1 Pension Funds System, Life Cycle & Risks Najat El Mekkaoui de Freitas Philippe Bernard University of Paris-Dauphine Université Paris-Dauphine
2 Plan 1 - Evolution of institutional investors in OECD countries 2 Demographic and economic trends 3 - Governance of pension funds system : Rules, types and evolution of DB/DC plans, the pension funds management, the funding and investment rules. 4 - The assets allocation policy : LDI, assets allocations 5 Risks and Investment strategy. 6 - A new governance : OECD guidelines and policy responses.
3 -1- Evolution of Institutional Investors in OECD countries
4 Def. of Institutional investors Institutional investors : pension funds insurance companies feature of many OECD countries, and some Emerging Market Economies in recent years, is growth of institutional investors.
5 Comparison: Insurance companies like pension funds : long term institutional investors with the large share of tradable assets in their portfolios.
6 Some aspects of pension funds system : Pension funds = one part of a system of income provision for old people Pension funds = financial intermediaries (collect, invest funds).
8 -A pension funds : crucial for retirement and for capital markets. In many OECD countries, pension funds are developed and are crucial in the retirement income system and in the capital market. More than one million pension funds operate in OECD countries.
9 Differences between life insurance and pension funds PF liabilities : linked to average earning (real terms); LI liabilities : nominal or fixed terms (offering a guaranteed return); PF : No liquidity risk (long duration, possibility to increase contribution, ); LI : offer many type of products; LI : Better control of the duration;
10 A pension funds : an important investor in the world A crucial investors in the equity markets :in UK, Netherlands, Canada and Japan as well as the United States, pension funds are a massive investors in the equity securities markets.
11 2 - The demographic and economic challenges
12 2 - The demographic and economic challenges Over the next decades many countries will see a big shift in the age-composition of its societies with the share of elderly people increasing vis-àvis the share of working age people. The most consequence of this trend is that : few workers per person of retirement age and thus an increasing demographic burden on the public pension and health care systems.
13 The demographic and economic challenges Demographic and economic challenges are more severe in developed country (less in some country - USA) than in developing countries.
14 World Population (source : ONU)
15 Type of system : Pay as you go (PAYG) system in which benefits are earnings related and with a strong redistribution ; Funded system :fully funded (FF) system with contribution related benefits and no redistribution.
16 - A pension plans in Asian countries Asian countries : an increasing on funded pensions in order to secure retirement income for the elderly. China and India : growth in defined contribution pension plans. Singapore : growth of private pension funds.
17 3 - Governance and financial management
18 3.1 Pension Funds Specificities
19 3.1 : Specificities of Pension Funds (1) Defined Benefit: A defined benefit plan promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. More commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service for example, 1 percent of average salary for the last 5 years of employment for every year of service with an employer : Salary related schemes. Traditional, supported by labor unions. Now in decline.
20 Pension Funds Types (2) Defined Contribution: A defined contribution plan does not promise a specific amount of benefits at retirement. In these plans, the employee or the employer (or both) contribute to the employee's individual account under the plan, sometimes at a set rate, such as 5 percent of earnings annually.
21 DC plans -3 - Contributions generally are invested on the employee's behalf. The employee will ultimately receive the balance in their account, which is based on contributions plus or minus investment gains or losses. The value of the account will fluctuate due to the changes in the value of the investments. Examples of defined contribution plans : 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans.
22 3.2 Fiscalité EET: les cotisations, les revenus des investissements et plus-values sont exonérés et les prestations sont taxés. ETT: les cotisations sont exonérées, les revenus des investissements et plus-values ainsi que les prestations sont taxés. TEE: les cotisations sont taxées
23 3.3 The management in DB plans The different parties concerned are : 1- the employer (or a group of employers) : the settlor or sponsor 2- the plan administrator : the trustee 3- the beneficiaries of pension benefits : the employees.
24 Assets management: the trustee The trustee manages the funds. The trustee must acts only in the best interest of the beneficiaries. Depending on the firm size, the trustee can be the employer himself or a group of employee : Internal management. The funds can be managed by a financial institution : External management.
25 The funding rules 1 - Rules define pension-fund liabilities as : The solvency level at which the firm can meet all its current obligation is known as the accumulated benefit obligation (ABO). Such a funding rule known as Accumulated Benefit Obligation (ABO).
26 The funding rules The assumption that rights will be indexed up to the retirement, as in normal finaly salary scheme, gives the Projected Benefit Obligation (PBO). PBO take into account the projected benefits rises (ie : that interest rates rise with expected inflation).
27 3.4 Investment Rules
28 3.4 Investment Rules A Prudent person rule (PPR) versus quantitative assets restrictions (QAR) (see table : Investment regulation) PPR : The rule is interpreted as requiring a sensible asset diversification. Ex. USA, UK. : According to the Department of Labour, the trustee must act "in the sole benefit of the beneficiaries", which means to select investment with "the care, skill, prudence and diligence".
30 The theoretical model DC fund DB fund individual saving decision LDI MaxE t U( A(T )) U( A( T ) L( T )) [ ] A: pension fund assets; L: DB fund liabilities MaxE t [ ] with the implicit constraint: A(T) L(T)
31 Investment strategy
32 Investment strategy A new paradigm in investment strategy: liability-driven investing Rapidly emerging among European pension funds, insurance companies and other institutional investors.
33 What is Liability-Driven Investing? o Many institutional investors have liabilities they must pay in the future : retirement benefits, disability payments,... o To meet these future obligations: o invest a pool of assets with the goal of paying their future liabilities.
34 What is Liability-Driven Investing? Construct a portfolio of assets that generates cash flows matching the liability cash flows. Example : a pension plan could match a $100 annual liability by investing in a bond that pays $100 annually in coupon payments.
35 Characteristics of Liability-Driven Investing Liability-driven investing is a flexible strategy ; Portfolios can take many forms depending on the institution s choice for excess returns and tolerance for risk. But the first step in creating a liability-driven portfolio is to understand the characteristics of the liabilities.
36 Characteristics Most liabilities are long-term. The longer-term the liabilities are, the more sensitive they are to changes in interest rates. Similarly, longer-term bonds are more sensitive to changes in interest rates.
37 Etapes 2 - Evaluer le risque et le niveau de performance souhaités. Mesures effectués à partir de paramètres (alpha, bêta, etc). 3 - Choix des portefeuilles.
39 -4 - Assets allocation of pension funds
40 4.1- Porfolio allocation of pension plans (world)
41 4.2- Assets Allocation of pension funds (US and Canada)
42 Fig. 1 : Private pension funds Allocation - US Allocation d'actifs des fonds de pension privés ,5 0,45 Action s 0,4 0,35 Proportion 0,3 0,25 0,2 OPCVM Actions OPCVM Obligations corporate et étrangères Titres du Trésor Dépôts à terme et d'épargne 0,15 obligatio ns 0,1 0, Année
43 Fig. 2 : Public pension funds Allocation -US Allocation d'actifs des fonds de pension publics ,7 0,6 0,5 Obligatio Action s Proportion 0,4 0,3 Actions OPCVM Obligations corporate et étrangères Titres du Trésor 0,2 0, Année
44 Fig. 3 : DB pension funds Allocation US Allocation d'actifs des fonds DB ,6 0,5 Actions Proportion 0,4 0,3 Actions OPCVM Obligations corporate et étrangères Titres du Trésor Dépôts à terme et d'épargne 0,2 Obligations 0, Année OPCVM
45 Fig. 3 : DC pension funds Allocation US Allocation d'actifs des fonds DC ,5 0,45 actions 0,4 0,35 Proportion 0,3 0,25 0,2 OPCV Actions OPCVM Obligations corporate et étrangères Titres du Trésor Dépôts à terme et d'épargne SICAV monétaires 0,15 0,1 0, Année
46 Fig. 4 :Pension funds allocation Canada Evolution de l'allocation d'actifs des fonds de pension canadiens sur la période Proportion actions obligations actifs monétaires hypothèques immobilier Année
47 Type of Allocations Non agressive assets allocation (gilts, national capital markets) European countries : germany, spain (QAR). Dynamic allocation : investment in equities (national and foreign capital markets) anglo-américan countries (PPR). Question : between PPR and QAR, the best policy allocation (in term of return-risk)?
48 Return Pension funds PPR versus QAR (source : Davis)
49 Rendement et risque des actions et des obligations sur le marché américain ,4 0,3 0,2 Rendement et volatilité 0,1 0 Rendement actions Volatilité actions Rendement obligations Volatilité obligations ,1-0,2 Année
50 Asset allocation: towards more diversity within portfolio A move towards greater international diversification of pension fund portfolios is observed, especially in those countries where pension funds exhibit high ratios of total pension funds investments to GDP; But wide disparities between countries remain.
51 4.3 Asset allocation and life cycle
52 Specificities of Pension Funds (1) Defined Benefit: A defined benefit plan promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. More commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service for example, 1 percent of average salary for the last 5 years of employment for every year of service with an employer : Salary related schemes. Traditional, supported by labor unions. Now in decline.
53 Pension Funds Types (2) Defined Contribution: A defined contribution plan does not promise a specific amount of benefits at retirement. In these plans, the employee or the employer (or both) contribute to the employee's individual account under the plan, sometimes at a set rate, such as 5 percent of earnings annually.
54 Fonds de pension :Actions vs Obligations la plupart des actifs financiers ont des rendements qui ne suivent pas une marche aléatoire. Cas des obligations est évident : un bon estimateur du taux d intérêt futur est le taux d intérêt présent.
55 Why funds must consider the investments in equities? Fonds de pension ont un engagement spécifique (ceux à prestations définies) : celui de verser une rente dont le pouvoir d achat souhaité doit être proche de celui du dernier salaire perçu. Cet objectif les conduit à détenir un actif permettant de se couvrir contre le risque de hausse de salaire (nominaux).
56 Fonds de pension :Actions vs Obligations Les actions sont les actifs ayant cette propriété. La dynamique des profits conditionnent celle des cours des actions.
57 Allocation and Age Financial advisers first questions to a client often deal with the client s investment horizon: while equities are more risky in the short run, they are less risky in the long run and could be considered at first glance as the first choice savings vehicle for retirement.
58 Rule 100 minus one s age At a more microeconomic level, financial advisors generally consider that older people should invest less in stocks than younger people (Mankiel 1996); The rule is : the equity share should be equal to 100 minus one s age. while young people can diversify risk with their wages, or with the incomes that they will earn over a long period of activity, this is not possible for older people.
59 Assets and human capital This advice have been criticized by Jagannathan and Kocherlakota (1996). Advice is correct only if the risks associated with their stock portfolio and the human capital are not correlated.
60 The vulgate «100 minus age» Merton (1969) : portfolio choices are independent of age. Portfolio allocation : not associated with wealth, age but only with the return of assets( Risk aversion fixed).
61 No consensus about Merton Model Results of empirical estimations : Different type of Asset allocation amoung household. Others explanations : liquidity constraint, others types of risks.
62 Risques assurables/non assurables Two types of risks ; insurable and no insurable risks (health, employment, ). Gollier et Zeckhauser (1997) : Disctinction between Young/seniors and their portfolio allocations : Young : high proba. To face to unemployment/education expenses. Better to select no risky assets. Seniors:low proba. to face to this risk. portofolio with equities.
63 Households, age and risk aversion : «vulgate 100 minus age» Tableau 1: Modification des portefeuilles de fonds de pension due au vieillissement de la population ( ) Royaume-Uni U.S.A. Pays-Bas Japon Actions 72% 60% 62% 54% 45% 30% 40% 28% Autres 28% 40% 38% 46% 55% 70% 60% 72% Source: Mantel (2000) pour Merril Lynch.
64 Investment in assets for younger and older people (UK and Netherlands)
65 4.4 Situation of pension funds systems
66 The situation today : the crisis 10 May 2005, US United Airlines obtained a bankruptcy judge authorization to default on its pension plans, underfunded by $9.8 billion.
67 The crisis 14 September 2005: Crisis in Delta and Northwest Airlines : the underfunding of the two companies pension plans reached $10.6 billion and $5.7 billion respectively.
68 The underfunding of US plans The PBGC estimates that underfunding of US corporations single-employer DB pension plans reached $450 billion in (it was never higher than $110 billion until 2002). This resulted in losses for the PBGC of $23 billion in 2004 and 2005 (never higher than $3.6 billion until 2002).
69 Why this situation? System unsaistanable : - Because of equities markets crashed ( ), - Because of bad governance : - lower contributions rate, - No consideration of the risk of longevity, - Collusion between trustees and companies.
70 Why this situation? -2- Because of «contributions holidays» : many firms used surplus of pension funds. Many sponsor act in the interests of the firm and not for the beneficiaries : assymetric informations.
71 External management It allows to benefit from economies of scale and from the diversity of managers and investments. But, external management involves management fees that reduce the pension benefits.
72 Concl. 1 - The OECD guidelines Funds must follow the prudent person rule, Define an overall investment policy and actively follow it, Require the governing body to act in the best interest of beneficiaries when investing pension plan assets, Establish internal controls and procedures to effectively implement and monitor the way investments are managed, Identify and measure the risks to which the fund is exposed.
73 Concl. 2 - The US : Change in discount rate for liabilities from a single rate approach to a yield curve approach. The yield curve would discount all liabilities of their exact maturities. Development of annuities ; Financial Innovation : gilt indexed in longevity risk.
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