Allison's ode to the second moment


Welcome to the 22nd issue of Allison’s Ode to the Second Moment, a newsletter that still believes in upside and that, with a little nudge, we can make savers rational again.

New president, new risks

The one certainty President Trump brings is more uncertainty. The policies he’ll pursue remain undefined. How he’ll respond to a major economic or political crisis is unknowable, and yet the markets don’t seem to care.

How can this be? You might think more risk and uncertainty would make investors skittish and tank the markets. But since the election, the stock market is up. Some argue the markets are just irrational and underpricing risk.

James Hamilton reminds us that risk is not just downside, as there is also the possibility of upside. He explains that if the distribution widens, but the mean stays the same, then markets may not crash.

Maybe that’s what’s happening. When some people say “more risk” they mean a bigger chance of something terrible happening. But more risk normally means a wider dispersion of good and bad outcomes. Many people fear a Trump economy means gloom and doom. But the markets appear to be putting odds on something good or bad happening. Maybe tax reform will improve efficiency (upside) or maybe there will be a trade war (downside).

Perhaps this is the take-away: commentators are pessimists and market participants are optimists.

There’s one near-certain investment

If there’s one investment almost always pays off, it is investing in your human capital. Going to college offers no guarantees, but the odds are excellent that attending will increase your lifetime earnings, assuming you go to a decent school and don’t drop out.

Like any investment, the more money put in, the bigger the potential pay-off. A new research paper estimates that one of the highest yielding majors—engineering—costs more to teach. In terms of cost/benefit when earning a degree, those in business or computer science are making better bets. It is relatively cheap to teach business and business majors tend to earn more. Philosophy and English are also cheap to teach, but don’t promise much earnings.

By the time you reach age 45, odds are that an engineering degree will pay off—a lot. Yet few people study engineering and universities are allocating fewer resources into that major. There could be a market failure, because you pay the same tuition no matter what you study. The university makes up some of the difference for higher-cost degrees. Then there’s the odd quirk that philosophy majors, to some degree, subsidize engineers. All this means students don’t get a price signal of which degree has more value.

This all raises questions that cut to the core of what we want from higher education. Should education be more vocational or a time to explore different ideas and fields? Price by major would undermine the latter, which makes me uncomfortable.

But maybe the college model of a-time-to-explore-ideas-and-yourself worked better when fewer people went to college. If education is the only remedy we have for low rates of economic mobility and more inequality, then we want more people to go to college and get higher earnings from having a degree. Perhaps we need a more pragmatic view of college.

Some sanity on the fiduciary standard

I’ve long felt lonely in my skepticism that applying fiduciary standards to financial advisors is a good idea. True, members of the finance community were not fans either, but some had financial interests. Others who asked reasonable questions were met with such a fierce backlash and therefore few dared to wonder if making advisors act in their clients’ best interests was really in their clients’ best interest.

This week AQR’s Cliff Asness expressed his concerns, too. Such a poorly defined objective can have bad, unintended consequences, such as suing advisors for strategies that don’t perform in all markets and less innovation in a market that needs it.

And speaking of bad advice

How do you feel about required minimum draw-downs (RMDs)? Many people don’t realize that once they reach age 70.5, they must start taking money from their tax-deferred retirement accounts or face penalties. This issue will get more attention as more people reach age 70. People are already upset. Sometimes the RMDs result in people taking out more money than they want to spend. And RMDs mean people have to pay taxes and no one likes doing that.

I think RMDs are a woefully under-used policy tool. Evidence suggests a tax-deferral doesn’t get people to save more when they are working, but there is evidence that paying taxes on the withdrawals, after people retire, does influence their behavior.

Right now the RMD rates were designed to make sure people paid their taxes. But they are playing a much more significant role in American’s retirement. As more people retire with a 401(k) instead of a defined benefit plan and don’t have a clue how much they can spend each year, some use their RMD rate as a spend-down plan. After all, many retirees don’t have much else in terms of post-retirement spending guidance.

RMDs are a missed opportunity to nudge people toward better spending behavior in retirement. Maybe we can use them to construct a phased withdrawal strategy that delivers somewhat regular income. Perhaps we can use the tax burden to incentivize people to buy an annuity—the possibilities are endless!

Will better RMD rules be a priority of this new Trump administration? Right now it does not seem that way, but I am optimistic.

Until next time, Pension Geeks!