to price a risky sequence of expected cash flows. We'll come back to rate r in a bit. But first let's think about whether this analysis changes if you might sell the stock at some point in the future. It turns out that this in not an issue at all. It actually doesn't effect the pricing. Next year's price is the price as of that time of the present value of all future dividends after that. So the price of the stock next year, P sub one. Is equal to the sum from t equals now, time two to infinity.

Of the expected dividend at each time t divided by 1 plus r to the t. Today's price can then be rewritten as the present value of the expected price next year, plus the expectation of next year's dividends. That is P sub 0, the price today, equals the expectation of P sub 1, the price tomorrow, plus div sub 1, the dividend that's gonna be paid, during the year, all divided by 1 plus R. Since at any point in time, the stocks price is the present value of expected future dividends from that time onwards, the right to resell the stock doesn't have specific additional value. Now, let's think about the value of the entire stock market. Consider the fact that the US stockmarket paid dividends of, roughly, $400 billion dollars in total, in 2012. If these dividends were expected to be constant, then we could value the entire stock market as the sum from time 1 to infinity of the expected dividend at each time T, divided by 1 plus R to the T. That's a perpetuity, so we can write that value as just the dividend divided by R, the discount rate, or 400 billion divided by R. But, dividends typically grow. So, we'd actually wanna use a formula for the present value of a growing perpetuity. Suppose dividends are expected to grow at a rate of 2%. That's around the current rate of inflation. And not far from the future implied expected rates inflation, that can be read from the yields on inflation protected bonds. Well, then the value the stock market is given is as follows. Now it's sum from t equals one to infinity of expected dividends divided by 1 plus r to the t which equals the dividend that was paid last year times 1 plus g the growth rate, all divided by r minus g. That's the growing perpetuity formula that equals 400 billion. Times 1.02 divided by r minus 0.02. This formula gives the present value of the stream of cash flows that starts next year, and pays out every year growing at 2%. So, the first cash flow comes in one year. And, it is not 400 billion, which was last years value, but rather. 400 times 1.02 or 408 billion. The second cash flow comes in two years and is 400 times 1.02 squared or 416 billion. The third comes in three years and is 400 times 1.02 cubed or 425 billion and so on. Now the US stock market, in total, had a value, in December 2012 of around $18.7 trillion. To make this growing perpetuity expression equal 18.7 trillion with a growth rate of g equal 2%, the market would be applying a discount rate of 4.2%. To make the expression equal 18.7 trillion with an expected dividend growth rate of a bit more, say 3%. The market would be applying a discount rate of 5.2%. Do these levels of a discount rate for r makes sense? Well recall that those dividends in the numerator are not guaranteed. They're just expected cash flows, in the sense that they are means over different states of the world. The actual dividends could be higher, but they could be lower. So, to account for this risk r, the discount rate, should certainly be much higher than the yield on a safe long term government bond. So, much higher than around 3% at the end of 2012. Even the yield on long term corporate bonds which was a couple of percentage points higher, around 5% Is not gonna work. That's also too low. Why? Well, the bonds of a given firm are a much safer investment than the equity. Equity is a residual claim on the firm's assets after all the debts have been serviced. Conceptually, since the dividends in the numerator are expected, or mean, values, the discount rate in the denominator should also be the required mean rate of return that investors demand to hold the stock market as a whole.

What that means is that there are many different possible states of the world. Historically, the return on stocks has been as much as 8% higher than the return on short term, risk free rates, which economists view as having been compensation for the risks the investors took on. Many people today do not believe that the past is a good indication of the future of the stock market. But if it were, then a more appropriate discount rate to calculate the present value of future dividends would be as high as 8% Short term risk free rates are around zero, and this historical return would be the mean perspective return investors would require to hold positions in the stock market. To make an 8% discount rate consistent with an $18.7 trillion stock market valuation, we would need a growth rate of dividends of 5.7% per year. Rather substantially higher than inflation, and higher than 2011 and 2012 nominal GDP growth rates of around 4%. To be consistent with lower dividend growth rates, stock market investors must also be requiring lower returns to hold stocks than they have in the past, and hence supplying lower discount rates. So the bottom line is that today's market valuations suggest that the stock market is being priced under investor assumptions that deviate from past experience. Either big investors in the market assume the dividend growth rates will be higher than they were in the past or they believe that the risk of the stock market, the appropriate discount rate for these dividends, is lower than it was in the past. There's no reason looking forward that we should use the same parameters as looking back. But this pricing of the stock market is somewhat troublesome. It's led some commentators to speculate the stock market has risen in recent years, not because of fundamentals, but under investor speculation. That the stock market will keep rising despite fundamentals. One version of this is called the greater fool theory. If investors are willing to hold stocks, not because of the fundamental value, but simply because the investors believe that another investor in the future, the greater fool, will be willing to buy the stock from them at a higher price, then the fundamentals based approach we've taken in this section, would not match market valuations. That situation is called a bubble. There are times in history when it's very apparent, at least with the benefit of hindsight, that valuations in certain markets had gone far beyond any fundamentals. The most famous of these is the bubble in tulip prices in the Netherlands in the 17th century. When it comes to stock markets whether they reflect fundamentals, or whether they have gotten away from fundamentals and are getting, frothy, is always a matter of great debate. So, for example. The run up of NASDAQ technology stocks in the late 1990s appears to many, at least in hindsight, to have been an irrational episode. But, academics are still involved in much discussion. As to whether this was really a frothy, bubbly, systematic overreaction to the new technologies or whether it was a rational reaction to the possibility that the technology would be revolutionary. One prominent theory to explain the runup in the stocks of new technologies. Says that the risks of the new technologies such as the internet, start out as idiosyncratic from specific risks. Those are risks that investors don't mind holding, so prices get bid up, since investors can diversify away that risk in their portfolio. Only later the theory goes, this becomes clear that the technology will be adopted on a much larger scale.

The risk then becomes systematic and investors are much less willing to take it on, and then you get a large decline in the value of the stocks. So is the quick rise in stock of companies involved in selling new technologies simply rational investors responding to the possibility that new technology might be revolutionary? Or does it reflect irrational investors going into a psychologically-driven bidding frenzy over the price of stock market assets? That remains a topic of very active debate and is likely to remain so. So in this segment, we asked the question of why the stock market has value. Under a valuation approach, based on fundamentals, the value of the stocks in the stock market derives from the fact that owning a piece of the market entitles the owner to the stream of future dividends paid by the companies in the market. The present value of the stock market is therefore the present value of that stream of all future dividends. The discount rate in the present value formula. When we're talking about the stock market must reflect the fact that the dividends are not contractually promised. These are not bonds, and that means that one cannot use bond-like discount rates to measure the value of stocks. Instead the discount rates should be higher. They should be the average return in the stock market. That investors required to bear that risk. That's an average over all the possible states of the world that could occur. There's an active debate though as to whether the stock market is really priced by fundamentals. That is really priced by the present value of future dividends. The alternative view is that investors take positions in the stock market or because they'll be able to sell their stocks to someone else in the future, at a higher price. If that is the case, then markets will be significantly more volatile than can be explained by changes in fundamentals. 6.4 - History of Market Returns and the Equity Risk Premium The history of market returns and the equity risk premium. Looking at the history of stock market returns in the U.S., as a first step, though not the final step to understanding these statistical properties of stock market returns. There are several ways to look at these returns. The first, and simplest, is just to calculate the annual return on the stock market each year, including dividends. We can then graph these returns and calculate their averages and standard deviations. Going back to 1926 and considering large company and small company stocks separately, that graph looks like this. You can see that these returns are quite volatile. In years like 1931, 1937, 1974, 2002 and 2008, large company stocks, despite being less volatile than small company stocks, lost more than 20% of their value. And in 1931, 1937, and 2008, more than 35% of their value is lost. On the other hand, there are many years where the stock market did very well. And in fact, you can see that most parts of these return lines lie above the zero percent axis. In 1933 and 1954, large companies stocks increased in value by over 50%. And most remarkably, in 32 of the 87 years, large company stock churned out returns of over 20%. Taking the simple mean, or arithmetic mean return for large company stocks over this time period, we get an average annual return of 11.8%. We can also look over shorter periods. During the post-war era, 1945 to 2012, the returns on large company stocks averaged 12.4%, and over 1980 to 2012, they averaged 12.6%. Small company stocks did even better. Their returns since 1926 averaged 16 and a half percent. And since 1980, they averaged 14 and a half percent. Let's now look at the annual standard deviations of

these long histories. Since 1926, the annual standard deviation of the returns on large stocks has been 20.2%. Since 1945 and since 1980, it's been closer to 17%. Small cap stocks, while they have had higher returns, have also been more volatile. Since 1926, their annual standard deviation has been over 32%, and since 1980, over 20%. This is a first hint at the notion that the extra returns achieved in small company stocks are not a free lunch. They've come along with higher volatility. Now, some of the high stock market returns happen during periods of relatively high inflation. What happens when we take out the effects of increases in the price level? That is, when we correct for decreases in the spending power of a dollar so as to get a measure of real stock market returns. Well, let's add a line to the nominal return graph that shows the rate of consumer price inflation. You can see that relative to the stock market returns, inflation has been a lot lower. It still had some high points in the mid-1940s when it reached around 18% and into the 1970s and early eighties, when it was over 10% for a number of years. We can correct the stock returns for this inflation by dividing the gross return, that is one plus the stock market return, by the gross inflation rate, that is one plus the inflation rate. That's really quite similar to just subtracting the inflation rate from the stock return. And here, we can see that the real returns are just about as volatile as the nominal returns. As for the level of these real returns, the real returns are around three to four percentage points per year lower than the nominal returns. That's not surprising given that inflation has averaged 3.1% since 1926, 3.9% since 1945, and 3.4% since 1980. Another transformation we might wanna look at is the excess return above and beyond what was achievable by investing in very short term government bonds called Treasury Bills. So, going back to the nominal returns, we can also show the returns that could be earned on these extremely safe assets. These risk-less returns were actually below inflation in many years in the 1940s and are below inflation today but, for many of the other years, have roughly tracked inflation. Taking the difference between the nominal stock return and it's risk-free rate gives the excess returns, which are shown here. And we can see that these excess returns above the risk-free rate, for large stocks, have averaged around 8.2% since 1926 and since 1945. Since 1980, they have averaged around 7.6%. Now what about for small stocks? For small stocks, the excess returns have been larger, around 13% since 1926, 12% since 1945, and 9.4% since 1980. Where does this excess return come from? Why have stocks earned excess returns over risk-free assets? The only possible reason any asset has the potential to earn more than a risk-free rate of return is because there is some risk at investing in the assets, specifically some risk that the asset might return substantially less then the risk-free rate. If, over a time period, an asset's return exceeded the risk-free rate, that must be because there was some risk that it might not have exceeded the risk-free rate, that it might have fallen short of the riskfree rate. Indeed, the second half of the 20th century was ultimately a time of great prosperity for the U.S. and really the entire western world. That this would happen was hardly a certainty ex ante from the beginning of the period. And, risk averse investors would have needed some incentive to hold risky assets and bear that risk. That incentive came

in the form of the possibility, not the certainty, but the possibility of much higher returns than riskfree rates. We call the historical excess return on equities the Historical Equity Risk Premium. As we saw just now, the Historical Equity Risk Premium, based on 1926 to 2012 data and relative to short term treasury bills, is around 8% for large cap stocks. Another way of measuring the Historical Equity Risk Premium is to do so relative to the returns on longer term government bonds as opposed to treasury bills. Compared to those longer term government bond returns, the Historical Equity Risk Premium is around 6%. But is the Historical Risk Premium, 8% above short term T-Bills and 6% above long term T-Bonds, a good measure of the future risk premium? On this topic there is a great deal of debate. Attempts by economists to model the kind of risk aversion someone would need to avoid investing in a market with an 8% risk premium above the T-bill, usually run into difficulty. They lead to the conclusion that if the forward looking market risk premium is truly that high, then people would have to be incredibly risk averse not to put all of their assets in the stock market. This is called the Equity Premium Puzzle. There have been many attempts to resolve the puzzle, but the most convincing explanation is that the returns observed on U.S. stocks and indeed global stocks in the 20th century represented an unusually lucky period of time. That is, there were many possible realizations of the stock market that could have occurred. And the one that actually occurred may have been one of the better ones that could have possibly occurred. Put another way, with only a hundred years of data, we can't really get a good sense of what the Equity Risk Premium actually is. There are some studies that argue that the Historical Risk Premium is lower when using even older data to look over longer time periods, say going back to the 18th century, and there are some other studies that show that if you just add a small probability of a total catastrophe for the stock market, these models can generate fairly large equity premiums. Investors require large premiums to hold assets that have very bad returns in these so-called tail events, or tail states of the world. Looking forward, a question that many investors ask is by how much can I expect the return on the stock market to exceed the return on risk-free assets? If you're thinking about this question, you must think in terms of states of the world. The so-called expected return of the stock market is the mean over many different possible outcomes. So here's a graph that shows a cumulative density function of one million possible outcomes for investing in a model stock market over one year. The X axis shows returns and the Y axis shows the probability that a return of at least that level is achieved. I gave this market an expected return of 8%. That's a mean over all the different states of the world. So if you take the average over all these one million possible returns, you find that the average or mean return is 8%. The exact way I simulated this market is a topic for another time. But I set this up using some very standard assumptions in finance about how stocks behave. So interpreting the graph, we can see that in this model market, there is around a 30% chance of having a negative return, a return of less than 0%, and a 70% chance of having a return greater than 0%, a positive return. The 25th percentile return here is around minus 4%, and the 75th percentile return is over 18%. The median return is 6.7%, and half of the state of the world the returns will be higher than 6.7%, and the

other half, it would be lower. As for the expected return, 8%, that's the mean over all possible states the world, which here is higher than the median. And similarly, that's how you should think of the forward looking market risk premium. It's the average over all the future states of the world that could prevail. So looking forward, what is that average amount? Well, if you view history since 1926 as containing enough data points and events to be a fully representative sample, you would say that the average would be 8% above T-bills or 6% above safe U.S. government bonds. But most people do not view the relatively short history of its, of the stock market as definitive on this matter. The most likely problem is that we simply don't have enough data, don't have enough history to include enough of the so called tail events, the catastrophes that could have happened but did not. Another point about the risk premium that is important is that it may change over time. There is some evidence that the risk premium, which represents both the risk and expected return of investing in equities, is higher when the business cycle, the Macro economy broadly defined, is at a trough and when it is at a peak. Related to this, we have to keep in mind what stocks are. They are levered claims on corporate assets. So the more leverage in the corporate sector, the higher we would expect the forward-looking, equity risk premium to be. That is, if firms are more levered than they were in the past, we would expect higher risk, as well as higher mean, or average return, over states of the world to compensate for that risk. If they are less levered, we'd expect lower risk as well as a lower average return over states of the world to compensate for that risk. A recent study suggests that total corporate leverage, defined as total liablilites over total assets, amounted to a little over 55% in 2010. That's about the same as it was in 1980 and lower than it's been in the intervening 30 years. It reached around 65% in 1990. But by longer-term historical standards, 55% is still quite a high level, having never been reached before 1980. Finally, it's important not to confuse average or expected returns over states of the world with average or expected returns over time. One of the most misleading propositions in all of finance is sometimes heard is the notion that stocks are not risky over the long run. Some risk of equity investing over the run may be mitigated to some extent by what is called mean reversion in returns, that strong bull markets often follow strong bear markets. Based on a belief in mean reversion, there is a very small minority of finance academics who believe in the notion that stocks are less risky in the long run than in the short run. But the fact is that there just aren't that many episodes of history on which to base that conclusion, and the vastly prevailing view among finance professors and academics, vastly prevailing, is that stocks are in fact more risky in the long run than the short run. This has been demonstrated in a number of ways. The simplest way to think of this is the longer you invest in the stock market, the more likely you are to eventually run up against a stock market crash, or tail event. A more formal way is to consider the fact that standard measures of stock market risk based on history, such as the variation of historical returns, generally do not reflect the uncertainty over whether average future stock returns will look like average past returns.

Taking into account the uncertainty of those historical estimates, the authors of a recent study have concluded that stocks are riskier in the long run than in the short run, despite some meaner version that might dampen long run volatility. In addition, that same study presents evidence that CFOs agree. Based on survey responses, the authors infer that the typical CFO of a publicly traded company in this survey view stock returns as having over two times the variance when looking at a ten-year horizon than they do when looking at a one-year horizon. And indeed, direct surveys of CFOs as to their views on the equity risk premium have resulted in much lower estimates than the historical equity risk premium. The latest such survey, the CFOs reported that they requiting with an average market risk premium of less than 4% over ten year treasury bonds, not the historical average of 6% over ten year treasury bonds. And that less than 4% also implies a total expected market return, that is the mean return of all potential future states of the world of under 6%. So to recap, we considered the history of the stock market returns in the U.S. and found that since 1926, stocks have had an average annual return of 11.8% per year. That's around 8% above short-term risk-less securities, Treasury Bills, and around 6% above long-term safe government bonds, Treasury Bonds. So based on history, we can say that the historical equity risk premium was 8% over bills and 6% over bonds. But there's much concern that this history is not a good guide to the future. The U.S. and entire western world was generally very prosperous during the latter part of this time period. As a result, most finance academics and practitioners believe that the prospective equity risk premium is a lot lower. Something like 4% over the ten year Treasury Bond yield is likely more appropriate, implying a mean or expected return on the stock market of less than 6%. But the most important thing to keep in mind here is that these numbers are averages over perspective future states of the world. The term expected return is much abused. The expected return is the average return investors are forecasting where that average is not over time but over possible states of the world. And, when you invest in the stock market, you are taking on the possibility that your returns could be much higher than the risk-free rate but also the possibility that they might be much lower. 6.5 - Overall Recap So, what have we learned about the stock market? First, we reviewed why it is, that when you put stocks together in a portfolio, you reduce your risk. For a specific risk, can always be diversified away when you combine the stocks of many companies into a portfolio. For example, in 2011 the company Netflix, saw it's stock battered by a number of business decisions that many viewed as questionable. But, if you had owned a diversified portfolio of stocks, you would have reaped the benefits of the fact that the same observers viewed those decisions as advantageous to the competitors of Netflix. What is left in a diversified portfolio is by definition non-diversifiable risk. Also called systematic risk. That is what investors in the stock market must and do bear, and get rewarded for. Second, we consider the sources of value for stocks. The fundamental value of the stocks in the stock market derives from the fact that owning a piece of the market entitles the owner to the stream of future dividends paid by the companies in the market. Those dividends are the fundamental cash flows that market investors value.

Markets discount them using the average return on the stock market required for investors to bear market risk. There's also an active devatge as to whether the stock market is really priced by thsese fundamentals. That is, by the present value of future dividends. The alternative view is that investors take positions in the stock market. More because they believe they'll be able to sell their stocks to someone else in the future, at a higher price. Finally, we defined the historical equity risk premium as the outperformance of the stock market relative to safe securities. One version is relative to treasury bonds, and the other, relative to treasury bills. So based on history, we could say that the historical equity risk premium was eight percent over treasury bills, and six percent over treasury bonds. But there's much concern that this history is not a good guide to the future. The US and the entire Western world was generally very prosperous during the latter part of this time period. As a result, most finance academics and practitioners believe that the prospective equity risk premium is a lot lower. A 2013 study of CFOs points to a forward looking market risk premium of four percent over the ten year Treasury Bond yield. Or, even less, the average in the survey was 3.83%. That would iimply a market risk premium of something like, five and a half percent over treasury bills. What have we not yet covered about the stock market? Well, we haven't said much about the key decisions you have to make as an investor. Even if you're focusing on diversified portfolios of stocks. First, how much market risk should you take on? If you have $100,000 to invest, you can invest the whole thing in the stock market, or you could invest half of it in the market, or you could invest all of it in the market. And borrow another $100,000 and also invest that in the market. I'm not advocating that but it's within the realm of theoretical possibility. To decide which of these you want to do, we'll have to take a much closer look at the distributions of outcomes you're taking on when you make these different investment choices. Second, you'll have to decide what is the best way to get market exposure? Specifically whether it's through mutual funds or ETFs. Two major considerations there will be taxes and expenses. Whereby expenses I mean the fees charged by different funds. You'll also have to choose whether to go with a fund that is actively managed. Where the managers of the fund are trying to buy and sell securities specifically to the advantage of the funds value. Or one that is passively managed. An Index fund. Where the managers are just trying to track a bench mark or an index. A thing we'll have to determine whether there's any point in focusing your investments on certain industries or segments of the market. For example value stocks have historically out performed growth stocks. And small stocks have out performed large stocks. And you can buy mutual funds and ETFs that focus on these segments, as well as specific industries like energy or healthcare. So there remains a rather large set of topics that need to be explored if you're gonna be an intelligent investor in stock markets. Lecture 7 - Making Smart Decisions as a Stock Market Investor 7.1 Decisions

Welcome to this lecture on making smart decisions as a stock market investor. If you have a 401 K, IRA, or a similar retirement plan, you probably own some stocks or equity mutual funds. And you may also own some of these assets outside of your retirement account, as well. What are the key decisions you have to make as an investor in the stock market? Well, first you have to decide how much stock market risk to take on. So suppose you have $100,000 to invest, and that you've decided that you just want, broad stock market exposure. You can achieve this in a broad US equity market index fund. Now, you could invest only $10,000 of your $100,000 in the stock market and keep $90,000 in safe assets. Or you could invest $50,000 in the stock market and $50,000 in safe assets. Or you could invest all $100,000 in the stock market. You could even take a levered investment in the stock market. By investing the $100,000 in the stock market and borrowing more money. So, for example, by taking on the biggest home mortgage you could and investing some of the cash you freed up in the market. Not an idea I'm advocating but within the realm of theoretical possibility. The key here is that investing in equities exposes you to a distribution of possible outcomes and by choosing your level of risk, you are choosing that distribution. Riskier strategies give you the possibility of higher returns in exchange for taking on the possibility of much lower returns. Now I'm not gonna be able to tell you how much risk to take on. That depends on your own risk tolerance. But I will be able to show you some of the distributions of outcomes so that you can decide for yourself. The second choice you have to make is to decide how you're going to invest in the stock market. Whether in a mutual fund, or an exchange traded fund, or through individual stocks. For most of you investing in individual stocks is gonna be a bad idea. What you have to realize is that there are many many investment professionals on Wall Street and elsewhere who are analyzing individual stocks in far greater depth than you, or even your broker, can. So, suppose you go to a financial news website and see some news about a company, Solid Corp. Solid Corp earnings beat expectations. Does that mean that you should go out and buy the stock of Solid Corp? Well, if this corporation is, in fact, solid, professional investors will have recognized that a while back. And if it's earnings have just beaten expectations, well there were traders, or computer trading algorithms, that already bought the stock and drove up its price. So you should not buy the stock on this news. For most individual retail investors, trading individual stocks you read about in the news, is a terrible idea. The benefits to diversification are far more important than trying to beat the market when you have no better information than millions of other investors. So assuming I've convinced you of the fact that you shouldn't try to pick individual stocks, you now face the decision of how to get broad equity market exposure. In a 401k plan, often your choices are limited to mutual funds. A mutual fund is simply a fund that pools money from investors to buy securities. You may also have access to Exchange Traded Funds or ETFs. An ETF is an investment fund that holds assets and trades on the stock exchange. Among other difference is Mutual Funds and ETFs have different fee and tax structures. You'll also have to choose whether to go with the fund that is actively managed, where the managers of the fund

are trying to buy and sell securities, specifically to the advantage of the fund's value, or one that is passively managed, an index fund, where the managers are just trying to track an index. A related consideration is the different fees charged by the funds that pursue these different strategies, and you'll generally find that actively managed funds have higher fees. The evidence that actively managed mutual funds deliver you enough extra returns to compensate for those higher fees is at best weak and at worst absent. So I and many other finance professors have a pretty strong view that investing in an index fund that tracks the broad US equity market index is sufficient for many investors. And if you pick the right index fund, you can pay minimal fees to mutual fund firms and brokers. There are other more or less active choices you can make as an investor, such as whether you should emphasize certain segments of the stock market, like small stocks, or value stocks, or certain industries. And, you could also try to time the whole market. Essentially trying to buy the market low and selling it high. We'll look at these decisions in detail, but it will turn out that with very few exceptions, your best approach is broad-equity indexed investing. Without trying to time the market, or gamble on specific sectors or segments of the market. >> 7.2 - The Stock Market as a Distribution of Outcomes The Stock Market as a distribution of outcomes. When you buy any risky asset, you're taking on a distribution of possible outcomes. Economists generally start from the view that there is no free lunch. That means that if an asset has a higher expected return than the risk free rate, which is to say higher mean return over different states of the world, then the asset also must have some states of the world where it returns less than the risk free rate. Many investors, by investing in stocks, are implicitly saying that they like the distribution of outcomes to which the stock market gives them access. An investment in the stock market will generate a return, R sub M, that is variable. Finance economists usually like to think in terms of excess returns over the riskfree rate, or r m minus r f. Here, the risk-free rate is generally 3 month treasury bills, or T-bills. Since T-bills today yield essentially 0% in annualized returns, the return on the market, r m, will be close to the excess return over riskless assets, r m minus r f although this hasn't always been the case. If you invest all your wealth in a diversified portfolio of stocks, the total return on all your wealth above the risk-free rate will be r m minus r f. But of course, you can actually scale down the amount of risk you are taking, by investing some of your wealth in T-bills, not stocks. Let's denote the share of your wealth you invest in stocks with the Greek letter beta. So you invest beta of your wealth in stocks and you invest 1 minus beta of your wealth in treasury bills. Your realized return will then be beta times the return of the market, r m, plus 1 minus beta times the return of the risk-free rate, r f, which equals the risk-free rate, r f. Plus beta, times the difference between r m and r f, r f plus beta times r m minus r f. So to put some concrete numbers on this, suppose you have $100,000 in total wealth. If you invest all of it in the stock market, your beta is 1, and your realized return is just the return on the stock market.

If instead you invest, say, $70,000 of your wealth in the stock market, and keep $30,000 in cash, or in T-bills, then the beta of your portfolio is 70% and at the end of the year you will have 100,000 times 0.3 times the risk free rate plus 0.7 times the market return. To make it even more concrete, let's suppose there were just two possible stock market returns, plus 19% or minus 16% at a risk free rate of 0%. And suppose you invest your entire $100,000 in the market. Well, if we have the good state of the world, and the return of the stock market is plus 19%, then the return on your entire $100,000 portfolio will be plus 19% or a $19,000 gain. If we have the bad state, and the return of the stock market is minus 16%, then the return your entire $100,000 portfolio will be a loss of $16,000. Now if instead you invest only 70% of your assets in the stocks and 30% in T-bills, then the effect is dampened. So, in the good state, you get a return of 0.7 times 19%, Times 100,000, or around $13,300, and the bad state you get 0.7 times minus 16% times 100,000, or a loss of around $11,200. Now, if you really liked stocks, you could not only invest all 100,000 of your wealth in the market, but you could also borrow money and invest the proceeds in the stock market in addition to the 100,000. Thereby making your beta more than one more thane one for example, a portfolio that returns two times the stock market, whether those returns are positive or negative, would be called a two beta portfolio. To construct this, you could invest your. $100,000 in the market, and borrow $100,000 to also invest in the market. Then your investment would generate either +$38,000, that's in the +19% scenario, or -$32,000, that's in the -16% scenario, respectively. That assumes, of course, that you can borrow at the risk-free rate, which you generally can't, you'll have to borrow at a bit of a higher rate. That'll actually reduce your return on the levered investments in both states of the world. Here's a graph of the entire portfolio return for one year, if the market returns plus 19%. For any beta you might choose, up to beta equals three. And, here's the line, if it is minus 16%. Now often this graph is drawn with respect to the mean return on the portfolio, which is to say, the mean over all states of the world. Let's now be a little more realistic and think about the stock market as having not just two states of the world, but rather a continuum of possible outcomes from a 100% loss to an essentially unlimited upside. The question then is, how much of a higher return averaged over states of the world, investors are getting, in exchange for the fact that they are bearing market risk. Recent polls of CFOs suggest that looking forward, this so-called market risk premium is a bit less than 4% over ten year treasury bonds. So those ten year treasury bonds Yielded around 2% at the time of the survey, that suggests a market risk premium of 5 or 6% over short-term treasury bills, the risk free rate. To put it another way, the market portfolio, a Beta equals one investment, has an expected return of 5 or 6%, where an expected return is the mean return over all the different states of the world. So let's work with a five and a half percent market risk premium, between five and six percent. So we'll do five and a half. Since the risk free rate is zero, this is also just the expected return in the market. We can now look at the mean or expected return in the market as a function of the portfolio beta. To make our two state model consistent with the real world, that would mean that there was a 64%

chance of the good outcome and a 36% chance of the bad outcome, since 64% times plus 19% plus 36% times minus 16% equals 5.5%. This graph shows a very important relationship. It illustrates one of the most widely used models of financial markets, called the capital asset pricing model, or CAPM. The CAPM says that the expected return on the stock market, which is the mean over all the different states of the world. Equals the risk free rate, which here is zero, plus the market risk premium. We write that relationship as the expected return on the market (E of R sub M), equals the risk free rate (RF), plus beta, times the market risk premium. Today, the risk free rate is zero. If the risk free rate were non zero, it would just shift up the lines in the graph by the risk free rate. So, for example, if the risk free rate were 5%, here is what the graph would look like, the slope of the line would still be the same, 5.5% by the way, when looking at these graphs, people often forget that there is a distribution of outcomes around that expected return, so try to keep that in mind. To remind yourself about that distribution, we can also change the horizontal axis to be not the beta. But rather the standard deviation or volatility of returns since these are proportionately related to each other. Historical volatility on the U.S. stock market is around 17% per year. So, a portfolio with beta equals 1 has a standard deviation of return or volatility of return of17%. The graph looks the same as when plotted against beta, it's just that now the X axis shows you how volatile and risky your strategy is instead of just showing it's loading on the stock market. This line has a special name, called the Capital Allocation Line. It's slope is the increase in the expected return you get for an additional percentage point of volatility that you take on. Since this market has an expected return of 5.5% and a volatility of 17%, that ratio is 5.5% divided by 17% which equals 0.32. This is known as the reward to volatility ratio or sharp ratio after Bill Sharp, a Stanford GSB meritous professor and Nobel Prize winner. What do these distributions look like? Let's start with beta equals 1 over a period of just one year. I have simulated this, so that the expected excess returns are given by a market risk premium of 5.5%. It would be that plus the risk free rate, but we are assuming the risk free rate is zero. And here are the volatilities given by the recent market volatility of 17%. I've used a set of very standard assumptions in finance. That the expected excess returns are proportional to the market risk premium, and to the beta, your loading on the market. That the volatility is proportional to market volatility and to the beta, to your loading on the market and that log returns are normally distributed. I'll come back to the end and say something about that. But that just means that the returns are well behaved. This distribution has a mean, or expected reutrn, of five and a half percent, but over one year that distribution of outcomes looks like this. The median outcome is right around 4.0%. That means in half of the states of the world, the return is better than 4.0%, and in half of the states of the world it's worse than 4.0%. The median is less than the mean return of 5.5% because there are a lot of extreme positive values that could occur, with very small likelihood, but the extreme negative returns are actually bounded by a loss of 100%. You can't lose more than all of your money here, this market over a period of one year has a first percentile outcome, a loss of 30%. That means there's only a one in 100 chance it will be this bad or worse, and a 99th percentile outcome of a gain of 54%.

That means there's a one in 100 chance They'll be that good or better. The 25th and 75th percentile outcomes are minus 7% and plus 17% respectively. What about over a longer period of years like ten years? Well, let's first look at the per year compound annualized return over that longer horizon of ten years. Note that the ultimate effect of the time horizon on your portfolio is not given by the per year returns but rather by the Per year returns compounded over the number of years on the horizon. We'll come back to that in a minute. But first, let's look at the per-year compound annualized returns over ten years versus over one year. The lines cross at the median return per year, which is the same, again, around 4.0%. In fact, no matter what the horizon, the median compound annualized return will be the same. But the extremes per year are much less variable for example, the 10th percentile loss is -3%, as opposed to -26%. This is just simply the fact that a particularly good or bad outcome from year one is unlikely to repeat itself in all of the years two through ten. And when we look at the distribution of annualized returns over 30 years, The median is still 4% and the extremes are even more muted. Note again, the median compound annualized return is the same at all horizons. All these distributions have expected returns of 5 1/2%. Expected in the sense of mean per year arithmetic return and yet they permit a very wide range of possible outcomes. Part of what is going on here is that the geometric return, which is the average over all the possible compound annualized returns, for a given horizon longer than one year, is not 5.5 percent, even if the simple arithmetic average annual return is five and a half percent. So, to explain. Here are examples of two possible returns over a ten year period, each of which have simple arithmetic average annual returns of 5.5%. The first series is riskless, and delivers 5.5% each year. The second series delivers is plus 15.5% in half the years, and minus 4.5% in the other half of the years For an arithmetic average of 5 1/2%, just the average of 15 1/2% and minus 4 1/2%. Note that here I've made them alternate years up and down, but the order doesn't, doesn't matter for this example. If you invest $1.00 in the first series, the constant 5 1/2%, you end up with $1.71 at the end of 10 years since each year you earned exactly 5.5%, the compound annualized or geometric return is 5.5%. But for the second series, you actually end up with something less than $1.71. Specifically, you get 1 plus 15.5% all to the power of 5. Times 1 minus 4 and a half percent all to the power of 5, times $1, which equals $1.63. So your compound annualized return over ten years is 1.63 to the power of 1 10th, or around 5.0%, half a percentage point less than 5 and a half percent. Going back to our simulated stock market over one, ten, and 30 years. The geometric mean, or compound annualized return, is 5.5% over one year, by definition, 4.13% over over 10 years, and 4.04% over 30 years. In fact, as the number of years gets large, the geometric mean return approaches the median. Which here, was 4.0%. Now in this graph, the variability of compound annualized returns seems to be getting less as we go to longer and longer periods. Does this by itself mean that stocks are less risky over the long run? Absolutely not, because the per year compound annualized analysis hides the fact that as we go to longer and longer periods, these returns are being compounded over more and more years.

So let's just look at the distribution of ultimate outcomes per dollar invested. Here again is the simple distribution over one year and here's what happens when we look at the distribution of total, cumulative returns over 10 years. The lines cross at around the 15th percentile, at a return of around 0%. That means that the 15th percentile outcome over one year of investing, investing, say $10,000 Is to have exactly $10,000 left at the end of the one year period. And, the fifteenth percentile outcome over ten years of investing $10,000, is also to have exactly $10,000 at the end of the period. After ten years, the median outcome would be to end up with around $14,800, from a median annualized return of around 4% per year. The first percentile outcome is around negative 58%, a 1 in 100 chance that it'll be this bad or worse, and that is far worse than the 32% that we saw with the first percentile outcome over 1 year. There is a 99th percentile outcome of a gain of around 416% over 10 years. A 1 in 100 chance that it'll be that good or better, and that's far better than the 99 percentile outcome over just one year. For completeness, here it is over 30 years. Now, these might not look like bad distributions, but so far, this is all in nominal terms. So, keep in mind, even if inflation is only 2% per year, you would still need a total return of around 22% over 10 years And around 80% over 30 years to avoid losing purchasing power. If we put all of these outcomes in today's dollars, assuming the 2% inflation rate, the distributions of outcomes shift to look like this. So making positive money in real terms in the stock market, is actually a 30th percentile outcome over 10 years and around a 25th percentile outcome over 30 years. Now, this was all for BETA equals 1. I won't have time to show you distributions at different BETAs, but there are a few properties of distributions of higher BETA investments I'd like to point out. First, the more you lever up, meaning go to BETAs greater than 1, the farther the geometric mean, the average outcome you actually will receive with compounding, goes below the so-called expected return or arithmetic mean For example, for beta equals 2, the expected return, or arithmetic mean, would be 11%, 5.5% market risk premium times 2 with a risk-free rate of 0. But it turns out that the geometric mean is only 5.6%. That's the mean compound annualized return you get over all states of the world. Second, the more you lever up, meaning go to betas greater than 1, the less representative the expected return is of a return that you're likely to get. In fact, if you lever up the stock market 10 times, you would have a rather impressive sounding 55% expected return. That's 10 times 5.5%. But you would only hit that expected return at the 98th percentile outcome. So that highlights the fact that the term expected return is a bit of a misnomer. All these distributions were based on a stylized stock market, based on a workhorse model in finance, in which stock prices are logged normally distributed There's some important ways in which this model might fail. One is what's called serially correlated returns. Either positively, if high returns tend to be followed by more high returns, and low returns by more low returns. Or negatively, if high returns tend to be followed by lower returns. And vice versa. Historical data suggests positive serial correlation at short horizons, but mean reversion, or negative serial correlation, at longer horizons. As I've alluded to before, the long run mean reversion has led some researchers to believe that stocks are less risky in the long run than the short run.

Others believe that stocks are, in fact, more risky in the long run than the short run. Due to either the possibility of, first of all parameter uncertainty that we don't have enough history to really know the statistical properties of the stock market. Or two, rare disasters otherwise known as tail events, the possibility of some really, really bad event happening. The ability to use expected returns on stocks as any kind of guide for the future Certainly becomes even more tenuous when one considers the possibility of very rare but extreme outcomes. And the technical point is that if you look at the history of daily stock returns, there are far more days of extreme movements in the market than the model I used above would predict. So to recap, we've seen that as a summary statistic expected returns really carry very little information about the possible future paths and their various likelihoods. The median returns are less than the mean returns so the expected return is actually achieved or surpassed with less than 50% probability. And, over the long term, the geometric mean return, which is the mean over all the states of the world that you could actually get, approaches the median compound annualized return. And investing in stocks exposes you to a wide range of possible outcomes. Levering up the portfolio makes both good and bad outcomes more extreme and makes outcomes that fall short of the expected return more likely. 7.3 - Expenses of Investing in Mutual Funds and ETFs, and Active vs Passive Management Expenses in active versus passive management. While investing in mutual funds and ETFs gives you access to a diversified portfolio of stocks. There are fees and expenses associated with investing in them. When you invest in mutual funds and ETFs, it's important to pay attention to those fees and expenses. The document that describes all the fees, holdings, investment objectives, allowable strategies. And other details for mutual fund or ETF is the prospectus. But, you can also get useful summary information from various financial websites online, notably morningstar.com. The first and most salient costs are operating expenses. Which are expressed as a fraction of the total assets that the fund takes annually from the account balance. These expenses include administrative costs, as well as payments to the fund managers. Often when expressed as a percentage, these amounts sound small, but they really add up. Also investors are not actually writing a check for these expenses or actively instructing their bank to pay these fees. But rather the expenses are rather quietly deducted from your fund balance. So, it's worth taking a close look at mutual fund expenses. The average expense ratio paid in 2011, by U.S. mutual fund investors was 0.62%. Also known as 62 basis points, or 62 cents for every $100 invested. Let's look at how $10,000 invested today would grow over thirty years if it earned a 5% rate of return. Note that this is a better rate of return than you can get on safe securities these days. And let's look at how this $10,000 would grow with a 0% expense ratio. And now, let's compare that to what you would get with a 62 basis point, or 0.62% expense ratio, that's the average that US investors are paying. Well, this is a difference of having your money grow from $10,000 to $43,219 with no expenses. That's a 4.3 times return on your investment. Versus having it grow to only $35,863 with the 62-basis-point annual expenses. That's only a 3.5% return on your investment. That's a pretty big difference, equal to almost 80% of your original investment over this time period.

Now, in the market for mutual funds, you can often find low-cost funds which might have expense ratios of 10 basis points or less. But there are also more expensive funds that charge one percentage point, 100 basis points or even more. The difference between a low expense, say ten basis point fund, and a high expense, 100 basis point fund is shown here. Around $42,000 versus around $32,000. So that difference ends up, over thirty years, being equal to the entire amount of your initial investment just going to fees. There's a range of other fees that can eat up your assets. These include front-end and back-end loads. A load is a one time payment to either get in or get out of a mutual fund. So, if you want to invest say $10,000 a fund with a 1% front-end load will eat up $100 at the very start. And your starting balance will be $9,900. A back end load takes the money on the way out. So suppose you wanted to redeem that $9,900 and there were a 1% back end load as well. Well you'd be left with only 99% of 9,900 or $9,801. So you would have lost the $199 just for round tripping your money into and out of this fund. Other things equal, it's important to select funds that have very low management fees, and to try to avoid loads entirely. If you're a mutual fund investor, take a careful look at those fees. You should be aiming to invest in the lowest cost mutual funds available. No-load funds with expense ratios of 0.1% or 0.2% are widely available. What about the investment strategies followed by mutual funds and ETFs? There are two main strategies. The first is called Indexing. Index Mutual Funds and Index ETFs, collectively know has Index Funds, aim to track a particular benchmark index as closely as possible. A very common benchmark index that many index funds follow is the S&P 500. An index based on the 500 leading U.S. companies as defined by the firm Standard and Poor's. Selection into the S&P 500 is done by committee and not strictly based on a size rule. But to a first approximation, you can think of it as the index consisting of the 500 largest companies by market capitalization in the US. The fact that the S&P 500 emphasizes the largest companies, means that it only approximately tracks the entire market. The Wilshire 5,000 is a broader valuated index representing an approximated market value of all stocks actively traded in the U.S. The second strategy for mutual funds is known as active management. In actively managed funds, the investment manager is not trying to track a given benchmark. But rather trying to beat the benchmark through the active trading of stocks. As a general rule, the more active the fund management strategy, the higher the fees. That is, fees are generally much lower for index funds than for actively managed funds. This figure shows that the average index equity fund in 2011, had an expanse ratio of only 14 basis points, or 0.14% per year. That's $0.14 per year per $100 invested. The average actively managed equity fund had an expense ratio of 93 basis points, or 0.93% per year. That's $0.93 per year per $100 invested taken by the fund as expenses. So before, when we saw the difference between a 0.1% expense ratio and a 1% expense ratio at a 5% realized return. Equaled about 1 times your entire investment over 30 years. Well, that's about the difference you're looking at when comparing the average actively managed fund to the average passively managed fund. By the way, these are of course averages. There are expensive index funds, which you should pay for only if you are literally captive by some employer provider or some other plan.

And then there are cheaper active funds, although rarely would you see an active fund with an expense ratio of as low as 14 basis points. Because it wouldn't compensate the managers for their effort. So, are actively managed mutual funds in general worth the higher fees? Do they deliver enough in extra performance to make up for the expenses? To answer this question, we need to think a bit about how best to evaluate mutual fund performance. If you saw a mutual fund that earned, say 30% annual returns last year. During a year that the stock market as a whole earned 16%, is that necessarily good? Well, at first glance, you might say yes, from an ex post perspective you would have liked to have invested in that mutual fund instead of the SMP500. But there are two main issues that should make you cautious. The first issue is just the possibility that the mutual fund managers got lucky. Suppose that, every year, half of the actively managed mutual funds outperformed passive benchmarks, and the other half did not. And suppose also, that there were no persistence from year to year in performance. That having done well one year did not predict whether a manager would do well the next year. Then we would say that, it is not worth paying for active management because, clearly some managers are just getting lucky each year. An age old example, often cited by John Bogle founder of Vanguard, which tends to focus on indexing strategies. And they may go back to Warren Buffet in 1984, is the following. Imagine a national coin flipping contest. All 312 million people in the U.S. today are gonna bet one dollar. On the flip of a coin. Each person gets to call it. Heads or tails? If you call correctly, you win a dollar. If you do not call correctly, you lose a dollar, and your one dollar goes to one of the winners. So after this first round, there will be around 156 million people, about half of the 312 million who started Who have lost their initial $1.00. They're gonna drop out. There will remain around 156 million winners. Those winners now have $2.00. And these winners are gonna go on to another round. This time betting $2.00 and trying to call heads or tails. After the $2 round, the same thing will happen. Half the participants will be losers, having not called correctly, and they will drop out. But around now 78 million people will have called it correctly again. And they will stay in the game, now with $4, and they'll try to call heads or tails again. If we keep going like this, after ten flips, around 1 in 1,024 individuals, that's 1 over 2 to the 10 will have called ten consecutive coin flips. That's around 305,000 people. After 20 flips, there will be only around 298 people who have called 20 coin tosses in a row. The question is, would you call these people expert coin flippers? Should you pay them to tell you what the next coin toss will be? Clearly not. These 298 people are just lucky and, analogously, even if picking stocks for actively managed mutual funds were literally as random as flipping coins. Some apparent winners will emerge in any given year who do better than average because of sheer luck. In stock markets, much publicity surrounds these so called winners, even without proof that they are skilled rather than lucky. The second issue is risk. If you observe a mutual fund that earned a high return, what kind of risk did the fund manager take on to obtain that return? Suppose the fund manager invested in highly leveraged companies. Companies that were very risky, because they used a lot of debt in their capital structure.

Those firms will naturally rise more in value when the stock market as a whole goes up. It would have been possible to obtain that return in an exchange traded fund in ETF that tracks say, two times the market. That instrument is called a levered ETF, and its managers do no stock picking. While levered ETFs can be as expensive as actively managed mutual funds for retail investors. Those who invest in them at large scale can actually do so very cheaply. Regardless, you shouldn't pay mutual fund managers fees for active management. if the returns could have been replicated with a passive portfolio. And in analyzing how much a mutual fund outperforms, you better consider it's beta, how much market risk did it take on? Well we've just seen is an example of the general problem of trying to infer ex post. Or after the fact, whether an investment decision was good idea ex ante, before it was made. The simplistic view taken by many people, is that if the investment generated a good return, well then it must've been a good decision to invest. And if it generated a bad return well then it must've been a bad decision to invest. Well, perhaps you know someone who went to Las Vegas last week-end and won a bunch of money generating a large return on his investment. He both took a lot of risk and got lucky, so his performance is unlikely to be repeated. He may have done well ex post but from an ex ante perspective, it would not be advisable for you to give him your money. And tell him to invest the next weekend. A long history of academic research has found that there is little value for investors in actively managed mutual funds after fees are paid. Many papers, in fact, argue that there is no evidence at all that excess mutual fund performance above benchmarks is even persistent. That is that last year's good performers can even repeat their performance the following year. These findings suggest that observing any out performance in the mutual fund space is more luck than skill. Some very recent state of the art work on this however, finds that there is some persistence in risk-adjusted mutual fund performance in dollar terms. That is, there are skilled mutual fund managers out there who can outperform. But after fees are paid, this persistence makes money for the skilled mutual fund managers. But does not generate any value at all for the retail investors. So to recap, we've talked about the expenses you pay if you invest in mutual funds and ETFs. And about how those fees are different with different investment strategies. Actively managed funds generally charge higher fees than passive or index funds. There's essentially no evidence that actively managed funds outperform passive funds or index funds. On a risk adjusted basis that it feeds. That means that if you're gonna invest in equity mutual funds or ETFs. Most economists will tell you that low cost index fund investing is your best strategy. One thing to keep in mind is that if you have a 401K or other workplace defined contribution plan. There may be lots of choices which may lead you to erroneously think that you need many of them in your portfolio. In fact, your first task in looking at that menu of choices should be to find the passively managed funds with low expense ratios and invest in those. They may or may not be listed at the top of the menu of investment choices, so look carefully. 7.4 - Selecting Market Segments and Timing the Market

Selecting market segments and timing the market. In the space between indexing and active stock picking, there are some intermediate strategies that focus on certain types of companies. For example, some mutual funds focus on firms that appear to trade at discounts to their accounting values, called value funds. Others take an opposite approach and attempt to target firms that focus on new technologies and have the potential for very high returns, but currently are returning no cash to investors. These are called growth funds. And then, there are income funds, also known as dividend funds, that aim to invest in stocks with a high dividend yield to get money to investors as sort of replacement for investing in bonds. There are also small-cap and mid-cap funds that in contrast to the funds that invest in say the S and P 500, focus on smaller companies. And there's an array of sector funds out there that focus on energy or health care or technology, or some other industrial sector of the economy Within these categories, some funds attempt to closely track an index. For example, a value index fund attempts to track and index not of the whole stock market, but of value stocks only. Others, particularly some ETFs, actually add leverage to a segment index. For example, the ETF with ticker QQQ seeks daily investment results that deliver two times the returns of the technology heavy NASDAQ index. The more active funds attempt to beat the relevant diversified portfolio through a more targeted selection of stocks that the managers believe will rise in value. So let's suppose you want to stick to relatively passive funds, for the reasons discussed in the previous segment. Is there a reason for emphasizing value funds, growth funds, income funds, or small cap funds in your portfolio? Well, the justifications for doing so usually relate to past performance. One major empirical finding is that value stocks, which appear to have low valuations relative to the replacement value of their assets, have outperformed growth stocks over a long period of time, 1926 to the present. Another finding is that small cap stocks have outperformed large cap stocks over the same time period, although much less decisively so since the early 1980's. Now, as a check on your comprehension, one question you should immediately ask is whether the outperforming categories, here value stocks and small stocks, might have had higher market risk than the under performing stocks. That is, did these stocks just have higher beta's on the market or just more sensitive to movements in the stock market as a whole. The answer for value stocks is no and for small stocks the answer is yes. They have slightly higher betas than 1 but not enough to explain all of their out performance. In particular for a small cap stocks we could look at the security market line, the relation between beta and the average realized return for the first decile of stocks by size, for the second decile stocks by size, for the third, and so on, up to the tebth decile, which are the smallest here. And we'd see that the small stocks lie above the security market line. So, both value stocks and small stocks appear to have outperformed stocks that have similar market betas. Does that mean that you should overweight them in your portfolio? Well, there are a couple of reasons why possibly not. First, the historical out performance might have reflected the risk that these stocks could have performed much worse, even though they ultimately didn't. So, for the same reason that you should be a little skeptical about investing in the stock market as a whole, on the basis of just as good past performance alone.

You should also be skeptical of investing in any segment of the market on the basis of its good past performance as a whole. Secondly, the no free lunch logic suggests that if there really were big opportunities in these market segments, traders would've bid up the prices of small cap and value stocks today, so that their returns looking forward would not be as strong. Indeed, the realized return premiums appear to be less in the recent past than they were in the more distant past. A similar analysis could be applied to sector funds. You might find that some sectors perform very well over certain periods of time. But the same caveats apply. What were the market betas where these more risky companies to begin with? Were there other risks faced by investing in these stocks that they might of performed much worse? And if there were big opportunities, smart money might well have already snatched up those opportunities and bid up the market. Finally, another partially active strategy is to try to time the market meaning trying to buy the market low and sell at high. Here, when I say the market, I don't mean individual stocks I mean the entire S and P 500 or, even more broadly, the entire Wiltshire 5000. There's much doubt as to whether it is possible to time the market. That said, academic researchers found that certain ratios have historically had some ability to predict market returns over a horizon of around a decade. One such ratio is the price earnings ratio which tells you for each dollar of reported corporate earnings, how much is the market willing to pay. There are, of course, many different ways to measure earnings. But the one that has empirically worked the best is the so called, Shiller P/E, Shiller Price Earnings Ratio, named after Professor Robert Shiller of Yale University. It takes today's stock prices divided by the past 10 years of stated corporate earnings, or trailing earnings, adjusted for inflation to calculate a price earnings ratio. Here you can see a historical Shiller P/E ratio for the U.S. stock market as a whole. Before the 1990s the historical peak of the Shiller P/E ratio had been at around $30 per $1 of earnings. That was right before the market crash of 1929. In the late 1990s, the Shiller P/E ratio rose to almost $45 per $1 of earnings. And as of May 2013, it was around $24 per $1 of earnings. So, stocks in 2013, which on average are trading at a Shiller P/E of around $24 are not near the peaks of the 1990s. They are however in the ninth decile. That is, the 80th to 90th percentile relative to history. This was recently pointed out in some commentary by Cliff Asness. And if we look at forward looking stock market performance by decile, we can see that there is a relationship. Although also are fairly widespread between the best outcomes and the worst outcomes within each decile. For the decile that the market was in in early 2013, the ninth decile, the average outcome is a little less than 1% per year over the following 10 years. The best outcome, for this decile, was 8.3% per year over the following 10 years. And the worst was a loss of 4.4% per year over the following 10 years. This is not a terribly encouraging picture, and one that should set modest expectations for the stock market going forward. So on average, the stock market does seem to perform worse when price earnings ratios and price dividend ratios are high. But in general, there is considerable risk and we have to consider the fact, once again, that the history of the statistical properties of the stock market is no guarantee of what those properties will be looking like going forward.

The key thing I want you to take away from this segment is that, as an individual investor, the biggest mistake you are likely to make is to invest in funds that have fees that are too high, have too much active management, and or that give you exposure to segments of the market that are too specialized. This is not to say that some professional investors do not have skill, but for those who have it, you will probably pay for it with high fees. And then there are some professional investors who don't have skill and pay the higher fees anyway. Based on history, there might be some reason to tilt portfolios slightly towards small stocks and value stocks but there's also evidence that the excess returns enjoyed by these categories have been greatly diminished in recent years. As for timing the entire stock market, there's some evidence that price earning ratios or price dividend ratios are related to future expected returns. So there might be better or worse times to invest in the market and valuations appeared somewhat high in 2013 by historical standards or roughly the ninth decile. But regardless, timing the market is difficult even for the professional investor. Your best strategy is probably to choose your desired level of market exposure and stick with it. 7.5 - Overall Recap So what are some of the keys to intelligent stock market investing? You must recognize that investing in the stock market means taking on a distribution of outcomes. We saw some ways you can conceptualize that distribution of outcomes. And how it differs if you invest say 100% of your money in stocks as opposed to 50/50 stocks and cash or T bills, or some other mix of stocks and cash or T bills. Mutual funds and ETFs are the best ways for individuals to gain equity market exposure. The most important consideration for mutual fund and ETF investors is probably the fees and expenses that investors pay to the managers. Actively managed funds generally charge higher fees than passive or index funds. But there's essentially no evidence that actively managed funds, on average, outperform passive funds or index funds on a risk adjusted basis net of fees. So, if you're gonna invest in equity mutual funds, or ETF's, most economists will tell you that low cost index fund investing is your best strategy. And probably, in the broadest possible funds but relatively constant market exposure. That is, you shouldn't try to time the market either. There are two important topics we have not covered and where it's logical to go next. First there is a range of tax deferred savings vehicles out there, such as 401Ks, IRAs, Roth IRAs, Roth 401Ks, and so on. Especially if you're saving and investing over a long period of time, it's important to learn how the tax advantages in those structures can work to your advantage. Second, we have not yet considered overall investment strategy. How one determines an appropriate allocation among stocks, bonds, cash, and other assets. To do that we'll need to take a more holistic view of individual portfolio choice. Lecture 8 - Institutional Arrangements for Tax-Deferred Accounts (TDAs) in the US Weekly Announcement - Week 4 Welcome everybody to the fourth week of our MOOC on the Finance of Retirement and Pensions. I hope that you all enjoyed the lectures on the stock market last week. Now you've probably heard me say dozens of times during these lectures the words distribution of outcomes. That's because I think one of

the really important things that a lot of people who haven't thought about this stuff a lot tend to miss is the idea that when you invest in any risky asset you're taking on a distribution of possible outcomes. It's something I talked about with bonds as well. And with the stock market, it becomes incredibly important because people often talk in the stock market about expected returns. For example, what's the expected return on the stock market? And it's really important that you take away from last week, that the expected return on the stock market is really the mean of a statistical distribution. What that means is that there are a lot of different possible outcomes the stock market could have. And the expected return is just the sort of average over those possible outcomes that could be achieved. And that's very important because you have to realize when you invest in the stock market, that the expected return may not be achieved. And also people tend to confuse the idea of this expected return with the idea of a median return. For example, they think that, okay, the expect return is gonna be met 50% of the time. Well, actually as we, we saw on the lecture, because of the way that asset returns are normally considered in finance, typically the mean of the distribution is actually above the median of the distribution. And that means that the mean is actually usually less than 50% likely to be met. That's particularly the case over longer time horizons and when there are a higher betas if you, if you lever up your, your investment. One extreme example I sometimes give about betas and expected returns is the idea of a what would happen if you could conceptually as an investment, lever up the stock market by a factor of, say, ten times. by you know, taking on borrowing basically ten times your wealth and investing all of that money in the stock market. Well, believe it or not, that strategy would have a very high expected return. The terminology, the way the terminology's typically used. Under some calculations that I expect the return might be about 90% per year. But what's often lost there is that this is a strategy where basically 98% of the time, or 98% of the possible future outcomes you could achieve, you would lose basically all of your money. So the words expected return are really something of a, of a misnomer. You have to be very careful when you use those words. Investing in any risky assets means taking on a, a distribution of, of outcomes. And, and the reason that those very highly leveraged and very risky strategies have such a high expected return is because there's a very, very small chance that you'll basically win the jackpot. Sort of win a lottery. And that amount that you would win if you got that would be so large that it makes the expected return. So-called expected return quite large as well even though the expected return is not something that one can really expect in any true sense of the word. So there was some discussion in the forums about the online assignments and the way that the formatting that you use to answer the questions. Some people were concerned that maybe if you left out a dollar sign or a comma you're getting marked wrong, marked incorrect, and that that's gonna somehow affect your performance in the course. please keep in mind that the only thing that's important for certificate of accomplishment in this course is that you've attempted the questions. That's really the, the most important thing, and so it's just important that you attempt the questions many times as you're allowed. You know, three times you know, until you're getting them right. And once

you've done that, you know, you're, you're, you're getting credit for having attempted the questions, and that's all you need to have done for the certificate of completion. So, so don't worry too much about the formatting issues there. Now, looking forward, you have the individual project due today. Actually it's due tonight at 11:59 PM Pacific Time. I hope you found it useful and interesting to dig into some information about mutual fund expenses, mutual fund performance, and benchmarks. what I find is that a lot of people who are working and have workplace provided defined contribution pension plans, defined contribution, plans like 401k's or 403b's or even people who have IRA's that they don't really, is that sometimes you're not aware of what exactly the expenses in the fund are. How much you actually pay in expenses, how much those expense may be eroding the value of your positions. And also the fact that may well be other funds out there others mutual funds out there. They are pretty much doing the same thing as what your fund is doing but at a much lower expense. And so what one thing I hope you'll take away from this is, you might look around a little bit at some other funds that might be similar to funds that you're investing in and ask, well gee, maybe you know, maybe I could, I could save some money by investing in this other fund that's really doing basically the same thing. Mutual funds also very much like to talk about their performance relative to benchmarks that they choose. Those benchmarks are other indices or other returns in other securities that they wanna compare themselves to. And it's important also to think about then the light of what we what we've talked about in the, in the past week. Which is that, you know, returns greater than a risk-free rate were only achieved with additional risk, only achieved when additional risk was taken on. And so similarly when one looks at benchmarks, you should always be thinking about whether the same amount of risk was taken in the benchmark portfolio as in the mutual fund itself. So speaking of projects, the next project is gonna be a team project, and that's really the kind of culminating project of the course. this week you're gonna start forming teams. And the way that you're going to form teams is very clearly directed in some texts under the assignment tab here in Novawid. you can basically, if you want to, you can invite certain people to, to join your team and this, this tool facilitates the formation of, of teams for the, for the project. This projects gonna have a local element it's gonna ask you to analyze the pension system of a state or local government in the United States. And as a result you should have at least one person from the state or local area that you're choosing to analyze. And you're gonna be asked to analyze the the health of this plan, the sustainability of the plan, and if there are any imbalances that need to be addressed, you should recommend some policy changes. And, and I should be very clear that I'm open to any kind of policy changes you want you wanna consider. You can specify how much additional revenue might have to be raised to pay for the the pension plan. Or you can also specify changes to the pension plan. But keep in mind, that one of the things I'm asking for, and this is for the proposed changes to be things that would be legally feasible, and also that this plan would be something that you could imagine actually being politically feasible and politically viable. so that's something I want you to be keeping in mind as well, as you talk about policy prescriptions that you, you might have in mind for these plans.

And it's important that you, form a team that you're happy with, because you'll have to work together on this project. It's a lot of work. You're gonna have to be dividing up the work to some extent. And also, you're going wanna work well with your team because there's a, a great reward if your project is selected as one of the, as one of the top ones, which is that one member of your team will get to come to Stanford to present the project in front of me and a couple other experts. So I'm very much looking forward to seeing what you come up with in the team project and really encourage you to you know, think carefully about your teams and talk with potential team members about what system you might want to analyze. The only one that's off bounds, is the one that I did in there is a screen cast that I'm gonna post that shows you how to collect the data, so it gives you an example of how to collect the data for the project. That one, the one I did, is the California Public Employee Retirement System, otherwise known as CALPERS, so because I already did that one for you on camera you should not do that one. Okay, so also looking at this week, what have we got? Well, we have a live webinar on November 7th on asset allocation. And even if you actually, say a live webinar is, you're going to be allowed to watch it live on Thursday. If you don't watch it live, that's fine as well. It'll be recorded and you'll be able to watch it after the fact. So we're still playing around a little bit with the time of that. We'll let you know as soon as possible, and then announce what the final time is of the live broadcast. But even if you can't join live, you can watch it afterwards. If you can join live, you'll have the opportunity to tweet in questions to the experts. I'm really excited about the panel that we've put together for this webinar. I'll be posting the roster of panelists very, very soon. And we have experts from some of the leading, some leading mutual fund firms on asset allocation. And the, the topic is webinar is going to be, is going to be about asset allocation. You know, how much of your investments should you being allocating towards stocks, versus bonds, versus other securities at different points in your lifecycles that is earlier on your working life or later on in your working life. there's some conventional wisdom that suggests you might want to get closer to sort of fixed income securities. As you get later on in your working life, as you get closer and closer to retirement, then you might want to rebalance away from stocks and work towards bonds. And that conventional wisdom has been has sort of been found some practical reality in a segment of mutual funds called lifecycle funds that have now become very popular. These are funds that automatically move you away from stocks and work towards bonds as you get close to retirement. So one of the main topics of the webinar is gonna be to discuss that strategy, to discuss the products that while we do it for you and one of these products are, are good, whether they whether that strategy's is, is even good for, for what types of people that would be good for what types it wouldn't be good. then we, we'll also have me on, on the panel and also Prof. Bill Sharp, the inventor of the Sharpe ratio. He's a Stanford professor as well. So he and I will be discussing these issues with with some economists from from some mutual fund companies. So very much looking forward to that I think you'll find that really an exciting panel and webinar. we're also releasing lecture eight today. That lecture is about we'd say that lecture is about what I call asset location, as opposed to asset allocation. The words asset allocation mean, how much should you

allocate to stocks versus bonds versus cash or other securities. The words asset location that's about the question of whether you should have an IRA or a Roth IRA or a 401k or a 403b. where you should be saving, or should you be saving outside of these tax deferred accounts entirely. And also to the extent that you've worked out your asset allocation that you might have decided that you're going to own some bonds in some stocks. Does it make more sense to own the bonds in the tax deferred account, so in the 401k or the IRA, or does it make more sense to own the bonds outside of the tax deferred account? And that's going to be a question that we're going to be talking about that I discuss at length in lecture eight. And some of the conclusions of the analysis that's been done on that is that, is a bit surprising. I think if you look at a lot of people's portfolios when I look at people's portfolios I see that they tend to have a lot of stock in their 401ks, and then they might have bonds outside of the, of the of the 401k. That, that's what some, what people often see in in surveys and, and evidence that's been provided in some academic papers that I've seen. however if you look at the analysis about this, it's actually much more tax efficient to own bonds in the 401k and stocks outside of the 401k. if you've determined that you actually want to own both of these in amounts that the tax deferred account would, would, would allow. So it's, this is a case where I think there's really some interesting analysis that can be brought to bear on what people are doing, and might make you rethink a little bit about your asset location strategies. Now, lecture eight also talks about the important questions of Roth IRAs and Roth IRA, what are Roth IRAs, how are their tax properties different from regular IRAs? Which one should you choose? And what are the considerations in thinking about whether you wanna convert a traditional IRA or a, a 401k from an old employer into a Roth IRA. That's something you can You could do. You actually have to prepay some taxes to do that, and that could be expensive from a, from a tax perspective. but it can also save you tax money down the line if the situation is right. So, it's really a question of what the various parameters are, and I'm going talk about that a lot in lecture eight as, as well. So, hopefully that will be useful to some of you who might be considering, such planning and these kinds of conversions. so that's what we have this week. Very exciting week lots of things going on in the MOOC thanks very much for your participation in the discussion forums. Those are great, I really enjoy reading those and seeing the great ideas that you have. And keep working on the assignments. Again, as I said before, I know they can sometimes be challenging. What's important is that you give them a try, you do your best, you discuss them in the discussion forums. And then everybody learns something. So have fun forming your teams this week and with the webinar and the new lectures and I will talk to you soon. 8.1 Introduction Welcome to this lecture on TAXES AND INVESTING. This lecture is about taxes. Why they're important for retirement saving and what strategies you can follow to minimize the impact of taxes on your retirement resources. We'll talk about the different kinds of tax to exist. And the considerations for choosing which types of accounts to use.

Broadly speaking there are three time periods or phases during which the Federal Government as well as State Governments might tax the resources you're saving towards retirement. The first point is the time at which you Earn the money that you might set aside. If you don't take certain actions at this point with the money, like if you don't contribute directly to a traditional 401 K or a traditional IRA, your earnings will be taxed. So, if your ordinary tax rate is say 35% and you're thinking about saving $1000 of earned income, whether the money's being taxed, right off the bat is the difference between starting out with only $650. That's what I'm calling after tax dollars, or starting with the full $1000, which I'm calling free tax dollars. That's a pretty big difference. The second point in time, really a phase, when the money can get taxed. Is during the time that you are saving and Investing it. During this time, your investments will usually pay some dividends or interest payments to you on a regular basis. And if you or a mutual fund that you invest in. Sells investments, there will be capital gains. Unless the investments are held in some sort of tax deferred account, really any kind of 401K or IRA, this investment income will be taxed. The third point in time when the money can get taxed is at Withdrawal. If your investments are in taxable accounts, you owe no tax at withdrawal. Although, of course, if you sell the investments you will pay capital gains taxes when you sell them. I think of that as more belonging to phase 2. Now if your investments are in a tax deferred retirement account, you may or may not owe tax at withdrawal. It depends on the type of account. In this lecture, we'll consider three basic types of accounts. First, there are taxable accounts which are basically any non-retirement account or any account that does not have special tax advantages. Here you're taxed at point one, you're contributing after tax dollars and at point two, you're paying dividend, interest and capital gains taxes. But not at point three when you withdraw the money. Second, there are traditional tax deferred accounts, specifically traditional 401K accounts and traditional individual retirement accounts, traditional IRAs. In these accounts you're generally not taxed at all. Until point three, when you withdraw the money. Third, there are what are called Roth 401 K and Roth IRA accounts, in which you contribute using after tax dollars at point one. So you had been taxed at that point, but you never pay tax again, either when you receive investment income, during phase two, or when you withdraw the money at point three. Retirement plan accounts can also be classified according to whether they're provided by an employer or accessed just by an individual. If you work for a firm, the firm probably provides you with access to a 401 K or similar type of account. In a 401 K, you contribute to the account and the employer also kicks in some contributions according to the rules of their plan. You select investments from a menu offered by the employer and pay taxes only much later when you withdraw the money. As of late 2012, Americans had $3.5 trillion of assets in 401 K accounts, about 60% of which were in mutual funds. These amounts have grown over time particularly as the stock market has climbed in recent years. Similar plans include the 403 B Which is generally offered by nonprofit employers and 401 A plans which are used by some government employers.

These plan types 401 K, 403 B, 401 A are all named after parts of the US Internal Revenue code which established them. 401ks, 403bs and the like have to be run through an employer. It's also possible for individuals to take advantage of tax deductable retirement savings through individual retirement accounts. Or IRAs, which are not linked to an employer. Both the 401k type accounts and the IRA type accounts come in traditional and ROTH varieties. Collectively, all of these vehicles, the tax-preferred, employerprovided, and the tax-preferred individual accounts, are called Tax Deferred Accounts, or TDAs. And again, we'll discuss the advantages and disadvantages of all of these different types of accounts. Keep in mind that the biggest difference between TDAs and non-TDAs, is how your investment earnings are taxes as you're earning them. Essentially phase 2 of the investment life cycle that we just discussed. Inside a TDA, those investment earnings are not taxed at all. As such, if you invest inside a tax deferred account, you don't have to worry too much about what is called the tax efficiency of the investments you're holding. That is to say, you don't care whether your investments pay you a lot of interest and dividends which are more heavily taxed, as opposed to retaining capital gains, which are lightly taxed and only taxed at all when you sell the assets. On the other hand, if you invest outside of a TDA, you do care a great deal about whether the fund pays interest and or dividends and how it deals with capital gains. Since many people saving for retirement, may also want to accumulate assets outside of TDAs. It will also be important for us to understand some of the tax properties of mutual funds and ETFs. Which are the main vehicles you should be using to save an invest for retirement. 8.2 - Taxes on Investments Taxes on investments. What taxes do you have to pay if your an investor in stocks and, or bonds? There are three ways that you can get money from these investments. First, interest payments. Which are the the regular payments made by bonds. Second, dividends, which are regular payments made by stocks. And third, capital gains, which you get from buying a security at a lower price and selling it at a higher price. These three different types of income receive different tax treatment in the US. In this section, we'll talk about the tax treatment of these different types of income for simple stocks and bonds. And later, the tax treatment of mutual funds. Now this tax treatment is only relevant if you are owning stocks and bonds outside a tax-deferred account. That is, if you're owning them in a taxable account. If you're owning them in a tax-deferred account, be a traditional 401k, or IRA, or the so-called Roth variant of the 401k or IRA, you do not have to pay these investment taxes. So first let's consider interest payments. Interest payments are taxed as ordinary income. That means that you pay tax on interest at the same marginal tax rate that you would pay on an additional dollar of earned income. I write this rate as Greek letter tau. For married households, those rates look like this. So the federal tax rate on earned income and on interest payments will be as high as 35% for married couples with household income below $450,000, and as high as 39.6% for married households on income above $450,000. And that's not even the whole story. Because there are also additional taxes at the state level. This map with information from the Tax Foundation shows top tax rates assessed by the States on ordinary income by extension generally on interest payments. So in California for example, top bracket

tax payers can pay as much as 13.3% of additional tax on interest income. Meaning that the top bracket taxpayers in California keep only, 1 minus 39.6%, times 1-13.3%, equals 52.4%, or 52.4 cents, of every dollar they receive in interest. Though most taxpayers in California actually pay a 9.3% rate. Leaving them with a few cents more. In 2013, there was also a new additional federal investment income tax of 3.8 percent for taxpayers in the top federal bracket. That's the 39.6 percent bracket for married couples earning over $450,000, or singles earning over $400,000. So some taxpayers are keeping only around 50 cents of every dollar in interest payments. What this means is that interest bearing bonds are heavily taxed instruments, and even zero coupon bonds can't escape this, because the IRS computes interest for you. Bonds in general, therefore, are heavily taxed securities. Now let's consider dividends. Investors can choose either to have dividends received as cash, or reinvested in the stock through a dividend reinvestment program. But regardless of whether the dividends are taken as cash or reinvested you must pay federal income tax on them at a dividend tax rate tau div. There are two types of dividends, qualified dividends and non-qualified dividends. For a dividend to be qualified for the lower tax treatment it must be paid by a US corporation or at least under certain parameters of US law. And it must be on a stock, held for more than 60 days out the 121 day proceeding period. So, basically you can't have held it for too short of a time. Most dividends you receive, then, should be qualified and that means that you will pay taxes at either 15% or 20% rates. 15% for most married households with income below $450,000 and 20% for married households with income above $450,000. The cut off is $400,000 for single people. I'll write this rate as tau div. Note that tau div is lower than the ordinary tax rate you would pay on wages, salaries and interest on bonds. So tau div is less that tau, the ordinary rate. However, if you have non qualified dividends, such as those paid by non U.S. listed shares or on shares of any company for too short a time period, you pay tau, the ordinary rate on those unqualified dividends. And the same caveats about state level taxes and the net investment income tax surcharge of 2013. Apply for dividends as they did for interest income. But in total, as long as the dividends you receive are qualified, the rates you pay will be lower by about 20 percentage points than they would be on interest income. Finally let's talk about capital gains. You incur capital gains when you sell an asset at a gain. If you held the asset for more than one year, then you pay at the long-term capital gains tax rate, tao cg long. Which as of 2013, equals tao div for qualified dividends. So that's usually 15% for married households with earnings below $450,000, or singles below $400,000. Or 20% plus the new 3.8% investment tax surcharge for a total of 23.8% for households above the $450,000 threshold. For holdings less than one year, you pay the ordinary income tax rate, that is, tau CG, short equals tau. Now, you don't pay the capital gains tax on the entire amount of the sale. But only on the difference between the amount you paid, the tax basis and the amount you sold it for. So when an investor buys a

given security in multiple rounds on different dates and then sells them in multiple rounds and different dates the calculations of the tax basis can get a bit complex. But a simple example would be that if you had bought a share or stock for $100 this year and sold it for a $120, say five years from now, your tax liability when you sold would be tow CG long times 120 minus 100, which equals tau cg long times 20 dollars. So if you're in the 15% bracket for long term capital gains. Then you'd have to pay $3 in taxes. And if you're in the 23.8% bracket, then you would owe $4.76 in capital gains taxes. And then again, one has to worry about the state taxes. In California, this is particularly a concern. Because California taxes capital gains at the ordinary income tax rate. Which is 9.3% for most taxpayers. Up to 13.3% for the top bracket taxpayers. That could add a lot to your capital gains tax bills. A key difference between capital gains taxes, and the taxes on interest and dividends is that, at least, for an individual security, the investor has total control over when the capital gains are realized. If you don't wanna pay a capital gains tax. Well, you can just hold onto the security, and not sell it. It's only if you wanna sell the security and use the proceeds for some other purpose that you incur capital gains taxes. The ability to defer capital gains taxation, however, is very valuable. And it raises the question of why companies pay dividends at all instead of just retaining the earnings as cash and letting it turn into capital gains for investors. After all, any investors in shares outside of TDAs have to pay much higher taxes if the firm pays dividends than they do if the firms just retain the earnings which increase the value of the stock. Why firms pay dividends at all is a question more for a corporate finance course. But the leading theories there are that firms either like to signal their cash flow generating ability by paying dividends, or that investors are concerned that the company will waste retained earnings and that they therefore demand or require dividends accordingly. Of course if you trade in and out of equity positions regularly. Then you will incur the capital gains taxes every time there's a gain. So going back to the example where you start with a $100. It ends up being $120 in five years. It's useful to consider what would happen if instead you bought one stock in the first year at a $100. Sold it at a $104. Bought another at $104 sold at $108. Bought another at $108 sold at $112, and so on, until you got to $120. Well to do that, you would along the way have to be kicking it extra cash. Because each time you realize those gains of $4. You'll have to remit tao cg long, say 15%, times $4. While the total will end up being tao cg long, say 15%, times $20, you will not enjoy the fact that by deferring the tax, you would be able to save money. That's just because $1 today is worth more than $1 tomorrow. So similarly, being able to postpone paying a given dollar amount of tax is worth something. Of course in a sense, my telling you about the tax drawbacks of trading in and out of stocks, is a bit like the old joke that inappropriately dismisses the dangers of drunk driving with a phrase, don't drink and drive, you might spill your beer. That statement of course, ignores the obvious major dangers of drunk driving, which are serious accidents, injuries, and death. Similarly saying, don't trade in and out of individual stocks because you'll

have to pay capital gains taxes sooner, cause leaving out the biggest danger of individual stocks, which is that you're unlikely to be able to beat the market. Unless you have very rare skill, or just happen to get lucky. And betting on individual stocks, particularly as a retail investor is a good way to lose a lot of money fast. The final thing I'll say about taxes on capital gains is about what happens if you don't have gains, but rather loses? Capital loses on one asset, can be used to offset capital gains on other assets. So, you really only pay capital gains taxes on your net capital gains across all your investments. If you have net capital losses. You can deduct the net from your other income up to a maximum of $3,000 per year. If the net capital loss is more than $3,000, you can carry the difference over to future years. Although if you have a lot of investments, it's likely to take a very long time before you can use all these carried forward loses. So it's clear that if you have a lot of investments the government is to a much greater extent your partner on the upside than it is on the downside. That is, they share more in your gains than they support you when you have losses. So to recap, when holding in investments outside of tax-deferred accounts, that is, outside of 401ks, IRAs and so on, one has to consider taxes on interest, dividends, and capital gains. In this section we looked at the basic tax treatment of investment income from holding individual securities, stocks, and bonds. In another segment we'll look at how these tax issues translate to more common and advisable ways that people would gain exposure to stocks and bonds, namely through investing in mutual funds and exchange traded funds, or ETFs. 8.3 - ETFs and Mutual Funds ETFs and mutual funds. Much more important for retirement savers than the tax treatment of individual stocks, is the tax treatment of the main investment vehicles that you can invest in to obtain a diversified portfolio of stocks. And while there are good reasons to perhaps own individual bonds, at least much better reasons than the reasons to own individual stocks, most people will also do bond investment using investment vehicles that pool many bonds together. What are these investment vehicles that pool together individual securities either stocks or bonds? As I've spoken about elsewhere, there are two. The first one and the much older structure is the mutual fund. A more recent innovation is the exchange-traded fund or ETF. There are many firms out there that sell mutual funds and or ETFs to investors in both taxable and tax deferred accounts. Two giants are Vanguard with $1.89 trillion of assets as of early 2013 And fidelity investments, with 1.2 trillion dollars of assets as of early 2013. The ETF, while newer, is actually easier to understand because it trades directly on an exchange, continuously during the day, just like a stock. The first ETF came along in 1993 called the SPDR or Spider which stands for Standard and Poor's Depository Receipt. Its assets consist of the components of the S and P 500 index. With an ETF, investors can trade a diversified portfolio like this in the same way as they might trade individual stocks. And the tax treatment of an ETF is exactly the same as the tax treatment of an individual stock. If the ETF pays dividends, which most ETFs do, either quarterly or monthly, and you hold it in a taxable account, you have to pay dividend taxes. If you sell the ETF at a profit, again in a taxable account, you pay capital gains tax on the profit.

Of course, if you do all this in a tax deferred acount, you don't pay these taxes. A mutual fund is the more traditional type of collective investment entity. It pools money from investors in order to invest in many different securities and gives each investor a small amount of exposure to all of them. Mutual funds are generally open-end which means that if more investors buy in the number of shares simply expands as is opposed to closed-end funds which have a fixed number of shares that trade. Shares and open end mutual funds transact, meaning are, are bought and sold at the funds net asset value or NAV. For the simpler types of mutual funds the NAV is simply the market value of all the assets in the mutual fund portfolio. There is one price at the end of each day at which mutual fund transactions take place. Now mutual funds have specific tax properties that are important to understand if you own them outside of a retirement account. In particular, they must pass dividends on to investors at least once a year, as well as any capital gains that are not offset by the fund's capital losses. That means that the dividend situation, for a mutual fund will be much like the dividend situation for an ETF. But the capital gains situation will be very different. With an ETF, you can postpone the realization of capital gains basically indefinitely. But for a mutual fund you're having to pay capital gains taxes much more regularly. When the mutual fund capital gains are distributed to you, you will pay tax either at the short-term capital gains rate, which is the same as your ordinary marginal income tax rate tau, up to 39.6% federal for the top bracket, or if the assets were held by the mutual fund for over one year, you'll pay at the long-term capital gains tax rate, taucg-long. And as we saw previously you also have to consider state taxes on capital gains, as well as any surcharges the federal government has in place for top bracket earners, such as the 3.8% net investment income surtax that went into effect in 2013. Buying a mutual fund, right before it makes a capital gains distribution can result in a tax hit to you for capital gains you actually did not enjoy. The NAV of the mutual fund will drop by the amount of the distribution you receive, and you'll have to remit a portion of the proceeds you receive to the IRS. So consider a mutual fund whose shares have an NAV of $100, including $10 of embedded capital gains, which you can think of as gains the fund has realized from trading during the past year. If the mutual fund has to pay out these capital gains and you own the fund outside your retirement account, you will receive $10 of capital gains income on which you'll almost certainly have to be at least $1.50 of capital gains taxes, and possibly as much as $3.70 in capital gains taxes, if you're a top-bracket tax payer in the most expensive state, California. The NAV of the fund when the capital gains are distributed will have dropped by $10 from $100 to $90. So at the end of the day you'll have the $90 NAV plus the $10 capital gain income minus the capital gains taxes that you paid. So if the capital gains taxes are $3.70 that ends up equaling $96.30. It would have been better, for you, more tax efficient, if a mutual fund could have just kept the $10 dollars in capital gains in the fund. Then, your position would still be worth $100 dollars and that's what an ETF can do. Both ETFs and mutual funds provide access to a wide range of investment strategies. And both are not limited just to equities. There are fixed income, bond, mutual funds, and ETFs including those that specialize in treasury bonds, muni bonds, corporate bonds, international bonds, and so on. The

advent of ETFs has actually given retail investors access to a broader range of investments. Some of these are clearly useful. For example, as an investor, you might want at least a small amount of gold in your portfolio. If there's a major geopolitical crisis, gold will do well, and all other assets will fall in value. There are ETFs that can provide you relatively cheap access, to a commodity like gold. Whereas the mutual fund structure did not lend itself to that very well. However, there are also ETFs that undertake more, exotic strategies. Including leveraged ETFs that amplify the gains and losses to investing in equities. Whether or not as an investor you really want or need those exotic ETFs is an important question. Most economists will say that for most people a relatively narrow set of mutual funds and ETFs giving indexed exposure to the major asset classes should be sufficient and that it's not worth paying extra expenses and taking on a lot of extra risk to get access to much more. The justification for investing in a leveraged ETF has gotta be that you like the distribution of outcomes of the stock market so much that you'll pay expenses to amplify your exposure to the stock market both the ups and to the downs. The justification for investing in an ETF that gives you exposure to some non traditional asset or commodity has got to be you believe it diversifes your portfolio. Unfortunately as we saw in the financial crisis, when the major asset collapses such as stocks go down in value, many other assets actually do as well. So to recap, mutual funds and ETFs both allow money from investors to be pooled and invested in securities that give diversification across investments and also allow investors to benefit from professional money management. When held outside of tax deferred accounts, that is outside of 401(k)s, IRAs, and so, one has to consider that taxes on dividends and capital gain will be owed on these investments. The tax advantage of ETF is that while you still have to pay taxes on dividend payment, no capital gains are owed until you sell the ETF. In the case of mutual funds capital gains will be passed on to you as the mutual funds sell shares for a profit. Of course, if you're owning mutual funds inside a tax-deferred account, a 401(k) or IRA and so on, then these issues about taxes on investment income become less important, as we'll discuss in another section. 8.4 - The Tax Advantages of Different Types of Tax-Deferred Account The tax advantages of different types of tax-deferred accounts. There are a number of different types of tax-deferred accounts. The main ones you may have access to and would consider investing in are traditional 401(k)s and their cousins, like 403(b)s So called roth 401(k)s, traditional IRAs with deductible contributions, traditional IRAs with nondeductible contributions, and the so called roth IRAs. So, let's think about the different characteristics that these different types of accounts have. First, there's the simple question of whether it is an employer sponsored plan, or an account that is not attached to an employer. On this dimension, the types of TDAs I mentioned break down as follows. The 401(k)s and their cousins, like 403(b)s and 401(a)s. As well the roth 401(k)s are employer sponsored plans. One of the biggest mistakes people make is not contributing to these plans. Because, in addition to tax deferred saving. You usually get some employer matching contributions. That is, if you contribute, say, 4% of your salary, the employer might kick in an additional amount.

Say 2%, 3%, or even another 4% of your salary. If you don't contribute yourself, you don't get these contributions from your employer. That's not so much a tax consideration, it's just an important opportunity for you to receive compensation from your employer. If you don't contribute yourself You're leaving additional compensation on the table. In contrast to 401(k)-type plans, IRAs, be they the traditional or roth variety, are purely individual plans and are not tied to the employer. Second, there's the question of how contributions, investment earnings, meaning capital gains, dividends, and interest, and withdrawals from accounts are taxed. Here is how that breaks down and how it compares to a taxable account. I'll go through some examples in a moment, but just observing the table let's look first at the taxable account. Meaning investments outside of a 401(k) or IRA or any of these other tax-deferred options. In the taxable account You make contributions in after tax dollars and you pay capital gains, dividends, and interest taxes on any investment income. But withdrawls from the taxable account are not taxed. Now the simplest point of comparison to that is actually the roth IRA. In a roth, you also make contributions in after tax dollars. But you do not pay the interest taxes, dividend taxes, or capital gains taxes. That is your money grows tax free. And like a taxable account, you also pay no taxes on withdrawals from a roth. So a roth IRA is really like a taxable account but without the taxes on the investment income. No interest taxes, no dividend taxes, and no capital gains taxes. And then the Roth 401k has the same treatment as the roth IRA, it's just an employer-sponsored plan. Next consider the traditional 401(k) and the traditional IRA. The difference between these traditional plans and the roth model is that here the contributions are paid out of pre-tax dollars. But then all withdrawals are taxed at the ordinary tax rate TAO when the money is taken out. The roth is the opposite of that. Contributions are after tax and the withdrawals are not taxed. The traditional IRA with nondeductible contributions is more complicated. I'll only have time to come back to talk about that briefly, later on. Now conventional and roth retirement accounts may seem to be very different, in terms of when the taxation is occurring. But actually, if tax rates are stable over time, then they offer very similar If not identical tax benefits. Let's compare an individual who wants to use $5,000 received as wages to save for retirement. And suppose he's comparing three options, a traditional plan, a roth plan, and a taxable account. Well in the traditional plan he will receive the $5,000 as wages and will not have to pay any tax on it. It will be an elective deferral. He'll invest the 5,000 will which grow at some compound annualized rate r over a certain number of years t, at which point you'll have to pay tax TAO, on the withdrawals. That is ordinary income tax rate. So at the end from the traditional plan, he's left with 5,000 times 1 plus r to the power of t, times 1 minus the ordinary tax rate TAO. Let's compare that to a roth plan. In a roth plan, the individual will receive the $5,000 as wages, pay tax on it, so he's actually start investing only 1 minus TAO, the ordinary tax rate, times the 5,000. And then that amount will grow at some compound annualized rate r, over a certain number of years t. So that the end of the day or the end of his Working career from the roth, he will have one minus TAO, times $5,000 times one plus r to the t.

But these two expressions, what you get from the traditional plan at the end of the day, and what you get from the roth at the end of the day, are mathematically equal. At least they are under one key assumption. On the other hand, the federal government has been running large budget deficits, and state governments also have large unfunded liabilities. That suggests that tax rates overall are likely to rise. Of course even given the government budget deficits. It's not a certainty that tax rates on income will rise. For example, the US government could decide to implement a large national value added tax, a VAT, similar to a sales tax. And it'd actually lower income tax rates, and that might even raise more revenue. So, if you used roth accounts in expectation of higher income tax rates in the future. You'd be disappointed if the taxes on your withdrawals, ended up being lower than your tax rates today. With the government making up the difference with a sales tax. The fact that there's uncertainty about tax rates. Suggests that an approach of diversifying across roth and traditional TDA arrangements, where possible, is a good idea. That is, you should probably try to do some of both. Of course, compared to the other option, the taxable account, both the roth and traditional retirement account structures save money. In the taxable account, the individual would receive the $5,000, pay tax on it, so that he's actually investing 1 minus TAO times 5,000. Then he'll earn investment income on it at rate r compounded over a certain number of years t, but that investment income will be taxed. Probably each year, and possibly at a rate as high as the ordinary tax rate TAO, if it's interest payments. But at least at some rate resulting from dividends or capital gains. I'll just write the investment tax rate as it is taxed as TAO investments. And you can think of that as the effective annualized, tax rates on the investments as the earnings are being, are being earned. So the investor will end up with at most 1 minus TAO times $5000, times one plus r, times one minus this investment tax rate to the power of t. Which is less than he gets from the traditional or roth retirement accounts. Namely one minus tau, times five thousand,times one plus r, to the t. The big difference is the avoidance of the taxes on investments, in the TDAs. And note that even if the investor in the taxable account could avoid paying investment taxes every year, as I've written here. Snd could just pay them at the end by selling his position at the end. He would still have less than he would if capital gains taxes could be avoided entirely. How much you can contribute to the various types of TDA's is restricted by the IRS. And those amounts change each year. In 401(k)s, how much you can contribute depends on your age. With so called catch up contributions being allowed for people over age 50. In 2013 employees under age 50 could contribute a maximum of $17,500. And if the employer wanted to, they could provide additional contributions, either matching or basic without any requirements. Up to a total employee plus employer contribution of $51,000 in that year. The limits are somewhat higher for people over 50. As for IRAs, the amounts you can contribute are considerably lower. The most, you, as an individual can contribute to a traditional or roth IRA is $5,500 in any given tax year, if you're under 50.

And $6,500 if you're over 50. For married couples, each person can contribute the amount, but there are further limitations. The main three are, first, income limitations to the roth. If you're married and make more than $178,000, you won't be able to contribute the total amount to the Roth. And at above $188,000, you won't be able to make any contributions at all to a Roth. Second there's an age limitation of traditional, but not roth IRA's. If you're over 70 and a half years of age at the end of 2013, you cannot contribute to a traditional IRA, but you can contribute to a roth. And third, there are income limitations and limitations on what you can do if you have retirement plan at work. Such as also being in a 401K, and those may mean that your contributions to traditional IRA's might not be tax deductible. That is they'd be considered as a nondeductible IRA if you made them. In a nondeductible IRA, the only benefit relative to a taxable account, is that you can postpone paying taxes on the gains and investment income, interest, dividends, et cetera until withdrawal. But a drawback of the non deductible IRA is that all of those gains and investment income are taxed when you withdraw at the ordinary tax rates TAO. Rather than any of the preferential capital gains and dividend tax rates. So that noted up for IRA by of some value of bonds which pay interest tax at ordinary rates. But seems less likely to be valuable for stocks which pay capital gains and dividends. Taxed the preferencial rates and may even come at a cost, when you consider that you don't have to realize capital gains in stocks every year. Because the limits on IRA contributions are so low, it's surprising to sometimes find out that people have built up very large IRA balances. That's largely because of what are called rollovers. When you leave a job with a 401(k), you can roll it over into a traditional IRA, without creating any tax liability. And you probably should do that since then you can choose the provider of the IRA. And you can often choose a provider with more low cost, diversified mutual funds and ETFs than 401(k) plans attached to an employer typically provide. Rollovers into roth IRA's entail more important tax consideration options which I'll discuss in another segment. A final consideration about IRAs and 401(k)s is when you can withdraw the funds without penalty. For a 401k you must be age 59 and a half or older to avoid being hit with a 10% penalty above and beyond the ordinary income tax. Although there are some exceptions that might all access without penalty as early as 55. After age 59 and a half, you can take withdrawals from a 401(k) whenever you want. But if you withdraw too much at once, you'll push yourself into higher tax brackets. The withdrawals can be used for any purpose. They most commonly are used to finance consumption or to buy annuities. Now once you reach age seventy and a half, you actually have to start taking distributions. These are called required minimum distributions or RMDs, unless that is you're still working. Now there are various calculators that you can use to calculate these RMDs. RMDs for traditional IRAs work in a similar way, although you can't delay them by continuing to work. For roth accounts there are warranties until the death of the owner. Which is the usually viewed as another advantage of roth plans, but these rules are now getting more into estate planning rather than retirement saving so I am not going to them in detail. But the bottom line is that the government has regulations that will force you to eventually take distributions from IRAs and 401(k)s and to pay taxes on those distributions where required.

So to recap in this segment we went through the tax advantages and limitations of the different types of tax differed accounts for retirement savings. Employer provided plans like 401(k)s often come with employer contributions. And in many cases, those employer contributions only come if you yourself also contribute. So one key takeaway is to make sure that you're not leaving any money on the table, that your employer would be giving you if you were contributing to 401(k)s. If there are no employer contributions, or if you do not have access to an employer provided account like a 401(k) then IRAs may be useful vehicles. Although the contribution limits can be low. And some high earners may be ineligible. Another advantage of IRAs, is that you can open them with whatever provider you want. Seeking out the provider who has the lowest expenses for diversified portfolio investments. As for the roth model, tax now, no tax later, versus traditional model, no tax now versus tax later. We saw that it really comes down to whether tax rates on earned income and/or retirement income, will be much different in the future than they are today. That's not knowable with any certainty, so some hedging across the different types of accounts may be warranted. Importantly, we did not yet address the question of whether you should pay to convert a traditional retirement account into a Roth. That's something we'll take up in another section. It turns out that this analysis not withstanding, there can be additional reasons to want to convert traditional accounts to a roth. 8.5 - Strategies for Minimizing the Tax Burden Strategies for minimizing the tax burden. In this section I'm gonna briefly discuss several strategies, for optimizing your tax situation, using tax deferred accounts. Now clearly the first thing you need to do, is not waste the opportunity to contribute to tax deferred accounts, 401k's and IRAs. If you have a lot of investments outside of these accounts, and have not maxed out your opportunity to contribute to them, you might consider trying to contributing more, going forward. Contributing more has the disadvantage, that you can't access the money if you absolutely need it, without paying tax due on it, if it's a traditional plan, not a Roth plan. Plus, a 10% penalty in either case. On the other hand, a behavioral economist would say that it could serve as a commitment device not to access that money until retirement, tying your own hands, if you will. There are two strategies I want to discuss here. The first, is that of optimally locating different types of assets, across taxable and tax deferred accounts. The big issue here is, if you invest in both bonds and stocks, and you have some taxable accounts and some tax deferred accounts, where do the bonds belong and where do the stocks belong? Should the bonds be in the taxable account, and the stocks in the tax-deferred account, or should the bonds be in the tax-deferred account, and the stocks in the taxable account? This is a situation where for many people, the intuition that they have about stocks and bonds leads them to fail to make the right decision. Let's look at two scenarios. First, bonds in the taxable account, with stocks in a tax-deferred Roth account. And second, stocks in a taxable account, with bonds in a tax-deferred Roth account. I chose Roth accounts here as the tax-deferred account. So that we wouldn't have to think about the extra step of taxes owed on withdrawals, although there is an analogous example, you can do with traditional tax deferred accounts.

Let's suppose the bond return is 4%, all from interest payments, and the stock return has two components, a dividend yield component at 1.5%, and a capital gains component of 2.5%, also for a total return of 4%. Now interest is taxed at an ordinary marginal tax rate. So let's say, that's 35% and dividends and capital gains are each taxed at the qualified dividend, or long term capital gains rate of 15%. Let's start out with $10,000 of bonds in a taxable account, and $10,000 of stocks in a tax deferred account for a total of $20,000. Well, the bonds will earn 2.6% net of tax, in the taxable account. That's 4% times 1 minus the 35% marginal tax rate. And the stocks will earn the total 4% return, because they're in the tax-deferred account. This will give you total resources in one year of $20,660. Now, let's flip it around, and suppose you have $10,000 of stocks in the taxable account, and $10,000 of bonds in the tax-deferred account. What happens at the end of one year? Well, you now have the net of tax return on the stocks of 3.4%, total. That's 1 minus the 15% capital gains or dividend tax rate, times the total 4% return on the stock, which is broken down into a 1.5% return from dividends, and a 2.5% return from capital gains. And you get the gross return on the bonds of 4%, because those are in the tax deferred account. Now since the stocks were more lightly taxed anyway, you get more bang for the buck of the tax shelter, with the bonds in the tax deferred account. As a result, you end up with $20,740 after one year. This suggests a value improving transaction that you could potentially undertake, if you look at your accounts and they look like scenario one. As long as the stocks, that were sitting there in the taxable account in scenario one, didn't have embedded capital gains that you'd have to realize when you sell them, to move them into some other security. You could move those stocks into the same bonds that had been in the tax deferred account, and at the same time move the bonds that had been in the tax deferred account, into the same stocks that you had previously had outside the tax deferred account. And presto, you've created around $80 of after tax value, one year from now, for no work at all. And of course, over longer periods of time, you can create much more value. By the way, I assumed here that at the end of one year, you would have to realize the capital gain on the stock in the taxable account. Of course, you do not. So if you consider that you can possibly defer the capital gains tax for a very long time, this analysis becomes even more compelling. Obviously, there's a point where if the equity return is high enough above the bond return, then you might want to shelter the stocks instead of the bonds. But that return has to be very high, to outweigh the fact that bonds make constant streams of payments, taxable at ordinary rates. Whereas, where many stocks are mainly taxed at sale, and only at much, much lower capital gains tax rates. The second thing I want to address is converting traditional 401(k)s and traditional IRAs to Roth accounts. You have several options with 401(k)s from jobs you have left. You can keep them where they are. Not always terrible, but it depends on whether the funds you have access to there, include inexpensive index funds. You can roll them over to a traditional IRA, which has no tax implications, and basically, just allows you to choose your provider. Or you can convert them to a Roth IRA, paying taxes on the entire balance now, but never paying any other taxes on it again. And there are no income restrictions on that strategy. We've seen before, that

the tax benefits of a Roth versus a traditional account depend on whether the ordinary income tax rate when you withdraw, tauT, will be higher or lower than it is today, tau0. And the relative tax rates between today and tomorrow, are indeed an important consideration in deciding whether to do a Roth conversion. But it turns out that even if rates are gonna be the same, it may still be beneficial to do the conversion, if you can come up with the money to pay the taxes. That is because the payment of taxes from non IRA assets, is actually allowing you to scale up your tax deferred saving. If you do the Roth and pay the taxes today, you'll have $50,000 of money in the account that will never be taxed again. If you do not convert, you'll have two things. $50,000 in the account that will be taxed, so that you really only have a claim to 1 minus tau times 50,000 of it, and you'll have tau times $50,000 outside the tax deferred account. So if you contrast that with the post-conversion situation, where you have $50,000 of investments on which you'll never have to pay any more tax. Here you have 1 minus tau times 50,000 of investments, on which you never have to pay more tax. And tau times 50,000 on which you have to pay regular dividends, and capital gains taxes. So converting to the Roth, buys you more access to tax deferred savings. There are many additional considerations. You need to consider the effects the conversion will have on your tax bracket, in the year of the conversion, as well as how your state taxes, Roth IRA conversions. For example, in Illinois, Roth conversions are untaxed. In California, you're probably paying a 9.3% state tax rate on the entire balance. One could also analyze the option to actually pay for the conversion, out of the 401(k) assets as necessary, with a 10% penalty. As well as the fact that until October of the year following the conversion, you have the option to recharacterize, or basically, take back any Roth conversion done in the previous tax year. So in this segment, we examined two considerations in tax planning for retirement. First we discussed how you should optimally allocate stocks and bonds, across TDAs and taxable accounts. The key principle there, is that you want to put the most heavily taxed assets in the TDA, which is usually bonds. Second, we discussed the idea of converting traditional IRAs, and traditional 401(k)s into Roth accounts. If you think tax rates on income are likely to go up, and you have some resources to pre-pay taxes today, converting to a Roth could be a smart tax planning strategy. Even if tax rates aren't going to go up, there's an advantage to paying for a Roth conversion, because you can access more tax deferred savings. Converting to a Roth, however, requires the liquid resources this year, to make the tax prepayments. If you wanted to make tax payments out of the funds that were in the tax deferred account, you'd have to pay the 10% withdrawal penalty on the amount that you're using to pay the taxes. 8.6 - Overall Recap So what are the key considerations about taxes and investments? The biggest difference between taxdeferred accounts, TDAs and non-TDAs, is how your investment earnings are taxed as you're earning them, essentially phase two of the investment life-cycle that we began with. If you're saving for the long term, you should not miss the opportunity to contribute to tax-deferred accounts.

If you're saving and investing outside a TDA and have not maximized your use of TDAs it's likely that you're paying more tax than you need to pay. Employer-provided plans like 401Ks often come with employer contributions. And in many cases those employer contributions only come if you yourself also contribute. So you don't want to miss those. As for the ROTH model, tax now and no tax later, versus the traditional model, no tax now and tax on withdrawal, it really comes down to whether tax rates on earned income and or retirement income will be much different in the future than they are today. That's not knowable with any degree of certainty today, so I advise some hedging across these different types. What have we not yet covered about saving and investing for retirement in individual accounts? Well by now you should have a good idea of the distributions of outcomes that stocks and bonds expose you to, as well as where to locate different types of investments in tax deferred accounts. So the next logical step to bring it all together is to examine how you should allocate assets across different investment choices over your investing life-cycle. Team Project: State and Local Pensions 1 - Team Project: Key Documents for Data Collection Hi everybody. In this screencast I'm going to walk you through some of the steps you're going to need to complete the group project, which is about the fiscal impact of public employee pension systems on the governments that sponsor them. Now the first major piece of this exercise I've asked you to do involves data collection. You're gonna need to collect a, a bunch of data to be able to, to analyze the systems. Each public sector pension system in the U.S. produces two reports that are gonna be very key for you to obtain in order to do this exercise. The first report is the comprehensive annual financial report, or CAFR, which we often say as cafer, it's pronounced cafer. Of the pension system, that's the first major report is the CAFR of the pension system. And the second major report is the Actuarial report of the pension system. The cafr is the report that includes, basically all the financials, the kinda of the main financial of the flows in the balances of the, of the pension system. The Actuarial report is the report prepared by the actuaries it includes the details of how they arrived at calculations about the present value of the pension liabilities and about the ongoing costs of the pension system. Particularly the normal costs and the employee and employer contribution shares. Now, these two documents the CAFR and the Actuarial report are the key critical sources, where you're gonna find the data about the pension system, that you choose to analyze in your project. Unfortunately, these reports are not standardized in their format across states and local government. So that means, every report has a different layout. And sometimes even different definitions of the various data items. And also there's no central repository, for all of these reports, you'll have to go to your pension system's website, and obtain the reports that way. Now recall that each public sector pension system in the US is sponsored by a state or local government. So, additional documents of interest are gonna include the reports that are issued by that government, by the sponsoring government. So those include the annual financial reports and the budget documents that are issued by that government.

Sometimes, the main document is also called a comprehensive annual financial report or CAFR. So this government level CAFR is distinct from the pension fund CAFR. The government level CAFR contains information on data items such as total revenues or tax revenues, ex-, expenditures by the sponsoring state or local government. So let me give you an example that's gonna be that we're gonna go through right now. the example is the California Public Employee Retirement System, or CALPERS. CALPERS publishes a CAFR, a comprehensive annual financial report. And so does the State of California. The State of California also publishes a CAFR or comprehensive annual financial report. The city California is the sponsor of CALPERS. And so these two CAFRs are gonna be the two CAFRs that you're gonna need. To be able to complete the assignment. now of course, you're also going to need the actuarial report of the pension system of CALPERS that will contain additional information. 2 - Team Project: Collecting and Recording Data, Part I Using CalPERS as an example, I'm gonna walk you through where to find the data for the project. Now this means, you'll not be allowed to choose CalPERS yourself, you'll have to choose another system. The first thing we need is the comprehensive annual financial report of CalPERS. So I'm gonna Google CalPERS comprehensive annual financial report. Okay. And here's a link to the comprehensive annual financial reports of Calpers. And we're gonna take the latest one, June 30th, 2012. And that opens as a PDF file, which we'll then, the best thing to do is actually to save it out of your browser, because you're gonna wanna be searching around these things. Let's start collecting some information. So I've provided for you a shell spreadsheet document, which contains titles of the data items that I want you to collect. So going through the data items, I want you to collect in the write-up of the assignment, in the assignment questions. You shouldn't rely just on this shell spreadsheet. You should go through everything that I've asked you to do in the, in the write-up of the assignment questions. And make sure you're collecting everything. And now it maybe I want to note ahead of time, maybe that you have to add columns to this spreadsheet to make it fit the information that you're able to collect from the pension system. And that's fine. It also may be that some of the data items here are not available in the CAFRs and actuarial reports of your pension system. And that's also fine. What's important is that any time you have a column heading, then that column heading is really suitable for the data item that you're collecting. So, alright, this will all become clear as we start actually doing it. So let's enter some general information first. So we have the name of the plan. So it's the California public employee retirement system. We then have the abbreviation of the plan, that is CalPERS. Next we have the name of the sponsoring state or city. That's going to be the state of California, and we have the year end date of the report. That's going to be June 30, 2012, because that's the report that we took. Now, there's a Note field here, if there's anything we want to note about the system and its components.

And here I'm going to note something that I, I know about CalPERS, and that you would figure out if it were your system. Of course you can't do this system, because I'm doing it for you but, you would figure out that it actually consists of a number of different subplans and subsystems. So CALPERS consists of what are called the PERF or PERF systems. Those are three. The state employees. The, non teacher school employees. And then the cities that participate in CALPERS. Those are called the public agencies. So, those three PERF groups, and then there's also some smaller plans, legislators and judges and things like that. So the note I want to make is that I'm going to focus on the PERF plans because the PERF plans really make up the bulk the program and those are state employees, school employees, and public agency employees. Those are the employees of cities who participate in CalPERS. Okay, now, let's move on to actually collecting some data items. So the first numerical data item is the membership of the funds. So these are numbers. Now I'm I'm gonna search in the PDF here for for membership. Okay, so the best way to do that is to do it, is to find. And we're gonna search for the, you know, search for the word membership. That's a good way to start finding this. And, you know, that word's going to appear in a number of different places here. It appears in the table of contents, here it appears in the middle of a paragraph of text. But if you, if you keep searching through, you'll find that you pretty quickly get to a table that actually shows you the number of members in in CalPERS. In particular, in the PERF systems. The state employees, the school employees, and the public agency employees. And so this is a table here from which I'm gonna collect the membership information. Cause we've got the, the PERF, systems, and we have the number of retirees, the number of survivors and beneficiaries, the number of active members, the number of inactive members, and the total number of members. So these are the data items that I'm gonna collect. Okay. So the first data item here in the spreadsheet. And also listed in the assignment are the total covered individuals in the plan. This is basically how big is CalPERS in terms of total individuals that are in the plan, either as retirees or beneficiaries or survivors or inactive members or currently active members. So the total number of covered individuals is in the table. These are the PERF only plans. That's 1,646,162. Next, we have the total number of active workers. That's also in here, it's members active. That's 786,586. Next, we have the total number of retirees. That's also in the table. 477,728. So, next we have the categories beneficiaries and survivors. These are people who are receiving who are not the initial retiree but somebody else. So here we have these separated out in the table, however we only really got survivors and beneficiaries put together. That's going to be 65,994 people and you can see we don't have beneficiaries and survivors separated out. And that's fine, we're gonna leave those blank. You know, some systems might only have retirees plus beneficiaries plus survivors all aggregated together. It might not break it out into the retirees, and their survivors or beneficiaries. And so, for that reason, we're gonna leave this column blank as well here. Although we could actually, if we wanted to, we could find out what this number is, just by simply adding these two. So why don't we, why don't we do that. So for 543,722. All right. Next we have the inactive employees. So these are employees who have worked for the state of California or for the,the non

teachers school employees or for the public agencies but are no longer working but could potentially in the future be entitled to a pension so we have the total inactive membership here. And that's listed in the table as 315,854. Okay so the next set of data items we need to collect are about the pensions assets. The assets that are sitting in the, in the CalPERS pension fund that are being invested. now CalPERS is one of the biggest systems that there is. It's the biggest public employee pension system in the US. So we're gonna find hundreds of billions of dollars of assets in this system. Now, let's go to the report. There is usually, at the beginning of the report. There's usually some, a table that is more or less a standardized table about the assets that are, that are in the pension fund. So let's, let's go see if we can find that. The way I usually find that is, is actually literally just by flipping through the document from the beginning. You know, here we have a table, net assets. And that's gonna give us the total net assets of the fund. So, let me show you that number here. $236,981,945,000. And note that these, these numbers are in dollars, in thousands. When we paste them into the spreadsheet, we're actually gonna wanna make sure that we're pasting them in just as dollars. so we're going to have to add some zeros. $236,981,945,000, and it probably isn't exactly zero, zero, zero at the end, but we don't, we don't care once, you know, we're rounding. This is a multi-hundred, multi-billion dollar pension system, we don't really care about amount is less than 1000 dollars here. Okay, so the next item, is what's called the actuarial value of pension assets. And you can think of this as, this is the value that actuaries kinda carry around the assets at, when they kind of write down how much the assets are worth. And what they've done is they've smoothed out the volatility in the assets, in order to try to, what they view is getting a better, kind of smoother picture, that doesn't show the ups and downs of the of the movements in the value of the assets. Now, most finance-oriented people kind of prefer to see the market value figure. This is what's called a marked-to-market number. This is really the value of the assets if Calper's had to sell them on that day, on June 30th, 2012. And the actuarial value sort of assumes that there's some ups and downs in the market that could be smoothed out. And from a finance perspective, we think that, that's probably not really a great thing to do because if it were so predictable what direction assets would move in, then there would be arbitrage opportunities and trading opportunities that people could take to exploit those. So you know, in finance, we generally think that the best measure of the value of the assets is the market value on any given day, but actuaries measure the assets differently and it's gonna be smoothing out the volatility. So let's look for the total pension assets actuarial value in the report. Okay, so here what I'm gonna do is a search, Ctrl+F, and I'm gonna put in actuarial value of assets. Okay. And it appears that word appears, those words appear in text a lot. We're really looking for is a table that looks like this. This is a pretty, pretty standard table you will see in many reports. here we have the actuarial value assets. This is as of June 30th, 2011. The actuarial value of assets is 271389. So that's 271 billion 389 million. So I'm gonna select this number here, I'm gonna copy it, and I'm gonna paste it into the spreadsheet.

And this is gotta be in dollars. Right now it's in millions of dollars. So what we need to do is add some zeros. And you can see that the actuarial value of assets, the value, the smooth value of the assets the actuaries are using on the, there is a much larger than the net assets at market value. One other issue that's going on here is that this smooth actuarial value actually is of 2011, so I'm gonna add something here that just is gonna be date of actuarial value. And that's gonna be June 30th, 2011. Okay, the next thing in the spreadsheet are the pension liabilities. And the first thing is the accrued actuary liabilities of the pension system, called the AAL. This is the system's own measurement of the present value of liabilities, usually at discount rate that is the expected return on assets. Which as we, as we discussed, is not consistent with the principle of financial economics, but it is really the, it's the going way that the systems do it. So one of the things you're gonna have to do in this project, is try to do some corrections of this to account for the fact that liability should be discounted at rates that reflect the risk of the liabilities, or the lack thereof. As opposed to the expected return on the assets. So let's find the AAL of the liabilities and pension system in the report. And this happens to be in the same table as what we were just looking at. But now we want the accrued actuarial liability. That's this guy here. And actuarial accrued liability. And that's 328 billion, 567 million dollars for these PERFS plans. And remember, we need this number to be in dollars. So I'm gonna add some zeros so that it is. Okay. The next thing this spreadsheet calls for is the discount rate used to calculate the accrued actuarial liability. What we've learned in the course is that, from a finance perspective, we should really be using bond-like discount rates. If we want to measure the actual cost of providing this liability, providing this benefit under the assumption that it's not going to be defaulted on. You want to use default-free discount rates, such as those from a Treasury, US Treasury yield curve. If we want it to reflect the perspective of taxpayers that the state might default on these obligations, and that perhaps taxpayers shouldn't be as worried as they might be if they had to buy treasury bonds to match the liabilities, to diffuse the liabilities. Then we could use a rate that's a little bit higher like a state municipal bond rate, but that would only be to reflect the possibility that the state might default. What this column is asking for is just what's the discount rate that the system itself used to calculate the accrued actuarial liability. So usually that's gonna be on the page after this table that we've just been looking at about the assets and liabilities, or before, or some, somewhere right, right around that page, we're gonna be able to find this information. So here we have a large table about actuarial information about the about the PERF funds. Remember, we're focusing on the, on the PERF funds. And here we can see, if we look down, we've got the some dates, some Amortization methods and Asset Valuation method. So you could see they smoothed the market value of the assets. Those are the assets we just collected. And then here we have the Actuarial Assumptions. Here's the net investment rate of return. That's the discount rate that they used. That's 7.5%. Next spreadsheet asks for the unfunded accrued actuarial liabilities, or UAAL. That is usually just gonna be a simple difference between actuarial value of liabilities and the actuarial value of assets. Note that if we

correct these liabilities for the fact that they are mis-measured, that they are measured using this expected return, of seven and a half percent. Then we're going to find that, actually, the unfunded liabilities are much bigger. This number is is really just the number that the system's own reporting implies that the unfunded liabilties are. And part of your assignment is going to be to try to get a better estimate of what the system's actual economic unfunded liabilities are. Now we want to check this number against the report to see if it actually makes sense. We're looking for something around 57,178,000,000 dollars. So let's look in the report, actually in this same table, as we had seen before. We can see that that number is actually indeed what they've got here, $5 billion 178 million. Okay. The next column on the spreadsheet and also in the, in the write-up of the assignment that I gave to you asked for the type of liability measurement. So this is regarding what liability concept they're using. Are they using an accrued accumulated benefit obligation? Are they using a present value of benefits? Are they using an entry age normal? Most of the time, most of the systems will use this entry age normal method we discussed in one of the lectures. But sometimes, they'll use other methods. So let-, let's go and check and see what they're using. So this information is also going to be found in the actuarial information table. And here where they're talking about the actuarial cost method. This method is the individual entry age method. So we're going to put an individual entry age. That's basically an entry age normal method. Okay, scrolling over the next items in the spreadsheet are what I refer to as the flows. We've already done the stocks of assets in the systems. We did the market value of assets and the actuarial value of assets, now we're going to look at the flows of the assets. So by flows, I'm talking about things like the total benefits paid out of the system, the total refunds of contributions the system made to people who left and had some claim to get their contributions back. These people, those people wouldn't actually get a pension when they retire. They would just be able to have the right, to get their contributions back. We're also looking at, the total administrative expenses of the system. Those are the flows that go out of the system to various managers of the money. We've got the investment income. That's money that's hopefully coming into the system if they earn money in a year. But maybe going, maybe a negative number as money goes out of the system. And then we have contributions which I've divided into two groups. As is common we have the total employee or member contributions and then we have the total government contributions. So let's look at the report to figure out where this information is. And, again, this kind of information is usually towards the beginning of the, of the CalPER. You can find a a table that's got information about the flows. So, pretty near we had the net asset table. We've got these changes in net assets here. Changes in the assets, and, and, and there, you can see this table has got this information pretty well at hand. There's another table that's, that's in this report that's also actually extremely nice. I've looked through this report before, so I, I know where to find it. You could find it by searching for contributions, or searching for, for benefit payments. It's on, in this one, it's on page 152. But it looks like this. it looks like this where it's, it's got a ten year review of all of

the flows in and out of the funds, so this is a really nice table, cuz it's showing us that in the year that ended in 2012, that's this year here, 2011/12, the total benefit payments were $15,356,696,000, we've actually got this information going back several years. Now in the assignment, I've asked you to actually try to collect this information for your system, going back a few years. So if you can find a table like this, it's really useful, because we can actually collect all five years of this data, all at once. So I'm going to put all of this, in the spread sheet. Now, okay, so where's the best place in the report to find the flows? Well, most of the reports are gonna have towards the beginning near the assets table that we looked at also something about the flows, the changes in the assets. So if we just flip through the report at the beginning we'll see, remember this was the, the assets table we used. We had the total net assets of around $237 billion. and below that we've got the changes in net assets which is nice cuz we've got the member contributions, we've got the employer contributions. We've got the investment income and these other data items. Now I've looked at this report a little before and I can see in this report that actually there's a really nice table. That's later on in the report. And you can find this my searching through the word contributions or benefit payments. This tables on page 150. We've got some really nice break downs here. That have member contributions, employer contributions investment income and other income as well as further breakdowns on the follow pages. And what's, what's, what's great about this. Is what we've actually got, is we've got the information going back a number a years, and remember in the assignment I've asked you to collect data going back a few years and here indeed we have enough information to go back around five years. So this information from these tables can all be entered into the spreadsheet. Okay, next we're gonna go to the asset allocation part of the spreadsheet. In this part of the spreadsheet we track how the roughly $237 billion of funds in Calpers are actually invested. So let's go back to the report. In the report, usually the asset allocation comes sort of toward the beginning. And near the general summary table. But it varies from report to report. In this one, I'm just gonna flip through from the beginning. You see this pie chart that we have over here. Here's the pie chart with the investments. And then we have this nice table here. Now the assignment asks you to try to collect around five to ten categories of asset allocation. The categories have to add up to a 100%. You'll find that in some systems, they report more categories. In others, they report fewer. So for example, in Calper's here, they've separated out domestic equity and international equity into two. Different categories. There are other systems that will just tell you equity. and then those two categories would be combined. So this is a part where you're gonna have to pay close attention to the headers in the Excel spreadsheet. So I set up the Excel spreadsheet with the same categories as CALPERS has, in this report. If you had a different category, or a category that didn't have one of these headers. Then you should definitely add that column to the spreadsheet. So we have 1.9% short term investments. We have 25.2% domestic equity. We have 23.3% international equity. We have 19.9% domestic debt. We have 1.5% international debt, we have 3.0% inflation assets. These are inflation linked assets. We have 10.6% real assets, and then we have 14.6% in private equity.

3 - Team Project: Collecting and Recording Data, Part II The next segment of the spreadsheet looks at the State and City level variables. Now, for this, we're going to need totally different CAFR. We're gonna need the the State's CAFR not the Pension CAFR. So I'm gonna have to pull up the browser and Google the state of California CAFR. And indeed here we have the state of California's website with the comprehensive annual financial reports here. This is the Controller's website. And we here have a 2012 comprehensive annual financial report. So, as usual, the best thing to do is to save this as a separate PDF document. That makes it easier to search through it. Okay, so in this report, we need to find the main table that shows the state of California's revenues and expenditures, with breakdowns into what those different categories of revenues are. Expenditures we're just gonna collect. Total expenditures. this segment is often called changes in net assets, because the state thinks of, of income revenue as increasing their net assets and expenditures as decreasing them. So if we just flip through this a little bit. Actually towards the beginning in the financial section. Whoop. There it is. You should pretty much be able to find the changes in net assets. And here we have the key data items of interest. So we have total revenues, which for the state of California's business activities were $185 billion 283 million. We also have their business type activities. So, here they're doing more charging for services. And this is for activities, such as providing electric power, water resources, the state lottery, things like that. and then we have a we have a, a total. Okay. So now we're gonna enter these numbers into the spreadsheet. So for revenues, we had $218 billion 603 million. For revenues that came from taxes, we have $104 billion 256 million. And then all other revenues is simply the difference between these two items. Okay, next we need these data items that are really only findable in the CalPERS actuarial report. Now here we have to go for the normal costs and the features of the plans we've really gotta go to the to the, to the CalPERS annual financial reports. And, you know, I mentioned before that CalPERS has these different sub-systems. They're the three major PERF systems which for the state employees, the non teacher school employees and the public agency employees. And then there also the smaller plans that are not part of the PERF funds. So, in the case where you have that going on, this might happen in some of your systems. I've asked you to just collect two of the primary sub plans. So when we looked at the actuarial report, you'll see what that looks like. That we will be collecting normal cost and planned features for just two of the, of the sub plans of CalPERS. Okay, so now I need to do a Google search for the CalPERS actuarial report, and what I've found here is the actuarial report website of CalPERS. We can click on that. And you can see that they've done the actuarial reports for all of the different subcategories of CalPERS, the sub funds, all these little, these little ones separately. There's a judge's retirement system that's part of CalPERS. Legislator's. But again, remember the, the key ones are the state and schools and the public agencies.

Now I'm gonna focus on the state and schools. Those are the two big ones I'm gonna chose to do. And for you, when you chose which of the two sub plans you wanna do for your system, you'll have to a little bit of digging into the system and figure out what are the sort of biggest and most important and most sensible ones to look at. So for, for CalPERS, I think it's the state employees and the non-school, non-teacher school employees. The public agency employees are, of course, very important as well. These are all the employees of all the municipal governments that participate in CalPERS. That's very fragmented, however, and I wanna collect some information about the pension parameters for the major parts of CalPERS. So that's why I'm going to focus on states and schools. So here we have the evaluation report. This is as of June 30, 2011. I'm gonna enter in the data of the actuarial report, usually the actuarial evaluations lag a year behind the release of the information about assets and revenues, and contributions. It's sort of easier and more immediate for the people overseeing the finances of these systems, to be able to tell us what assets are in the pension fund, and what flows of money are going in and out than to calculate present values of liabilities which require various actuarial assumptions and details. So often there's a lag of the present value of the liabilities in all, lag in general, the, of the actuarial reports. So here, this is for the 30th of June 2011. Now the data items I want to collect are the normal costs for the two major plans. we're gonna have to put in whether these normal costs are for the employer only or the total. Remember the normal cost is the present value of new benefit accruals. Think of that as being the sort of ongoing compensation cost of providing, of offering this pension system to the employees. It's the, the change in the liability that is due to additional years of service, additional work that is put in by the, by the employee. And sometimes it's reported as a total. Sometimes it's reported as an employer-only normal cost, which is to say it the total is gonna be the employer-only normal cost plus whatever the employee contributions are. So we'll have to enter here whether it's an employer only or the total. Now there's plan one and plan two. I asked you to collect the two major plans here for for the system. So for CalPERS I'm gonna pick two major ones. And then I'm gonna collect the features of these things information about benefit factors. The definition of pensionable salary. COLA's another post-retirement benefit increases the retirement ages and the vesting rules. And we're going to collect those features for both of the plans. Okay, so to determine which of the plans I'm gonna collect here, I'm gonna scroll through a little bit. I'm just gonna look at how the report is laid out, it looks like they're breaking it down into the following categories here, we have the state and miscellaneous employees here, that's one, that's the first category, and we have the state miscellaneous tier two. Then we have the state industrial employees, state safety, we got peace officers and fire fighters. California Highway Patrol, and they add all of those up see the subtotal of the state. And they have the Schools here. And just at a first glace, you know, it appears to me that the biggest plans is based on, I mean here we're talking about expected employer contributions not numbers of individuals, but it's gonna line up pretty well.

Seems like the State Miscellaneous Tier one and the Schools are gonna kind of be the biggest ones that we're gonna want to focus on. You know, we'll see if that continues to be the case as I look through the report a little bit more. And here we have some accounts of the numbers of active members in these different in these different pension systems. So we have members, active members in tier one 151,000 members in in the tier one state miscellaneous employees. We have altogether category state industrial, state safety, the peace officers, the highway patrol, and then the, and then the schools, and the schools have 291,000 active members, 656,000 active total members. So, so based on this, I'm happy with my choice of the tier one industrial employees and the school employees as being the information that I'm going to collect in this spreadsheet. So given that I'm going to go to the spreadsheet, I'm gonna put in the plan names. Plan one is gonna be the tier one employees, and plan two is gonna be the school employees. Let's collect the normal costs for these employees. Let's look at the report. I'm gonna search for normal cost, and this appears in a number of different tables here. Here we have the employer normal cost, but this is the present value of future employer normal cost. That's not what we want. We want the normal cost in a given year. Here we have the employer contribution amount that is derived based on the normal cost, so that's the number that we want. This is an employer normal cost, we have it for the state miscellaneous tier-one employees here. And we have it for the school employees over here. So those are the two numbers that I'm gonna, I'm gonna collect here. So I'm gonna copy those numbers into the spreadsheet. And we just need to think about the units here. Are the units right? This is $842 million, $843 million. This is $782 million. And that's correct. This is, this should not be in billions that earned, and if we added zeroes that would be, that would be too much. This is the correct units. We want everything in, in dollars. Okay, and we have to enter in whether this is the employer normal cost or the total normal cost, and this is, I said before, if we look at the, if we look at the report, you can see that this is a build up of the employer contribution amount. The idea is that the actuaries are helping CalPERS figure out what the different groups have to pay into the system, and that in, payment into the system is comprised of CalPERS estimates of the normal costs, the present value of new benefit accruals, and also, the, you know, payments towards the unfunded liability systems are making, or are supposed to be making. So here, this is only the employer normal cost, it's not the employee part. The employee contribution would be added to this to get to the total number of costs. So that's something one could do based on the information that you have all ready collected, actually. So we're gonna put employer only. Okay. Next, I wanna look at some of the features of the plans. Okay. And so that's something we can obtain here from the reports themselves. So this information about the features of the plans can be found in the actuarial report. And we wanna go to the part of the actual report that's got that information. So if you, you're gonna have to look at your actual report, and sort of find your way around. I mean, there's an awful lot of information in these reports. And I'll tell you that, in the CALPERS reports, what happens is, towards the end of the CalPERS actuarial reports, if we just kinda keep, keep going.

And there's all, all kinds of information here that I'll talk about in a, in a minute. If we keep going, we can find that there is an appendix that has really the rules of all of the, all of the, the sub plans. So if we look at the statements laying as tier one employees, it'll tell us here, you know, how you become eligible and what you are when you become vested, and when you have invested a deferred benefit and various other pieces of the benefit the, the aspects of the benefit formulas, and so on. So there's an awful lot of information here that one can collect. If you read through this, you can get the benefit information clearly. So having read through the tier one rules, the, the rules for the tierone industrial employees in, on page B1 of that appendix. And then if you move later on into the appendix, you can find the information about the plant features for the school employees further on in appendix B, is page 50, around page 50 or 52. I'm just gonna enter, enter those right in here. The plan one, the tier one has a 2% benefit factor, the definition of pensionable salary is the average of the members highest 12 consecutive months full-time equivalent monthly pay. We've got cost of living adjustments, and other post-benefit increases which are 2% per year but not to exceed the cumulative increase in consumer price inflation. The normal retirement age is 55 if you were hired before 2011. 60 if hired afterwards. There's an early retirement age of 5. That's the first tier one's eligible to receive any benefits and the vesting period is five years. Now I should say that if you really wanna do an outstanding job on this assignment you would really probably want to do more than just two plans. I mean the fact is, that is, y, you know as I've told you before. The, the peo, people who produce the best assignments and the best overall analysis of their pension systems, and the best overall policy recommendations will have the opportunity to come to Stanford to present their analysis and policy recommendations in front of some panels of experts and other observers. So if you really wanna rise to the top of that, if you want me to select you as the winner, you're gonna have to do even more than the detail I've provided here. You're gonna have to really did deep into the details of the system, and that would probably mean collecting some additional plans information and maybe even some other planned features. Not to show me in, in a spreadsheet, per se, but, but as part of your analysis, you're probably gonna need that. Now, an additional piece of information I asked you for in the assignment document is some, something called the uh,age service matrix, as well as the age distribution of the retirees. So these are pieces of information. These are tables that tell us how, how old the active workforce is, how old the retirees are, how many of them are in each different age category, how many of them are say, age 40 to 45, 45 to 50, 50 to 55, etc. and also for the active employs. And what's the distribution of the number of years of service. Are there a lot of employees who have worked for 20, 25, 30 years? Or are most people just kinda coming in for a few years and, and leaving? So that's gonna be important pieces of information. So, if we look at let's look for the age distribution of the retirees first. That actually comes in this actuarial report here. Here is the distribution of retired members and beneficiaries for the tier, statemiscellaneous tier one employees that we've collected. And you can see here that the total, you know there are very few. There are some, some people in CalPERS who somehow manage to take disability retirements very, very early. Perhaps these are people are injured in the line of service. And, and as we look more up higher in

the age distribution the most retirees are ages 60 to 64. Right, now it's the real bulge of people who are ages 60-64 and also a fair number, who are 85 and older which reminds that people can live for a long time. Some of these people retired when they are very young. They're actually receiving a pension from the state for many decades. And the additional piece of information I wanted you to collect uh,about these distributions is what, what called the age service matrix. And for CalPERS you can find that in the the CalPERS Annual report, not the actuarial report, but the CalPERS annual report. Here we have them. That is members invaluation. That's what it's called here. And you know, you'll recognize this matrix because it looks, it looks like this. So here we have the state miscellaneous firsttier employees and this tells us how many employees are between the ages of say, 50 and 54 and have recently been hired, have zero to four years of service. Or how many of the miscellaneous first tier employees are ages 60 to 64, and have more than 25 years of service. And we have this entire distribution of these employees here. And so that's something, I'm not gonna ask you to enter this into the spreadsheet, but it's something that you'll want to collect and it may be of interest for you to look at these and to compare them to other systems to try to understand what is the distribution of ages and years of service in your workforce. Now what does that mean going forward for how much in the way of new benefits you're gonna accrue? Alright. The last part of the data collection you need to do involves the bond market information. So if you have a look at the assignment. The assignment asks you for a recent date. Please collect the following bond market information. You need to collect the US treasury par yield curve, the US treasury's zero-coupon yield curve, the credit rating of the city or state that sponsors your pension plan, and the municipal bond yield curve for the state or city in question. Or failing a cityspecific or state-specific yield curve, just get the yield curve of the rating category in question. That's what we want to be, we want to be doing there. so, let me show you some of this information comes from. And it's not really important to me what format you collect this information in. But you're, you're gonna need this information in order to be able to do the calculations in part three. So I've given you links for where to find these, some of these data in the in the footnotes. And, one source is the daily treasury yield curve website from the U.S. Treasury department. You can see here, we have the entire treasury yield curve. The other source is gonna be if you're looking for the zero coupon yield curves. Probably the best place to look there is the Wall Street Journal website. And you've seen these yield curves before, is what I've done in the various lectures about bond markets. I've shown you these sources before, so you should be able to find these, using these links, fairly easily. Now the credit rating of the city or state that sponsors your plan, that's something you should also be able to find out by looking around on the Internet. For the state of California, what I'm gonna do is I'm going to Google state of California credit rating, and there's actually a website that says California's current credit ratings, and there are three rating agencies. We can see here what the ratings are for the state of California. We want the general obligation bond ratings. So Fitch has California at an A. Moody's at an A1, and S and P as it is in A. Now when you, keep in mind that, I mean, an A sounds good if you got an A in school.

But actually you know, there's triple A and double A above A. And California's actually one of the worst rated states, as the time I'm talking about this. Illinois is worse at A minus. But, but California is not doing that much better at, at A. Okay, finally, the municipal bond yield curve for the state or city in question. Or failing that, just get the yield curve for the ratings category in question. So that's gonna be information that you can try to find out on the web. as it comes time to do this assignment, I'm gonna be posting some yield curves for you to use. So, so you can you can rely on me to provide you some information that will help you do that. I'll be collecting information from, from blue. 4 - Team Project: Comprehension Questions, Calculations, and Analysis Alright, well that was the data collection part of the assignment. The assignment continues with some comprehension questions, some calculations, and some additional analysis that you're gonna do as well as policy recommendations. So in the comprehension questions, they're asking you things that you should be able to figure out from what we've talked about in the course so far, and also maybe from the your data collection and your talking to your group. One question is whether the Unfunded Actuarial Liability in the report is a good measure of the funding status of the pension system and, and why or why not. So that's the, that's the first question here. And I actually eluded to some of that when I was talking about the unfunded. Actuarial liability when I was walking you through where to find that. Next question is whether the discount rate they're using is appropriate, why or why not. That is something we've also discussed in the, in the class. And then these are sort of shortcut calculations that you're going to do. What's the ratio of the contributions to the pension system, divided by total government expenditures. You collected that data, so I want you to do that division, figure out what that ratio is. And I'm asking whether that's a good measure of the burden of the pension system on the government, why or why not? And I'm also asking you for the ratio of the normal cost to government expenditures, and whether that's a good measure of the burden of the pension system on the government, why or why not? Okay, the next segment of the assignment is asking you to do some calculations. And in particular, one of the things that I'm asking you to do here, is to consider three different possible liability durations. 12 years, 15 years, and 20 years. And for each of those durations, to recalculate the actuarial crude liability under the following different rates. An appropriate U.S. Treasury bond yield, An appropriate municipal bond yield. And to do that, what you're going to have to do, is, you know say we're thinking about a, let's do the, do an example for the 15-year, duration. What I want you to do there, is to find me a point on the treasury yield curve, that is 15 years. And, remember we collect the treasury yield curve in part 2. And, so, if that may or may not be directly available from the treasury direct website, but you could And linearly interpolate, so you have it, maybe you have it for ten years and for 20 years. If so, maybe you could find a 15-year yield curve point as being the midpoint. And then just assume that the entire liability is a 15-year liability and re-discount it. And in particular, the way you're gonna do this adjustment is this fall is you're trying to calculate L, which is the corrected liability And L is equal to

the AAL that is stated by the state itself, times 1 plus the discount rate that they used, r stated to the power of this duration. Okay, so say if we're using a duration of 15 years, that'd be to the power of 15 divided by 1 plus the discount rate that you're actually gonna use. Okay, which I'll just call, I'm gonna call it r-star maybe. Okay. Also to the power of 15. So you can think about this AAL stated item as having already been discounted at a rate of 1 plus r stated. And we're basically just multiplying it by that 1 plus r stated And then dividing by 1 plus R to the, at the new rate, with the power her, power of 15; being the liability duration that we're assuming. So, for each of these bullet points here, you're going to have to do three different calculations. A 12 year, a 15 year and a 20 year calculation. That's going to give you six different numbers. The second part of the question asks you to calculate how long the assets are likely to last to pay pensions if the plan is frozen today and only the plan assets and the returns on those assets are available to pay pensions. This is a calculation I've walked you through in my lectures. So you should be able to, to calculate that. As well as part 3 here, which tells you to calculate how long the assets are likely to last to pay pensions if the plan continues on an ongoing basis, but without using the resources from additional tax increases, spending cuts, bond issues, or other sources. That's a calculation I've also gone through in the lectures. So the next part of the assignment is really the meat of the assignment. And this sections asks you to make some policy recommendations that would address any physical imbalances that you;ve identified in your analysis so far. So first, we have to start out with some general questions. I want you and your group To discuss and answer what are some good features of this pension system.What are some bad features of this pension system? I want you to think about whether this system provides adequate benefits for it's members.Whether those benefits might be more than adequate or less than adequate. And to some extent, adequacy is going to be a judgment call. So I want you to try to back up your assertions as well as possible. And of course, if members of your group are disagreeing, I want to hear all of the points that you have to make. and the key question then that I want you to try to address is whether the system is actually fiscally. Stable or not. You'll want to look into the recent history of the pension system before you actually start proposing reform so in particular, you wanna find out whether reforms have already been proposed to the system, whether reforms have been implemented to the system, how these reforms have impacted the adequacy of the benefits and the solvency of the system And then if, if it is the case, some reforms are proposed, but not implemented, what happened? Why did those reforms fail. So next I really want you to, I want you to propose a way of addressing the physical imbalances in the system, and this doesn't have to be exclusively reforming the benefits of the pension system. Your proposal could include changes to the benefit structure, but it could also include Tax increases, or cuts to other spending, for example. And I've given you some guidelines here. You know, one key guideline is that you should always be bringing your discussion about the proposals back to the economics of the situation. If you're proposing

changes to benefits, then the goal should be try to improve the solvency of the system without excessively impacting the adequacy of the benefits. If you wanna propose tax increases or spending cuts to Pay for the physical imbalances, then you should be very specific about what you think your state or city should do. That is, what specific taxing increases and / or spending cuts would raise the required amount of money in conjunction with any changes to the, to the benefit structure that you have in mind? Also, it's very important that your proposal is politically and legally feasible.Which means that you could envision a scenario, in which the necessary parties would agree to it and a court would rule it constitutional. Now, in the realm of political and legal feasibility, there's always a question as to what's actually gonna happen in the event. What's the court going to decide, how will the politics play out and of course, you know, you can't be a hundred percent sure that your plan will work, politically, will work legally But I want you to be able to make a, a, a decent case that it would. So I noted here that a stellar project, you know? The, the, the kinds of projects that will really rise to the very top will be ones in which policy recommendations are essentially ready to present before your local city council. Or to your state legislature. I mean, that, that, that's kind of the, the, the level at which the very best projects are gonna, are gonna be here. and part of the idea behind this group project is to get to a point where we've got new ideas coming from you for how to address the physical imbalances that exist in public sector pension systems. And to that end, in the last. section I've, I've added here, a little bit about strategy. I'd, I'd like you to propose a follow-up strategy for how you might implement these policy recommendations. So that could a press conference, or an online forum, or a sort of grassroots organization, or something like that. So I'd be interested in hearing you know, the names and descriptions of people you would contact. And some clearly defined steps for carrying out your proposed reforms. We're trying to get proposals here that would actually be actionable, and so I'd like you to think a little bit about The strategy for how you would go about trying to actually get your policy recommendations heard and implemented. So I'm very much looking forward to what you come up with, with these systems. I'm looking forward to your analysis, to your calculations. Looking forward to your policy recommendations. And the best projects will have the opportunity to be showcased here. And of course, that will also be showcased to all of the, all of the MOOC participants. So best of luck. Webinar: Analyzing Investment Strategies Welcome everybody to this webinar on saving and investing strategies for long term financial planning, particularly for retirement. My name is Josh Rauh. Those of you who have been taking my massive online open course, my MOOC, on the finance of retirement and pensions already know me. Some of you, I want to welcome my students to this webinar, very much looking forward to your participation. I'll tell you in a moment how you can participate and also to welcome everybody everyone who might be watching this around the U.S and around the world and invite you to participate in this very exciting

webinar. Yeah, we're going to be talking today about the the strategies for long term financial planning saving and investment, particularly when you're thinking about a strategy for saving for retirement. Talk a little bit about some of the conventional wisdom, and we'll be asking whether that conventional wisdom is right for everybody or not. so welcome to all. I'm really excited today about the panel that we have here with us today. Now I have three very esteemed guests, and I'd like to introduce them introduce them now. So the first guest with me here is William Sharp. Bill Sharp, the STANCO 25 Professor of Finance, Emeritus at the Stanford Graduate School of Business. Welcome, Bill. Bill has a PhD and a Masters degree, and a Bachelor's degree in economics from UCLA. So he did all of his education at UCLA. He joined the faculty here at Stanford in 1970 And in 1990 he received the Nobel Prize in Economic Sciences. He is one of the originators of the Capital Asset Pricing Model, a model that will be familiar to my students. And he also developed, the sharp ratio or investment performance analysis named after him. He's published articles in every possible professional journal, he's written several books including, including portfolio theory in capital markets, and we're delighted to have him with us here today. My second guest is John Ameriks. John Ameriks is a principle and head of active equity research at the Vanguard Equity Investment Group. His team manages or co-manages Vanguard's active stock funds using quantitative methods. Vanguard, as many of you know, is a mutual fund firm, an investment firm with around $2 trillion in assets. they provide mutual funds and exchange traded funds, have been done doing mutual funds since 1929. He's also done a, a great amount of academic research published in top journals, so welcome John. Delighted to have you here, John Emericks. >> Glad to be here. >> And my third guest today is John Cunniff. John Cunniff is a managing director and quantitative portfolio manager for the TIAA-CREF organization since 2006. TIAA-CREF was founded in 1918, and it's also an investment firm. They specialize in the needs of nonprofit organizations and their employees. John Cunniff was previously the director of US Research at Morgan Stanley Investment Management and has been a portfolio manager at several other investment firms. So welcome to to my entire panel and, and thank you all very much for being here. Now I'd like to call your attention to some of the features of this of, of this webinar today. So first we have a Twitter feed, and I encourage you to Tweet in any questions that you might have or any comments you might have about this, about this webinar. And that includes questions and comments that you'd would like me to ask our panel. So, the hash tag for this is going to be Rauh Finance so #RauhFinance. That's my last name and finance, all one word. And please feel free to use Twitter and get the social media buzzing about this exciting webinar today. Another way I'd like to invite you to participate is, through some polls and survey questions that I'm going to be asking you. And we've designed four poll questions for you that you're going to be able to answer and to I'm very interested in hearing what, what your answers are to these questions. And when I have the results i'm gonna be telling you about the audience here today, what you've answered, and what the what the distribution of of responses has been.

So, let me walk you through what the questions are. The first question is, in how many years you plan to retire? And you can either say I don't know, or you can say a range of dates or you can say you never plan to retire. second question is gonna be what percentage of your 401k, or you can also answer this, you know, if you have other employer provided defined contribution funds. What percentage of those funds are invested in stocks, or equity mutual funds? So I'm interested in how much stock market investing you all are doing. So I think that would be a very interesting question. The third question I'd like you to talk about, answer yes or no, is do you think. This is an opinion question. Do you think that stocks are safer in the long-run than they are in the shortrun? Yes, no or I don't know. That's a question for you. And the fourth question is whether you have reduced or do plan to reduce your exposure to stocks in your 401k or other defined contribution retirement account as you approach retirement? Yes or no? So I'm very much looking forward to, seeing your responses to this, to these survey questions and to presenting you with the, the distribution of responses that this, wonderful viewership here gives. Well, with that I'd like to, jump right in and, and turn to the themes for today and, start right up by asking my panel, the first question that I had. Which is really, I wanna know, maybe, John Ameriks, maybe you can, you can start with this. what is number one consideration that people planning during long term financial planning, particularly planning for retirement, what is the number one consideration that they need to be thinking of? >> you need to start saving, you need to get in the plan. very simply there are a lot of people out there with opportunities to save, that they're not taking advantage of. And so I would say the number one thing is, make sure you participate and start putting something away through the vehicles available to you. >> Mm-hm. And wha, you know, in terms of make sure you're participating, wha, what exactly should people be participating in? Maybe you could just be a little more specific about what, what, what, what are the opportunities people have got? >> Abs, absolutely. >> Yeah. >> The, the big one that a lot of people have are 401k plans through their employer or 403b plans if they're in the nonprofit sector. Those plans will allow them to defer portions of their income and put those away for the future and invest them, and we'll talk a little bit more about how they can invest them later. Most, and importantly, many of those plans feature what's called an employer match. Which essentially provides an additional incentive for people to save. If you put 4% of your pay in, your employer may match up to, say, an additional 4%. you should definitely take advantage of that. You get an immediate return on your contributions by doing so. >> Free money, in essence. If you're able to contribute the money today. >> In essence. >> Then your employer is giving you free money. If you're not, then you're not gonna be getting access to those, to those funds. Now,

>> You're not cashing your paycheck. That's what I like to say. You're not cashing your paycheck, I like that. now, Bill Sharp, maybe you could say something about the the following question. Which is you know, how can people even begin to think about how much they need to to save. You know, where, where, where do they even start. I mean, what's the, what, what kind of, what kind of rules would you, would you think about giving people, or guidelines, in terms of thinking about how much they need to save, to be able to be prepared for retirement? >> Well it depends on, sort of the obvious things. How many years you've got before you plan to, or at least hope to retire. How much money you're saving as a percentage of your salary. And what you think you might earn on those investments, understanding that in all likelihood, that's gonna be a range of distribution as you point out in the course. So you need to think about all those issues. There are rules of thumb that if you start at a fairly young age, the total with you and your employer need to put in as a percent of your salary is probably somewhere between 15 and 20%. Now that's, that's, that's in making a lot of assumptions but I think the important that that number is typically larger than most people think it is, which is required. That you gotta save a lot in almost every circumstance and so, so that will find a way to put in numbers there in that range. >> And John Cuniff, do you, do you agree with that? What do you, wha, wha, wha, what kinds of savings, savings strategies do you advise for your clients? >> Yes. Well, your class earlier on savings for retirement had an assignment, and you had a 10% contribution rate. The Employee Benefit Research Institute in a recent study shows that the average American is contributing 7% of their salary to retirement. So as Bill Sharp mentioned, those numbers generally, Americans generally need to save more for retirement. I'd definitely look for opportunities for a company match and, consider a plan. Consider retirement readiness. Look out many years in the future or if you're approaching retirement, potentially meet with a financial advisor. And have a budget for your retirement. And look at how your investments can match income, create income and match that for your budget. >> Now one, one thing I've always found very interesting I talk to people about, about these issues. Sometimes, people don't really even know whether they're saving in a 401k plan, or not. how how can that be I mean So if you just started a job is it Maybe talk a little bit what typically happens to people if they don't take any action if they take no action. do, is some money going into an account or not? What, what, how does this typically work John Ameriks maybe you want to take a shot at that one? >> So, it's a, it's a big area, it's one of the, the areas where I think there's been a lot of very recent research in the last ten to 15 years about this issue of defaults. What happens to an employee that starts a new job Are they in the plan to begin with or not? And, you know, 20 years ago or even 15 years ago, the normal situation was you had to get up and proactively go sign up for the retirement plan in order to be in it. And surprise, surprise, lots of very young workers who were in their first job we're not real interested or real cognizant of these issues around retirement saving and a lot fewer people signed up for those plans than, I think, most benefits officers, most policymakers would like to have seen.

And research that's been done by behavioral economists and others over the years has shown an incredibly power, powerful effect, effect of just flipping the default on it's head, auto enrolling people into a plan. And that will get people to save. It will solve the first problem that I told you needed to be solved. It gets someone in the plan and saving. but it can raise other issues, as you mentioned of people not being aware of, of, of what's going on. But you know, that's, ultimately you've gotta get involved, you've gotta get engaged to understand what's happening with your retirement money, and it's very important to do so as young as you can. >> So, if, if I might just sort of summarize what, just something we've heard, you know. for those of you out there I mean it may be that you're watching this and you're think what, what exactly is, is going on, am I contributing to my own retirement fund right now, or not? you may not remember what you did when you signed up for your job. You may not remember how much money is going in there. And it might be useful to especially now those of you who are students in the, in the open online course. We've done these kind of, this kind of spreadsheet modeling. It might be useful for you to compare, what it is, you know, go look up, what it is you're actually doing. Are you, are you really contributing to your, to your 401k or not. How much money is going in there every month and is it likely to, to be sufficient. By the way, as I'm mentioning the MOOC, one thing I did want to do is I want to just invite all viewers, even if you just tuned in, just for this webinar, to feel free to check out the MOOC. the link to the MOOC is available online. It's it's it's available, you can see, at the same link that you found this webinar at, you can also find the link to the to the, to the MOOC. and feel, you know anyone is welcome. It's not too late to sign up. Feel free to just sign up and check out all the interesting things that we're, that we're, that we're doing there. the, the url is www.novoed.com/rauh/finance. so inviting everybody to feel free to, to check that out. So going back to the panel now, just a couple issues about about savings I want to talk about before we, we move on to to investing to asset allocation. One big question I was wondering about is it seems like people are increasingly kind of doing things to try and access their money from their 401k before the time that they're actually retired. anybody want to, maybe Bill Sharp you want to talk a little bit about, about that, I mean er, can people, do people you know borrow from their 401ks? Is that a good idea to be borrowing money from your 401k to try and move consumption forward? >> I would say as a general rule, probably not a good idea. But obviously circumstances in which it may be necessary if there's a emergency need for, for funds. But hence the danger problem that we see is that people don't seem to be saving enough. If you borrow, that is therefore less, unless you pay it back and that, that may be questionable, whether you will or not. Then there are all kinds of tax issues which I can't say I fully understand but I think we should, we should be negative about borrowing absent of really, really compelling reason. >> And I believe, in most cases, if you lose your job, or you quit, you owe the money back. Is that, is that right John Ameriks. Do I understand that correctly?

>> It, it, that is a feature of the 401k system for sure. I believe the rules are slightly different for different types of plans. but for most people that are in the private sector, that's gonna be an issue. That's one of the things you really should worry about if you don't know. Whether you're required to pay it back when you lose your job, or when you change jobs, you should ask at the time you go to lo, to get the loan. >> Mm-hm. Well, now, what about, what about people who are approaching retirement? Actually, I was looking at some of the survey results, the distribution of your responses, to the question not from today but the question in the MOOC about how many years away you are from retirement. I noticed that there is definitely a mass of people in this course who are zero to ten years before retirement and I imagine that some of you, if you've been taking this course, you might of actually taken a look at your own accounts. And some people may have seen well, gee, actually, it seems like I have this kind of hodgepodge of accounts from old jobs, you know. I have a 401K from this job, and I have an IRA here, a Roth IRA here, You know, actually I'll stick with you John Ameriks. I mean, wha, wha, wha, what do advise people who do who are say zero to ten years away from retirement, you know, getting close and they have this kind of hodgepodge of accounts out there? What, what, what, do you have any advice for, for those people? >> Well, I, you know, I think the hodge podge by itself it doesn't necessarily create a problem. I want to be, I want to be clear about that. we, we would argue as well as most other financial services companies that consolidating your assets you know, allows you a lot of convenience. you know it, it is harder to manage when you have a lot of things in different places. but the bottom line is if you've got to look at all of that together and if it constitutes a diversified portfolio it may not necessarily, be, be a problem. >> So, so by consolidating, you mean maybe rolling over into a traditional IRA or even perhaps a Roth IRA. >> Right, that's correct. And there, there are an awful lot of tax issues to tax and other, other legal issues that you need to sort through. There are trade offs to be made when you make those, those rollovers and it may be one of those areas where, especially for people close to retirement. John, John C's advice about talking to an adviser to work through some of these things gets increasingly important. especially if there's company stock in a 401k plan, because that's subject to special treatment according to the tax laws that you probably ought to think about. >> Company stock in a 401K plan. Well, that gets to the next general set of topics I want to discuss which is investment strategies in 401k plans. and many of you are probably thinking, okay, I get the message. We need to save a lot. And, all right, so now that we've, we've, let's suppose we've kind of optimized this saving. what, you know, what should we be investing in? Now, John Ameriks you just alluded to the idea that there are a lot of people out there who are investing in, in company stock, the stock of their, of their own company. you know, actually I want to turn to Bill Sharp a little bit about this since Bill is one of the founders of modern finance theory. I mean, what does modern finance theory tell us about whether you should be investing in your own company stock or not.

>> simple answer, bad idea. The the argument is that in many situations, if not, not all, certainly, but most, there's plenty of company-specific risk in your job, in your employment. If things go bad in your company or in the industry your job may be jeopardized. You may have to suffer a cutback in salary or hours, what have you. So the last thing you want to do is add to that specific risk. The basic mantra of being widely diversified would argue that when you take the human capital into account you've got a concentration of some sort depending on your job. company specific risks, so, adding to that by holding company stock is not a good idea. There's a tension here, because many companies want employees to have company stock. Give them incentives to work harder and be more devoted to the company. There's a tension between what might be good from a company policy standpoint and what is good from a strictly investment standpoint, but by and large, a, a lot of people in the investment industry would say 10% or under it. You know, absent compelling reason, keep it down in the single digits if you must do it at all. >> I mean, in essence, you know, your eggs are sort of already in that basket, >> Yes. >> And by investing in company stock you're putting more eggs in the basket, in that same basket. And your eggs are already in the basket because your financial future depends upon how well, you know, how, how, whether you get to keep your job. And do you really want to also be investing in the stock of a company that's gonna be deciding whether you keep your job or not. especially since the forces of that company will determine whether or not you keep your job. >> You know, it's historically, there's some very tragic cases. IBM went into a tailspin at one point. And many of their executives had their entire retirement savings in company stock. and there have been other cases of that sort. I don't think that happens as much anymore. Most 401k plans are cognizant of this issue and they tend not to encourage people to have huge concentrations in company stock, but its something to watch out for. >> Hm. Definitely. that's that's not a red flag. what I wanna talk now is just about more generally about investment strategies. So, let's suppose that you have reached the point where you have optimized your savings strategy and you're, you're saving as much as you can, and you're taking advantage of employer matches. what about the investment side of things. You know, how should you actually allocate these assets? And I just wanna turn to, to John Cuniff of TIAA CREF, and just ask him. John, you know, what would you advise us, just kinda the general investment strategy for people, I mean, where do you start? I imagine some of our viewers are probably, they're probably at this point, you know, kinda scrambling around their laptop and looking at their portfolios, and thinking: oh my gosh, what a mess, what am I doing here? What, what, can you just give us, just some general advice, about, about how asset allocation should be looking for younger people, middle age people, people approaching retirement. What do you think? >> Sure, well here at TIAA CREF, I manage the TIAA-CREF life cycle funds. >> What is that, by the way, a life cycle fund? >> a life cycle fund is a series of target retirement date portfolios. For example, here, we have a life cycle 2055 fund, which is for someone who's young, and has more than 40 years ahead of them, and will

plan to retire in 2055. And we have funds every five years through 2010, and also a retirement income fund. The portfolios are designed with an asset allocation that glides appropriate for your years to retirement. They start aggressive with high allocations to stocks and then as you approach retirement, become more conservative and have more allocations to bonds. The investment thesis behind life cycle funds in general are a human capital - financial capital model. And as Bill Sharp mentioned with human capital, when you're young, you have many years ahead of you to be able to contribute and invest in your savings. So you have a large position in human capital. And hence, your financial capital can be a very aggressive when you're young. When you approach retirement and in retirement, you need to have a more balance portfolio, a more conservative portfolio, with more allocation to bonds. So life cycle funds are used today as the autoenroll. It's, it's very important to emphasize that anyone currently investing in a life cycle fund or considering it You should look at the prospectus and the material at the company's website. Each glide path is a little different, and you should be aware of what you're investing in. And it's also important that lifecycle funds don't guarantee an income, or capital value. That if you wanna go in that direction, we can talk later about annuities. >> Mm-hm. >> I think you know, life cycle funds, I mean, they're, they're undertaking a more sophisticated investment strategy for you by, you know, by re-balancing towards safer securities as the investor gets close to retirement. And, you know, for that, you're gonna see, you know, the fees on lifecycle funds being somewhat higher than the fees on index funds. But that, you know, that's sort of a service you're paying for, so you gotta, you gotta take a look and, and, and see how you, you, you view that, view that, that trade-off. You can also you know, those of you who are not in lifecycle funds, you can also consider doing some of that rebalancing on your, on your own. now I think one of, a very interesting topic we've kind of been touching on here. Is that, you know, you can think about the household balance sheet as consisting of both financial capital and also human capital. And so by financial capital we mean whatever stocks or bonds or savings you might have. And by, by human capital we mean the fact that your, your, your, your labor income, you know, your earnings, your, your lifetime earnings. Those are, the fact that you own this sort of stock of whatever is skills or education or something, that kind of allows you to earn money over the course of years. And, I, I guess, you know, one interesting question I pose, maybe, John Ameriks, you could, you could take this up a little bit. Is >> Mm-hm. >> You know, how does, how does say the optimal investment strategy of somebody who is got a really, really safe stream of labor income that is sort of not, you know, not really volatile or moving around in the stock market. How does that investment strategy compare to maybe the investment strategy of somebody whose, whose life, lifetime earnings are essentially gonna rise and fall with the fortunes of, you know, the stock market or the U.S. economy. Do you have any different recommendations? >> So >> for those kinds of people, or?

>> Well, sure, I mean, I, I don't know whether it's a recommendation, but it is a conclusion that comes out of the type of modeling that we do that sort of posits rational behavior and well defined preferences over risk. And in that kind of a world, the correlation patterns that you're talking about, in the one situation are very safe for secure future income stream. A college professor, let's say. although you have to decide whether the business school. >> The business school, yeah. >> Is the safest portion of the of the professorship. But you know, one with tenure there's an income there that's very, very solid and perhaps that means you can afford to take a little bit more risk with your financial investments. And on the other hand someone whose working in the finance industry whose, whose human capital paycheck and certainly bonus payments may be correlated with what happens in the equity markets, might want to think very carefully about exactly how much, how much of their eggs they want to put in that basket. It's sort of a very similar problem to the company stock problem, just sort of one step removed. You know, company stock is very specifically tied to your human capital. Now, we're kind of talking about relationships that are a little fuzzier. And there's room to move around, around the edges. you know, in general, estimating those correlations over very long periods of time is very, very tricky business, for sure. >> Now, Bill Sharp, what, what do you think about life cycle funds, and the, the strategy of a of life cycle, and you know life cycle investing, where you invest in the target date fund, such as the ones described by John Cuniff, where the investors are getting re-balanced towards something that's less risky as the investors approach retirement. What do you think of those, of those strategies, and how do they, you know how do they tie in with this sort of, with the economic theory surrounding asset allocation? >> Well, I think in this as, as what John said, they're the best rationale for what's called the glide path. Start out with a relatively high power number portion in stocks, glide down to lower portions. Rationalization or rationale for that is the human capital argument. As when, when you're young, the present value, if you will, of your future savings from your earnings is large, and your financial capital is small. So, you need to sort of think of the risk and return of the totality. And as you go closer to retirement, those proportions change and so, you keep, if you will, the same overall risk and return. And you need to re-balance along some sort of wide path. two things I think are important to point out. The target date funds or life cycle funds are designed with some notion of an average investor in mind, average in terms of your profession and its risks, average in terms of your risk tolerance, what have you. So if you differ from the average, you're more willing to take risk or you're in a different profession. Then that means you have to either do something different and maybe find a, a life cycle fund that's designed for somebody older or younger than you are. The other thing I'd point out, the argument for a glide path, increase in conservatism, to the extent it's based on human capital, falls away when you retire.

And we see some funds that continue to do the segway close to retirement. I'm, I'm, I'm a little bit stressed trying to figure out what the rationale for that is. Then the final fund I would, I would point out is. That when you look at funds for people retiring in, let's say, 2035 across different financial providers. They differ considerably. And, of course, in any given period, their performance will differ considerably. So it's not as if there is an agreediupon notion of what that average investment situation is. So there are different funds that take somewhat different views, even about the average investor. So, there are a lot of uncertainties there. that said, the basic premise is, I think, good, up to retirement. >> Yeah. And I think it's also worth emphasizing that, you know, different life cycle funds are gonna be re-balancing you towards, you know, different actual investments. So some will go more heavily into longer term nominal treasury bonds, some into shorter term treasury bonds, some into TIPS, Treasury Inflation Protected Securities which are protected against increases in inflation, some into cash maybe some into other things. So it seems worthwhile if you're going to investigate these products to really look at what they're rebalancing into and consider the risks of those investments as well. You know, I, I think if your horizon is short, then you know long term treasury bonds, you know, they carry some risks. >> And before but, lest we leave it, as you've emphasized over and over again, expense ratios, expense ratios, expense ratios. >> Critical, critical what the actual fees and expenses are. I'd like to bring in a, a tweet, actually, that we've, we've come, from Phil Geller, at Working Max. he's tweeted, in retirement, how do you go about spending down a diversified portfolio? What do you sell off first, and, and what do you, what do you retain? And that's very good timing, because I was just thinking about trying to, to get to some of those ideas. >> Yeah. >> what, what do you do if you've, you've reached retirement and you say I, I've done my best and now I have this, this nest egg or this balance. what, what, what should I, what should I do? maybe John Cuniff, do you want to take a shot at that one, >> Sure. yes well, as I mentioned before meeting with a financial advisor looking at retirement readiness. You can have a budget for retirement and then you have different possible sources of income. You have Social Security, potentially, 401k savings that you can draw down, potentially a defined benefit plan, annuities or other savings. And there's tax consequences as well, so each person's situation is different. you, you did have I noticed a, a paper that you attached with different rates and some financial advisers historically have talked about a 4% draw down rate. Though there's a range but it, it will differ based upon your asset allocation, your time horizon, your expected returns. There's a lot of math there. and assumptions in each person's situations is unique. >> Mm-hm. John Ameriks, what would you add to that? >> Yeah, so those, those things are right, and maybe try to be a little more you know, represent a lot of the research. The four, 4% rule.

I think that, that comes out of variety of different places, and it. I know Bill and I have interacted over the years and, and talked a little bit about where this comes from. there are a lot of problems with some of the analysis that's done. But bottom line is, for someone who's got a sort of endowment like view of what they're trying to do with their assets, they're really not trying to spend it down aggressively. They're trying to draw some portion spend in some way, some systematic way, from their portfolio. you know, you can, there are very large endowment around that world that will use that kind of 4% rate of, of draw down assumption. So it's not unreasonable. That, that said, all the consideration that John brought up were very, very important. There are some people who really are, they're looking to spend. They save, spend their lifetime. They took our advice, accumulated large amounts of money, and now its time to spend it. How do I spend it so that I'm actually dipping into principles and running the balance down in such a way that it lasts as long as I want it to? it will get complicted depending on time horizon and, and what, what people are investing, are invested in. So, the first step is sort of understanding what your objectives are for your retirement planning. >> And, when I, when I looked at you know, the typical retirement dates and I look at expected returns in the stock market and the, and the distribution of the outcomes and what can I expect from the stock market, 4% seems like a pretty aggressive spend down, at least in, in, in today, in today's environment. I mean, idepends obviously when you retire, right? How many years do you expect this to last? but it might, it might be, might be somewhat regress, somewhat aggressive. that brings me to the other thing that we often discuss a lot in the class. Is of course annuities and obviously as those of you who have been taking the MOOC know, annuities are an interesting financial product that provides longevity insurance, and that is sort of insurance against living a long time. Usually we we think if you live a long time, hey, that's a great thing. You know, I lived a long time. But it's not such a great thing if you outlive all of your resources. so maybe some of you on the panel could speak to that. What do you, what do you think the role is of life annuities, in investor portfolios? And, I wanna be clear that here I'm talking about sort of, fairly plain vanilla life annuities. I mean, there's a whole range of annuity products that use the word annuity. But I'm talking about just a product where, an investor, you know, gives a, an amount of money up front to a, to the provider of the annuity, the insurance company or investment firm and that firm promises them a guaranteed income. for life. What, what do you think the rules of that would be in investor portfolios? I'll leave, any of you wants to grab that one to grab it. Bill Sharp. >> I Well, I, I think, you know, one of the great mysteries, and you alluded to it in the course, is that our procedures for supplemental savings, supplemental to social security were for years in the US defined benefit, which is as you pointed out, it's an annuity. You pay in, and then you take out until you die or your spouse dies or what have you. we went to a defined contribution regime, which could have, a defined contribution plan could provide annuities in the plan, you could take your lump sum out at the end and buy an annuity. And almost nobody does. I mean, it's like maybe 10% or some number in that range, of the DC money at retirement is annuitized. Though it was when this tectonic shift away from using their savings to buy a short income until you die. Few gains and there are millions gains and there's no 4% rule that you mentioned.

And there's no settled agreement in the industry, or certainly in academia. On the, the desirability of this scheme or that scheme or this person or that person. That's an area of incredible turmoil at the moment. But I think that annuities are fine. If you're very rich why bother, you know your happy to have large amounts of your wealth go to your kids or your charities. But for people who are close to it, where the social security annuity is not enough, and they really aren't in a position to take much risk with the remainder or plan to leave a lot to their heirs. I think annuities are extremely sensible ways to take care of your post-retirement needs. But for a number of reasons, some behavioral, some otherwise, perhaps, we don't see a lot of voluntary annuitization, which concerns me. >> You know, it's interesting because I think a lot of people get to retirement, they say, okay, what should I do? Then they think about maybe buying an annuity, and they look at the rates, and they say, gee, you know, I'm gonna fork over $100,000 at this point and I'm only gonna get paid $400, $500 a month. That's a frightening proposition to to, to, a lot of people and it also raises the idea of, products that might actually kind of default you into some annuitization before. John Cunniff, I know TIA-CREF has a long history of providing products that have an annuity feature with them. I don't know you want to say any words about those? The role of those products? >> Yeah we. Yes, here at TIA Cref we have a very long history with annuities. Our TIA traditional account dates back to 1918. Our CREF stock account dates back to 1952. It's the first variable annuity in America. And a benefit that TIA offers is that in our plans, in many of our plans, you have the opportunity, during your working years, to contribute to an annuity. And that seems, from a behavioral point of view, as Bill Sharp was mentioning, is that can help people stay in annuity through retirement. And, annuities provide guaranteed income for years in retirement, for potentially, your lifetime. There's at least two types of annuity. A fixed annuity, that'll provide a guaranteed income for a period of time. And then also variable annuities, which could provide higher income, but have exposure to the stock market as well. So that can vary. >> I think it's the way I think about these products, and you can correct me if I'm, if I'm, if I'm wrong. The way I think about them is, during the working life, you know, an individual is basically accruing, you know, rights to receive an annuity when he or she retires. And that, if that's a fixed, you know, fixed deferred annuity, that amount is gonna be, not a function of how the stock market does or other or assets that things are invested in. If it's a, if it's a variable annuity, then it is gonna be a, a, a function of the of the stock market. John Ameriks, would you wanna weigh in here a little bit on the this question, annuities life annuities? >> It's. >> Fixed annuities, deferred annuities, variable annuities? I'd, I'd love to, and probably your class doesn't have enough time to hear everything I have to say about it. >> >> So, it's been an area of active academic research for me for about 15 years.

thinking about you know why, why do people choose annuities why don't they. you know I, I view them as very much as very useful to provide a floor of income. You know they, they do for retirees provide someone with ability to know you know how much will I have as a base for my income going forward. We think about social security. We think about the fund benefits pensions as forms of annuities. Many, many people have those. by far the most fascinating thing to me is that where we, where auto enrollment, as I mentioned earlier, and life cycle funds. when those are used as default options in retirement savings plans, the rates at which people reject those defaults are very small. Most people go along with that. They enter into the plan, they save, they also seem to go along with and be happy with The glide paths that we've talked about. The one big difference about annuities at the point of retirement is people seem to actively want to unannuitize. There is active deannuitization going on so couple of different forms, people retiring with defined benefit plan entitlements, that, that the default pad is an annuity, will elect to take a cash payment instead. The other thing is that many retirement plan participants when looking at their assets that are in a form of a plan that requires annuitization, will take a spouse to a notary public in order to get permission to take the money out of the plan as a lump sum. So, the behavioral issues are very complex. and I think it relates to thinking about retirement security in a very, very different way maybe than we have traditionally. income's very, very important. We need to have some, but there are expenditures and events that happen in retirement that are not linear in nature. That, that are not. You can't buy insurance for them. You can't know that it's gonna cost you x dollars a year for the rest of your life. To deal with long term care necessarily. and you know, those type of risk what I'm currently studying trying to find out whether as Bill mentioned, is this irrational? Is this people saying irrationally that I can do better and I don't have to worry about longevity risks? Or is it something that's a little bit more reasonable and rational. That, no, I can't predict what's my situation is going to be in 20 years. I wanna maximize flexibility, and I need liquid assets to do that. We don't know the answers right now. >> We don't know the answer. We don't know the answer. So you know, I'd like to turn and take in another tweet. And I'm also looking forward, in a minute, to getting the poll results. so let's take another tweeted question. from Iechen Chang. Are financial advisers worth it at 1%? Most don't want you unless you have a million dollars. How do you get there in the mean time? Anyone want to talk to that? Speak to that. Bill Sharp please, professor. >> Well, we are seeing the growth of online lower cost quote financial advice at this point it's varied, highly varied quality. But as you point in the, in the you know in the course, 1% is a big chunk if you're, you know, if you're gonna take sort of 4% out, and your advisor is gonna take another 1%. And in some ways you're loosing one, yeah, 1% divided by 4 plus 1 which is a huge, huge get Vanguard has tools that can show you this and this accumulation phase. But you better be getting an awful lot if you're paying 1% a year every year, in your retirement. So there needs to be some way, and there are other procedures. Sometimes through your employer, you can get what amounts to a tailored procedure post retirement as well. But we need to bring the costs down significantly.

That's just too much. >> Well I wanna, actually go over some of these survey results, if we've got them. the greats who will be able to tell you how people answer the answer the survey. so, and in how many years do you plan to retire. Of our viewership, it turns out that about 25% of you are retired. Only 3% of you do not plan to retire. 11% of you have got 30 or more years to retirement. and run to quarter view got 10 to 30 years to retirement. And 34 of you have 0 to 10. So some. 34% have 0 to 10, so I would say, and we had, we had over 15,000 votes here. I, I would say there's definitely the, a lot of people are getting close to retirement who are Who are thinking about these issues. we have the other questions up there. It'd be great to see those. What percentage of your 401k do you invest in stocks or equity mutual funds? Well, this is great, we got a, a great distribution, here. So we've got about ten percent of you invest less than 20%. 8%, 20 to 40%, and then a lot of people you know, around 30% investing 40 to 60%, 60 to 80, and 80 to 100. So, a fair number of stock investors, here. the next question was related to whether you think stocks are safer in the long run than they are in the short run. >> >> And 74% of, of our of our viewers said the stocks are safer in the long run than in the short run. and 17% said no, 9% said I don't know. Now, before I go to that last question, which was about life cycle strategies, I'd just like somebody on the panel, maybe, maybe John Ameriks, could speak a little to this question of whether stocks are safer in the long or in the short run? Because there, there definitely seems to be a view out there that that they are. >> Yeah. What do you think of that? Well you know I, I think this, this again is you know the way it asked the question terms are safer. We, we know that in the mathematical sense, based on the studies that the, the risks that people face, even though stocks will appear to have high rates of return with low volatilities around the annual averages over long periods of time. you can still save for twenty-five years and get to a point in 2008 where you've seen above average returns for most of your lifetime. And in a course of a few short months lose, lose half of that. So, I would be very careful with the notion that stocks are safer in the long term in that sense. However, you know, the life cycle considerations that we've talked about, if you think about the answer to that question: Are they safer for me as a young investor than as an older investor? you know, because of the flexibilities that human capital provides. they can, they can little be more sense for young investors than for older investors but it shouldn't be interpreted as a safety of the investment option itself. >> I have to go to BIll Sharp here. I have to go to Bill Sharp and ask him and ask him, what, what he thinks, he's one of the founders of finance theory. I need to, I need to ask this question, I should know. >> I should tell you this statement has driven me crazy for 50 years. That's five zero. it, it comes from a really misleading kind of analysis in what you say. What is the average, or, you know, geometric term, return. We talked about over 100 years versus 50 versus 10.

Here's the simple idea. Put $100 in stocks today. Look at the range of how much you have in one year, then look at the, the bad part of that, you know, how bad could it be? Look and think about putting a $100 in stocks today and waiting ten years, and look at how bad it would be in ten years, how much money you'd have. It could be a lot worse if you hold for ten years than if you hold for one year. And that is and even if there's mean reversion or some of the other things that you've talk about. That's jus a fact The idea that you look at something called the geometric mean return or arithmetic mean return is basically irrelevant in terms of. What matters for risk is how bad can it be? The worst outcome or the 10% worst outcome, whatever though. And no important theory in sense, economic sense, personal sense. Is it true that stocks are less risky in the long run? >> Well very interesting. I, I, I concur. And, I'd just like to, you know, we're pretty much at our time, but I'd like to wrap up a little bit. I just want to do this one last question. Have you reduced, or do you plan to reduce your exposure to stocks in your 401k as you approach retirement? And 62% of you said yes, 38% of you said no. So 62% of you are sort of following this life cycle portfolio theory. 38% of you said no. Of course, you also like, if you're invested in target date funds, you might not be aware whether you've done it or not. So those target date funds are actually rebalancing you out of stocks. so very interesting to see that some people are, some people aren't. Perhaps those people who are not have different investment goals, they have different maybe they have got a longer time horizon. Perhaps it's the case that they're hoping to leave some money to their, to their beneficiaries. So I guess I'll ask one more tweet question, and then we'll wrap it up, if that would be possible. so someone has asked, Patty Eisenhower has asked: as some of us near retirement in ten years, are investments like bond funds really less risky than stock mutual funds? So what about bond funds? Are they? Are they less, are they less risky then in that case? Are they really less risky? who wants to take a stab at that one? Maybe John Cuniff, would you like to take a stab at that one? >> Sure, yeah, I'm very glad. Well, there's a lot of financial risk as you approach retirement. There's market risk, inflation risk and longevity risk. I mean one way to offset market risk, which is you invest in stocks they may fall, and be volatile is to invest in bonds. Yields currently are low but they do pay coupon. Yields may likely gradually rise over time. and that, that will eat something into the return there. but over a long period of time, they do provide less volatility, can offset market risk. Inflation risk could be offset with investments in inflation link bonds or indirectly through stocks and longevity risk, risk of outliving your savings generally consider an annuity. >> Mm-hm, all right. Well, I think it's time that we've wrapped up our, at the end of our time here. I want to thank you all for participating, great thanks for participating in the surveys. Thanks to those of you who tweeted in. I'm sorry we didn't get to every tweet today, but looking forward to doing one of these webinars again with you all in the future. Those of you who are not in the MOOC, feel free to check out the MOOC.

those of you who are in the MOOC, thank you very much for your participation. I hope that you're getting something out if it, and looking forward to your continued participation in the discussion forums. So thank you very much to everybody, and have a great evening. Lecture 9 - Basics of Defined Benefit Pensions Weekly Announcement - Week 5 Hi everybody and welcome to week five of the Mooc, the finance of retirement and pensions, I hope you are all having a good week. let me tell a little bit about some deadlines that are coming up first of all the deadline for the peer review of the individual project is tonight, so please get your peer reviews in as soon as you can for the individual projects. I'm looking forward to hopefully compiling this data and being able to show you summary statistics about all of the interesting data that you've collected. And it was very interesting to, and inspiring to see how many of you had done the assignment and had done such a good job with it. Also coming up you should be forming your groups for the group project. There's a deadline for the formation of the groups. That is on November 18th. That's when the groups actually have to be formed. And I hope that you will use the tools on the website for meeting other people and figuring out who would be a good person to be in a group with you. And, remember, the group project is gonna be about analysing the solvency of state or local government pension system. So you wanna you know, try to find a group that where you have some common interests and can together pick a system that's gonna work well for you. I also urge you if you missed it to check out the webinar that we did last week. I was very proud of this webinar. I think we really had some great guests. And I think the, the technological team did a wonderful job of putting this together. So I hope you'll check it out. And I think it really brings together a lot of the material we've been talking about in the course. You know, in the, in the course we did a lot of discussion of the. The properties of stocks and bonds of, of what kind of distributions of outcomes you get if you invest in one or the other. What we didn't get to so much in the material up until the webinar, was this question of asset allocation. You know, how do you optimally allocate your assets over your lifetime in your 401k. Do you start out more in, in stocks and then move towards bonds for example. That's a very common strategy. Might be right for some people. Might not be right for everybody. There are also products you can buy that will do that for you. That will re-balance for you on your behalf. And we talked about those a lot in the webinar as well. So if you saw the webinar, if you joined us, thank you for joining us and thanks for your participation. If you haven't seen it yet, I suggest that you check it out. So at this point in the course, the video lectures turn to the theme of defined benefit pensions, DB pensions. These are the traditional form of pension that existed for a very long time in both the public sector and the private sector in the US and is now. Become more of of a, of a form of retirement benefit provision for the public sector is remain the former retirement benefit provision for the public sector.

In the private sector is been kind of gradually being phased out in the US or around the world one sees defined benefit pensions in both the public and the private sector. So defined benefit pension is the traditional form of pension arrangement where an employee earns the right through an employer to receive a monthly benefit when he or she retires, essentially an annuity. And, it's really a life annuity, because as we saw earlier in this course, a life annuity is a product that pays you a fixed stream of cash flows until you die. And so that's exactly what a defined benefit pension promise is. So, as of now, about 78% of people in the public sector in the US have a defined benefit pension plan, and only about 17% of people in the private sector in the US have a defined benefit pension plan. So, one thing I talk about in the video lecture is, sort of motivating why we should care about this. Some people, some of you might say, well great, I'm, I'm part of the the relatively small number of people in the private sector that have a defined benefit pension plan. Or I am a public employee, I have a defined benefit pension plan, so this part of the course is really good for me and really important for me. Others say,you might wonder, well, why, should I really care about this? I have a 401K or maybe, you don't even have access to a employer provided pension plan. So why should you care? Well, the reason why is that if you're a taxpayer in the United States, you're actually sponsoring these defined benefit pension plans through your government. Now keep in mind your government is employing people on your behalf. They're employing teachers and policeman and fire officials and other public workers on your behalf and they're offering them defined benefit pensions. And it's important for you to think about how this provision, the defined benefit pensions on your behalf, is gonna affect what you owe in taxes. In fact, it turns out, and we'll see this in the course and you'll see it in your projects, that there are a lot of public sector pension systems around the U.S. that aren't in that great financial shape. And what that means is that taxpayers around the U.S. will at some point have to come up with the money to pay for these pensions. The alternative to trying to raise taxes to pay for the pensions of public employees that haven't been completely funded in the past would be to try to cut services to do so. Or alternatively to try to reduce the pension benefits themselves. All of these are quite difficult propositions. They're not easy propositions to, to handle. And as a taxpayer, the defined benefit pensions that you are offering to public employees. That fact, the fact that you're offering these is often something that kind of flies under the radar. So that's why I'm hoping in this course to give you a sense of what it is that you're actually promising. What the benefits are that you're actually promising. And just in general also, you know, what is the value of a defined benefit pension promise. How do, how does one measure how much it costs to provide that benefit. Now finance, as we've learned it so far, is very clear as to what the cost is of providing a benefit. Providing a pension benefit. Because really, all one is doing is providing employees with deferred annuities. And we learned in the first week of class, and to deepen our understanding as the course went on, that a deferred annuity has a price. And that's a, you can imagine it being a price that an insurance company would have to, would, would charge or would have to collect in order to pay such a pension. And so, that's the way that. In finance,

we think about defined benefit pensions. We think about the rights to defined benefit pensions as being deferred annuities and we think that, basically, the price or the cost of a defined benefit pension, is equals the price or the cost of a deferred annuity. The budgeting in the public sector is done in a quite different way. In the public sector, the budgeting is typically done by assuming an expected return. On the assets in the pension plan, and funding towards that expected return. Basically funding under the assumption that expected return is going to be achieved. And as we learned in the section of the course, where we thought about the distribution of stock market outcomes. What, what's really done, being done there is the planning is being made, assuming that the expected return on a distribution of outcomes. Distri, distrution, distribution of risky outcomes. That the expect return is going to be achieved and, and as we saw, you know, those expected returns are really, they're mean returns of a distribution. And they may not be that likely to be achieved, if the systems are targeting a seven and a half or 8%. Expect a return, that might be something that's only achieved in, say, 30% of the states of the world. So the way that finance economists think about defined benefit pensions in the way that public sector actuaries think about defined benefit pensions are really quite different. And that's one of the major themes of lecture ten this week, is to understand those differences. The other topics we'll get to this week include just the basic idea behind the defined benefit pension contract. what is the definition of a pension liability? Do you recognize the benefit that's just been accrued up until today, or do you recognize the benefit that the employee might be expected to, to get conditional on working more and earning more pension rights? Those are two different definitions of pension benefits. One is just the accrued benefit. So, if everybody stopped working today and collected a pension that they were owed, what would that be? That's the accrued benefit. And then, the alternative is the expected benefit, which is, the question of if an employee is gonna continue working, how much can that employee expect? Are they expecting that they're gonna get when they retire. Those are two different definitions and they're used for very different purposes. So as we turn our focus towards defined benefit pensions, I hope that you will use the discussion forums to talk about these defined benefit pensions talk about what you learn about them. And what your views are about the, the policies surrounding them because this is actually a topic where there is quite a bit of discussion today as to what should be done about underfunded. Public employee defined benefit pensions in the US and I think once you've mastered the finance behind these, behind these instruments it will be you will be well equipped to be able to have a discussion about what should best be done going forward. Other things to check out this week if you look at the under the lectures in the platform, you can see the results of the surveys that you've been filling out. So, lecture three,four and five. Those results are available right now. You can see, kind of roughly, what percentage you are investing in what different types of bonds and also, what inflation expectations are that you have. Interestingly, it seems to be a mass of people who expected in, in 2033, the prices will be about 50% higher than they are today. So that seem to be the, the kind of winning, winning pick. But, there's a distribution of responses around that. So, please feel free to check that out and comment on it the discussion forums.

Thanks so much everybody for your continued participation and looking forward to hearing more from you about your group projects, how your group formation is going and about what what kinds of systems you're gonna be analysing. Nor remember the idea behind this group project is you're gonna take this information that we've learned about defying benefit pension systems. And apply that to a defined benefit pension system of a state or local government around the US and, you know, do some calculations, do some measuring. And also make some policy proposals to think about what might be done going forward to make sure that these systems are sustainable. So thank you very much, everybody, and I hope you have a great week. 9.1 - What is a Defined Benefit Pension and Who has One? Welcome to this lecture on the basics of defined benefit pensions. A lot of you have probably thought about the problem of your own saving for your own retirement, in, say, 401K plans. But another form of retirement benefit is a monthly payment provided by an employer to a worker. That begins when that worker retires. This is called a defined benefit or DB pension. Because the monthly retirement benefit the employee receives is defined and known in advance. Who has DB pensions in the U.S.? The latest data tell us that only about 17% Of private sector employees participate in DB pension plans. In contrast, 78% of state or local government employees, and also many federal government employees, participate in DB plans. If we contrast this to define contribution, or DC plans, such as the 401K, we see that private sector employees are much more likely to participate in a DC plan. Over 40% of them do. Whereas only 15% of public sector employees participate in DC plans. We can also compare this to access figures. That is who has access to these plans and who participates? Just about everyone who has access to a DB plan seems to participate in it. They seem to think it's a good deal. On the other hand, if all private sector workers with access to DC plans Participate in those plans. There would be DC participation rates of closer to 60% as opposed to 40%. Now at this point, some small group of you is saying great, I'm involved in a DB plan, I have one,. So this is right up my alley. Or those of you might be saying I don't have DB pension, so why should I care. Well, if you are a US citizen, your federal, state, and possibly local government employs people and in most cases, offers them DB pensions. That means that actually, you employ them, and offer DB pensions. So, if you're a taxpayer, it's gonna be important to understand these arrangements since you, as the employer are also offering them to your employees. One way to begin to think about the DB plans, whether you're one of the citizens who has one, or whether you're one of the citizens who as a tax payer offers one to government employees. Is to imagine that you wanted to try to pay yourself a DB pension when you retire. Say you have something like $30,000 per year. Well you might start out by imaging that you could just save in your 401K and then, when you retire, you could by an annuity from an insurance company.

But if you invest in risky assets in the 401K you have no way of guaranteeing yourself any particular level of benefit cuz you don't know how these risky assets are gonna perform. Even if you had been investing in risk-free assets in your 401K. You couldn't have know what interest rates would be when you retire. So, for example, arriving at retirement with a balance of say, $500, 000. That would allow you to provide a much higher stream of monthly consumption for yourself. If interest rates are 10% when you get there, then if they are 1%. The only way you could pay yourself a guaranteed benefit at retirement would have been to buy yourself a deferred annuity. A financial product that gives you a stream of fixed or an index stream of payments beginning at some future date. So, thinking about it from the perspective of an employee who has one of these DB plans. A DB pension eliminates a lot of the uncertainty. However, on the other side of the coin, is that the employer must figure out how to provide this guaranteed stream of payments. The savings and investment problem for how to do that is now in the hands of the employer not the employee. And this highlights one crucial difference between the employer's problem, preparing to provide DB payments for employees in retirement. And the employee's problem if, if he or she is saving in a 401K or other type of plan for his or her own retirement. As an individual or household, if you decide to invest in risky assets in your 401K. Well you can scale up or down your consumption in retirement. If the assets perform better or worse than you expect. If the assets perform really well in your 401K. Well maybe you can buy that boat you always wanted. Without scaling back your lifestyle in other ways. If the assets perform poorly. You might not only be unable to buy the boat. You may have to downsize your apartment and spend less money going out to dinner. So if your 401K assets don't do well. You basically just pay yourself a smaller consumption stream in retirement. In contrast, if you as a taxpayer, an employer of public employees, are sponsoring a DB plan, that invests in risky assets, and those assets do not perform as hoped for, or expected, you the employer Still has to provide the same consumption stream. The employer in a traditional DB plan cannot tell the employees, sorry, the assets did poorly, so I'm scaling back your pension. Doing that would be a violation of the contract between the employer and the employee. And it would be viewed as a default on an obligation. A default that could only be legal, perhaps, if the employer entered some kind of legal bankruptcy proceedings. And more on that later. So if the employee is expecting a pension that would allow her to say, buy a boat, whether a small one or a large one, and the assets in the employer's DB pension fund less than expectations, the employee does not have to scale back her plans to buy the boat. The employer, or you, the taxpayer, must come up with the money one way or another. If it's a government, then out of increased revenue. Or spending cuts. In addition to sponsoring government employee pensions, one other area where many people have exposure to DB pension risk is through the shares of stock that you invest in. While only 17% of private sector employees participate in DB plans. There are still many companies that are carrying around legacy DB promises, that is older promises that they owe to older, active employees and retirees and in some cases, even offering to new employees. If the firm finds itself having a shortfall in the assets required to pay, to pay the pensions, then that shortfall must come out of corporate profits, and hence, out of shareholder value.

So if you have a DB plan, if you're in one, then this lecture should be helpful for understanding what benefits you are entitled to. If you do not have a DB plan then this lecture should help you understand the nature of the DB promises you have implicitly made to others either as a taxpayer or a shareholder. Whether you know it or not you are an employer who offers employees. DB pension plans. That means that you have to instruct your delegates, particularly city councils, and state legislatures, to make decisions about various aspects of the DB pension contract. And you need to understand what pensions you owe contractually for every employee today, as well as the pensions you're likely to owe given the probability that your workforce will continue to earn pension rights in the future. And you shouldn't just assume that someone else is gonna do this work for you in the way that represents your best interests. Maybe they will, but maybe they won't. 9.2 - The DB Pension Contract The defined benefit pension contract, okay. So, what does a defined benefit pension contract actually promise you if you have one? Or, from the perspective of a taxpayer or shareholder, what kind of annuity have you actually promised to your employees? A typical contract looks something like this. There's a formula, a benefit formula, that says that the starting annual pension, will equal a benefit factor, times the number of years worked, times something called the pensionable salary. So, here's how this works. Think about the first two components together, benefit factor times years worked. That's gonna give you a percentage of the pensionable salary that the employer has gotta pay as a pension for the rest of the retired employee's life. Pensionable salary will be either the employee's career average salary, or more commonly, the employee's salary, late in his or her career at the very end of his or her career. So, I'll have more on that in a minute. The idea behind this formula, is that the pension is gonna replace some portion of the employee's salary. And the first two terms, benefit factor times years worked, to find what portion. Now, benefit factors can in theory, be anything. But they're typically in the range of 1% to 3%. So, consider a benefit factor of, say, 2%. If the employee works for 20 years, then benefit factor times years worked will equal 20 times 2% or 40%. And the retired employees starting pension will replace 40% of his or her salary. If the employee works for 30 years, then benefit factor times years worked will equal 2% times 30 or 60% and the employee's starting pension will replace 60% of his or her salary. If the employee works for 40 years, then the benefit factor times years worked, will be 80% and the starting pension will replace 80% of the employee's salary. Of course the higher the benefit factor, the more of the salary the pension will replace. So, suppose now that the benefit factor is 3%. If the employee works for 30 years, his or her starting pension will replace 90% of his or her salary. If he or she works for 40 years, well, if this were the extent of the contract, then the pension would replace 120% of the employees salary. That's more than the employees salary. But often the plan will have what's called a maximum replacement factor, or something to, to prevent the employee from taking a pension that is more than 100% of the employee's late career salary. Now as always, the devil is in the details. One detail just came up, which is whether there is a replacement rate cap.

There are four other important details I'd like to discuss. First, the definition of pensionable salary. Second, cost of living adjustments or COLAs and other host retirement benefit increases. Third, the retirement age, normal and early. And fourth, what's called vesting. Let me take these in turn. So first, the pensionable salary or the salary on which the pension is based, can be defined in one of a few ways. One way to do it is the pensionable salary is just the final salary. That's the salary earned in the year before the employee quits or retires. Another way the pensionable salary might be defined is what's called the final average salary. Which is the average salary earned in a certain number of years before the employee quits or retires, often the last three years of the employees career. And then, another way that the pensionable salary could be defined, is what's called the Career Average salary. That's the average salary the employee earned over his or her entire career. So, suppose for example an employee starts his or her working career earning $50,000 at age 35 and that we experience 2% inflation. And no salary growth, in real terms, just to keep it simple. So, suppose the plan uses the standard formula and has a 2% benefit factor. Well, if the employee works for 30 years, his or her pension will replace 30 times 2% or 60% of his or her pensionable salary. You can see in just the standard calculation that he or she will be earning $90,568 dollars in his or her 30th year of work. Well, what would the pension be if he or she retires after that at age 65? Well, that depends on the salary definition. Under the final salary definition, the pension is 60%, that's the 2% times the 30, of that $90,568, which would be a pension of a little over $54,000. Per year. $54,341 per year. What about under the final average salary for, say, a final average salary of the last three years? Well here the retired employee's gonna get a slightly smaller pension. The final three year average salary ends up at $88,804. Less than the last year's salary of over 90 K. So, the pension is gonna be 60% percent of that. 2% times 30 times $88,804 or $53,282 per year. What about under a career average salary formula? Well, there there the pension's gonna be even lower. At the end of the career, the employee's career average salary is only $48,552, way less than the 54,000 cuz We're averaging over the employee's entire career. So in that case, the pension would be 60% of 48,552 or only $41,000 per year, a lot less than the 54,000 that they get under the final salary. So the detail of the definition of pensionable salary really matters and there have been cases where employees have'nt able to. Let's say manage their final salary in order to increase their lifetime pension benefit. For example, if an employee can cash out unused vacation pay or sick leave, or can take excessive overtime pay. Then they might be able to count that in their final salary and if it's a final salary pensionable salary calculation, then that can really affect the pension. One very widely publicized example was the chief executive of Ventura County, in California. Who earned $228,000 in salary the year before retirement at age 62, but is now able to draw a $272,000 pension for life through these tactics of having cashed out unused vacation pay, sick leave, etcetera. That practice is called spiking. And it can be mitigated, if the plans either use final average salary, with averaging over periods of several years. Or if they just ban the use of unused sick or vacation pay in final in final salary. Now, how widespread is this practice of spiking?

It's actually hard to say. It seems that many state and local governments have uncovered examples. But like most questionable financial practices that exist in the world, it can be hard to get a handle on just how widespread these practices really are. The second of the four terms I wanna discuss are these cost of living adjustments or COLAs. That's not a soft drink, that's a pension provision. And other post-retirement benefit increases. So for many pension systems, particularly those of state and local governments in the US. The pension we calculated from the formula, is only the starting value. That is, it's the first year of the pension payments, that the individual receives after retirement. Most systems also specify some kind of post retirement benefit adjustment. And these can take a number of forms. Including, well first of all, quite commonly a link. To consumer price inflation, which gonna happen with or without a cap. the main index here was called the CPIU, or consumer price index for all urban consumers. Let's take an example you could look at the Virginia retirement system, where the COLA, the Guass living adjustment is based on this CPIU, and that's published by the US bureau of labor statistics and updated every July first. During years of no inflation, or deflation. The COLA is 0%. But, if there's inflation then the, the retired employees benefit is gonna go up with inflation each year. Or another way the COLA could be specified is in the form of a fraction. A fraction of CPI inflation. Again, with or without a cap. So, take the New York State and Local Employees' Retirement System for state and local employees in the state of New York. COLA payments equal 50% of the cost of living index and can be as much as 3% per year, but not less than 1% per year. So that has a COLA that is not direclty 100% linked to CPI inflation, but partly linked to it. They get 50% of whatever inflation was as the benefit increase. Another way of specifying the COLA, is with a fixed pre-specified increase that's not tied to inflation at all. So a fixed 2% or a fixed 3% benefit inflator is common in many California plans. The Florida retirement system as well had 3%. For credits earned before 2011. The Ohio Public Employment Retirement System has 3%. Regardless of what inflation actually is, if inflation is less than 3%, as it's been running recently. Then the employees get a real benefit increase. If it's more than 3%, then the purchasing power of their benefits will actually get eroded. next there can also be ad hoc increases in COLAs or in benefits at the discretion of the sponsor. So for example, the state legislature. For example, the Texas Teachers Retirement System, that's the second largest retirement system by membership in the US with 1.33 million members. 25% of whom are retired has one of these ad hoc increases at the, at the discretion of the state legislature. Finally there could be a post retirement benefit adjustment related to the performance of the fund assets. This is common in some other countries like in the Netherlands and the US. You don't see it very often, but in Wisconsin, retirees of the Wisconsin Retirement System only recieve post-retirement benefit increases in a given year if the fund generates returns of more than 5%. Benefits can even be rolled back if the fund performs poorly enough but not below your initial level. Now, while most public sector pension plans in the US have COLAs, most corporate plans do not. Here you can see an example, of COLAs on top of the same three variations in pensionable salary we saw

previously. You can think of this either as a COLA, that is tied to CPI inflation which we've assumed to be 2% or a fixed pre-specified increase of 2%. The third of the four terms I wanna discuss, is the retirement age, actually two retirement ages, the normal retirement age and the early retirement age. This is about when the employee can actually start taking the retirement benefit. So the normal retirement age, that's the age at which the employee can retire with the full benefit, specified by the formula. And then the early retirement age is the earliest age at which the employee can receive any pension at all. Although the pension will almost certainly be reduced if they're retiring before the normal age. And the amount of that reduction will, again, be determined by formula. There are other ways to specify eligibility for normal un-reduced retirment. One is what's called the rule of 80. Or rule of some other similar number, where that number is the sum of the years of service and age that the employee has to have attained. This is best illustrated with an example. consider again the teachers in Texas, the second biggest system in the US. Teachers in Texas who started before the year 2007 Can retire at age 65, but they can also choose to retire earlier than that with an unreduced pension benefit, if they meet the rule of 80. For example, if the teacher is aged 55 with 25 years of service. He or she gets an unreduced benefits, that's 55 plus 25 equals 80. Still other systems have an either / or with age and service. For example, employees who join the Florida Retirement System before 2011, get an unreduced benefit either at age 62 or when they reach 30 years of service. And some states offer options to defer retirement. And increase the benefit in the meantime. Also, in the Florida retirement system, for example. If an employee is eligible for full normal retirement. He can, instead, have the state calculate an account balance. And pay a 6.5% annual interest on that balance. Taking a much higher annuity later. Those are called DROP programs, or deferred retirement option programs, and may be costly. The last set of provisions I wanna discuss is vesting. Vesting is the question of how many years the employee has to work before being eligible for benefits. Most plans have what is called cliff vesting, where, if you leave employment or are fired before a certain number of years, often five, you lose all rights to a pension. But if you leave or are fired after that time, you retain all rights to the pension you have earned based on your work up to that date. By the way, the verb, to separate from employment is a convenient way for economists to refer to any departure of an employee from a job. Whether forced or voluntary. Whether they were fired or whether they quit. Note that if an employee separates from the job with a vested benefit before allowable retirement age, he or she can not take a benefit. Until they reach the allowable retirement age. So, if there's Cliff vesting and the vesting period is five years, this means that the last day of an employee's fifth year of work for a given employer is quite pivotal. If the employee leaves before that day, he is not entitled to any pension. If he leaves after that day, he is entitled to the pension under his formula when he reaches the allowable retirement age. Of course with years worked in the pension formula, only reaching five you can see it would in any case be a very modest pension.

For example, at the end of five years if the employee is earning $40,000 and there's a 2% benefit factor. And the pension that will be claimed at retirement will be 2% times 5 times $40,000, or $4,000 per year. So that's fairly modest, and the employee wouldn't get it until much, much later. Also, even for plans with COLAs, there's almost never indexation between the time when the vested worker separates before the retirement age, and when he or she actually draws the pension at the allowable retirement age. So that $4000 per year matching up the worth this much in spending power many many years in the future. So to recap the basic pension contract defines a starting annual pension that's equalling the product of 2 things. First, a benefit factor often in the range of 1% to 3%. Second the number of years that employee has worked and third some variance of the late career salary. We've seen that the details of the pension contracts can be very important determinants of the value of pension benefits. Specifically the definition of a penstionable salary. The cost of living adjustments, the retirement ages and the vesting provisions. 9.3 - What is a Pension Liability? What is a pension liability? To what extent does a promise to make a payment in the future to a public employee employed by, say, a state government, represent a liability to taxpayers today? To understand this question, let's consider an example of a worker who begins working on his 25th birthday, in a plan with a 2% benefit factor, pensionable salary equal to the salary the employee earns in his final year of work, and a normal retirement age of 60. Suppose that during his first year of work, he earns a salary of $20,000, and that salary will grow by 4% per year for his entire career. And suppose there is cliff vesting, where he must work for five years before being entitled to any pension at all. Until the worker's 30th birthday, after which he will have five years of service behind him, he has accrued no pension rights. That means that if he quits before his 30th birthday, he won't receive any pension from his employer. When the worker reaches his 30th birthday, he suddenly vests into an accrued benefit of 2% times 5 years times his salary at that point, that salary is $23,397.00, for a benefit of $2340. That means that even if he quits employment on his 30th birthday, at age 60 he can call up his former employer and request an annual pension of $2340 be paid to him. And then on his 31st birthday if he didn't quit, the situation looks like this. He's now accrued a benefit of 2% times 6 years times his salary at that point, which would be $24,333, for a benefit of $2,920. That means that even if he quits employment on his 31st birthday, at age 60 he can call up his former employer and request that an annual pension of $2,920 be paid to him. Now I didn't specify whether this benefit is inflation-indexed or not. But even if it is, in virtually no case does the employee have a claim to ask that the earned benefit be inflated between the time he stops work and the time he starts taking the benefit. So if he quits on his 31st birthday with that earned benefit of $2,920 per year, that is what he will get starting at age 60, not $2920 grossed up for whatever inflation will have happened in the intervening 29 years. So continuing to build this example up, a worker at age 35, if he didn't quit before that, will have accumulated ten years of service and earned the right to $5693 in annual pension benefits when he later retires at age 60 or when he reaches age 60.

He can quit and walk away with that right. What about at age 45? Well, he will have accumulated, at that point, 20 years of service, and he will have earned the right to a $16,855 annual pension at age 60. What about at age 55, if he works all the way to 55. Well, if he works all the way to age 55, he'll have 30 years of service, and he will have earned the right to a $37,424 pension at the age of 60. And what if he works all the way to age 60, the retirement age, the normal retirement age for this plan? Well then he will have 35 years of service and a pension of $53,120 commencing immediately, assuming he retires at that point. Now what are the cash flows to which the state should view itself as obligated at any given point in time? Well the narrowest possible definition, would start by assuming that the state is not gonna default on any pension promises that it's made already. But that for the employee at any given age, the state is on the hook to pay the accumulated pension benefits at the time when the employee retires. So when the employee turns age 30, the state now has an obligation to pay him a deferred annuity, an annuity that will start in 30 years when he turns 60 in the amount of $2340 per year until he dies. Now, if he keeps working till age 35, or when he turns age 35, the state's obligation will be to pay him a deferred annuity starting in 25 years, again, starting when he turns 60, in the amount of $5,693 per year until he dies. What about when he turns age 45, if he didn't quit before that? Well, then the deferred annuity the state is obligated to pay begins in 15 years at the amount of $16,855, but if he keeps working to age 55, well then the deferred annuity would have to commence in five years at the amount of $37,424 and would pay until the individual dies. And what about what if he turns age 60, works all the way to age 60? Well, then the state is on the hook to pay an immediate fixed life annuity of $53,120 until the employee dies. These annuities, these deferred annuities each have values in a financial market, and we can value them as streams of payments using the principles of bond pricing and annuity pricing. We'll eventually get to that, but first I want to think a bit more carefully about the concept of the state's obligation. Let's think again about the employee when he is 45 years old. His earned benefit, we'll call this his accumulated benefit, is $16,855, starting in 15 years, when he reaches the eligible retirement age. The way it would work, is that the employee would receive a monthly pension payment, and the first monthly pension payment would come on the employee's 60th birthday plus one month. Now that creates a lot to keep track of. So let's instead assume that he is just gonna receive annual benefits, starting on his 61st birthday. The state's minimum obligation for this employee is equal to the present value of a deferred annuity of $16,855, beginning in 16 years, or the present value of this stream of cash flows here. There are no cash flows until he is 61 years old, after which point the state is paying $16,855 per year for the retiree's entire life. The present value of these cash flows is called the accumulated benefit obligation, which you can think of as just whatever the employee has earned under the narrowest definition of the contract. It doesn't consider the fact that this 45 year old will probably keep working. It just considers what the state owes based on the employee's work up to that point.

And, you can think of this present value as the cost of buying a deferred annuity for the employee, and, of course, that cost will vary with a discount rate, r. Formally, the present value cost here, the, the present value of the employer's obligation, equals the sum from time year 16 onwards of the following expression, S sub t times the 16,855 annuity, divided by 1 plus r, to the t. What is S sub t here? That's the probability that the individual is still alive at time t, so we summed that up year 16, 17, 18, etcetera onwards, and at some point, the probability the individual is still alive at time t, which, essentially, is zero. What we just saw there, is what's called the accumulated benefit obligation. But if we look at state employment patterns, well, of course, most 45 year olds do not quit right away. They stay on the job. So if the state looks at that employee, and asks, gee, what are we likely to have to pay to the employee in retirement? Well it's actually much more than an annual pension of $16,855. To give a simplified example, let's imagine that this is a work force in which half of the employees will actually quit at age 45, and the other half are gonna work until age 60 and they are gonna quit then. If the state then asks what it expects to owe for any given 45 year old employee, it is now the following. There's a 50% chance that employee is going to quit tomorrow at age 45, and in that case, the employer owes the present value of a deferred annuity of $16.855 beginning in 15 years. But there's a 50% chance that the employee is going to keep working until age 60, and in that case, what the employer expects to owe is the present value of a deferred annuity of a much larger amount, $53,120, again, beginning in 15 years. So you take the average of those two deferred annuities, that's much more than the present value of a deferred annuity of just $16855 beginning in 15 years. Now note that, here, $53120 equals 2% times the 35 years of service, times the final salary of $75886. That's the pension the employee gets if he works until age 60, $53,000, which ends up being around 70% of his final pay of $76,000. This concept, the average over different annuities that the employer expects to have to pay, is called the present value of benefits, or PVB. You can think of it as the average present value of what the employer can expect to have to pay for a 45 year old employee, again, on average, over the employee's possible employment behavior. So a more realistic version of this might be that, say, 5% of the workforce leaves every year. Then the projected value of benefits, the PVB, would be a weighted average of the 15 possible deferred annuities, depending on the 15 possible ages at which the employee might quit. There are intermediate calculations between the narrow accumulated benefit obligation and the broad present value of benefits. What is the so-called projected benefit obligation, or PBO, which includes future salary increases but not increases in future years of service? So, the PBO for the 45 year old in the case where half the workforce will quit immediately, and half will quit at age 60, is the following, it's 50% times the present value of a deferred annuity of just the $16,855 beginning in 15 years. Plus 50% times the present value of a deferred annuity of a little more than $30,000 beginning in 15 years. So what's the difference between this and the, the much bigger PVB? Well, the difference is that, here, the employer does not include the, the additional years of service in calculating that second deferred annuity that they would have to pay, so here, $30,355 is less than $53,120 because it doesn't take future years of service into account.

Specifically, $53,120 equals 2% times 35 years of service times the final salary of, of almost $76,000, but the $30,355 that's used in the PBO calculation is just 2% times 20 years of service times that same final salary, expected final salary, of almost $76,000. The other intermediate calculation is the so-called entry age normal, or EAN approach, which apportions the cost of the pensions as a fixed percentage of employee salary. This is a much more involved calculation because it requires discounting the future benefits back to the present to get a, a cost, something we're not gonna deal with right now. If using an entry age normal method, however, as many state and local governments do, it will be basically stating an NPV pension liability that is something close to a PBO, a projected benefit obligation. That is not as narrow as just the accumulated obligation, but not as broad as the total expected value of the pensions that they will have to pay. So in this segment, we've covered the cash flows associated with these different liability concepts. We've focused on the narrowest concept, the ABO, accumulated benefits, and on the broadest concept, the PVB, the projected or expected benefits. These have the cleanest economic interpretations, but many actuarial schemes use some intermediate measurements between these two things. The next thing we have to consider is, for what purposes these different concepts might be useful, as well as what discount rates should be used to measure their present values. 9.4 - Uses of Different Liability Measures Uses of the different liability measures. Different measures of liabilities, are useful for different purposes. Let's deepen our understanding, of some of these liability concepts. So-called accumulated benefit obligation or abo, is the present value of the pension promises, made on the basis of each employee's current service and salary, as of today. Even if the vast majority of the workforce will continue to work and accrue benefits, the accumulated benefit obligation, the ABO, reflects only the current obligation of the employer. The ABO is sometimes called a termination liability, since it reflects the pensions that will be owed, even if the pension plan were shut down completely or the entire workforce laid off. Calculating the ABO is relatively simple because beyond some mortality tables, you really only need, well, the benefit formula and the current wages of the employees, by years of service, and if the plan has a cost of living adjustment, some inflation assumption. To calculate a plan's total ABO, you simply add up the ABO's, represented by each individual employee. You can also think of the ABO, as a frozen plan liability, or the total present value of the employer owed amounts, if the pension plan were frozen. What does that mean? Well the freezing of a pension plan is process whereby, the workers are told, they will receive no further growth to their earned or accrued benefits. So take for example of a worker aged 45, who has a 2% benefit factor, 20 years of service and a $60,000 salary. Well, he currently has rights to a pension of the product of those things, or $24,000 per year, when he reaches the normal retirement age. Now, he may expect to continue to be able to grow his pension, as he gets more and more years of service and salary. But the ABO would only recoginze the employers obligation to pay him an annuity of $24,000 per year, when he retires. And if the employer, freezes this plan, then the 45 year old worker will indeed be told that he's gonna get a pension of $24,000 when he retires, but no more.

To be clear, this is called a hard freeze. That distinguishes it from a soft freeze, in which the plan would simply be closed to new workers, but current workers would continue to accrue benefits. Usually when defined benefit plans are frozen, the employer begins contributing to a defined contribution, a 401k type of plan, as some compensation for the fact, but the employee's defined benefit pension, will not actually grow with his future work. One common source of confusion is, whether a cost of living adjustment, a COLA, counts as part of an ABO, an accrued benefit, or only as part of one of the broader expected measures? A COLA would be if the employer had pledged the $24,000 pension. Our employee in this example had earned, for when he retires at say, age 60 or 65, would grow with inflation or at some fixed rate. Well, because the employee would get this, this inflater, even if the pension were, were, were frozen, the COLA is usually thought of, as having been earned as part of the ABO. It's thought of as being accumulated and something that the employer can't go back on. Now the broadest possible measure of the sponsor's pension obligation, was the present value of benefits, that projects forward what each employee is likely to attain, in terms of earned pensions on the basis of statistical assumptions about how likely they are to continue to work. So for that, we also need a projection of their future salaries. So we'd have to have some estimates of the average pay increases, that are likely to prevail, or the 45 year old worker, over the next 15 years, as was how likely he is to stay on the job. Interestingly while on day one of our worker's employment, he has zero recruit benefits. His hiring a medially leads to a jump in expected benefits, this graph shows liabilities by age, for a hypothetical worker hired at age 20 and retiring at age 65. A bit of a longer working life, under a variety of standard actuarial assumptions, used by state governments. Here, I'm assuming that the worker works for the entire time period. That is there are no early departures. For each age less than 65, the expected benefits are more than the accrued benefits, but at the retirement age of 65, the two are going to be equal. The graph also shows one of the intermediate calculations, a PBO, that takes future salary increases into account, at an entry age normal approach, that apportions pension costs to be a fixed percentage of salary each year. All of these measures only consider current hires, not future hires, so one could formulate a concept that's even broader and then included the present value of all benefits the state was expected to have to pay out to all employees, even those who have not yet been hired. Okay, so what are the reasons for and uses of these different measures? To discuss this question intelligently, we first have to keep in mind, what total compensation for a worker really is? Total compensation is the following. Well first you got salary, that's obvious. Then there are also what we call immediate benefits, okay? Health insurance, defined contribution, pension contributions, payments into 401K types of accounts, and so on. Then we've also got the increases, in the value of deferred compensation, as that the newly accrued rights to deferred compensation, that includes defined benefit pensions, the promise of health insurance and retirement to which the worker earns additional rights in a given year. So arguments of those who advocate for using one of these broader measures, include the following. First of all, in the public sector, the right of the state or local government to freeze pensions as much less clear, than in the private sector. For example in California, the law has been interpreted by many to

stipulate that public sector employees are entitled to whatever benefit package was in place, on the first day of work or more generous, but not less generous. If that is really true, then the employer has a broader legal obligation, than just what the formula says. Broader obligation than the accrued benefit obligation because the employer can't freeze the pension. Second, second argument for using one of these broader measures, broader than just the accumulated benefit obligation is that, if the work force is unionized, even if a worker were earning more than his or her marginal product, it could be hard to lay the worker off. So, in that case, the state really has a much broader obligation than just what the ABO would say. Third, the third argument is that it might be the case that, younger workers are getting systematically underpaid relative to the actual value of their work, and older, older workers systematically overpaid and these broader pension concepts would capture some of that. fourth argument for using the broad concepts would be the one might wanna have contributions and funding levels higher than when the workers are young. Because the narrowly defined cost, the ABO costs, start to increase very sharply when the employees get older. So, from a planning perspective, you might wanna use one of thse broader measures. And, finally there are argumetns that investment stragetgies. Should think about correlations between the evolution of future salaries in the stock market. To many economists however, probably the majority, the narrow abo, just the level of accumulated benefits today, is the cleanest measure and the reasons for this are as follows, first of all in theory, employers have the right to freeze pensions. In the private sector, this right is quite clear. In fact, there have been many pension freezes in recent years in the private sector. So contractually, the employer is only on the hook, for the ABO. And it's, it's hard to believe that any employer really literally, could not freeze the pension benefits, at their levels today. Second, just like you wouldn't recognize, as an employer, liability. The fact that the employer will have to pay future salaries. You also wouldn't realize, that the employees will have more accruals of pension rights. I mean, a company, you don't book as a liability for the company the present value of future salaries that the company has to pay. After all in theory, the employer could fire the worker and the worker has to put in the work, if they're going to get the compensation. The third reasons they use one of these AVO is they use the narrow AVO approach would be that it seems unlikely that younger employees are really getting undercompensated. Relative to the overall contribution to the upper the workforce. So there is really no need to reflect more than the contractually earned pension rights. Fourth, it makes sense to compare an ABO, to the assets that have been set aside to fund the plans. So that's a really clean reason to think a out this ABO, just the level of benefits earned up until today, because you know, benefits earned in the past should be funded by contributions and investment returns, that have already happened. Benefits that are expected to be earned in the future, can be paid for, from future contributions and investment returns, so the ABO should be something that is very comparable. You can compare it to the assets, that have been set aside today and you can see how well-funded the plan is on that basis. Finally, a pension sponsor, an employer can follow a strategy of immunizing the ABO pension promise, by buying bonds that will match the cash flows, that must be paid out. I'll wrap up this segment by saying that, this is not a debate that has been resolved. If a vote were taken of academic experts and pensions,

most would probably find the ABO accumulative in obligation arguments, more compelling, but it's not overwhelming. The thing to keep in mind is that, the ABO recognizes relatively little pension liability, early in a worker's career because the employee hasn't technically, earned them yet. And also as a result, the pension cost under an ABO, that is the cost in any given year, the thing that would go into the compensation formula, is relatively low when the employee is young and high when the employee is older. The broader measures generally smooth out that ongoing cost over the employee's life. Perhaps consistent with the more continuous nature of employment, in the public sector, relative to more risky employment in the private sector. Most public sector accounting, uses a broader measure, like entry age normal measure or the private sector tends to use PBO's for financial statement purposes and ABO's, for regulatory and funding purposes. 9.5 - Overall Recap Overall recap. What have we learned in this lecture? Well, some of you may receive DB pensions. For others, you have to recognize that your city, state, and federal government, are providing DB pensions to public employees. That means that you, as a taxpayer, are providing DB pensions to public employees. In that role, it's important to consider. What the parameters are of taxpayer funded, to find benefit plans as well as how they're measured. You shouldn't assume someone else is gonna do this for you. We've seen several different definitions of pension liabilities. The accumulated benefit obligation or ABO, gives the employer full credit for being able to stop the accrual of new pen, pension benefits whenever they want to or need to. And that narrow measure also doesn't recognize much liability upfront. And instead guarantees that we're gonna have a rather sharp increase in the liabilities any worker is gonna be owed as the worker gets older. The broadest measure, the PVB, on the other hand, the present value of expected benefits, gives the employer no credit for being able to stop the accrual of benefits, but gives them more gradual recognition of the benefits that are earned. Which is more appropriate really depends on what the purpose is and what the legal framework is that surrounds pensions. If your state or local government would not be legally entitled to or politically able to freeze pensions, then actually taxpayers might think of themselves today as needing to prepare for more than just the benefits that have been legally accrued under the narrow accumulated benefit obligation definition. In this lecture, we also learned to view defined benefit pension promises as deferred annuities, and so their value is given by the value of the deferred annuity. The value of the deferred annuity, comes from the net present value formula for cash flows beginning at some point in the future multiplied by some probability that the individual in question is still alive. We have not yet discussed what would be an appropriate discount rate for the liabilities. A discount rate that we would use to convert these streams of cash flows in to the present value. The appropriate use of discount rates is a critical topic for further study. As well as the accounting and regulatory frameworks that are in use for both public sector, and corporate sector pension promises. Lecture 10 - Measuring Defined Benefit Pension Liabilities 10.1 - Are You Paying Now or Will You Pay Later?

Welcome to this lecture on measuring defined benefit pension liabilities. Would you make a major financial decision without understanding your household's balance sheet, your assets and liabilities? When a company or government promises to pay a worker a traditional pension when that worker retires, it creates a financial liability for itself. In essence the employer must have the resources to be able to provide an annuity to the employee when the employee retires. Possibly an annuity indexed to inflation. To prepare for this the employers, companies and governments, typically contribute to and manage their own pension funds, pools of money dedicated to providing their retirement benefits. If these pools, do not have sufficient funds when the worker retires, the empolyers must take the resources to pay pension benefits out of other sources. Governments will either increase taxes, or cut spending on social programs. Assuming, that is, they don't want to or can not default, on their promises to retired employees. Companies would have to take the resources out of their profits. So, that means the definition of what constitutes sufficient funds for a pension system to be well funded today is crucial. To determining whether employers are actually satisfying their responsibilities today. For example, consider the firm General Motors. The gap, between contributions to company pension funds and the amounts, that would eventually be necessary to meet pension promises, proved ruinous, to anyone who owned shares in General Motors when it went bankrupt. And it proved ruinous, to many other people, who lost their jobs as a result of these problems. The bailout of the company may have cost taxpayers more than $10 billion. And the company still had $13 billion of unfunded pension obligations on its balance sheet at the end of 2011. If you're a US taxpayer, you will contribute to paying down those amounts. A larger group to whom taxpayers, and again, that means all of you, are obligated to pay pensions, are public employees. All levels of government in the US, federal, state, and local, offer pensions to public servants. But this is particularly the case, with the state and local government workers, who number around 17 million. With many millions of retirees as well. These include firemen, policemen, public school teachers and others who provide public services, most of them essential public services. So, if say a state or city government, finds itself without sufficient funds to pay pensions, then someone has to make up the difference. The same thing as if the government, had not been running a balanced budget all along and then had to bring its books back into balance. Let me illustrate this with a simple example. Imagine a state, that every year followed a balanced budget in which the dollars that they collected in taxes, in this bag here, equaled the dollars that it spent on services in this bag here. Now suppose that the only expenditures, were the salaries for public employees. At first glance, the budget might appear to be balanced. But what if in addition to the money that was being paid as wages to public employees, public employees are also told that they'll receive a pension when they retire. That the government will pay them an annuity from the day they retire until they die. Well, if today we do not set aside sufficient funds to cover that promise, then tomorrow's taxpayers plus in the future or our kids will face a double burden. They will have to pay the salary of tomorrow's public employees, who provide them with services plus they will have to pay the pensions of the retired public servants who provided us with the services today.

An by the way, they would also not have had the benefit, of earning some interest, if the money had been set aside earlier. So, how can we figure out if a government has fully funded its pension system, or whether the system is perhaps, over-funded, that means it has more money than needed, or underfunded, that means it has less money than needed. The key to keep in mind is that a pension promise is nothing more than a deferred annuity. It's a contract from taxpayers to the employee. It says we will pay you an annuity. It will begin when you retire. So, whether a pension system is fully funded or not, there is a question of whether the resources the employer is devoting to pensions, would be sufficient to buy those deferred annuities. If you are a taxpayer, then you are actually the one providing and guaranteeing these promises to public employees. And finance is clear, that in order to understand the funding status of a pension system you need two ingredients. First you need the streams of cash flows promised to workers with separate accounting for benefits already earned and benefits yet to be earned. Second, you need a discount rate for those streams of cash flows. What should that discount rate be? Well, to value the cash flows as a default free benefit, you need a default free treasury bond-like yield curve. If you wanna credit the state or local government, there's a possibility that it might default on the payments. Then you need something more like a municipal bond yield curve. These present values can then be compared to the value of the assets in the pension fund, to understand the financial staus of the pension fund. The next steps are to consider these two ingredients, cash flows and discount rates in detail. 10.2 - Streams of Benefit Cash Flows Streams of benefit cash flows. Suppose you're looking at a pension system that is sponsored by your local governments or state government, these are benefits that you as a taxpayer will have to pay for, so understanding them is important. The first the most basic question. Before we get into any discounting, or measurement is what is the stream of cash flows look like that has been promised to workers. What do I mean by a stream of cash flows? Well it would start with actual pension benefit payments from the past few years. Let's say these were $100 million in 2012 for a hypothetical system. And suppose that they had been rising they had risen up from $80 million in 2009, this rise in recent years would not be a typical. And the stream of cash flows would continue with next year's pension benefits under two scenarios. The first scenario is, what is our best forecast of what the pension benefits will be next year? And then in years two, and three, and so on. Given that we typically only do this for today's work force, not for future workers, at some point in the future, the streams of cash flows would peak and bend downward. This is called the PVB, or projected value of benefits method. The second scenario is, what if all pensions were frozen today, this is called the ABO, or accumulated benefit obligation method. Note that if plans were frozen today benefits will still rise from today. Why. More workers will retire as time goes on you can think of these cash flows as the sum of all of the annuities that the sponsor is providing and will provide to employees, that includes the deferred annuities that will begin at some year in the future when current employees retire. As well as the annuities that are being currently provided. So in a pension freeze there is no additional accrual of benefits but benefit payouts will still rise from today. Here already there is a lot of

information. In fact with this information alone you could set about trying to figure out how much money needs to go into the pension systems under various assumptions in order for the system to remain solvent For example you might combine this information with the information that this system has say $2 billion, that's $2000 million in assets today. Keep in mind these are hypothetical numbers not those of a specific system. You can then see if the system were frozen how long the assets would last under various assumptions. Note that for a frozen plan We wouldn't consider any future contributions because there wouldn't be any. In this case, we can see that the plans were frozen today. We would have a surplus of assets that would continue to grow if returns are 8% per year compound annualized. But if the compound annualized returns are only 6% per year than the assets will be exhausted in 2042. If the compound annualized returns are only 4% per year, then they'd be exhausted in 2032. And if they are 2% per year, then they'd be exhausted in 2028. And if there's 0% compound annualized returns, then the exhaustion will happen in 2026. So a lot really depends on what the realized returns here are gonna be. And if the system is investing in risky assets It's taking on a distribution of possible return outcomes. We could also take the full expected cash flows and consider them along side investment returns and future contributions. Here's what happens if we do that, and I assume that contributions start at $65 million and grow at 2% per year with inflation. Here again, we can see that 8% compound annualized returns, will be more than sufficient for this system. 6% compound annualized returns, will be just about right, in fact if you continue this out, you find that the fund would expire just as all the benefits for existing employees are getting paid off. But there are still future employees to consider. A 4% compound annualized return would lead to exhaustion in 2043. A 2% compound annualized return would give exhaustion in 2035. And a 0% return would give exhaustion in 2032. Now, the assumption that contributions will grow with inflation is not totally harmless. Supposed it's for a fund for a city that was experiencing a downward secular trend in its economics, say, Detroit. Contributions can only increase with inflation if government revenues are also increasing with inflation. Or, of course, if taxes go up. But the point here is precisely not to include future tax increases, or future benefit cuts, or any change in future policy. It's to show what happens under the status quo. The point here is that if you have the benefit cash flows, you can do this kind of analysis and figure out what it takes for the funds to be in balance For some reason that I've not been able to ascertain, governments do not generally published these streams of benefit cash flows, even upon request. Now what happens if the funds do actually run out? Well that means that the pensions will have to be paid out of general revenue. And if the budgeting has been for pension contributions to be much less, than benefit payment in any given year And in this example, we were contributing 65 million and paying out a 100 million, counting on investment returns to do the rest for us. Well if that's going on then there could be a pretty sizable hit to the budget if we have to start paying for pension benefits out of general revenues. The hit to the budget would depend on the size of these pension benefits relative to the budgets of the sponsors.

So to recap. The cash flows that the pension system has committed itself to are very important for understanding the system's sustainability. Today, pension benefit payments will in almost all cases grow, even if pension plans are frozen. As a result, if you're intereted in whether your state or local government has a sustainable pension system, then getting an estimate of these cash flows is critical. Unfortunately, systems don't usually publish the cash flows, because they're generally not required to. It doesn't hurt to petition city councils for this information, however. And if you can't get the information, the best you may be able to do is to apply some assumptions to today's benefit payments. 10.3 - Discounting Pension Cash Flows Using Default-Free Yields: The Finance Approach Part I Discounting pension cash flows using default-free yields, the finance approach part one. Suppose you have good projections of the cash that must be paid out to beneficiaries for a pension system you are trying to analyze. Say a pension system that is sponsored by your local or state government. What is the right approach for determining the present value of those liabilities? In particular, if you want to know how well funded the system is, you will want to compare the assets that the system has in its pension fund, to the value of its liabilities. But how should the present value of those liabilities be calculated? For example, suppose the system has $2 billion in assets and you've projected the cash flows out over the next say 100 years. Well how can you know whether $2 billion is adequate for making the payments? The first decision you have to make is whether you want to find the present value of only the cash flows that have been contractually promised based on work performed up until today, the accumulated benefit obligation, or ABO, or whether you want to find the present value of the full expected cash flows the sponsor is going to owe, the projected value of benefits, PVB, or whether you want to do something in between. If you're comparing the present value of the liability to the current assets, the ABO makes the most sense. This is a very clean interpretation. Are the assets that have been set aside today sufficient to pay for the promises that have been made up until today? That is the question a present value of the ABO can allow us to answer. Put another way, if the plan were frozen today or discontinued, would their be enough assets to pay all the promises that have been made up until today. The broader measures, in contrast, add additional future benefit accruals to the ABO. If you want to compare the broader measures to assets, you would also have to consider some components of future contributions. For the ABO, you do not have to consider future contributions. Just like when you consider a firm's current balance sheet, you do not include future revenues as an asset. Of course, if future revenues are going to be so large that they make balance sheet problems appears small, then we may be less concerned about the firm's or government's balance sheet deficit. Those future revenues then may shade the interpretation of the balance sheet, that is inform how concerned we should be about it, but they do not change its calculation. So let's take an example where we have the ABO cash flows that were $100 million in 2012. And now we're trying to determine the current funding status of a pension system on the basis of this stream of cash flows. Let's suppose we're doing this calculation as of the end of 2012. So we're discounting a stream of cash flows. That stream begins in 2013, at around $108 million, it rises to a maximum of around $167 million in 2028 and it eventually goes down to 0 after 2100, since this is just current employees and already accrued benefits we're talking about.

The big question is, what discount rates, Rs, should be used? And here I have indicated with subscripts that like any stream of cash flows we would like to discount at rates that are appropriate for each time horizon. A one year cash flow should be discounted at a one year rate, a two year cash flow at a two year rate and so on. That is there is a term structure of interest rates. Well, finance is quite clear. That the value of a stream of cash flows is given by discounting those cash flows at a rate that reflects the risk properties of the cash flows. Employees of states or cities, in these systems, are told that they will receive the payments specified by their benefit formulas. And they are told they will receive them with certainty. They are not told that the payments might vary with the stock market, or with the level of interest rates, or with any other financial or economic factor. And this is particularly true of the ABO cash flows, the cash flows related to benefits that have already been earned by the employees based on current levels of service and salary. Any employee in one of these plans can take their current salary, years worked and benefit formula and figure out what annuity they are owed. They can walk away from their job and still claim the annuity at that level at retirement. So evaluation of the pension payment as a promise would use a risk free yield curve, such as the US Treasury yield curve. As of early June 2013 these rates look like this, a one year treasury had a 0.14% yield, a five year treasury had a 1.02% annualized yield, a ten year treasury had a 2.1% annualized yield and a 30 year treasury had a 3.25% annualized yield. But these are the bond equivalent yields on securities that pay semiannual interest. What we really need here is a zero-coupon curve, those rates are a little bit higher. Here are rates on treasury stripped interest from wallstreetjournal.com. I've just taken the first date after the June date in question in each case. And here we can see that a one year zero-coupon treasury bond would have a 0.18% yield, a five year treasury zero-coupon bond would have a 1.09% annualized yield, a ten year zero-coupon bond would have a 2.26% annualized yield, and a 30 year treasury bond would have a 3.5% annualized yield. To discount the stream of payments in the example which are at one year intervals, we need an interpolated version of this curve. That means a curve, where we have a point for every year. We can easily do that by just linearly extrapolating between the points. There are some considerations regarding what to do with cash flows beyond 30 years. I and others have written about this. But for now, let's just assume that it flattens out after 30 years so that a 35, 40, 45, 50 year promise is discounted at the same rates as promises at 30 years. So now we can see an interpolated version of the entire yield curve. And we can then apply that yield curve to the ABO cash flows to get a present discounted value of the cash flows. Undiscounted, that would be ignoring the time value of money and risk, the undiscounted sum of these cash flows would be 5.805 billion. Discounted to the treasury curve, the sum would be 3.283 billion so that 3.283 billion is our present value. Now this discounting approach prices the pension promise as though it were a guaranteed sure thing. Or put another way, it measures the value of the zero-coupon treasury bonds that would have to be bought, in order to replicate the stream of cash flows promised by the pensions. Another word for this is Defeasance.

An employer can defease the stream of cash flows by setting aside treasury bonds that will pay out exactly at those times that the cash flows are due. You'll buy a bunch of one year zero-coupon bonds that will mature at a value of $108 million at the end of year one. And a bunch of two year zero-coupon bonds that will mature at a value of 115 million at the end of year two. And a bunch of three year zero-coupon that will mature at a 122 million at the end of year three. And so on. These bonds will pay the pension cash flows in essentially any state of the world that might occur. Another word for this investment strategy is immunization. A sponsor can immunize itself against the pension liability by buying matched treasury bonds. And as the ABO grows with new benefit accruals the cost of those new benefit accruals is given by the bonds the sponsor would have to buy to immunize them. The beauty of this calculation is that it allows a direct comparison between assets on the one hand and benefits already earned or accrued on the other. We don't need to consider future contributions here since those are supposed to cover future accruals, the future growth in the ABO. If future contributions, be it from employees or employers, are going to pay for the ABO, or going to pay for the legacy liabilities, then whoever is paying those contributions is catching up to pay down these unfunded liabilities. That is, they are over contributing relative to on-going actual compensation costs. So comparing the ABO to current assets really does reflect the current funding status of a pension system. Keep in mind that I've been talking only about the ABO here, accrued benefits only. If a city say, puts new employees on a 401K plan, that does nothing to the ABO. If a city freezes everyone's pensions keeping COLAs in place, that does nothing to the ABO. Changing the ABO would require changing COLAs or benefit parameters, and the pension laws that govern the private sector at least clearly protect those benefits from being impaired. As such, discounting the ABO at treasury rates is the recommendation of the majority of finance economists. One could also consider the broader measures, like the projected benefit obligation or full expected value of benefits. These are going to be greater than the ABO because they include some future expected increases in benefit cash flow promises. As such, there's a component of these broader measures that is above and beyond the bond-like ABO. And just like we would not want to value a stock using a discount rate on safe bonds for its dividends, we would not want to value the risky components of the expected pension benefit cash flows, using that kind of bond-like discount rate. For the component that was not covered by the ABO, that is the component of the broader measure above and beyond the ABO, we would want a discount rate that also included a couple things. First of all the fact that there is some possibility that the plan might be frozen in the future and secondly that the future evolution of pension liabilities is correlated with wage growth. So the discount rate for that above and beyond part, might be higher than the ABO strictly by itself, to account for these risks. But in no case should these broader measures in total be less than the ABO. To recap, public employees are generally told that their pensions are guaranteed. Financial economics clearly says that the value of a default free stream of cash flows is measured at a default free rate. The only justification for using a

rate higher than that implied by the default free treasury-like yield curve would be to credit states or cities for their option to default on pension promises. The next step will be to think about whether that would under any circumstances be a useful approach. {MUSIC} 10.4 - Discounting Pension Cash Flows Using Yields on Non-Treasury Bonds: The Finance Approach Part II Discounting Pension Cash Flows Using Yields on Non-Treasury Bonds, The Finance Approach part two. Finance is quite clear that the value of a stream of cash flows is given by discounting the cash flows at a rate that reflects the risk properties of those cash flows. So, as I've talked about before, the valuation of the pension payment as a promise would use a risk free yield curve, such as the US Treasury yield curve. I want to start out by discussing a couple of very legitimate reasons why even if we want to value the pension payments as a default free promise, the treasury yield curve may not be exactly the right curve to use. In some senses, the treasury yield curve will turn out be too high, in others, it may turn out to be too low. Using the treasury yield curve, prices the pension payments as though they were liquid, tradable and nominal obligations promised by the US government. Let's consider the implications of each of these, liquid, tradable and nominal. A pension promise is not as liquid as a US government bond and it is much less tradable. Treasury bonds enjoy particularly low yields because of their extreme convenience as liquid, tradable and easy to value securities. That suggests that a more appropriate discount rate for a default free pension promise would still be a curve that is default free, but that would it not be for a promise that is as tradable and liquid as that on a treasury bond. The state of the art research on this suggests that if treasuries weren't very liquid, weren't as extremely liquid as they are, yields on treasury bonds would be around 50 basis points higher, that's half a percentage point higher than they are now. On the other hand, state employee pensions typically contain cost of living adjustments or COLAs. These are in some cases indexed to inflation. If inflation risk is priced, then an appropriate default free discount rate would result in a downward adjustment of the nominally treasury yields to remove that inflation risk premium. The most compelling research on this suggests that the ten year inflation risk premium in treasury bonds is also around 50 basis points, or half a percentage point. That is, if one compares nominal bond yields to the yield on fully inflation indexed treasury bonds plus expected inflation, the nominal bonds still yield 50 basis points more to protect investors against the possibility that the expected inflation might be very wide of the mark. Keep in mind the relationship, the nominal yield equals the real yield plus expected inflation plus an inflation risk premium. So, the bottom line is that while the treasury yield curve might be 50 basis points too low due to the extreme liquidity of treasury bonds, the countervailing force is that they are 50 basis points too high for a promise that is fully indexed to inflation. Note that the ABO cash flows should include the expected increases in payments due to expected inflation with the COLA, as these are already earned by the employee according to contract, as long as the employee has a vested pension.

Now that was all still assuming we wanted to value the pension as a non-defaultable promise. If you as a taxpayer want to be sure your government will be able to pay the pensions in any state of the world, you would set aside duration matched treasury bonds to do that. But what if instead we wanted to value the pension as a defaultable promise? That is, as a tax payer in some states in the US, I might reason that my government could default on the pensions, not pay them in full, if things get bad enough. As I'll discuss later, it really depends on the laws of your state and or city as to whether such a default could be possible. And de facto, it also depends on the political climate. But if, as a tax payer, you think that you might be able to default on the pensions in some states of the world, then in some sense these pensions might be less costly to you or seem less costly to you. And as a recipient of a pension in a locality where a default is possible, you would naturally value the promise less if you think there is a default possibility. The way that you would reflect that lower cost, or from the participants perspective, lower value of the pension, would be to use a rate higher than a default free rate. To flip it around, we can ask the question, what does finance say about using rates higher than a defaultfree rate to value pension obligations? Finance tells us that the only reason to use a higher rate than a default-free rate, is if we want to somehow credit the sponsor for the possibility that the sponsor might default, might not pay the benefit in full. So, for example, suppose the state government that sponsors the pension plan in our example, also issues taxable general obligation municipal bonds that trade at a premium of 150 basis points, that's 1.5%, over treasury bonds of similar maturities. So, for example, say that that 20 year taxable muni bond issued by state traded in early June at 4.4% compared to a 20 year treasury yield of 2.9%. Now so as not to get tangled up in tax effects, I want to note that I'm using a taxable municipal bond yield. That is, I'm using the yield on a general obligation bond issued by the state that for, for some reason was not qualified for tax exempt status. These taxable munis exist, though tax exempt munis are much more common. So, more likely approach is that you would see tax exempt munis trading at something less than 4.4% and you could do a tax adjustment on that. Let's suppose either way that you got a taxable muni yield of 4.4% for this city. Now, around 50 basis points of the 150 basis point difference between the munis and the treasuries, might well be due just to liquidity differences between treasuries and municipal bonds. But the remaining 100 basis points of it are probably due to default risk, the fact that these muni bonds are not default free the way that treasury bonds are. So let's consider benefit cash flows which will be 108 million in year one, 115 million in year two, and so on. What if we discounted these at a rate that was a hundred basis points higher than treasuries? A rate that reflected the additional default risk of the muni bonds. Well, then we can see that the total present value of discounted cash flows is now lower and we've actually taken about 14% off the value of the liability. What does this calculation mean? It basically treats the pension promise as being just like a general obligation bond issued by the state, a taxable one, since pension payments are taxable. This would be the value that a participant might ascribe to the pension promise if one believes that the

state will actually cut pensions in the same states of the world as if it cuts the value of its municipal bonds. And that it would do so to the same extent giving them the same haircut if you will. The calculation using the muni yields treats pension promises exactly like municipal bonds. Would this be a good approach? Well from the perspective of the employees or taxpayers, it might tell you something. But imagine that the state got downgraded by a rating agency and the bonds sold off so that the yields rose by another, say 25 basis points. The pension promises under this municipal yield curve discounting would all of a sudden have appeared to have gotten cheaper, because now the market is telling everyone hey, there's a higher likelihood of default on these things. This would certainly create some perverse incentives. A city or state financial manager could reason, hey, let's damage our credit quality so that the market thinks we're not credit worthy, and therefore our pensions will look cheaper. Well, it may be that as a state's credit gets downgraded as pensions become less likely to be paid but the participants in the plan certainly would not accept that as a reason to call the plan cheaper than it actually is. Finally, there's the question of whether it is even appropriate to think of pensions as having the same priority with the same recovery rates as municipal bonds. By priority, I mean that if there were a bankruptcy proceeding or default on some obligations, who would get served first? Pension claimants or holders of the bonds issued by the sponsor. And by recovery rates, I mean how big of a cut would bond holders and pension recipients take respectively on their positions, 10% cuts, 20% cuts? I will leave a detailed discussion about priority to another segment, but I'll preview it by saying that there's clearly substantial heterogeneity in what state laws allow. There are some states where the state constitution appears to give pensions priority, such as in Illinois where the state constitution says that pension benefits may not be diminished or impaired. If accrued pension rights, the ABO, really cannot be altered in any way, then clearly one has to use default free rates, so treasury based rates, not municipal bond rates to discount them. In California, courts have also consistently held that prospective benefits, so not just the ABO but also future benefits that might be earned by an employee, are protected by contract. So whether the pensions are ironclad or not, boils down to whether these contracts can be renegotiated. De facto, in the bankruptcies of California cities, like Orange County in the 1990s, and more recently Vallejo, pensions were preserved and bonds were restructured. On the other hand, the state of Rhode Island recently passed a law that made municipal bonds at the local level senior to pension promises I'll recap by summarizing what this all means for discounting. It means that if we're looking at this from the perspective of tax payers wondering how much they're likely to have to come up with in extra payments, the appropriate discount rate might depend on the state and its laws and political climate. In states where there have been pension cuts, one could justify from a taxpayer perspective, using taxable municipal rates as opposed to treasury rates, to give a sense of the present value of how much taxpayers are likely to have to come up with. And just like taking the present value of a risky bond, there you'd use the yield on risky debt to take the present value of a risky pension, you also use the yield on risky debt. But the only justification for using these higher rates is that the state is saying to everyone, we will cut benefits if the going gets tough.

You'd never want to use that calculation for measure of how the state should appropriately fund a pension system. If you did that, the worse the credit quality or credit rating of the state, the less the state would think it had to fund. But if the pension promise is really analogous to public employees owning portfolios of taxable municipal bonds, then the economic value of the promise would be equal to the present value using taxable muni bond discount rates. 10.5 - The Actuarial Approach The Actuarial Approach. The approach that finance economists take to measuring pension obligations is to treat them like bonds. If pension obligations are ironclad promises, then we treat them like defaultfree treasury-like instruments. In order to actually pay those certain promises, one would need to buy a portfolio of maturity matched treasury bonds. If the pension promises are only as safe as muni bonds, then one could reconstruct the cash flows of the pension promise using a portfolio of municipal bonds. And so, we could treat the pension obligation there like a not totally riskless bond. However, one must consider the participants in these plans would presumably not accept a portfolio of muni bonds as a replacement for their pension plan as they consider the pension plan safer. Now, actuaries of state and local governments, the people who, who prepare the reports for state and local governments in the US take a very different approach. They discount pension liabilities using the expected return on the portfolio of assets they have set aside to match the promises, regardless of what those assets are. This is the directive of the Governmental Accounting Standards Board, or GASB. Now, this would be equivalent to the financial economics approach, if the assets that they had set aside had been chosen to match the liabilities. That is, if they had invested in bonds chosen to mature at the required cash payment value at each point in time in each future state of the world. That's called Asset Liability Management, or ALM. However, bonds are only about 30% of public pension fund portfolios. And then a rather large share of those bonds are not high quality enough to match the pension payments. They might be speculative grade corporate bonds, or a mortgage backed security. In the absence of ALM, we have a mismatch between the distribution of outcomes that the assets generate and the distribution of outcomes that the liabilities generate. So, for example, imagine you wanted to retire in 15 years with a guaranteed pension of $5,000 per month, that is $60,000 per year for exactly 22 years. Finance is clear what you should do. The value of this stream of cash flows is the value of a 22 year annunity with a deferred start. That is, it's a stream of 22 $60,000 annual cash flows starting in 15 years. Using the Treasury Yield curve, which today ranges from around 2.7% at 15 years to 3.5% at 37 years. That's 22 plus 15 years is 37 years. We can do the discounting would find that this stream of cash flows would be worth $585,000 today. If $585,000 were set aside today in an account, economists would consider this a fully funded promise. Actuaries that compile state government reports however, use as a discount rate, the expected return on the assets in the pension fund to determine what they call the value of the pension promise. So, let's suppose that they're investing in the stock market, and the expected return on the stock market is 5.5%. Well then, they would take the $60,000 payments and discount each one at a 5.5% rate. So they would use 1 over 1.055 to the 15 for the payment 15 years from now.

1 over 1.055 to the 16, for the payment 16 years from now, and so on. In that case, the value ascribed to the promise would be only $357,000. Or around 60% of the value of the promise using the finance approach. More commonly, even higher expected returns are used. Today, the average among public plans is around 7.8% with many still using rates of around 8%. At 8%, the value of the promise is only $208,000. Less than 40% of the value of the promise using the finance approach with treasury yields. What is really going on here is that the governments, by targeting these expected returns, are taking on a distribution of outcomes. And they're focusing on the mean of that distribution. And assuming that the mean is definitive, ignoring the rest of the distribution. Much of which might lie below the mean. Remember, the mean is generally greater than the median. When you have a long right tail of possibly very good outcomes. But when you can't lose more than 100% of your money. And even as means, some of these expected returns of 8% just may not be realistic estimates. What I wanna do now is to illustrate what a standard model in finance, the Black-Scholes-Merton Model, would say the distribution of outcomes is for a 30 year investment under a 0% risk free T-bill rate with a market risk premium of 5.5% over that riskless rate, assuming that the investor wants to target an 8% expected return. Now, in order to target an 8% expected return with a Market Risk Premium of only 5.5%, the investor has to take some risks. What we would need here is to lever up the investment with a beta of around 1.4. Since 1.4 times 5.5% is around 8%. Public pension funds add leverage to their portfolios by investing in private equity, and putting some of their money with hedge funds. Though most of them are probably assuming a Market Risk Premium of more than 5.5%. If they're doing this calculation. 5.5% over T-bills is about the Market Risk Premium rate that is consistent with recent surveys of practitioners and academics. So let's look at the distribution of geometric, that is, compound annualized returns over 30 years for a strategy that targets this 8% annual arithmetic return. As I've discussed elsewhere, the geometric average returns. The average actual compound annualized returns realized over a period of time longer than one year is gonna be substantially lower than this 8% because of the variability of returns year by year. And the fact that say losing 6% one year and gaining 10% the next year does not leave you as well off as having gained a steady 8% each year. So it turns out here that the geometric mean return over this time period, will be less than 5%, only 4.93%. And I don't think it's possible to a target an 8% geometric mean return in this environment. If public pension systems have a way of targeting an 8% geometric mean return over the next 30 years in an environment where riskless rates are close to zero and Market Risk Premiums are 5.5%, it'd be interesting for me to learn about it. What they can say, is that historically, they have actually realized compound annualized geometric returns of 8%. But this was in an era when the yields on safe securities, bonds in particular, were much higher. As an alternative, the accounts could present the distribution of possible outcomes. And under the Black-Scholes-Merton Model that distribution would look like this. If you as a tax payer don't like this distribution, well, you can change it. You can see how much of a cost actually pay for defease the pinch of promises with bonds. If you don't wanna do that, then you have to accept the equity risk and distribution of outcomes.

Although note that as citizens saving and investing in 401Ks you already have a lot of equity risk in you life. If you don't like either of those alternatives, you could discuss pension reductions for the work force. Although they are probably justifiably, in most instances, gonna view the pension benefits they have accrued as the ABO as their legal right. One justification that is often given for these high discount rates is the argument that somehow stock market investing in the long run is safe. Well, one only has to look at Japan's stock market since the 1980s to see that investing in the stock market, even over a period of decades, is anything but safe. It's interesting to note that in the US we have outlawed states running budget deficits for any extended period of time. But we do allow them de facto, through the pension system, to borrow and invest in the stock market. Realistically, if governments are taking risk in pension funds, they need to budget towards some point in the distribution, but what point should that be? Well, the median might be a good place to start. But finance would suggest that it should be even lower than the median. Why? Because of state pricing. Those states of the world with bad outcomes are also bad outcomes for individual tax payers in their own portfolio. I would like now to point out three fallacies of expected return discounting. These are truly absurd things that can happen if you allow expected return discounting in full generality. The first is, a system could decide that it doesn't want to stop at a 7 and 3 quarters or 8%, rate and it could actually raise the expected rate of return enough to make it's debts practically disappear. The city of Tampa, Florida uses a 10% return assumption. But why stop there? One could invest the pension fund assests in a ten times levered equity fund Suppose we assume a market risk premium of 6.5%. A ten times levered equity fund would have around a 90% expected return. Now in about 98% of the states of the world that could prevail in the future, you would lose almost all your money. But the returns in the top couple of percentiles are so good that averaged over the states of the world, there is a 90% expected return. Under GASB rules, just moving assets into this ten times leverage fund and assuming an expected return of 90%, would appear to fully fund government pension promises. And would actually appear to allow most of the money in the pension funds to be freed up, so it could be paid out to taxpayers as dividends or gifts. It would amount to well over $3,000 per US household, but that clearly does not make economic sense. The second absurdity of the GASB rules is what would happen if you applied them to personal finance. Consider the following scenario. You have a debt of $100,000 due in 15 years. No other debt and it's just that one payment that will be due. Suppose you have $20,072 in cash in a bank account and you have no other assets. You go to the bank and you wanna apply for another loan. The bank will assess your financial position. They'll look at your liability, your $100,000 due in 15 years. They'll look at your assets, your $20,072 in cash in the bank account. They'll see a difference and depending on whether you're earnings are sufficiently high, they might give you a new loan or they might not. Okay now, let's suppose they didn't give you a new loan. Here's the question, suppose you went home and you thought about it and you came back the next day and you said, I have a plan, I'm gonna move the $20,072 from cash into stocks. And now I'd like to reapply for the loan, because I think something has changed.

Do you think that will help the circumstance of the borrower here? Well, common sense says, no. Yesterday he had 20,072 cash. Today he's got 20,072 stocks. But GASB rules imply actually that yes, this would improve his financial position. Why? Well, let's look at this since 1900 stocks have returned around 11.3% annually. Now if you have $20,072 and you grow it at 11.3% per year for 15 years. You will see that 20,072 times 1.113 at the 15 is right at around $100,000. So, if you move this money from the bank account into stocks. Maybe you could just say you're debt-free today, because that $20,000 is gonna grow to be worth 100,000 in 15 years. And therefore, your $100,000 debt that you have due in 15 years isn't really a debt at all. Well, common sense says that that makes no sense, but under GASB rules, this is really exactly what state and local governments are doing. The third absurdity is an illustration developed by my co-author Robert NovyMarx. Consider two workers with identical pension benefits. Each is age 35 and has worked for ten years. Each worker has accrued a benefit that you measure will require $175,000 in 30 years to be able to pay for it. So how would that work? Well, let's suppose that each of these workers was in a pension system with a 2% benefit factor. They each worked for 10 years from the age 25 to 35, and they each had a salary of around $52,500 per year. While multiplying those three things together in a formula tells you that they would be entitled to pensions of $10,500 per year when they retire in 30 years. And let's suppose the annuities pay, say, 6% per year on principle. So, you can see that you would need $175,000. For each of these workers in 30 years to be able to pay for the pension. Now supposed the employee's belong to two separate plans. In plan A, you have one of the employees. Okay. And he's owed $175,000 in 30 years. That's what's needed to pay for the, for the liability. And in this plan, there are $10,000 of assets invested in the stock market. In plan B where the other worker is, the liabilities are the same and the assets are different. Here in this plan are $20,000 in assets. $10,000 of which are invested in the stock market and $10,000 of which are invested in bonds. So plan B looks just like plan A except that plan B. As an additional 10,000 dollars of assets and those additional 10,000 dollars of assets are in bonds. So the question is, which of these plans is better funded and how much better funded. Well, trust your common sense. Obviously plan B is better funded by $10,000, since it has $10,000 more of assets and otherwise the plans are identical. But not under governmental accounting standards board rules. Under governmental accounting standards board rules we have the following plan A according to these rules is actually according to GASB, nearly fully funded because the present value of the liability. He has a $175,000 divided by 1 plus the expected return on stocks to the power of 30. Let's suppose the expected return on stocks is 10%. Well you can see here, then that we're going to end up with a present value of the liability of only $10,029. So the unfunded liability in plan A under GASB is $29. So its basically fully funded. Plan B according to GASB on the other hand is $3,000 underfunded.

Why is that? Well, this assumes that the expected return on bonds is 4% per year and the expected return on stocks is 10% per year. So the overall expected return in this portfolio is 7% per year. If we take the present value of the $175,000. Liability that's over 30 years in the future at a 7% rate, for 30 years, we see that the present value of the liability in plan B, even though it's the same pension is $22,989. So relative to the assets of $20,000 the unfunded liability here would be $2,989. GASB clearly fails to capture economic reality here. It's obvious that Plan B is $10,000 better funded than Plan A. That's simple common sense. But under GASB rules, Plan A would be better funded than Plan B. So GASB is failing to, to capture economic reality. So to recap this section, the point is if a pension payment is guaranteed and the sponsor of government has told employees that they will get these they will get these pensions no matter what the stock market does. Then the financial value of that the promise is given by default free rates. One logically consistent reason to use high rates would be if benefits were linked to the stock market. But they're not linked to the stock market. We saw what is effectively happening under expected return discounting is that the accounting focuses on the mean of the distribution of a risky investment strategy. This method implicitly assumes that the mean is definitive and will be realized, ignoring the rest of the distribution, most of which might lie below the mean. The more risk you take on the higher the mean is above the media. Finally, we saw a three examples of what can happen with expected return discounting. And two of them taking on more risk, made real debts seem to disappear. And the third burning money but investing the rest and risking your assets could improve apparent funding ratios even though it would deteriorate the true economic condition of the plan. The only argument for expected return discounting, that it is even intellectually coherent, would be to somehow argue that investing in risky assets in the long run is not risky. But one only needs to look at Japan since the 1980s. And many other countries around the world, in areas of economic downturns, to see that this is simply not the case. There's a pretty good case to be made, that in fact stocks are more risky in the long run than in the short run.