The backdrop on retirement funds

David Laibson, who serves on Harvard’s Retirement Investment Committee, spoke with the Harvard Gazette recently about upcoming changes to the University’s retirement investment options. Laibson is the Robert I. Goldman Professor of Economics at the Faculty of Arts and Sciences.

Gazette: On Nov. 12, Harvard will reduce the lineup of mutual funds offered through its retirement plan. “Lifecycle funds” will now be the automatic, or default, choice for employees who do not actively choose to manage their own investments. What are some of the benefits of these changes, in your view?

David Laibson: With the new lineup, we’ve stripped out the funds that are really not appropriate and included only those that are people’s best options, so it’s a lot easier for them to choose wise investments. That’s one benefit.

A second benefit is that lifecycle funds are easier to use in the long run. For instance, the funds automatically reduce your exposure to stocks as you approach retirement, so you don’t suddenly lose half your wealth on the brink of retirement because the market plummets. They also rebalance, as asset classes perform well or perform poorly. Let’s say your fund held 50 percent of its assets in stocks. Then prices double, and now stocks are a much larger percentage of your portfolio. Lifecycle funds automatically rebalance so that you aren’t overwhelmingly weighted to stocks just because prices went up. That’s another benefit.

Another benefit has to do with fees. Funds charge an annual fee — maybe a percent or two of your total account balances — as compensation for managing your money. As the University reduces the number of funds it offers, we end up with more assets in the ones that remain. That allows Harvard to demand lower fees from the fund companies [Fidelity, Vanguard, and TIAA-CREF]. It might be only half of a percent extra return each year. But if you can get that for 40 years, it’s like increasing your final wealth by as much as 20 percent.

Gazette: How are lifecycle funds better than, say, picking stocks on my own?

Laibson: If you pick stocks, you could be very lucky and put your money in the Google IPO and get rich. You could also be very unlucky and put your money in a company like Enron and lose all your wealth when it entered bankruptcy. Saving for retirement should not be like buying a lottery ticket.

Finance professors and economists generally believe that a diversified portfolio — one that holds foreign and domestic stocks, corporate and government bonds, and money market assets — is the best way to invest. Lifecycle funds are fully diversified. Their goal is to get the best tradeoff of risk and return.

Gazette: Lifecycle funds do a lot of work for the investor. Is that a good thing? Take automatic rebalancing: If stocks are doing well, wouldn’t I want more of my money in stocks?

Laibson: There’s a lot of academic work — including my own — that shows that human psychology goes in just the right way for people to shoot themselves in the foot when it comes to investing. They think, “Stocks went up a lot. I want even more stocks. Stocks went down a lot. I want to dump whatever I have.” Pretty soon, their portfolio is no longer diversified. They end up doubling their exposure at the height of the tech boom — just in time for the crash. They also end up exiting stocks in 2008 and early 2009 when stocks reach their bottom, and they miss the rebound. That’s why giving people something that’s going to automatically do the right thing for them is a big plus.

Gazette: The new lineup will also include a number of “core funds.” Why is Harvard offering them, and how were they chosen?

Laibson: It’s all about giving people choice. If they want to be in the driver’s seat, the core funds give them that option. We’ve made sure that these funds are low cost, that they are diversified, and that they span the universe of assets that are appropriate for retirement savings. If people want even more choices, they can open a brokerage account and get access to thousands of funds. They can hold undiversified mutual funds if they really want to. I don’t recommend it, but they have that freedom.

You can visit the Compensation & Benefits section of the HARVie website to get other answers to questions about the new retirement investment choices, to find out about on-campus information sessions, and to learn how to make appointments with fund representatives.