Equity Premium Puzzle ( EPP ) and Lifetime Retirement Investment Scheme ( LRIS )

CPF advisory committee just revealed another two proposals to enhance and ensure better retirement planning for members.

1) A CPF Life Escalating Plan

2) An alternative CPF Lifetime Retirement Investment Scheme (LRIS)

As usual, many good article and debate from fellow bloggers in recent days, allow me to link two which I think gave a very good explanation and suggestion on these 2 proposals:

From Investmentmoats :

http://investmentmoats.com/saving-money/what-is-this-new-cpf-life-escalating-plan-and-cpf-lifetime-retirement-investment-scheme-lris/

From BIGfatpurse :

http://www.bigfatpurse.com/2016/08/cpfs-lifetime-retirement-investment-scheme-good-or-bad/

In the following blog, I would like to share my thoughts on proposal 2) which is the LRIS and Equity Premium Puzzle.

Apart from political issue or debate on low CPF’s return in the long run vs other sovereigns retirement fund and big” huha” on “ Return my CPF money “ at Hong Lim Park which is absolutely out of my discussion in this blog. I just want to pen down my thoughts on how this proposal related to Equity Premium Puzzle (EPP) and how it will affect our choice subsequently.

What is Equity Premium Puzzle ( EPP ) ? Concept Explained :

According to Wikipedia: The equity premium puzzle refers to the phenomenon that observed returns on stocks over the past century are much higher than returns on government bonds. It is a term coined by Rajnish Mehra and Edward C. Prescott in 1985, although in 1982 Robert J. Shiller published the first calculation that showed that either a large risk aversion coefficient or counter-factually large consumption variability was required to explain the means and variances of asset returns. 

Economists expect arbitrage opportunities would reduce the difference in returns on these two investment opportunities to reflect the risk premium investors demand to invest in relatively riskier stocks.

The intuitive notion that stocks are much riskier than bonds is not a sufficient explanation of the observation that the magnitude of the disparity between the two returns, the equity risk premium (ERP), is so great that it implies an implausibly high level of investor risk aversion that is fundamentally incompatible with other branches of economics, particularly macroeconomic and financial economics.

The process of calculating the equity risk premium, and selection of the data used, is highly subjective to the study in question but is generally accepted to be in the range of 3–7% in the long run. Dimson et al. calculated a premium of "around 3–3.5% on a geometric mean basis" for global equity markets during 1900–2005 (2006). However, over any decade, the premium shows great variability—from over 19% in the 1950s to 0.3% in the 1970s.

To quantify the level of risk aversion implied if these figures represented the expected out-performance of equities over bonds, investors would prefer a certain payoff of $51,300 to a 50/50 bet paying either $50,000 or $100,000.

The puzzle has led to an extensive research effort in both macroeconomics and finance. So far a range of useful theoretical tools and numerically plausible explanations have been presented, but no one solution is generally accepted by economists.

 Further reading on this can be found in Investopedia :

http://www.investopedia.com/terms/e/epp.asp

Imagine that you just inherited $100K from your grandmother in early 20s and still, have 30-40 years to retirement age. Suppose also, that you were an economist who tried to do the best long-run investment decision at the very early stage of your life. At that time, say, you had two options: you could have invested in a safe risk-less government bond, or in a riskier stock market. What was the best option? What would you have done? 

If you had invested this $100 K  in government bonds, the return will be much lower if you put the money into government bond instead of stocks, as we know, historically, investing in stocks gave an 8-9 % average annual return (including dividend ), whereas the government bonds were only  1-3 % average annual return. 

The difference in returns between a safe asset and a risky asset can easily be explained with the following argument: given their risky nature, stocks are able to attract investors only if they are compensated with a risk-premium, which is an additional price that investors ask for bearing the risk of holding unsafe assets.

 In fact, if the returns of government bonds and stocks were the same, no investor would hold stocks. However, it is very important to clarify what "risky" means. It is not possible to predict the return of stocks, given the underlying uncertainty in the performance of the firms. On the other hand, investors know what is the return of the government bonds once they buy them (ignoring possible defaults).

I always treat my money in CPF as investing in AAA-rated bond ( where Singapore is enjoying such rating from credit agency now ) and also since money in CPF will be kept for long term ( maybe 30-40 years ) depending on your age group.

Now the dilemma is should I keep the money in CPF as it is and enjoying 3-4% ( on average, depending on how much one have in OA and SA account ), or investing the money into the newly create funds which might give 2-3 % premium over the current rate.

One needs to take not on 2 distinct factors which are :

1) CPF prevailing rate might change (up and down depending ) on global interest situation. 

2) Equity Risk Premium ( ERP) may diminish or increase depending on the world economy and corporate profitability or performance.

Latest research from Mckinsey shown that equity return should be lower in the coming years. Please refer to below link for more detail :

http://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/why-investors-may-need-to-lower-their-sights

Base on the above report from Mckinsey, even with slow growth recovery scenario, the Equity Risk Premium still will have an average 3-4 % point over Government Bond.

Even with 2% point different over the long period of time, it could have quite a huge impact on overall return. Please refer to below illustration :

Example :

Assuming that a  CPF member with an initial contribution of $8K and increasing his contribution by 3% point each year.

The result showed the total return in different interest level of 3.5% and 5.5 %, at a different of 2 % point, which is quite reasonable and conservative, base on past and future Equity Risk Premium over a long period of time.

Base on the below calculation, the different of total return at the end of 25 years could be huge, at around $130 K, with just a small 2 % point different. This is what one should take note and not merely rule out the impact lightly.

Remark: ERP of 3 % ( Increasing return = + $213 K) , ERP of 4 % ( Increasing return = + $310K )

For younger CPF members, I would think that they should seriously consider using such option to increase their overall return on CPF contribution for retirement in the long run, where this is what exactly other country’s sovereigns retirement fund was doing and managing their fund in the past .. with combination of bond and equity which resulted in a much higher return on our current CPF’s system (which is basically a bond rate return from the government).

Now, with this new proposal, CPF is giving back such option to members but maybe in a more DIY form of managing your own portfolio at your own RISK, if one would like to have a higher return as compared to current CPF’s interest rate.

As suggest from fellow bloggers, Government should put a lock-in period for such fund as the ERP is being calculated on a much longer period of time frame while waiting for the compounding effect to take place. Such lock-in period will avoid the emotional aspect of members in view of short term market volatility.

Also, there might be too many choices of funds which might confuse members in making the selection. Remember the concept of “ Paradox of Choice “,,,, Limiting the fund's option may avoid and address such a situation :

Concept Explained: " Paradox of Choice "

Link :

 https://en.wikipedia.org/wiki/The_Paradox_of_Choice

Allow me to quote :

" Whether we are buying a pair of jeans, selecting a long-distance carrier, choosing a doctor, or setting up a 401(k), everyday decision- from the mundane to the profound challenges of balancing career, family, and individual needs, have become increasingly complex due to the overwhelming abundance o choice with which we are presented. We assume that more choice means better options and greater satisfaction. But beware of choice overload: it can set you up for unrealistic high expectation, and it can make you blame yourself for any and all failures."

The biggest challenge now for CPF Board is how to convince the members that this Equity Risk Premium does exist and members could really make use of it.

Finally, with these new options, members will have the choice now !! By weighing in the Risk-Return factors and your own choice, do you think we should have another parade at “ Hong Lim Park “ again? your choice !!

Think long term, think compounding effect !! not just the meagre 2 % point different.

Cheers !!

Quote Of The Day :

"Equity risk premiums are a central component of every risk and return model in finance and are a key input into estimating costs of equity and capital in both corporate finance and valuation. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. " by Prof. Aswath Damodaran