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Improving Outcomes with Behavioral Finance

Featuring Richard Thaler, Distinguished Service Professor of Economics and Behavioral Science at the University of Chicago’s Booth School of Business - Dan Ivascyn, Group Chief Investment Officer - Emmanuel Roman, Chief Executive Officer

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Emmanuel Roman, Chief Executive Officer: So clearly things have been done and haven’t worked out so well, so I’m now changing my job to be the Charlie Rose of PIMCO and interviewing two of my great friends, Richard Thaler and Dan Ivascyn, and that’s exactly what I’m going to do. So we are going to make this session lively. It’s the end of the program, and we’re going to talk about lots of things about behavioral finance and how we apply it and how we think about it.

So let me – Richard, let me pick on you first. So October, 4:00 in the morning the phone rings. Since when do you pick up your phone? There has to be – there has to be an inch that someone is going to call.

Richard Thaler, Distinguised Service Professor of Economics and Behavioral Science at the University of Chicago’s Booth School of Business: Well, it’s impossible not to know that it’s that day because, you know, economics is the lowest rank of all of the Nobel prizes.

Emmanuel Roman: As it should be.

Richard Thaler: Yeah. But, you know, the thing that they rub in when you are in Stockholm is among sciences, it comes after literature. So the previous week, all week, every morning on your phone "Breaking news,” blah, blah, blah, "won the physics prize,” and then that reminds all of your friends that oh, this is Nobel week, and economics is always the following Monday. So it’s impossible not to know.

Emmanuel Roman: How did they have your number? I mean, that’s a reasonable question; right? I mean, you know, we better have your home number or you wouldn’t know about it.

Richard Thaler: The Swedes have their ways. I mean, look. This is – you don’t need to be geniuses to do this.

Emmanuel Roman: Well, that’s good. (Undecipherable).

Richard Thaler: Because, you know, so Ben is probably here somewhere. We managed to get the cell phone numbers of the people we picked to be president of – So – so the only concession I made to knowing that it was this night was to turn the ringer on my cell phone, but otherwise, I was sleeping like a baby. One of our friends Goul told me he won money betting on me at 20 to 1.

Emmanuel Roman: You could have told me.

Richard Thaler: You know, but he said they would only let him bet 20 quid, so he didn’t win a lot of money.

So – and then that day is complete madness. I mean, they call you at 4:00 a.m., and I’m just dead, and my wife is trying to wake me up. The phone is ringing, and they spend a lot of time trying to convince you this is not a prank, and then when they are finally convinced you are awake, they say, "Okay. Go get some coffee.

There is a press conference in 45 minutes."

Emmanuel Roman: And then you're up?

Richard Thaler: And then you're up, and then the people from the university start showing up at 5:30.

Emmanuel Roman: Oh, lovely.

Richard Thaler: Yeah. So – and I – and I had passed that night at 6:00, so it was a long day, but I'm not complaining.

Let's start with bias, and I think – I think maybe for those of you who don't know much about – about behavioral economics, give us a 30-second summary on the cashew example and the epiphany you had in Cornell about a million years ago about the bowl of cashew, and then we are going to talk about bias

Richard Thaler: This story is that – it was even before Cornell I was in grad school, and had in Rochester a dinner party and we were having cocktails, and I brought out a bowl of cashew nuts that we started devouring. There was some nice aromas coming from the kitchen, we are eating these cashews, and I realized we were going to eat way too many cashews, kind of like those cookies out there, and at some point I grabbed the bowl of cashews and picked it up and went eating a few more myself and hid it in the kitchen.

And then I came back, and since this was an assembled group of economics graduate students, we began to analyze what just happened, which teaches you something about why you don’t want to have too many economists at a dinner party.

But the – so the analysis was, A, we were happy. Everyone thanked me. "Oh, thank God you got rid of those cashew nuts," and B, we were not allowed to be happy because the basic axiom of economics is more choices is better than fewer choices. So what business did we have being happy, and, you know, at some point “hmm, interesting.”

Emmanuel Roman: Interesting.

Richard Thaler: And I started a list of dumb stuff people do and that won a Nobel prize.

Emmanuel Roman: That is good.

All right. We are going to talk about bias.

Dan, listen, the world of finance is full of overconfident people. We have a long list of overconfident investors, some have worked for PIMCO, some have worked elsewhere, and, you know, what are the bias you’ve seen? What do you think about them, and then I want to have Richard reacting in terms of what we see and what we do about it.

Dan Ivascyn, Group Chief Investment Officer: Perfect. Yeah, and we’ll talk more about, you know, some of Richard’s work for us in the past a little bit later, but sure, we’re all guilty of overconfidence, myself included. I think it’s the most obvious bias, overconfidence, and then, you know, from a research perspective, a confirmation bias, and I was thinking ahead of this conference even over the weekend, you know, what’s the most recent example? And for me it occurred Friday evening and Saturday morning of this past week.

Late Friday evening now Barron’s will come out, and just take a look at the most recent Barron’s issue and you’ll see examples of money managers being confident, perhaps overconfident. You see it all the time whether it’s a forecast of, you know, where the ten-year is going to be end of the year, how many tightenings is the fed going to do this year. You never hear someone say, "Well, I’m not quite sure. I don’t know,” but the reality is we don’t know for sure.

Saturday mornings I typically catch up on research, Wall Street research, you know, what you may find during the week on Twitter and other areas where a paper will be attached, and I find myself going through the research, and when I find a story or a paper that’s supportive of my view in the investment committee relative to someone else, it’s like “wow, there. I got them,” and I’m ready to type it and forward it along to the group and say, "Hey, there. See? I’m right." Now, in the meantime I’m receiving about five of those from other investment committee members, you know, supporting their points.

So this is an area where I just provided you with the simplest examples of the way the human mind can play tricks on us, and I think realizing that that’s an issue is a step in the right direction, and that’s a simple example. I know there are many more that are more subtle, but I think those are two pretty good examples of very simple ways in which you can protect ourselves, our investors, all of us from being fooled I guess by our own human mind.

Richard Thaler: Overconfidence is one of those that everybody agrees other people suffer from.

Emmanuel Roman: Yeah.

Richard Thaler: And there is a related thing called the planning fallacy, which is that everything takes longer than you think even if you know about the planning fallacy, and my friend Danny Kahneman has this story he likes telling about a book project many years ago that halfway – well, a few years into it he went around and asked the people working on it how long did they think it was going to take, and everybody wrote down their numbers, and then he asked one of the guys who had been in many such groups how long on average does it take from where we are, and he started to get a little embarrassed and admitted well, half never finish, and the range he gave was totally out of the numbers they had given including him.

Now, here is the follow-up to this. Years later after Amos died, Danny was working on some book not thinking fast and slow. It was just a collection of papers that they had worked on together, and I'm talking to him, and I said, "When do you think it's going to be out?”

He says, "Oh, there is not much left to do.

Maybe a couple months."

And I started laughing, and he says, "Oh, you're thinking of that book. This book is totally different."

And 18 months later, yeah.

Emmanuel Roman: Dan, we have a bias board at the IC, so describe it and, yeah.

Dan Ivascyn: Well, it’s probably the most complicated chart in the world, and I think that was part of the point. It’s in very fine print, and there it is up on the screen.

Sudi Mariappa, who is a very big fan of the behavioral finance research and literature, sent this over to me a couple of years ago, and there is a lot on that but, you know, we decided to put it up in front of the investment committee. Many of you that took tours up on the 20th floor, you know, during this conference will see that before we come in.

It’s really a remainder to everyone that’s walking into the room where we make investment decisions that there are a lot of issues to think about in the decision making process, and the goal isn’t to go through every one. It’s really to remind us all that these issues exist and that we require good structures to help combat these biases.

And the good news is it’s not without hope.

There is a positive angle here, and that is that given that so many members of the investment community tend to succumb to some of these inefficiencies in decision making, in theory there is hope for investment platforms that do our best to help control the biases, create good structures and make as a rational set of decisions as possible. So that’s really what this is set out to accomplish, and hopefully it’s helping in a small, small way.

Emmanuel Roman: What do you make of this, Richard?

I mean, we did this after you came three years ago. So you said –

Richard Thaler: I would say the font needs to be bigger. That’s my main comment.

Emmanuel Roman: Okay. So we are going to sort of talk about how we think of the world. So the way there is sort of two school; right? There is asset pricing, and asset pricing is important to us because that’s how we think about bonds and what’s cheap, what’s expensive, and then we have behavioral factors, and one of the question we have debated often, most of the times around a bottle of wine, is how do we reconcile both of them, the behavioral school and the asset pricing school, and how can the two work together in terms of finding a way to explain what we see on there, and I always have this example about behavioral that momentum to me is a behavioral factor.

Richard Thaler: Well, you know, so Gene Fama, who of course is the father of the efficient market hypothesis literally, I think he is the first person to write those three words down and very belatedly won the Nobel prize five years ago, and he and I are golf buddies, so we talk about this stuff all the time, and his line is that "We agree about all of the facts, and we disagree about the interpretation," and I think that's mostly right, because if you look at the Fama-French research, they kept adding factors.

Emmanuel Roman: Yeah, because it wasn't quite working.

Richard Thaler: And it was – yeah, or it was – it could be made better, but you add more – well, whichever way.

Emmanuel Roman: Whichever way.

Richard Thaler: But, you know, now there – momentum Gene has never liked because you can't possibly call that a risk factor. So he’s refused to put that in there.

Emmanuel Roman: It worked for 120 years; right?

Richard Thaler: Yeah.

Emmanuel Roman: There is a very good paper by Andy Haldane from the Bank of England. I mean it’s as close to a grade back.

Richard Thaler: Well, but now they have profitability in their model. Now, explain to me how that can be a risk factor. I mean –

Emmanuel Roman: Is it profitability or quality?

Richard Thaler: Well, I mean, those are just two different words for the same thing.

Emmanuel Roman: It’s for the same thing; right?

Richard Thaler: So Cliff calls it one and Fama and French call it another, but it’s basically the same thing, and, you know, take Apple. They make a lot of money. Now, we can certainly have a good debate about whether their stock price is too high or too low, but I wouldn’t call that company risky.

Richard Thaler: But so I don’t think these distinctions, there is an industry of people that write down highly technical models that are consistent with the empirical facts, but no one would have predicted those variables; Right? The only model that came from first principals was capital asset pricing model, and I think I’m the only person, this is a very minority view, in my view, in a rational world, the CAPM would be true.

Emmanuel Roman: Yeah.

Richard Thaler: Right? Certainly size and value would not be there. The first thing you learn in finance is you put a bunch of companies together and, you know, that’s a portfolio and – right? It can’t be that a portfolio of small companies is riskier than one big company. That just cannot be true. So I – I think now there’s – look. There is no theory. That’s the problem, and the asset pricers will say, "Look, you guys have no theory."

And I say, "What’s your theory?"

Years ago I went into a session at the American Economic Association on finance, and one of my colleagues said, "What are you going in there? You don’t know anything about finance," and – which was even more true then.

And I said, "Yeah, that’s true, but they know less and less each year."

Emmanuel Roman: (Undecipherable).

Richard Thaler: Yeah, at some point they are catching up to my – to my lack of knowledge.

Emmanuel Roman: Dan, you know, one of the thing we always ask our self is try to distinguish when we look at track record and performance, and I think a lot of you do the exact same thing, you know, what’s signal, what’s noise, who is sustainable, who is not, why does a track record mean something. How do you think about it in light of what we are talking about and just from a practical standpoint?

Dan Ivascyn: Yeah – I think one helpful way to combat some of these issues is to measure more. When we spoke a few years ago, one of your recommendations was – well, first of all observations was PIMCO already does a lot of this. Every investment professional at the firm submits best ideas as part of our quarterly process whether you joined five minutes ago or if you have been at the firm for 30 years, and we’ve tracked that historically, but we also felt that a bit more measurement would be beneficial here.

Portfolio attribution as we all know is –sounds pretty simple and straightforward. In reality it can become quite complex, and I think it’s important, you know, to spend time, and Ravi Mattu, our head of analytics, has helped us in a far more detailed attribution process not just for our end clients, but for you all to understand what we’re doing, but to remind portfolio managers what in fact drove returns and –

Emmanuel Roman: And where we make money and where we don’t, yeah.

Dan Ivascyn: Where you make money, where you don’t make money, and, Manny, you know, we had this discussion at a very high level with Ravi Mattu just the other day from the perspective of planning for the future, where do we want to add resources, where do we think we can benefit from further investments or process improvements.

And what you’ll see, whether it’s at a very high level or even at the mutual fund or portfolio level is at times, particularly in complex, more volatile market environments, even understanding the drivers of performance in your own portfolios can be challenging without a lot of more detailed analysis.

And it’s all not one way. You know, none of these attribution models are perfect. They are just like tracking error models and other types of more quantitative frameworks, but having more tools and sitting down and reviewing this information I think has been very, very beneficial to our process.

And in fact, over the last of couple years, we've taken that concept even further. So today not only does every portfolio manager at PIMCO submit best idea recommendations like they've had now for 30 plus years, everyone submits a model portfolio, a simplified portfolio similar to what the investment committee creates as part of our process, which we had discussed with you yesterday.

We have the ability to stratify that by seniority, by title, whether you are an investment committee member or a nonmember, geographic, gender, other ways to segregate the different groups, more bottoms up versus top down to try to understand, you know, where there is positive perspective or, you know, strong contributions to returns or forecasting and where there very well may not be, where there biases or perspectives.

And, again, that's the challenge is you need a lot of data to determine whether it's a bias or a unique perspective, but through this process, we're learning, and I think at the end of the day, that's what it's all about is learning within our own group, within our own firm what works, what doesn't work, what drove returns now, what may drive returns going forward, and there is no simple answer, but I believe it’s been helpful.

And then the last example I’ll give real quickly and, Professor Thaler, you came by our investment committee a few years ago. I had just taken over along with my teammates, you know, at the CIO level the leadership responsibilities, and you talked about a group process and how group decisions, when carefully arrived at, can be quite powerful. Group decisions that are somewhat arbitrary and not thought of in more of a controlled fashion cannot only be poor, but they could lead to this false sense of security, and I’ll give you almost a humorous example that occurs at the investment committee from time to time. You’ll get a sense we can be an argumentative bunch at the investment committee, and, you know, we like to intellectually tussle from time to time over issues.

What you’ll find a lot of times is we will be sitting in a room for a few days talking about what the fed may be doing over the course of the next year or so, and we’ll go on and on and on, and the debates will get heated, spirited, quite interesting to say the least, and then, you know, we decide to measure, you know, what people’s views are, and you’ll find out when we actually go around and write down what people’s range of outcomes were, you went like wait a minute. We are basically in agreement. There is not much to do from a portfolio implementation perspective. It’s almost argument for the sport of arguing.

And what we do now, and Joachim Fels has been very helpful here, is we try to measure up front, take a timeout during discussions and measure midstream and then record views on the back end of the process, and, again, you know, at a minimum, it saves us from time to time a few hours of more circular discussions, but I think it’s actually a quite powerful tool to learning to understand how debate takes place, occurs, and to combat group think and hopefully make better overall decisions.

Richard Thaler: Yeah, one of the things that folks like you are always asking me that I don’t have a very good answer for is "Can you tell us how to improve the quality of investment committees" or better "Have you studied how investment committees work?"

The answer is no, and why? No one has ever given us the data, and, you know, each one of you probably has an investment committee that’s deciding asset allocation and managers, and they are all operating independently, and it’s a black box to us.

So, I mean, there are some things we know from studying things in other domains like jury decision making, and, I mean, there are some basics that will improve group decision making. One is get people to write down their opinions before you start talking, and something we do in our group at Chicago Booth is when we're going around talking about a faculty candidate, we talk from youngest to oldest, and the reason is that people don't want to agree with the – disagree with the boss. So there – so there’s some good hygiene that you can practice. The most important of course is what we talked about three years ago, keeping track.

And, you know, for years, I’ve seen my colleagues, I’ll ask them "We’ve made an offer to this guy or this gal. What’s the chance that she’s going to come?"

And they’ll say, "Oh, 80 percent."

I say, "Really? You know, that person has an offer from Stanford or MIT or Warton, you know. We don’t get everybody we make offers to.”

"Oh, yeah. No, I’m sure that one is going to come because they said very nice things about Chicago while he was here."

And I say, you know, "What do you think he’s saying at Stanford, you know? ’Oh, yeah, this place stinks.’"

So, yeah, keeping track is a way of making everybody humble, which is good.

Emmanuel Roman: So you have two other activity, Richard. One is you are a consultant for an NFL football team.

Richard Thaler: Yep.

Emmanuel Roman: And you are also a principal in a quant equity asset management company. So let’s talk about both. Let’s talk about the story about the draft. You wrote a paper with Cade Massey on the draft. I mean, this is just fascinating in terms of behavioral economics and anything else we can talk about when it comes to behavioral –

Richard Thaler: Yeah. Well – Yeah, the football thing, there is a paper I wrote with a former student of mine Cade Massey who is now a fellow at Warton, and it started years ago when Mike Ditka, a larger-than-life character, who is from Chicago, he was then coaching one of the teams, and he announced publicly that he would give away all of his draft picks if he could just get this one guy called Ricky Williams, and he did that, and Ricky turned out to be an okay but not transformative player, and Ditka got fired at the end the year.

And – but we decided, you know, why would anybody do that, and we did a study. So for those of you like Manny who are not fanatical National Football League fans, let me remind you that the way NFL teams choose players is they have a draft, there are 32 teams, and they take turns picking, and the worst team last year picks first, the best – the winner of the Super Bowl picks last, and the picks are traded, and what we did is study the market efficiency of that market, that is, the market for trading picks, and what we found is that high picks are enormously valuable in the market. The first pick is worth twice the sixth or seventh pick and is worth half a dozen second round picks.

Emmanuel Roman: And that makes no sense.

Richard Thaler: Well, that's what we – that was the next thing was does that make sense, because you also have to pay those guys more. So the price, the price in terms of opportunity cost and the price in terms of salary, because the league basically sets the salary.

The first guy gets paid the most. So you give up in opportunity cost a lot of picks to have that first one, and as a benefit, you get to pay them a lot of money.

And what we found, our results were that the second round picks that you could get lots of for getting rid of the first pick are each worth more than the first pick, worth more in terms of surplus to the team, because the National Football League unlike, say, European football where the richest team, the guy with the biggest Russian can just buy any players he wants, the – in the National Football League there is a budget constraint that they all have to follow called a salary cap. So the only way you can win is to buy players that are undervalued. It’s just like portfolio management, and basically almost everybody in the league is convinced that Cade and I are nuts, and we’ve gone through three teams, and gradually the football guys drive us out.

Emmanuel Roman: Because they hate what you say.

Richard Thaler: Yeah.

Emmanuel Roman: Because they think they can pick the first draft pick and this is going to be the second coming of Christ and so on and so forth.

Richard Thaler: Yeah. So what I was mentioning to Manny that there is an aspect of this research that we didn’t really emphasize but is interesting and is related in particular to asset management, which is if you think about this, there are trades, maybe 20 a year, something like that, but almost all the picks are taken by the team that’s next in line, and if you think about that, that makes no sense. What’s the chance that the team that owns this pick is the team that values the highest player left most? So in a rational world of zero transaction costs, almost all of the picks would be traded and, in fact, none of them are. And there is another major asymmetry which is if you trade up to get one the first picks, you are considered bold and aggressive and you want to win, and if you do the smart arbitrage trade of getting rid of the first pick and getting six second picks and some picks next year, because their discount rate is 137 percent for each year.

Emmanuel Roman: It’s not a joke; right?

Richard Thaler: That is the number we calculated. And it’s funny. It comes from the following rule of thumb:        And – a third round pick this year is equal to a second round pick next year.

Now, if you think about it, that kind of makes sense; right? Next year that ought to be some return in now versus later, and that’s the rule of thumb they’ve adopted, and it’s still in place, and if you do the math, it’s 137 percent a year.

Now, these NFL owners are billionaires. In fact, they are rich enough to have a spare billion because that’s what it costs to buy a team, and they didn’t get rich borrowing at 137 percent per year except the ones we work for.

So, you know, the approach we took in that model was to say what are the biases in this market, and it's the same approach that we take in managing stocks. We mostly do small cap U.S. equities, and what we're trying to do is say, “What are the mistakes other people are making?”

And, you know, the comparison with the football is there's – there are these guys if you've seen the movie "Money Ball" or read the book, but there is a vivid scene in the movie where there are all these scouts sitting around chewing tobacco and spitting, and they just know what a good baseball player looks like, and he looks like Billy Beane who is the guy that is the star of the book and the movie, and Billy Beane really looked like a great baseball player but wasn’t, and stocks that look like really good companies are not necessarily the ones you want to buy. So there are people that are doing like fundamental analysis, and I think Benjamin Graham had this great line that "Fundamental analysis is a science that makes astrology look good."

So the problem is that figuring out what Apple is worth is impossible. Nobody knows, and it’s a fool’s game. So – and we’ve forbid our portfolio managers from engaging in that. What we’re interested in is what are the characteristics of a stock that will make that stock undervalued.

And let me – let me wrap this back up to football with a one liner. Cade and I did the following analysis: We studied wide receivers. These are the really fast guys with 28-inch waists that run down the field and catch footballs, and we asked the question if you take guys that are drafted consecutively, which one do you want, the faster one or the slower one? And like 60 percent of the time you want the slower one.

Now, think about why would that be? Because there are – there’s sort of two interesting behavioral insights behind that finding. One is speed is measured in hundredths of seconds. So a guy that runs the 40 in 4.42 is blazing fast whereas if he runs 4.52, he’s kind of average. Now, Jerry Rice, the greatest receiver of all time, was kind of average. The other skill is getting open and catching the ball. They can’t measure that in hundredths. So they’ll say like "good hands” or "average hands."

So if there’s something quantifiable, it gets overweighted. If there is something that is not easy to quantify, it gets underweighted, and you can use that in any – in any domain where you are essentially doing portfolio management.

Emmanuel Roman: What do you think, Dan? I mean, one of the thing you’ve done is to try to have a contrarian on the IC whose job is to basically disagree and, Mohsen, I don’t know if you are here, but, Mohsen, that’s your job and –

Dan Ivascyn: Well, I think that’s one thing that came to mind was, you know, the need to have credible contrarians as part of the investment process. Now, well before Mohsen finally arrived at PIMCO, and I’m not sure if he is in the room here, but Chris Dialynas is the ultimate long-standing, more-than-credible contrarian who has for decades at PIMCO challenged conventional thinking, continues to do so. He and Mohsen finally, a recent addition who I know many of you have gotten to meet and interact with, is the current version, and they even today are challenging us with a view that's different than the official view that you heard over the course of the last couple of days. So I think that’s an important macro point, and we are constantly seeking out these types of insights even at more junior levels within the organization.

And I think on a related point, and we didn’t talk about this in the past, I think this also relates to diversity.

Richard Thaler: Yeah.

Dan Ivascyn: And diversity is an area where we at PIMCO, us within this industry, have a lot more work to do, but which is perfectly consistent with maximizing return to have different perspectives, feeling empowered to contribute to the overall investment process, and I know there has been some literature there as well that suggests that these initiatives aren’t just important from a cultural perspective, but they could absolutely lead to better bottom line results, and we absolutely agree with that here at PIMCO.

And the second point I was trying to think as you were speaking of, you know, the – a more direct example of this draft dynamic, and one may be that there is certain positions out there in the markets that are more difficult to hold. I think a good example I have uncovered throughout my career are, you know, assets that are – or companies that are close to default. There are many situations where we see people selling into the marketplace right before a default occurs even in situations where the particular bond within the capital structure is very well insulated from actual economic loss, but it takes some explaining, it can mess with the default statistics that you may share with investors if you are launching more defensive credit products, or it's just going to lead to, you know, negative views from the boss, negative reports from the media.

And what I found throughout my career, and we try to, you know, again have this philosophy across PIMCO portfolios is that sometimes this is the best opportunity to take those types of positions off of other investors' hands, because at the end of the day, we’re all working here together to maximize returns with limited volatility. We are not here to manage our public profiles in the press, you know, just because you happen to get in a tricky situation, so that’s the example of credit –

Richard Thaler: You know, I think it’s an interesting comparative advantage PIMCO has because of its giant size that you guys should be the ones that are willing to hold the stuff that is embarrassing, because you’ve got –

Emmanuel Roman: I just worry this is going to be bad. You know where you’re going?

Richard Thaler: You can always blame Manny, you know.

So, I mean, I totally agree there are unpopular things, and, you know, the holding the bonds of a company that’s on the verge of default is one, but there are –you could give thousands of other ones, and, you know, the old style value investing in stocks is often portrayed in that way. It’s owning the companies that –you know, it’s easy to brag about owning Google and Amazon. It’s very hard to brag about some company that’s been in the doldrums.

Emmanuel Roman: PetsMart or Toys R Us.

Richard Thaler: Well, right. So the same thing is true in bonds. It’s not as – quite as salient but –so, you know, there are advantages and disadvantages of being big, and, you know, the disadvantage can be can we get a big enough position. The advantage can be that maybe we can afford to take some risks that other people would be afraid to take on.

Emmanuel Roman: I am going to ask a few questions about the DC market and how people make decision about retirement. While I do this, please think of question you want to ask Richard or Dan while I do this.

So I am going to start by saying, you know, you have spent a lot of time on the DC market. A lot of people in this room have pension plan, they have big DC plan. What are your thought on this?

Richard Thaler: So let me tell you something new since many people here have heard or read some of the things I’ve written about this. Coincidentally, when –three weeks before I won the Nobel prize, I was in Stockholm giving a talk to parliament about their privatized part of their Social Security system.

So they implemented in 2000 what George W. Bush – he was talking about it yesterday – what he wanted to do in 2005, and so they took – they have like a 16 percent payroll tax that funds their Social Security. Two and a half percent goes into individual accounts. And I won’t give you the whole story, but they launched this in 2000, and there was a big scandal last year with one of the funds, and so they asked me and my student that I had worked with on this, a Swedish guy, to come and have a look.

And here’s the interesting thing we found.

When they launched in 2000, there were two nudges. Nudge number one, there was a default, and we all know if you make one of the funds a default, it’s going to get a big market share. The other nudge was they launched a huge advertising campaign saying don’t take the default.

Now, this is an interesting – it turns out the party in power at that time was the Swedish version of libertarian, which is a little hard to get your head around, but anyway, if there’s any Swedes, maybe they can explain what that was, but anyway, so that was the policy.

Now, I call this the battle of the nudges; right? Which one is going to win? And so if you’ve read "Nudge," there is a little piece on this on this part, this 2000 part. So the nudge that won was the advertising campaign. Two-thirds of the people chose to be their own portfolio managers, and I should say the default fund was very good: Globally diversified, 16 basis points, a fund anybody here would have been happy to own.

Okay. Now, the next year a couple hundred thousand new people enter the system, and that’s been happening every year since, mostly young or immigrants.

The first time you get a paycheck, you're in the system. What are they doing?

Well, so the first year two-thirds are taking active; right? Next year 10 percent, and the last few years less than 1 percent. So steady decline. Almost no one is declining the default, but what about those people who were nudged to be do-it-yourselfers 20 years ago? 97 percent are still doing it.

Now, here's the thing that our new paper looked at. They decided I think in 2011 that this default fund should add leverage, 50 percent leverage. So the default fund is 150 percent equity. We calculated that if this fund had been in place in the financial crisis, it would have lost 82 percent of its value, and this is the fund you are giving to the people who don't want to make a decision.

So we looked did anybody change their portfolio? 300 people. There is seven million people in this system; right? So no one noticed.

And then there was a fund that was caught cheating. There was front page stories on all of the newspapers. The owner of this fund made the mistake of buying the biggest house in Stockholm and a helicopter. Not a good combination.

Emmanuel Roman: Not good.

Richard Thaler: No. You don’t want to own a helicopter, and so he got caught by the newspapers, and this was front page story. Did people run out of this? No.

So the little paper that is coming out in the American Economic Review in a couple months that we wrote on this is nudges are forever.

Emmanuel Roman: Do you have any explanation – do you have an explanation why the first generation didn’t – you know, kept on? I mean the –

Richard Thaler: No one – they’re all asleep. I gave in my big Nobel lecture, I had a slide that said, ”We cannot reject the hypothesis that three million Swedes are asleep.”

Emmanuel Roman: That must have gone well.

Richard Thaler: Well, it got a good reaction, you know. They can’t take the prize away once they give it to you, you know.

Emmanuel Roman: That is absolutely true.

What do you make of this, Dan, in terms of, you know, because a lot of in the DC market, you could make the argument that people would be better served by having perfectly competent professional actually in the DC space making investment decision and being trained and so on and so forth, and it's always quite surprising to some of us that the DC market is what's best from a – from a – from a long-term result standpoint.

Dan Ivascyn: Yeah. You know, again, in, you know, in actually the DC plan work, I'm very much a student, and, you know, we spent some time talking about this and I’ve seen the research. We spent a lot of time speaking, you know, even outside of these organized sessions over the last few days, and my sense is, you know, there’s obviously a lot of tension in terms of, you know, putting together appropriate options, and these tensions are getting stronger rather than going away.

I think these are important decisions, and it’s likely frustrating that the end employee, you know, probably doesn’t get the full range of choices and advice at sufficient costs that they, in fact, deserve, and, again, we’re probably a little bias here as well in terms of the active and the passive discussion, but we are of the mindset that this shift towards passive alternatives has likely come at a somewhat inopportune time.

I think empirically in environments where valuations become more stretched, these absolute and relative decisions in the context of what’s appropriate, you know, at different stages of one’s life cycle become all the more important, and in some cases there is a tremendous amount of pressure to simplify.

So I do think there is a way to marry a lot of the research in trends and themes that you’ve uncovered with, you know, good, careful, thoughtful asset allocation input, but with all that said, the more I have these discussions in an area where I spend less of my time from a day-to-day perspective, the more I understand the real challenges there, which is why I think this is a key area where, you know, we are all partners, you know, in this area, and we have to work together just to –just to work through solutions in what amounts to a very, very critical, you know, area of importance for – and for people not just in this country but around the globe really.

Richard Thaler: Yeah, and, you know, the topic that has not been addressed nearly enough is the decumulation phase, which is harder. So I’ve spent a lot of time studying saving for retirement and trying to help people with that, but the flip side is way harder. Just think about it. Let’s say somebody is retiring at 67. Let’s say it’s a male, life expectancy of 20, a spouse maybe with a life expectancy of 25 or 30 and now has to manage that thing doing – updating each year.

Emmanuel Roman: Yeah.

Richard Thaler: and, I mean, I don't know any economist –

Emmanuel Roman: Because I was going to ask you this. I never see any paper on this. I mean, there is a lot on retirement but very little on deaccumulation, right?

Richard Thaler: There's is a tiny literature. I wrote a paper with Benartzi on the fact that almost no one chooses to annuitize, which is a puzzle.

Emmanuel Roman: Yeah, because that's one other thing we're talking about income solution for deaccumulation.

Dan Ivascyn: And that's what I said too, and again, I'm now getting further outside my area of expertise, but I thought too that, you know, you and others have talked about just this reluctance to dip into principal and – or to annuitize, and I think of my own parents, you know, they are old New Englanders. They'll do absolute everything in their power not to dip into principal just for the sake of being –

Richard Thaler: I had this argument with my father who was an actuary, and in his 80's, he's telling me that he's worried because he's spending more than his income, and I said, "Dad, you're 87, you know, and by my rough calculation, you have enough money to live to 140. What are the chances?"

Emmanuel Roman: (Unintelligible) Yeah, yeah, exactly. And what did he say? "Shut up."

Richard Thaler: Yeah. You're – you know, he thought of me as an economist which is somebody not smart enough to pass the actuarial exam.

Emmanuel Roman: But, Dan, we're talking about trying to find solution in terms of providing income for retirement which I think is a huge problem for everyone in this room.

Richard Thaler: Yeah. There are going to be big innovations, and somebody has to grab the ball.

Annuities have a bad name partly for good reasons. So they are complicated and have traditionally been sold with big loads, but there's no reason why that has to be true, and I think the plan sponsors are going to have to be the ones that solve this problem with providers giving them the ingredients, but we hold the employee's hand up until they retire, and then we say, "Good luck. See you later."

And you know, maybe we give them some help with the Medicare Advantage health insurance supplements, but in terms of spreading out their money, and if you compare that to, you know, my father’s generation had, he worked for Prudential most of his career and then, you know, got an annuity and –

Emmanuel Roman: That was fine.

Richard Thaler: – he never had to make a decision; right? There is not a single decision in that model. It’s like Social Security.

Emmanuel Roman: What do you make of this, Dan?

Dan Ivascyn: Well, again, I —

Emmanuel Roman: Because, you know, you are like the specialist in income; right?

Dan Ivascyn: Yeah. I’ll say this. You know, it’s obviously a major issue, you know, from a demographic perspective, you know, most societies are ageing and quickly facing these challenges.

Secondly from a valuation perspective, I think I used the term the other day fully valued, and I don’t want to sound really doom’s day, but as asset valuations get more stretched, the risks of bad decisions become greater, and, again, we live in a world where there have been significant subsidies out there, you know, during this cycle the central banks who may be heading in the other direction in upcoming years.

So, you know, I don’t have any grand answers, you know, given my role other than, you know, at a platform like PIMCO’s, you know, what we try to do is leverage global scale, scope and be as flexible as possible and as creative as possible in generating income while protecting the down side, and I don’t think that those are necessarily inconsistent, but they will be more important. We are a decade into this post-crisis recovery period, and these decisions become more and more consequential. So that’s what we’ve tried to do.

And as you know, Manny, in terms of my focus area throughout the years, it’s been at least partially within the more flexible income space, lower case ”f” on flexible.

And it’s an important area. So hopefully through providing value and, again, working on more customized solutions, we can help in our own way to get to the right answer, and that’s where we’ve been focused.

Emmanuel Roman: Is giving more choices to people a good thing or a bad thing when you look at the DC market? I mean, we talked about this not long ago.

Richard Thaler: Yeah, look, no. I think we clearly went overboard in number of choices in 401K plans.

In the Swedish system, they started with 450 and are now up to 900, right? So this is madness. But – so nobody can deal with that. And the evolution toward creating sensible default options like target date funds, whether –how they are managed is another story, but giving people a sensible default I think makes a great deal of sense. People don't have the expertise to be a portfolio manager, and my answer to the decumulation side is that employers are going to have to have default decumulation strategies, keep people in the system.

Emmanuel Roman: But is one of the question that people are asking is where people are just spending given the fact there is not enough money in the system, or are we going to have to find another solution?

Richard Thaler: Well, look. I mean, there are –there are a lot of people who are just not saving enough.

Emmanuel Roman: Take Chicago; right? I mean, I don't think there is a single public pension fund that doesn't have a level of underfunding, which is quite staggering.

And it’s tough to find solutions. It’s not like they are not trying.

Richard Thaler: Well, yeah. We don’t have time to go into the Illinois pension plan. There was a reasonable compromise reached, but the state supreme court ruled it unconstitutional. So it’s in the state constitution that you cannot reduce by a penny anything you once promised to people, and so that makes compromise pretty hard. Maybe we need a constitutional convention or something, but a hundred percent sure taxes will have to go up at some point because you are not allowed to default. I mean, that’s what – a state can’t go bankrupt, and the supreme court said we can’t reduce benefits. I – there is only one lever left to push. Fortunately, Illinois has a relatively low state income tax, so there is some room. I think they are going to have to just bite the bullet and say there is a 2 percent income tax surcharge for ”N” years that will pay this off and then we’ll be done, but the politician who gets that through will have to be very talented and brave.

Emmanuel Roman: Thank you so, so much Richard.

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