Yikes! How to Think About Risk?

Alicia H. MunnellMauricio Soto Steven A. Sass

IB#27

Introduction

The same issue keeps reappearing. How to deal with the risk associated with equity investments when evaluating the financial health of retirement systems? Some experts argue that retirement plans holding equities can make smaller funding contributions than those invested primarily in bonds. After all, stocks yield 7 percent, after inflation, and bonds only 3 percent. Nonsense, say others. The higher expected returns on equities reflect their greater risk. Any serious financial evaluation of retirement arrangements must “risk-adjust” these returns. After accounting for risk, the contribution needed today to fund future pension obligations is the same regardless of whether the fund is invested in equities or bonds…