Life-Cycle Pension Funds: A Way Forward for Lithuania

Transcription

1 ASSET ALLOCATION FOR INSTITUTIONAL INVESTORS Palace of the Grand Dukes of Lithuania, September 2015, Vilnius Life-Cycle Pension Funds: A Way Forward for Lithuania Andrius Škarnulis, Bank of Lithuania, 11 September 2015

2 Outline Current characteristics of Lithuanian 2 nd Pillar Weaknesses of current system Life-cycle pension funds project in Lithuania Glide Path: model, reality and regulatory aspects 2

3 Characteristics of Lithuanian 2 nd Pillar (1) 2 nd Pillar is optional, but 3

4 Characteristics of Lithuanian 2 nd Pillar (2) 2 nd Pillar is optional, but once you in, you cannot escape (opt out system) 4

5 Characteristics of Lithuanian 2 nd Pillar (3) 2 nd Pillar is optional, but once you in, you cannot escape (opt out system) DC scheme, 3-channel contribution 5

6 Characteristics of Lithuanian 2 nd Pillar (4) 2 nd Pillar is optional, but once you in, you cannot escape (opt out system) DC scheme, 3-channel contribution Life-style funds (from conservative to 100% equities) 6

7 Characteristics of Lithuanian 2 nd Pillar (5) 7

8 Characteristics of Lithuanian 2 nd Pillar (6) * * as of

9 Weaknesses of current system (1) More than 50% are in the wrong fund according to participants age* * based on reference Glide Path 9

10 Weaknesses of current system (2) More than 50% are in the wrong fund according to participants age* More than 2/3 are passive one fund for the whole life (questionnaire) Just ~2% changed a pension fund or a company ( real data) * based on reference Glide Path 10

11 Weaknesses of current system (3) More than 50% are in the wrong fund according to participants age* More than 2/3 are passive one fund for the whole life (questionnaire) Just ~2% changed a pension fund or a company ( real data) During crisis 92 % of participants decisions were wrong * based on reference Glide Path 11

12 Weaknesses of current system (4) More than 50% are in the wrong fund according to participants age* More than 2/3 are passive one fund for the whole life (questionnaire) Just ~2% changed a pension fund or a company ( real data) During crisis 92 % of participants decisions were wrong Active clients follow one indicator short term returns For a typical participant it is too difficult to compare funds * based on reference Glide Path 12

13 Weaknesses of current system (5) More than 50% are in the wrong fund according to participants age* More than 2/3 are passive one fund for the whole life (questionnaire) Just ~2% changed a pension fund or a company ( real data) During crisis 92 % of participants decisions were wrong Active clients follow one indicator short term returns For a typical participant it is too difficult to compare funds Active clients follow one indicator short term returns * based on reference Glide Path 13

14 Weaknesses of current system (6) More than 50% are in the wrong fund according to participants age* More than 2/3 are passive one fund for the whole life (questionnaire) Just ~2% changed a pension fund or a company ( real data) During crisis 92 % of participants decisions were wrong Active clients follow one indicator short term returns For a typical participant it is too difficult to compare funds Active clients follow one indicator short term returns Competition for short term goals does not create value and makes the 2 nd pillar unsustainable * based on reference Glide Path 14

15 Life cycle project in Lithuania (1) Primary discussions already in

16 Life cycle project in Lithuania (2) Primary discussions already in Cooperation and consultations with the World Bank 16

17 Life cycle project in Lithuania (3) Primary discussions already in Cooperation and consultations with the World Bank Project reinitiated

18 Life cycle project in Lithuania (4) Primary discussions already in Cooperation and consultations with the World Bank Project reinitiated 2014 Chosen design for implementation of LCF idea Target date funds 18

19 Target Date concept Target date fund Glide Path 19

20 Life cycle project in Lithuania (4) Primary discussions already in Cooperation and consultations with the World Bank Project reinitiated 2014 Chosen design for implementation of LCF idea Target date funds 20

21 Life cycle project in Lithuania (5) Primary discussions already in Cooperation and consultations with the World Bank Project reinitiated 2014 Chosen design for implementation of LCF idea Target date funds Glide Path modelling and regulatory concepts 21

22 Why Target Date PF is a Solution? (1) Target Date scheme the most simple and the easiest to understand One fund for entire life 22

23 Why Target Date PF is a Solution? (2) Target Date scheme the most simple and the easiest to understand One fund for entire life Participants are still passive but it is pro not con 23

24 Why Target Date PF is a Solution? (3) Target Date scheme the most simple and the easiest to understand One fund for entire life Participants are still passive but it is pro not con Lower behavioral risks than in the Life style multi-funds case You are in the right fund, and it ages with you (default option) 24

25 Why Target Date PF is a Solution? (4) Target Date scheme the most simple and the easiest to understand One fund for entire life Participants are still passive but it is pro not con Lower behavioral risks than in the Life style multi-funds case You are in the right fund, and it ages with you (default option) Risk becomes measurable, comparable and controlled The same Glide Path construction concept for all companies 25

26 Why Target Date PF is a Solution? (5) Target Date scheme the most simple and the easiest to understand One fund for entire life Participants are still passive but it is pro not con Lower behavioral risks than in the Life style multi-funds case You are in the right fund, and it ages with you (default option) Risk becomes measurable, comparable and controlled The same Glide Path construction concept for all companies Long term goals become superior to short term ones Tracking long term strategies 26

27 Why Target Date PF is a Solution? (6) Target Date scheme the most simple and the easiest to understand One fund for entire life Participants are still passive but it is pro not con Lower behavioral risks than in the Life style multi-funds case You are in the right fund, and it ages with you (default option) Risk becomes measurable, comparable and controlled The same Glide Path construction concept for all companies Long term goals become superior to short term ones Tracking long term strategies No unnecessary timing risks (e.g. as in Life style multi-funds case) 27

28 Why Target Date PF is a Solution? (7) BUT it is likely more expensive and harder to afford especially for the smallest market participants 28

29 Why Target Date PF is a Solution? (8) BUT it is likely more expensive and harder to afford especially for the smallest market participants THEREFORE simplifications of administrative, licencing and reporting requirements are being discussed 29

30 Glide path: model, reality and regulatory aspects (1) Scientific models* - country adaptation is necessary (DC scheme, pension wealth is locked till retirement, etc.) *[1] J.F. Cocco, F.J. Gomes, P.J. Maenhout, Consumption and Portfolio Choice over the Life Cycle, 2005 *[2] F.C. Bagliano, C. Fugazza, G. Nicodano, Pension Funds, Life-Cycle Asset Allocation and Performance Evaluation, CeRP-Collegio Carlo Alberto and University of Turin, 2009 etc. 30

31 Glide path: model, reality and regulatory aspects (2) Scientific models* - country adaptation is necessary (DC scheme, pension wealth is locked till retirement, etc.) Based on utility maximization idea. Inputs risk/return parameters, income profile, starting and retirement age, dependencies, etc. *[1] J.F. Cocco, F.J. Gomes, P.J. Maenhout, Consumption and Portfolio Choice over the Life Cycle, 2005 *[2] F.C. Bagliano, C. Fugazza, G. Nicodano, Pension Funds, Life-Cycle Asset Allocation and Performance Evaluation, CeRP-Collegio Carlo Alberto and University of Turin, 2009 etc. 31

32 Glide path: model, reality and regulatory aspects (3) Scientific models* - country adaptation is necessary (DC scheme, pension wealth is locked till retirement, etc.) Based on utility maximization idea. Inputs risk/return parameters, income profile, starting and retirement age, dependencies, etc. Each PF management company constructs its own Glide Path strategy but *[1] J.F. Cocco, F.J. Gomes, P.J. Maenhout, Consumption and Portfolio Choice over the Life Cycle, 2005 *[2] F.C. Bagliano, C. Fugazza, G. Nicodano, Pension Funds, Life-Cycle Asset Allocation and Performance Evaluation, CeRP-Collegio Carlo Alberto and University of Turin, 2009 etc. 32

33 Glide path: model, reality and regulatory aspects (4) Scientific models* - country adaptation is necessary (DC scheme, pension wealth is locked till retirement, etc.) Based on utility maximization idea. Inputs risk/return parameters, income profile, starting and retirement age, dependencies, etc. Each PF management company constructs its own Glide Path strategy but the same conceptual model is used in order to ensure consistency and comparability *[1] J.F. Cocco, F.J. Gomes, P.J. Maenhout, Consumption and Portfolio Choice over the Life Cycle, 2005 *[2] F.C. Bagliano, C. Fugazza, G. Nicodano, Pension Funds, Life-Cycle Asset Allocation and Performance Evaluation, CeRP-Collegio Carlo Alberto and University of Turin, 2009 etc. 33

34 Glide path: model, reality and regulatory aspects (5) Scientific models* - country adaptation is necessary (DC scheme, pension wealth is locked till retirement, etc.) Based on utility maximization idea. Inputs risk/return parameters, income profile, starting and retirement age, dependencies, etc. Each PF management company constructs its own Glide Path strategy but the same conceptual model is used in order to ensure consistency and comparability Tracking the chosen long-term Glide path strategy *[1] J.F. Cocco, F.J. Gomes, P.J. Maenhout, Consumption and Portfolio Choice over the Life Cycle, 2005 *[2] F.C. Bagliano, C. Fugazza, G. Nicodano, Pension Funds, Life-Cycle Asset Allocation and Performance Evaluation, CeRP-Collegio Carlo Alberto and University of Turin, 2009 etc. 34

35 Glide path: model, reality and regulatory aspects (6) Scientific models* - country adaptation is necessary (DC scheme, pension wealth is locked till retirement, etc.) Based on utility maximization idea. Inputs risk/return parameters, income profile, starting and retirement age, dependencies, etc. Each PF management company constructs its own Glide Path strategy but the same conceptual model is used in order to ensure consistency and comparability Tracking the chosen long-term Glide path strategy with adequate freedom for an active management (e.g., limits on tracking-error-type indicators) *[1] J.F. Cocco, F.J. Gomes, P.J. Maenhout, Consumption and Portfolio Choice over the Life Cycle, 2005 *[2] F.C. Bagliano, C. Fugazza, G. Nicodano, Pension Funds, Life-Cycle Asset Allocation and Performance Evaluation, CeRP-Collegio Carlo Alberto and University of Turin, 2009 etc. 35

36 Glide path: model, reality and regulatory aspects (7) Scientific models* - country adaptation is necessary (DC scheme, pension wealth is locked till retirement, etc.) Based on utility maximization idea. Inputs risk/return parameters, income profile, starting and retirement age, dependencies, etc. Each PF management company constructs its own Glide Path strategy but the same conceptual model is used in order to ensure consistency and comparability Tracking the chosen long-term Glide path strategy + with forward adequate looking freedom assessment for active from management the supervisory (e.g., side limits on tracking-error-type indicators) *[1] J.F. Cocco, F.J. Gomes, P.J. Maenhout, Consumption and Portfolio Choice over the Life Cycle, 2005 *[2] F.C. Bagliano, C. Fugazza, G. Nicodano, Pension Funds, Life-Cycle Asset Allocation and Performance Evaluation, CeRP-Collegio Carlo Alberto and University of Turin, 2009 etc. 36

37 Glide path (example) *Baseline scenario: power utility function; mean long-term risk-free rate 1,5%; volatility of risk-free rate 1%; volatility of risky asset 15%; mean risk premium decreasing in the long-term (from 5% to 1%) due to population ageing risk; correlation between shocks to equity returns and income = 0.35; income profile (age impact on personal income) estimated using real data from social insurance database; risk aversion coefficient = 3; starting age 20; retirement age 65; contribution rate 6%; 37

38 Glide Path vs. other strategies Utility Cost (Utility Loss) generated by the choice of other strategy than the optimized Glide Path* *Baseline scenario: power utility function; mean long-term risk-free rate 1,5%; volatility of risk-free rate 1%; volatility of risky asset 15%; mean risk premium decreasing in the long-term (from 5% to 1%) due to population ageing risk; correlation between shocks to equity returns and income = 0.35; income profile (age impact on personal income) estimated using real data from social insurance database; risk aversion coefficient = 3; starting age 20; retirement age 65; contribution rate 6%; 38

39 Strategy 1 (S1): 0% invested in equity 39

40 S1: 0% invested in equity. Utility cost 40

41 S2: 25% invested in equity 41

42 S2: 25% invested in equity. Utility cost 42

43 S3: 50% invested in equity 43

44 S3: 50% invested in equity. Utility cost 44

45 S4: 75% invested in equity 45

46 S4: 75% invested in equity. Utility cost 46

47 S5: 100% invested in equity 47

48 S5: 100% invested in equity. Utility cost 48

49 S6: equity share decreases linearly 100% 0% 49

50 S6: equity share decreases linearly 100% 0%. Utility cost 50

51 S7: equity share decreases linearly 100% 20% 51

52 S7: equity share decreases linearly 100% 20%. Utility cost 52

53 S8: equity share increases linearly 0% 80% 53

54 S8: equity share increases linearly 0% 80%. Utility cost 54

55 S9: Stair-step structure 1 55

56 S9: Stair-step structure 1. Utility cost 56

57 S10: Stair-step structure 2 57

58 S10: Stair-step structure 2. Utility cost 58

59 S11: Stair-step structure 3 59

60 S11: Stair-step structure 3. Utility cost 60

61 S12: Partly straight-line glide path 1 61

62 S12: Partly straight-line glide path 1. Utility cost 62

63 S13: Partly straight-line glide path 2 63

64 S13: Partly straight-line glide path 2. Utility cost 64

65 S14: Partly straight-line glide path 3 65

66 S14: Partly straight-line glide path 3. Utility cost 66

67 S7: equity share decreases linearly 100% 20% 67

68 Main points Apparent weaknesses in the 2 nd pillar threaten sustainability in the long term The main and the most effective step forward introduction of a Life-cycle principle as a default option Target date scheme the most simple and the easiest to understand Consistent, comparable and long-term oriented strategies with adequate freedom for active management 68

69 Thank you! 69