1. Portfolio Diversification Rules in Mandated Defined Contribution Plans Hemant Shah International Monetary Fund hshah@imf.org Pensions for the Future: the Development of Individually Funded Plans

2. Relevance of Diversification Strong basis in financial theory for diversification, to optimize risk-return tradeoff, for all managers – DC, DB, mutual funds Diversification desirable across issuers, instruments, maturities, risk classes, jurisdictions, currencies Little controversy on: – Limit on one security/ issuer, share of one instrument – DB plans may prioritize ALM over diversification – Wide latitude for mutual fund mangers, or voluntary DC plans Significant controversy on diversification in mandated DC (MDC) plans across risk classes (equity, bonds, alt. investments), countries and currencies

3. Arguments to limit domestic or foreign diversification in MDC Plans State has a responsibility for a minimum return – But not always. Also, better alternatives possible. Unsophisticated affiliates better off with fewer choice – No. Low diversification always suboptimal, affiliates can still make mistakes, and managers not affiliates choose portfolios. Insufficient risk management capacity, poor governance – Insider trading, price manipulation, etc. – Possible, but limited diversification still hurts, and investment restrictions do not typically reduce such abuse

4. Arguments to Limit Domestic or Foreign Diversification (cont’d) “Prudential” limitations – Minimum public debt (fiscal/prudential motive?) – Limits on specific assets do not reduce risk or improve return/risk – Limits on specific issues in a permitted class (such as listed securities) may make sense but those based on liquidity, trading, market cap, or rating thresholds or on number of funds/AFP or affiliate are more dubious Some arguments for restricting foreign investments: – Macro situation: Most EM now have an adequate safety net in terms of reserves, current a/c, inflation/currency stability – Local capital market development: But can also create local price bubbles, lack of discipline from foreign investors

5. Trends in Mature and Emerging Markets: Formal Limits No limits on asset classes in most mature markets (Australia, Canada, Germany, Ireland, Netherlands, UK, US), Table 1 Most have no limits on foreign investment (some have no limits on OECD or EU countries), Table 1 In contrast, most EM limit foreign investment, and domestic investment in equity and variable income, Table 1 Limits being relaxed but slowly in EM

6. Trends in Actual Investments Strong, but declining home bias Limits are generally not binding, but – May not reflect true preferences – Home bias may not be comparable across EM and MM MM invest substantially more in equity and foreign assets Some data problems if DB and DC plans are mixed Conclusion: EM MDC plans invest less in equities, other non- fixed income products and in foreign assets, and regulation is a major cause.

7. Effect of Domestic Investment Limits Large rents to favored issuers (government, top corporates) Potential bubbles in local markets Predictable investment strategies in shallow local markets where MDC plans are large players Possibilities of front-running by managers, others Risks disguised by high initial returns

12. Gains from Diversification (Faruqee et al)

13. Impact of Diversification Country100% Dom Bonds50/50 Dom Bonds and Stocks 100% Dom Stocks100% For Stocks (EW) 100% For. Stocks (Mkt Wt) Australia 416289110118 Canada 425873112119 France 334860105109 Germany 364657314313 Italy 374448105109 Japan 274685122124 UK 345171116124 US 284776100126 Source: Burtless (2007)

14. Multiple Funds Many MDC now permit multiple funds (Chile, Peru, Mexico, others) Basic rationale – Changes in portfolio needed with risk aversion [age, income, wealth, family situation] – One portfolio does not suit all investors But restrictions remain on portfolio composition and sometimes on eligible investors, no. of transfers An important improvement in portfolio choice, but still an administratively complex solution Is this a “golden mean”?

15. Multiple funds (cont’d) Pros: Better than a single, “one-size fits all” fund Cons – Perpetuates problems of investment restrictions – Particularly complex with AFP’s minimum return guarantee – Mixed portfolios inconsistent with market practice to specialize in money market, bond, equity, or foreign funds. – Not true lifestyle funds (dynamically rebalanced) A better, more fundamental, solution may exist – Drop barriers between voluntary and mandated investments Separate these investment accounts, not systems – Permit all suitable investments (CDs, bond or stock funds, foreign funds, annuities, etc.)

18. Conclusions Diversification limits are highly suboptimal. Conclusion robust across many countries, periods, measurement specifications (real returns, downside variation only, etc., Table 3). No limits (prudent man rule) is a “first best” solution. Case for limiting diversification generally weak. Multiple funds better, but only a partial solution. Better to open mandated savings to most permissible retain vehicles. Such a reform should be accompanied by stronger capital market supervision, financial literacy, and harmonization of regulation of different asset managers.

19. References Burtless, G. (2007), “International Investment for Retirement Savers: Historical Evidence on Risk and Returns”, Center for Retirement Research Working Paper No.5, Boston College. Faruqee, H. (2007), “Equity Market Integration”, in J. Decressin, H. Faruqee, and W. Fonteyne (eds.), Integrating Europe’s Financial Markets, IMF. Shah, Hemant (1997), “Towards Better Regulation of Private Pension Funds”, Working Paper 1791, World Bank. (source for Figures 1-6]. Shah, Hemant and Bebczuk Ricardo (2008), Second Generation Reforms of Mandated Defined Contribution Systems, IMF (forthcoming).

20. Contact Hemant Shah Deputy Division Chief Capital Market Development and Financial Infrastructure Division International Monetary Fund 700 19th Street, N.W. Washington DC 20431 Phone: 202-623-9831 Fax: 202-589-9831