Public Disclosure Authorized DIRECTIONS IN DEVELOPMENT Public Disclosure Authorized Finance Evaluating the Financial Performance of Pension Funds Richard Hinz, Heinz P. Rudolph, Pablo Antolín, and Juan Yermo Public Disclosure Authorized Editors Public Disclosure Authorized Evaluating the Financial Performance of Pension Funds Evaluating the Financial Performance of Pension Funds Richard Hinz, Heinz P. Rudolph, Pablo Antolín, and Juan Yermo Editors © 2010 The International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org E-mail: [email protected] All rights reserved 1 2 3 4 13 12 11 10 This volume is a product of the staff of the International Bank for Reconstruction and Development / The World Bank. The findings, interpretations, and conclusions expressed in this volume do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. 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All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2422; e-mail: [email protected]. ISBN: 978-0-8213-8159-5 eISBN: 978-0-8213-8160-1 DOI: 10.1596/978-0-8213-8159-5 Library of Congress Cataloging-in-Publication Data Evaluating the financial performance of pension funds / Richard Hinz ... [et al.], editors. p. cm. — (Directions in development) Includes bibliographical references and index. ISBN 978-0-8213-8159-5 (alk. paper) — ISBN 978-0-8213-8160-1 1. Pension trusts—Evaluation. 2. Rate of return—Evaluation. I. Hinz, Richard P. II. World Bank. HD7105.4.E93 2010 331.25'24—dc22 2009043702 Cover photograph: Aziz Gökdemir Cover design: Naylor Design Contents Preface and Acknowledgments xi Abbreviations xv Chapter 1 Evaluating the Financial Performance of Pension Funds1 Heinz P. Rudolph, Richard Hinz, Pablo Antolín, and Juan Yermo Background and Motivation for the Research Program1 The Importance of Appropriate Measures of Performance3 Overview and Summary of the Book7 Policy Implications of the Research Findings 18 Notes 22 References 23 v vi Contents Chapter 2 Investment Performance of Privately Managed Pension Funds: Overview of the Available Data 25 Pablo Antolín and Waldo Tapia 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 39 Eduardo Walker and Augusto Iglesias 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 97 Pablo Castañeda and Heinz P. Rudolph A Model Economy 99 Equilibrium Portfolios under Benchmarking Constraints 103 Discussion 107 Annex 108 Notes 115 References 116 Contents vii Chapter 5 Labor Market Uncertainty and Pension System Performance 119 Olivia S. Mitchell and John A. Turner 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 159 Fabio C. Bagliano, Carolina Fugazza, and Giovanna Nicodano 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 203 Luis M. Viceira 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 viii Contents 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 by Keith Ambachtsheer 244 Commentary by Olivia Mitchell 251 Commentary by Luis Viceira 258 Commentary by 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 Contents ix 6.8 Age Profiles of Optimal Stock and Bond Holdings, Low Replacement Ratio 187 6.9 Age Profiles of Optimal Stock and Bond Holdings, High Replacement Rate 188 6.10 Age Profiles of Optimal Stock and Bond Holdings, Decreasing Replacement Ratio 189 7.1 Balance Sheet of Typical Plan Participant 209 7.2 Balance Sheet of Typical Plan Participant with a Safe Job 210 7.3 Stylized Life-Cycle Asset Allocation 212 7.4 Realistically Calibrated Life-Cycle Portfolio Allocation 213 7.5 Correlations across International Equity Markets 219 7.6 Estimated Live-Cycle Labor Earnings of Chilean Males 223 7.7 Distribution of Labor Earnings in Final Working Year 224 Tables 2.1 Privately Managed Pension Funds Included in This Study, by Country and Form of Provision 27 2.2 Investment Regulations 29 2.3 Basic Statistical Information on Real Investment Returns by Economy 33 3.1 Performance Measures 44 3.2 Example of Proper Calculations of Pension System Returns 54 3.3 General Description of the OECD Pension Fund Database 57 3.4 Summary of Investment Regulations 59 5.1 How Human Capital Risks Translate into Pension Outcomes: A Framework 124 5.2 Life-Cycle Earnings Profiles Reported in U.S. Microdata 126 5.3 Examples of Pension Modeling Approaches 132 5.4 Simulated Difference between a DC Account Balance and a DB Lump-Sum Amount: Age 65 Retirees Arrayed by Tenure Quintile (on Longest Job) and Lifetime Earnings Quintile 139 5.5 Sensitivity of Optimal DB Pension Replacement Rate to Human Capital Risk 140 6.1 Welfare Gains 190 6.2 Welfare Ratios 193 7.1 Portfolio Composition in Mandatory Pension Funds (December 2007) 215 xContents 7.2 Capital Markets Assumptions 226 7.3 Summary Table of Simulation Results 228 7.4 Simulation Results for Investment Strategies When Labor Income Is Nonstochastic 230 7.5 Simulation Results for Investment Strategies When Labor Income Is Stochastic and Uncorrelated with Stock Returns 232 7.6 Simulation Results for Investment Strategies When Labor Income Is Stochastic and Correlated with Stock Returns 234 Preface and Acknowledgments This volume is the product of a partnership organized by the World Bank that includes the Organisation for Economic Co-operation and Development (OECD), two private sector entities with worldwide pension-related business and a significant interest in public policy—the ING Group headquartered in the Netherlands and BBVA with head- quarters in Spain—and VB, the Dutch Association of Industry-wide Pension Funds. Although not formally members of the partnership, the American Council of Life Insurers (ACLI), which provided funding, and the U.K. Department for Work and Pensions, through a staff second- ment to the OECD, also supported the work. The partnership repre- sents a promising approach to organizing and financing policy research on issues of importance to international policy and research institutions and the business community. The project originated with a proposal from