Pensions Core Course 2013: Pension Fund Management at the World Bank


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Pensions Core Course 2013: Pension Fund Management at the World Bank

  1. 1. Pension Fund Managementat the World BankFinancial Advisory and BankingWorld Bank TreasuryWashington, DCtreasury.worldbank.orgSudhir RajkumarHead of Pension Advisoryemail: srajkumar@worldbank.orgTel: (202) 473-0799
  2. 2. 2Road Map Background on World Bank Treasury Overview of World Bank Pension Fund Pension Fund Investment Framework Governance Structure Investment Policy Investment Management Risk Management Performance Measurement Accounting & Reporting Information Technology
  3. 3. 3World Bank Treasury Activities US$120-140 billion of investment management 85% managed internally 15% managed externally Full spectrum of assets, from fixed income (bonds)to private equity Includes US$18 billion of Pension Plan Assets US$20-40 billion borrowings per year Frequent international issuer with hundredsof transactions per year Wide variety of products with different maturities,currencies, and structures US$25-50 billion derivative operations per year Variety of derivative products for risk management
  4. 4. 4 Established in 1948 Current fund size: USD 18 billion Membership: 14400 active staff, 8500 retirees Well-funded plan, with assets close to liabilities Investments in a wide range of asset classes includingequities, bonds, real estate, hedge funds and private equity Investment activities overseen by Pension FinanceCommittee, and managed by qualified professional staffOverview of WB Pension Fund
  5. 5. 5Pension Fund Management Decisions Pension plan design resulting in creation of contractualobligations or liabilitiesFunded or Payas You Go(PAYG)SchemeEmployerPensionScheme Funded scheme ensures security of entitlement andsustainabilityContributionsParticipants &Employer Contributions to a funded scheme have to be determinedInvestmentProcess Investment Policy devised for maximizing Plan wealthsubject to risk constraintsInvestmentPolicyHR PolicyOverallPolicyFundingPolicyPolicy
  6. 6. 6 Overall goal is to build up and sustain a well-fundedpension plan that can meet the contractual pensionliabilities over time Ultimately, the pension benefit payments have to be metthrough some combination of contributions from thesponsor and investment returns on plan assets (FundingPolicy and Investment Policy) Critical decision involves making the appropriate tradeoffbetween return and risk A very conservative investment policy could result inmeager investment returns, and force the sponsor to makelarge contributions A very aggressive investment policy could make the fundvulnerable to adverse investment outcomes, and jeopardizethe financial health and security of the planPension Fund Management Decisions
  7. 7. 7Investment FrameworkGovernanceStructureInvestmentPolicyInvestmentManagementRiskManagementPerformanceMeasurementAccounting& ReportingInformationTechnology
  8. 8. 8Guiding Principles Good governance = Clear separation of roles and accountabilities; Every pension fund has a unique risk profile based on: the liability characteristics of the Fund; and the size of the Fund relative to its liabilities; Board should “own” the Fund’s risk profile (both SAA & Risk Budget),and should review it at regular intervals, as well as in response tostructural changes (e.g. availability of new asset classes,demographic profile of beneficiaries, cash-flow needs, capacity ofdomestic markets, ability to hedge currency risk); Policy decisions need to be clearly articulated and documented; All other decisions should be delegated to levels where they can bemade most effectively, together with enhanced controls which createaccountability; and Risk usage, total return, and performance versus benchmarks, shouldbe monitored and reported regularly with a focus on the Fund’sinvestment horizon;
  9. 9. 9Organizational StructureInvestmentManagementIn-house Mgmt.Mgmt. of Ext.ManagersActive risk Mgmt.Risk &AnalyticsRiskBenchmarksPerformanceSettlement &ControlBank balancesTrade settlementOperational riskmeasurementInternal AuditPeriodic reviewof processesand proceduresInvestment CommitteeInvestment GuidelinesRisk AllocationExternal vs In-house Mgmt.Governing BoardInvestment PolicyOverall Risk BudgetOversightLegal CounselAccounting &ValuationsPricingAccountingReconciliationControllerFinancial StatementsInternal ControlEnvironment
  10. 10. What decisions do we need to make?Range of required investment-related decisions Roles and responsibilities of oversight committee and staff Investment philosophy, objectives, investment horizon, and risk tolerance Investment policy role of liabilities asset class strategies performance benchmarks risk budget for active management Internal versus external management of the pension assets Portfolio construction and manager selection Engagement of auditors and custodian Frequency and content of reporting to – staff, management, investmentcommittee, board, stakeholders Budget for investment management 1010
  11. 11. 11Key RolesGOVERNING BOARDApproves Investment Policy: FundObjectives, Investment Horizon,Risk Tolerance & Metrics, EligibleAsset Classes, SAA, Risk BudgetINVESTMENTCOMMITTEESets Policy Benchmarks, AllocatesRisk Budget, Approves InvestmentGuidelinesSTAFF Implements Investment Policy
  12. 12. Pension FinanceCommitteeInvestment Staff:Internal &External MgtStrategy, Riskand AnalyticsOperations &AccountingGovernance: World Bank Pension Plan –Staff DelegationSignificant delegation of decision-making to staffStaff develop, recommend and implement asset allocation, investmentmanagement and other policies in a well segregated and specializedinstitutional environment1212
  13. 13. Importance of On-going Board Education Continuing orientation and education of Board members, bothindividually and as a group Education ensures understanding of fiduciary responsibilitiesand scope of authority Participation by external “experts” in Board meetings asnecessary, particularly when specialized topics are beingpresented by staff Ultimate objective is to facilitate the Board’s ability to makenecessary decisions, and “own” these decisions1313
  14. 14. Importance of Strategic PublicCommunication6. How do you Measure and Evaluate Results?1. What are your Objectives?2. Who is your Audience?5. What Channels can youuse to Communicate?3. Whatbehavior changeare youaiming for?4. What Message(s) doyou want to Communicate?14
  15. 15. 15Investment FrameworkGovernanceStructureInvestmentPolicyInvestmentManagementRiskManagementPerformanceMeasurementAccounting& ReportingInformationTechnology
  16. 16. 161. Fund Objectives and Investment Horizon2. Risk Toleranceand OtherConstraints3. Capital MarketsAssumptions andEligible Asset Classes4. SAA ModelOptimization/simulationmethods to determinethe best long-termallocation5. Implementing theSAASetting the policybenchmarkInvestment Policy Process
  17. 17. 17Investment Policy IssuesDefined Benefit Pension Funds Fund Objectives: Fund stream of cash outflows in cheapest possible way, giventhat: cash inflows (e.g. contributions) can be controlled cash outflows (e.g. benefit payments) uncertain and cannoteasily be controlled or influenced Investment Horizon: Typically fairly long, but may be affected by regulatory andaccounting factors Risk Tolerance: Moderate to High, but can vary depending on funded status anddemographic profile of beneficiaries
  18. 18. 18Investment Policy IssuesDefined Contribution Pension Funds Fund Objectives: Create stable and sufficient retirement income, given that: cash inflows (e.g. contributions) are known cash outflows (e.g. required income in retirement) relativelymore uncertain Investment Horizon: Typically fairly long, but depends on age of individual Risk Tolerance: Low, Moderate, or High, depending on age and retirement goals ofindividual
  19. 19. 19“The process by which an institution determines theappropriate neutral asset allocation to achieve its long-term investment objectives” SAA is neutral (should not be driven by short-term market views) Objectives are long-term and can be varied (help meet certain futurepayment obligations or liabilities, preserve and grow capital etc.) SAA should be reviewed periodically (conditions can change, bothinternal and external) Essentially involves trade-off between return and risk Typically SAA seeks to maximize return subject to a set of riskconstraints Pension SAA should be liability drivenWhat is Strategic Asset Allocation?
  20. 20. 16Importance of long-terminvestment policyStrategic asset allocation is thekey driver of long-terminvestment success: defines the overall return-riskprofile of the portfolio ranks high in the hierarchy ofinvestment decisions needs to be owned at thehighest levelSource: Brinson, Hood & Beebower. “Determinants of PortfolioPerformance” Financial Analysts Journal. May/June 1991.Tactical AssetAllocation1.80% Other Factors2.10%ExternalManager Selection4.60%Strategic AssetAllocation91.5%
  21. 21. 21Typical Investment Objectives Maintain and grow the plan surplus, which isthe difference between the value of assets andliabilities Maintain and grow the funded ratio, which isthe ratio of assets to liabilities Liabilities are the key to definition of pensionplan investment objectives Critical to understand the nature of liabilities(e.g., are they indexed to inflation, etc.) and howthey are valued
  22. 22. 22Measuring LiabilitiesPast Future Salary NewService Service Increase EntrantsABO PBO  Closed Group   Open Group    Liabilities are the present value of benefit payments and can bevalued using different assumptions and measuresDefine key actuarial assumptions such as mortality, termination rates,cost-of-living increases in pensions, investment return, inflation
  23. 23. Asset-only versusasset-liability approach Portfolios should be constructed on an asset-liability basis– Correlations between assets and liabilities matter0 0.05 0.1 0.15 0.2 0.25-0.0500.050.1Surplus Standard DeviationExpectedSurplusReturnasset-liability efficient frontierasset-only efficient frontier100% stocks60%/40% stocks/bonds100% bondsliability mimicking portfolio
  24. 24. Illustrative back-test– liabilities matterSource: Ryan Labs Liabilities Index, Bloomberg and World Bank Treasury calculations.Impact of Fixed Income duration on the Funded RatioUS Equity 35% US Equity 35%International Equity 15% International Equity 15%Lehman Global Agg.(Hedged)40%Long maturityTreasury Bonds40%Real Estate 10% Real Estate 10%Surplus return -7.1% Surplus return -5.3%Surplus volatility 17.8% Surplus volatility 13.1%Asset-only volatility 9.5% Asset-only volatility 10.6%Asset-only Pension Portfolio LDI PortfolioAllocation Allocation
  25. 25. Determinants of InstitutionalRisk ToleranceSponsorFinancial Strength-Size of the plan relativeto the sponsor- Financial health of the sponsorStronger sponsor implies ahigher ability to take riskInvestment Horizon- Net cash flow profile of the plan-Demographics of the planA longer investment horizonimplies ahigher ability to take riskFunded StatusFunded ratio of the planon mark to market basisA higher funded ratio impliesa higher ability to take riskRisk Tolerance
  26. 26. 26Avoid low funded ratios(Staff and RetireesObjective)Avoid highcontributions(Plan Sponsor’sObjective)Two measures of risk :a. Minimum acceptable funded ratio levelsb. Maximum acceptable contribution ratesMaximize Return(max. wealth of Fund)Typical Risk ConstraintsMinimum acceptablefunded ratioMaximum acceptablecontribution rate
  27. 27. 27Portfolio RisksI.Liquidity RiskThe risk that assetscannot be converted intocash in a timely manner orincurring reasonabletransaction costs in orderto meet any and allforecasted andunpredicted cash flowsIII.Credit RiskThe risk of default on anobligation by the counter-partyII.Market RiskPotential change in marketvalue of assets due to:- interest rate changes(interest rate risk)- change in spread to anunderlying security (spreadrisk)- change in expectations offuture earning potential(equity risk)
  28. 28. 28Evaluating Eligible Asset ClassesLiquidityRisk*Corporate Inv. GradeAgency Bonds/MBSABS/CMBSGovernment Bonds (Dev. Mkt.)Emerging Market EquityEmerging Market DebtCorporate High Yield (junk bonds)Equities (Dev. Mkt.)Hedge FundsPrivate EquityReal EstateLL/MMM/HLHHHHHHMarketRisk*LL/MMMHHHHHHCreditRisk*Total Risk ScoreLL/MMMM/HHHHHHH*L = Low, M = Moderate, H = HighHLLMMM/HHHHHHH
  29. 29. 29Risk-Return Profileof Different Asset Classes54.0%26.9%20.1%17.3%22.6%14.6%11.6%9.4%14.9%11.3%9.3% 7.8%-43.3%-12.5%-0.9%3.1%-2.3%1.0% 1.3% 1.6%-0.1%0.1% 0.1% 0.4%-60.0%-40.0%-20.0%0.0%20.0%40.0%60.0%1 year holding periods5 year holding periods10 year holding periods20 year holding periodsStocks Government Bonds Cash/T-bills• Stocks are much more volatile than bonds or cash investments, especiallyover short horizons, but can produce higher returns over the long runHistorical performance of US asset classes (1926-2010):Maximum and Minimum Returns
  30. 30. 30Risk-Return Profileof Different Asset ClassesAsset classes are typically evaluated in terms of risk (measuredby volatility) and expected returnHistorical returns based on quarterly data from 1990 to 2010Fixed IncomeEquitiesCommoditiesReal EstateTimberlandEM EquitiesPrivate EquityInfrastructureGlobal TIPS0%2%4%6%8%10%12%0% 5% 10% 15% 20% 25% 30%ExcessReturnoverUSCashStandard DeviationRisk andReturnTrade-off
  31. 31. 31Risk and Return: Efficient FrontierExpected return versus volatility over next 5 years
  32. 32. 32The World Bank SAA Model We evaluate different SAA allocations over these scenarios anddetermine funded ratios and contribution rates under each scenario We identify the SAA that meets the PFC’s risk criteria and maximizesthe Plan’s wealth We then establish an appropriate benchmark for each of the assetclasses in the SAA, which results in a “benchmark” portfolio We use an Asset Liability model to generate multiple futureeconomic scenarios based on asset class risk/return assumptionsStrategic Asset Allocation (SAA) is set by the PensionFinance Committee (PFC) every three years
  33. 33. ReturnGeneratingPortfolioLiabilityHedgingPortfolioInvestment PolicyStatementAsset Strategy PolicyImplementation, monitoringand reportingLiabilities Objectives &Risk BudgetIdentify hedginginstruments andstrategyIdentify assetallocation withinrisk budgetLiability HedgingStrategyFund Separation PhilosophyInvestmentPortfolio
  34. 34. 34WB Pension Fund:Target Asset AllocationCash, 2% FixedIncome, 9%LiabilityHedging,20%EquityStrategies,42%Real AssetsStrategies,12%AbsoluteReturnStrategies,15%
  35. 35. 35Investment FrameworkGovernanceStructureInvestmentPolicyInvestmentManagementRiskManagementPerformanceMeasurementAccounting& ReportingInformationTechnology
  36. 36. 36Investment Management Benchmark portfolio represents: the “practical” strategic asset allocation optimal and feasible portfolio reference portfolio to assess added value from active investment management Investment Management may involve: just a replication of the benchmark (passive management or ‘indexing’), or tactical deviations from benchmark to implement market views with the objective ofoutperforming the benchmark (active management), or an intermediate strategy focusing mostly on profiting, within defined risk limits, fromarbitrage opportunities thrown up by short-term market conditions (‘enhancedindexing’)
  37. 37. 37Investment Management Styles:Key ElementsPassiveManagementEnhancedIndexingActiveManagementInvestment StyleBenchmarkReplicationArbitrage based Taking MarketViewsExcess Returns Low Moderate VolatileRisks Low Moderate HighRisk ManagementCompliance Basic ComplexStaffingImplicationsNo InvestmentManagerDiscretionInvestmentManagersengaged inmarketInvestmentManagers 100%market focused
  38. 38. 38Role of External Asset ManagersExternal AssetManagersBenchmark for Internal ManagementSkills & Technology SharingReduce Staff Turnover RiskAccess to Resource IntensiveInvestment StrategiesEnhancing Risk-Adjusted ReturnsReduce Cost
  39. 39. 39Manager 1Manager 2Manager 3CustodianPricingVendorsTradeDataPriceReconciliationSponsorPerformanceAccountingDataRisk andComplianceReportingVendorOngoing Monitoringof Monthly Data FlowsHoldingsDataRisk ReportsPerformance, Risk, Positions, Market ColorPrice Data
  40. 40. 40Investment FrameworkGovernanceStructureInvestmentPolicyInvestmentManagementRiskManagementPerformanceMeasurementAccounting& ReportingInformationTechnology
  41. 41. 41Risk in Investment Decision ProcessStrategic Asset AllocationBenchmark: LiabilitiesTotal Plan InvestmentsActive ManagementBenchmark:Manager benchmarksManager Selection1. TAA Across Asset ClassesBenchmark: SAA weights2. TAA Within Asset ClassesBenchmark: SAA benchmarks3. Misfit/Benchmark RiskTactical Asset Allocation
  42. 42. 42Risk structure should reflect governance and responsibility structure oforganization (which decision incurs what risk)Total RiskStrategic AssetAllocation RiskActive ManagementRiskTactical AssetAllocation RiskManager Active Risk(SecuritySelection, Timing, and others)Deviation Riskacross asset classes(risk from under/over weight)BenchmarkAllocation Riskwithin asset classesSurplus volatility, Surplus-at-risk(Actual portfolio vs Liabilities)Surplus volatility, Surplus-at-risk(SAA portfolio vs Liabilities)Tracking error(Actual portfolio vs SAA portfolio)Tracking error(Actual weight vs SAA weight)Tracking error(SAA Benchmark vs Manager Benchmark)Tracking error(Actual portfolio vs Manager BM)Risk Structure should reflectGovernance Structure
  43. 43. 43Three Stages of Risk ManagementI. Risk MeasurementWhat is our risk?How do we measureour risk?III. Risk AllocationHow do we utilize andmanage risk goingforward?How do we want toallocate risk?II. RiskAttributionWhere does our riskcome from?Which decisionscontributed to risk?Risk Management
  44. 44. 44Sample Risk Measurement Report
  45. 45. 45Investment FrameworkGovernanceStructureInvestmentPolicyInvestmentManagementRiskManagementPerformanceMeasurementAccounting& ReportingInformationTechnology
  46. 46. 46TOTAL-1.84.8TAAEquities Fixed Income-6.6ActiveEquities Fixed Income5.1-0.3US EquitiesNon-US Equities Emerging MarketsGlobal Fixed Income7.3(-)3.3(-)-2.8(+)-0.3(=)-2.4(+)4.3 -3.23.0 -2.1-0.2 -1.44.4(-)US EquitiesNon-US Equities Emerging MarketsGlobal Fixed IncomeSample Performance Attribution Report4.8TAA0.85.1-0.3BenchmarkValue AddedTAA +BenchmarkValue AddedTAA ValueAddedReturn toRisk Ratio4.8TAA0.85.1-0.3BenchmarkValue AddedTAA +BenchmarkValue AddedTAA ValueAddedReturn toRisk RatioSource RAM2002: excess return
  47. 47. 47Investment FrameworkGovernanceStructureInvestmentPolicyInvestmentManagementRiskManagementPerformanceMeasurementAccounting& ReportingInformationTechnology
  48. 48. 48Role of a CustodianCore functionsSettlement & SafekeepingPortfolio Accounting & ReportingValue Added functionsPerformancereporting& Compliance checkSecuritieslendingRisk & ReturnanalysisTaxreclamationBenefit paymentCashmanagement
  49. 49. Internal Audit alsoplays an importantrole in the periodicassessment of risksand controlsPeriodic, relevant and reliable reportingare key to our governanceFront, middle and back-office staff: Daily/on-goingmonitoring and decision-makingTreasury Management: Monthlyn Performance n Risk n Exposures n Portfoliorebalancing and cash requirementsPension Finance Committee: QuarterlyBoard of Directors andBeneficiaries: Annually49
  50. 50. 50Investment FrameworkGovernanceStructureInvestmentPolicyInvestmentManagementRiskManagementPerformanceMeasurementAccounting& ReportingInformationTechnology
  51. 51. 51The risk/volume profiledefines IT solutions  which drive costs!$ $$$3 $$$$Low HighLowHighVolume: Size and # of Tx’sRiskProfileDesk topsolutionsfortrading &analyticsPortfoliosystem +high endanalyticsPortfoliosystem +desktopanalytics
  52. 52. 52SUMMARY Create a governance structure which aligns incentivesof fiduciaries with those of stakeholders in the assetsand ensures accountability for results Focus on continuing Board education as well as anexplicit strategic communication strategy with allstakeholders. Define investment objectives and risk tolerance in thecontext of liability characteristics when settinginvestment policy. Evaluate passive versus active management decisionsin the context of your risk tolerance and organizationalcapabilities; recognize that managing externalmanagers requires significant investment ininfrastructure.
  53. 53. 53SUMMARY (continued) Understand the linkages between measurement,attribution, and allocation of risk and its impact oneffective investment management. Measure performance regularly as it provides animportant check on the quality of investment decisionsand serves as an ex-post risk control mechanism. Select the right custodian as this will determine thequality and timeliness of reporting to the governingboard, which in turn will impact the quality of decisionsmade by the governing board. Recognize the importance of hiring and retainingqualified professional staff with the right skills mix.
  54. 54. This presentation has been prepared by the Treasury of IBRD (TRE) forworking purposes for prospective partner institutions and for clients participating inthe RAMP programme to guide them in understanding certain concepts underlyinginvestment management. It does not represent, and shall not be interpreted asspecific advice or recommendation as to any particular matter covered herein, noras an indication of market standard in a particular area. Nothing contained in thepresentation constitutes or shall be construed as a representation or warranty byIBRD.The participants acknowledge that this presentation is a proprietary document ofIBRD and by receipt hereof agree to treat it as confidential and not disclose it, orpermit disclosure of it, to third parties without prior written consent of IBRD.54
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