Life-Cycle Pension Funds: A Way Forward for Lithuania

ASSET ALLOCATION FOR INSTITUTIONAL INVESTORS Palace of the Grand Dukes of Lithuania, 10-11 September 2015, Vilnius Life-Cycle Pension Funds: A Way Forward for Lithuania Andrius Škarnulis, Bank of Lithuania, 11 September 2015

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

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

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

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

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

Characteristics of Lithuanian 2 nd Pillar (5) 7

Characteristics of Lithuanian 2 nd Pillar (6) * * as of 2015-06-30 8

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

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 (2014-2015 real data) * based on reference Glide Path 10

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 (2014-2015 real data) During crisis 92 % of participants decisions were wrong * based on reference Glide Path 11

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 (2014-2015 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

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 (2014-2015 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

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 (2014-2015 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

Life cycle project in Lithuania (1) Primary discussions already in 2009-2010 15

Life cycle project in Lithuania (2) Primary discussions already in 2009-2010 Cooperation and consultations with the World Bank 16

Life cycle project in Lithuania (3) Primary discussions already in 2009-2010 Cooperation and consultations with the World Bank Project reinitiated 2014 17

Life cycle project in Lithuania (4) Primary discussions already in 2009-2010 Cooperation and consultations with the World Bank Project reinitiated 2014 Chosen design for implementation of LCF idea Target date funds 18

Target Date concept Target date fund 1991-1995 Glide Path 19

Life cycle project in Lithuania (4) Primary discussions already in 2009-2010 Cooperation and consultations with the World Bank Project reinitiated 2014 Chosen design for implementation of LCF idea Target date funds 20

Life cycle project in Lithuania (5) Primary discussions already in 2009-2010 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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

S1: 0% invested in equity. Utility cost 40

S2: 25% invested in equity 41

S6: equity share decreases linearly 100% 0% 49

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

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

S8: equity share increases linearly 0% 80% 53

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

S9: Stair-step structure 1 55

S9: Stair-step structure 1. Utility cost 56

S12: Partly straight-line glide path 1 61

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

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

Thank you! 69