Evaluating the Financial Performance of Pension Funds »

Countries throughout the world are increasingly relying on individual pension savings accounts to provide income replacement in old age for their citizens. Although these have now been in place for several decades, the metrics for the measurement of their performance has not always meaningful from the perspective the long term objectives of pension funds. The recent financial crisis has highlighted the need to establish meaningful performance measures that consider pension funds in relation to the ability to effectively provide income replacement at retirement age.

The book discusses the theoretical basis and a number of implementation issues related to the emerging view that at meaningful evaluation of the investment performance of pension funds requires the design of life-cycle benchmarks against which performance can be evaluated. The composition of these benchmarks would depend on a number of factors, including the presence of other sources of retirement income; the age of individuals; the rate of contributions; the target replacement rate; the expected density of contributions; the type of retirement income in the payout phase, and the risk aversion of policymakers and individuals.

This book provides an evaluation of the financial performance of funded pension systems within the standard mean variance framework. It then provides a discussion of the limitations inherent to applying these methods to pension funds and proceeds to review the many other issues that should be addressed in developing more useful and meaningful performance measures through the formulation of pension specific benchmark portfolios.

Evaluating the Financial Performance of Pension Funds concludes with commentary and observations about the need for and application of this new approach to performance measurement and the impact of the recent global financial crisis on the pension funds.

Preface and Acknowledgments xi

Abbreviations xv

Chapter 1 Evaluating the Financial Performance of Pension Funds Heinz P. Rudolph Richard Hinz Pablo Antolín Juan Yermo 1

Background and Motivation for the Research Program 1

The Importance of Appropriate Measures of Performance 3

Overview and Summary of the Book 7

Policy Implications of the Research Findings 18

Notes 22

References 23

Chapter 2 Investment Performance of Privately Managed Pension Funds: Overview of the Available Data Pablo Antolín Waldo Tapia 25

Description of Privately Managed Pension Funds around the World 26

Additional Problems with the Data Reported on Investment Returns 35

Preliminary Observations from the Initial Data Review 35

Notes 36

References 37

Chapter 3 Financial Performance of Pension Funds: An Exploratory Study Eduardo Walker Augusto Iglesias 39

Introduction and Overview of Findings 39

Portfolio Performance Measurement 40

Required Data 53

The Pension Fund Database 56

Legal and Administrative Considerations 58

Results 60

Conclusions 67

Annex: Country Performance Fact Sheets 69

Notes 94

References 94

Chapter 4 Portfolio Choice, Minimum Return Guarantees, and Competition in Defined Contribution Pension Systems Pablo Castañeda Heinz P. Rudolph 97

A Model Economy 99

Equilibrium Portfolios under Benchmarking Constraints 103

Discussion 107

Annex 108

Notes 115

Reference 116

Chapter 5 Labor Market Uncertainty and Pension System Performance Olivia S. Mitchell John A. Turner 119

Pension Structures and Human Capital Uncertainty 120

Interactions between Human Capital Uncertainty and Pension Performance 123

Integrating Human Capital Uncertainty into Models of Pension Outcomes 131

Benchmarks for Pension Performance 139

Conclusions and Policy Implications 145

Notes 146

References 151

Chapter 6 Pension Funds, life-Cycle Asset Allocation, and Performance Evaluation Fabio C. Bagliano Carolina Fugazza Giovanna Nicodano 159

Methodological Issues in Developing Optimal Portfolios That Include Pension-Specific Parameters 163

Asset Allocation with Human Wealth 168

A Basic Life-Cycle Model 172

Welfare Ratios for Performance Evaluation 191

Conclusions 194

Notes 197

References 198

Chapter 7 Application of Advances in Financial Theory and Evidence to Pension Fund Design in Developing Economies Luis M. Viceira 203

Global Trends of DC Pension Systems 204

Policy Challenges of DC Pension Systems 205

Innovations in Pension Fund Design 207

Life-Cycle Investing 209

Pension Fund Design in Developing Economies 215

Performance Evaluation of Investment Options 222

Concluding Remarks 238

References 239

Chapter 8 Future Directions in Measuring the Financial Performance of Pension Funds: A Roundtable Discussion 243

Commentary Keith Ambachtsheer 244

Commentary Olivia Mitchell 251

Commentary Luis Viceira 258

Commentary Zvi Bodie 264

Index 269

Figures

2.1 Total Assets and Asset Allocation, 2004 31

3.1 The Sharpe Ratio 41

3.2 Sharpe Ratios of U.S. Stocks and Bonds, Five-Year Rolling Estimates 50

3.3 Short-Term Local Currency Sharpe Ratios 65

3.4 Long-Term Local Currency Sharpe Ratios 66

3.5 In-Sample Selection Returns 67

3.6 Out-of-Sample Selection Returns 68

5.1 Patterns of Earnings over the Lifetime, with Wage Level Indicator: Excluding and Including Zero Earners 125

5.2 Pension Contribution Patterns in Chile by Age: Percentage of Available Years in Which Contributions Were Made 128

6.1 Labor Income Process 178

6.2 Life-Cycle Profiles of Consumption, Income, and Wealth 179

6.3 Policy Functions: Sensitivity to Stocks 180

6.4 Policy Functions: Sensitivity to Bonds 180

6.5 Age Profiles of Optimal Stock and Bond Holdings (Averages) 182

6.6 Age Profiles of Optimal Stock and Bond Holdings, Benchmark Case 185

6.7 Age Profiles of Optimal Stock and Bond Holdings High Risk Aversion 186