False sense of comfort - especially if oversight committee is not paying attention.
Cost of providing adequate information to oversight committee/regulators.
Ensuring timely/appropriate feedback on decision to oversight committee/regulators.
Governance must be just right - not too little and not too much
Governance Country Systems Provident Fund (PF) Individual Provident Fund Oversight Committee NO Defined Contribution (DC) Individual Fund Manager Regulators YES Defined Benefit (DB) Government Government Social Security Administration YES Agent Oversight Incentive compatible Principal
Importance Investment Decisions Sources of Long-Term Performance Source: Brinson, Hood & Beebower. “Determinants of Portfolio Performance” Financial Analysts Journal. May/June 1991. Note: Cross products account for 2.1% of the variance Tactical Asset Allocation 1.80% Other Factors 2.10% Security Selection 4.60% Strategic Asset Allocation 91.5%
As much as 91.5% of performance attributed to Strategic Asset Allocation
Assets and Liabilities Liabilities are unique for every pension plan Pension fund assets, in $ billions, annually Ratio of assets to liabilities, annually Note: Figures include a majority of private pension plans (45,000) Source: Pension Benefit Guaranty Corp. U.S. Pension Funds: 1980-1996
Liabilities are the only reason for a pension plan to make investment choices
Mean - Variance Efficient Frontier 6.00% 7.00% 8.00% 9.00% 10.00% 11.00% 5.00% 7.00% 9.00% 11.00% 13.00% 15.00% 17.00% 19.00% 21.00% Risk - Standard Deviation Return - Mean Traditional approach to Strategic Asset Allocation Market Portfolio Capital Market Line Asset Allocation Risk Tolerance determines Asset Allocation
Is standard deviation meaningful as risk tolerance measure for pension plans
The Pension Problem Asset and Liability matching problem LIABILITIES ASSETS
Traditional asset allocation approach does not take liabilities into account
Pension Plan investors have many other risk measures besides standard deviation of expected returns.
The appropriate risk measures for pension plans depends on the parties that are involved in the decision making process.
Different objectives Objectives of parties concerned with pension plans PENSION FUND Source: Ortec Consultant BV
Objectives dictates the risk measures and risk preference
PLAN SPONSOR Low and stable contributions REGULATING AUTHORITIES Solvency requirements EMPLOYEES Maintaining pension scheme CENTRAL GOVERNMENT Reduction public pensions RETIREES Maintaining compensation cost of living
Objectives and Risk Measures World Bank’s Pension Plan Maximize Return (max. wealth of plan) II. Avoid high contribution rate levels I. Avoid low funded ratio levels (ratio Asset to Liabilities)
Risks: I. Low funded ratios II. High contribution rates
Risk measured as tracking error against the strategic benchmark
177 TOTAL RISK 83 TAA - Risk 125 Active - Risk 40 Equity 45 Fixed Income 60 Others 100 Equity 20 Fixed Income 50 Others 10 US - Equity 120 Non US - Equity 15 High Yield 10 Global FI 0 Real Estate 50 Hedge funds 55 US - Equity 45 Non US - Equity 30 High Yield 7 Global FI 100 Hedge funds 15 Real Estate
Performance in same format as risk enables evaluation of risk and return
of each investment decision
50 TOT. PERFORM 15 TAA-PERFORM 35 Active-PERFORM 20 Equity 5 Fixed Income -10 Others 25 Equity 5 Fixed Income 5 Others 10 US - Equity 15 Non US - Equity 5 High Yield 0 Global FI 0 Real Estate 5 Hedge funds 15 US - Equity 5 Non US - Equity 0 High Yield 5 Global FI -20 Hedge funds 10 Real Estate