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					  Risk Sharing and Individual Lifecycle
Investing in Funded Collective Pensions

          Roderick Molenaar
            Eduard Ponds

            Exeter, January 2010
Agenda
1. Pension funds Netherlands


2. Increasing maturity


3. Optimal Lifecycle Investing


4. Challenge: Need of age-differentiation in policy
   •   Variant A: return-related & wage-related indexation
   •   Variant B: “First DC, then DB”




                                                             2
Pension funds Netherlands

• 600 funds, all offering an indexed funded pension plan
  (DB-like)

• 90% of labour force participates




                                                           3
Set up pension plan similar

1. Uniform accrual of new pension rights for all workers

2. Uniform indexation policy for all ages

3. Uniform contribution rate

4. Uniform asset mix for all ages




                                                           4
Evaluation: strengths
• Proven benefits due to:
   – Mandatory participation
   – Collective risk sharing
   – Low costs ( economies of scale)


• Academic studies:
   – Net-welfare gain ranging from 4% to 12% extra consumption
     yearly vis-à-vis optimal DC plan in an ideal setting




                                                                 5
Evaluation: Problems

1. Increasing maturity
                                                  Focus
2. Insights optimal lifecycle investing           paper



1. Transparency and communication
2. Actuarial fairness (degressive accrual rate)   Other studies

3. Property rights and representation



                                                            6
 Increase maturity pension funds


  Relative share retirees and other non-actives in total
  liabilities
                        2001         2006         D

  All pension funds     47%          50%        +3%-point

  ABP                   48%          53%        +5%-point

Source: DNB, ABP


                                                           7
 ABP Demographics

• The share of inactive participants in total liabilities is
  now 53% but will increase to 75% after 2010

  100%

   80%

   60%                                                 A c t i ev en

   40%                                                 I nac t i ev en
   20%

    0%
          2004   2009   2 0 14   2 0 19




                                                                       8
Potential conflict of interests between
young and old

• Mature funds may shift focus to interests elderly

• Elderly: conservative asset mix to safeguard payout
  benefits

• … but younger members will prefer a risky asset mix to
  have prospect on low contribution rate

• Conflict may arise




                                                           9
Theory of Optimal Lifecycle Planning

• Uniform risk profile over lifecycle is not optimal from
  theoretical perspective of lifecycle investing

• On the agenda in the Dutch pension discussion since
  Teulings & de Vries (2005)




                                                            10
Personal wealth over lifecycle

                          Human Capital         Financial Capital
Personal Wealth =                         +
                           (PV Wages)         (retirement savings)

     Personal
      Wealth
                Human
                Capital
                            Financial
                             Capital

                 25             65



                                                               11
Risk profile over lifecycle
• Human capital is perceived as long term bond

• Wages comparable with yearly coupon bond

• Optimal risk profile based on risk diversification
  – Young individual:
      • Add stock market risk to large human capital (wage)
  – Old individual:
      • No human capital
      • Optimal mix consists of bonds and stocks


                                                         12
 Portfolio choice and Optimal Financial Planning
                                                    
                                              r    HC x  FCx 
                                        ax   r f   
                                                                  
                                                                   
                                              2       FCx     
                                                    
            ax = % real assets in
            Financial Capital per age       ax declines because
                                            of risk diversification
                                            considerations,
                                            and not because of a
100%                                        shrinking remaining
                                            investment horizon


       25                       65



                                                                  13
Problem set of paper
• Combining advantages of risk sharing and collectivity with new
  approach of lifecycle asset allocation policy

• Comparison of current plan with two variants




                                                              14
1. Base variant:
   Wage-indexed DB, conditional indexation and fixed
   contribution rate
2. Variant A:
   Current plan, but age-based indexation related partly to
   return and partly to wage growth
3. Variant B:
   Individual pension account with age-based participation in
   two funds: a DC fund (risky one aimed at high return) and
   indexation fund (aimed at mimicking DB-like payoffs)



                                                              15
Base variant
• Initial funding ratio = 100% real = 150% nominal

• Fixed contribution rate

• Indexation conditional on funding ratio

• Mix = 60% real assets and 40% nominal (fixed income) assets




                                                         16
Base case: Pension result
                            Pension result of
                            100 means 100%
                            full indexation
                            (cumulative)

                            Downside risk
                            (cuts in
                            indexation) ..

                            …but no upside
                            reward




                                         17
Base case: nominal funding ratio
Nominal initial funding ratio = 150% (100% real)


                                                   Upside potential is
                                                   large…

                                                   … as overfunding
                                                   is not allocated

                                                   Who owns surplus?

                                                   Property rights not
                                                   defined




                                                                  18
Variant A: return-related & wage-related
indexation
• Age - differentiation via change in indexation rule
• Indexation < 65 year two components:
   Indexationx   =   ax * real return   + (1-ax) * wage


• Wage component increases with age x
• Indexation retirees (>65) fully related to wage



                                                          19
Relationship age and size return component
in indexation rule (ax)


   1



                      ax




   0
       25              65         leeftijd
                                             20
Variant A: age-dependent indexation (2)




                        65  35                  35  25 
      indexation 35y             realreturn             wage
                        40                       40 

                          3 / 4 * [7%  2.5%]        1 / 4 * 3%       4.1%



                        65  55                  55  25 
      indexation 55y             realreturn             wage
                        40                       40 

                           1 / 4 * [7%  2.5%]       3 / 4 * 3%       3.4%




                                                                                21
Variant A: Pension result
                            Large spread
                            but …

                            expected value
                            higher than in base
                            case, and ….

                            also 25th- en 2.5th-
                            percentile higher
                            than in base case




                                           22
Variant A: Pension result at retirement and thereafter


                                             Median of
                                             pension result

                                             The younger the
                                             participant at
                                             transition, the
                                             better the median

                                             Young higher
                                             expected reward
                                             on each euro
                                             contribution



                                                              23
Variant A: Nominal funding ratio
                                   Higher pension
                                   result mitigates
                                   overfunding …

                                   … but funding
                                   ratio higher than
                                   100%, even 2.5th-
                                   percentile




                                                 24
Variant A: INDEXATION result for different age
cohorts as % of wage indexation




                                                 25
Variant A: PENSION result for different age cohorts




                                                26
Variant B: “First DC, then DB”
Age-differentiation via age-based adjustments in asset mix

100%
            DC account
                                         90%
                                               Indexation mix
            DC mix

 10%                                           Annuity account
  0%
       25                45         65



                                                                27
Variant B: voorbeeld




Change wealth 35y  0.9  Re turnDCmix  0.1  (Re turn Indexationmix  PV Increase)

                               0.9 * 8%          0.1 * (5,5%  2.5%)            7.5%
                                           lifecycle investing
Change wealth 55y  0.5  Re turnDCmix  0.5  (Re turn Indexationmix  PV Increase)

                               0.5 * 8%          0.5 * (5,5%  2.5%)            5.5%

Change wealth 65y     0.1  Re turnDCmix  0.9  (Re turn Indexationmix  PV Increase)


                               0.1 * 8%            0.9 * (5,5%  2.5%)          3.5%




                                                                                          28
Variant B: Pension result at age 65
                                      Median
                                      • Larger than
                                        100%
                                      • Increasing to
                                        reach steady
                                        state value after
                                        20 years
                                      Large spread
                                        around median
                                      • High upward
                                        potential above
                                        100
                                      • 25th- and 2,5th
                                        percentile higher
                                        than base case


                                                     29
Variant B: Median pension result after retirement

       Pension result
 125
               55
                                           Median
               60


 120
               65+
                                           increasing
                                           after 65 years
 115                                       as mix
                                           contains 10%
 110
                                           stocks
 105




 100




         0              5   10   15   20




                                                       30
Final (1)
 • Current policy Dutch pension funds:
    – Uniform for all participants regarding asset mix,
      funding, contribution rate, indexation policy

 • Challenges pension funds:
    – Increase in maturity will force them to conservative mix
    – Age-based risk profile seems more optimal (lifecycle
      investing)

   => Towards integration of lifecycle investing in collective
   pension plans



                                                             31
Final (2)

• Exploration by means of two variants:
   – Variant A: Age-based indexation rule with partly return
     indexation and partly wage indexation
   – Variant B: individual pension accounts with lifecycle
     investment strategy combined with collective elements
     fixed conversion rate and wage-indexed annuity with
     risk sharing)

• First results are promising

• Age-differentiation in collective funded plans is possible



                                                               32

				
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posted:10/3/2011
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