1. FUNDED PENSIONS REFORM: DEVELOPING ASSET MANAGEMENT STRATEGIES AND PAYOUT MECHANISMS TO PRESERVE FINAL PENSION VALUE
Europe and Central Asia – Private and Financial Sector Development Department
John Pollner, Lead Financial Officer, World Bank
Sofia – December 2011

2. Pension Reforms: Lessons from the 2008-09 Crisis
Reputation of funded 2nd pillars suffered when equity and securities markets held by mandatory pension funds “tanked”.
However, for the most part these have recovered, but the risk perception remains that pensioners can permanently lose asset value and hence their retirement wealth.
A new phase of reforms aims to avoid such risks in the future and several market and public mechanisms are available to achieve this.

3. Pension returns through the crisis (2008-09)
Funded Pension Systems – Real Rates of return
(nominal returns less inflation)
Selected Countries (%)
Pension returns through the crisis ( )
Funded Pension Systems – Real Rates of Return
(nominal rates less inflation)
Selected Countries (%)
2005
2006
2007
2008
2009
2010
Bulgaria
6.85
14.19
-17.94
7.70
4.87
Poland
14.81
2.13
-16.89
9.90
7.88
Romania
3.50
12.37
6.61
Chile
5.70
17.04
6.50
-18.94
27.73
9.34
Croatia
6.83
5.56
6.62
-8.61
8.50
8.54
Slovakia
-9.69
Estonia
-24.44
Both Entities have made progress in recent years on improving the environment for doing business. This has included reducing business registration steps and days required for conducting government inspections, as well as increasing the use of bankruptcy procedures. Nevertheless, there still remain obstacles that, in contrast with comparator countries, affect the attractiveness of BiH as a destination for outside investors. The Doing Business 2008 report, for example, ranked BiH 105 out of 178 countries. Thus, enhancing the regulatory environment by further reducing delays and administrative barriers would constitute a relatively straightforward way of advertising BiH as a business friendly environment for both international as well as domestic investors.
Business surveys show that a few key areas remain top priorities for reform: specific attention is needed in reducing business licensing delays. Other areas include further simplification of business start-up requirements, reducing the number of required permit steps, cutting the number of tax payments, and reducing delays in transferring property and land ownership. Coupled with overlapping jurisdictions and provisions, as well as lack of transparency in enforcement, these create obstacles for strong SME growth.

4. Pension Reforms: Lessons from the 2008-09 Crisis II
Thus, pension returns during the crisis “tanked” but they then recovered. They may “tank” again with the eurozone crisis but will likely recover again if they have balanced portfolios (e.g.: half
stocks and half bonds – moderate risk).
However, this is insufficient reassurance
If a worker retires and obtains an annuity when the market “tanked” he/she will suffer from a lower pension in retirement. An annuity gives lifetime income but if it starts from a lower base, this severely tests the support of the 2nd pillar.
Volatility in Financial Movements
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1000
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1400
1600 1

5. Loss of Value is the Major Risk in Funded Pension Schemes
Public Policy and Design Solutions Include:
Multiple fund types – (a) high risk equity funds (for young workers), (b) balanced equity/bond funds (mid career workers), (c) fixed income funds held to maturity (for near-retirement), and/or additional combinations and gradations.
Lifecycle funds can be more promising: These have automatic asset allocation adjustments every 5 years of a worker’s life.

6. 2nd and 3rd Phase Designs for Funded Pension Pillars
Life-Cycle Asset Allocation Considerations:
Provides less need for employee to make (or miss) decisions about portfolio reallocations.
But requires strong regulation and oversight to:
Classify assets and securities by volatility and return potential and allowable assets.
Ensure portfolio “transformation” into
higher risk & return to lower risk, uses
liquid markets and avoids losses.

7. Pension Portfolio Volatility Reduction -- Measures
Lifecycle or multiple funds can therefore reduce portfolio volatility & maintain value, for conversion into a higher annuity at retirement.
But besides asset classes, even a lifecycle or multiple funds approach needs a much more diversified asset allocation strategy: domestic stocks and bonds will be very volatile!
 Asset allocation should be global.
Regulators need to permit at least 50%
or more to be internationally diversified.

8. Pension Portfolio Volatility Reduction -- Measures
Pension regulations attempt to protect participants by requiring conservative & fixed income securities

9. Pension Portfolio Volatility Reduction – Global Assets
First sin: investing all pension assets in the domestic economy: Recipe for major volatility and potential loss of value!
A global diversified allocation will be much more stable, diversify risks, and provide decent returns during the life of the portfolio. For example: A balanced 50/50 portfolio of equities and bonds invested in index funds and ETFs of the G20 countries and selected emerging markets, will reduce portfolio volatility.

10. Pension Portfolio Volatility Reduction – Global Assets
A global portfolio of stocks and bonds will stabilize portfolio value. Even in global market downturns, the broad country diversification will balance out some declines (witness close to triple digit % equity index returns between 69% to 145% in 2009, as the crisis still abated, for countries such as Brazil, China, India, Korea, Russia, Turkey, Australia and South Africa).
Even in 2008, half of a sample
of diversified global bond funds
produced positive returns.

11. Minimum Guarantees on funded private pensions
No minimum return guarantees should be given on asset portfolio returns as fund managers would then have less incentives to perform.
Guarantee should only be provided (by State, if needed) upon retirement. Criteria should be conservative and can include the following:
Retirement annuity based on at least a 0% (but not negative) r.o.r. – capital protection.
Top up pension to a “minimum pension” level.

12. Minimum Guarantees on funded private pensions
Example 1: Government of Chile uses minimum pension guarantee – if retirement annuity turns out less than minimum pension defined in law, State tops up the difference.
Example 2: If conversion to an annuity at retirement will yield too low a pension, allow conversion deferral for up to 5 years until portfolio recovers - in the meantime
allow limited withdrawals from the
account to pay for initial “pension.”

13. Minimum Guarantees on funded private pensions
Example 3: If pension annuity results in less than a zero r.o.r. (i.e., no earnings and loss of principal), government to top up resultant pension annuity to make up for difference.
The entire pension system can be pre-funded. With these features, it limits the gov’t liability to topping up to a minimum acceptable pension.
Important: Government can charge a guarantee fee to pension fund managers for this service.

14. Annuity Instruments, Benefits and Applications
In a good annuities/insurance market, annuities give lifetime income in exchange for a premium.
As discussed, at point of retirement the risk is the “condition” of the asset portfolio market value before it is annuitized into lifetime paymts.
To avoid major ‘conversion’ risks, some countries are adopting variable
annuities options which can provide
higher payments if the underlying
portfolio recovers.

15. Annuity Instruments: – Trade offs
Fixed annuities are more predictable but to protect against price inflation they need an inflation-indexed bond market as the underlying asset. Most countries don’t have such bonds.
Denmark is one country that has developed the variable annuities market and underlying regulation of such instruments. Extreme transparency is required in the allocation and accounting of surplus profits for this purpose.

16. Annuity Instruments: – Pooling Longevity Risks
Risk of longevity (lower mortality than expected) results in higher annuity liability for the annuity company (i.e., pay for a longer period of time). This results in adding more premium paid by other retirees to compensate company for risk.
Alternative is to pool longevity risk which implies a more centralized annuity provider (as practiced in Sweden and Denmark).

17. Centralized vs. Decentralized Annuity Providers
The Swedish and Danish case reduce costs substantially because (a) by centralizing the annuity pool, longevity risks get diversified and diluted, (b) there are efficiencies of cost, and (c) the solvency capital requirements are less.
However, in the Swedish case, the asset
management function is not
centralized and choice of several
fund managers can be selected,
solely for the investment role.

18. Annuity Institutional Structures
Decentralizing the asset managers mean they need only focus on the portfolio and market risks but not on longevity risks or actuarial insurance solvency concerns. This helps lower industry costs and spread risks more sensibly.
A decentralized market of annuity firm
providers(insurance or pension companies) can be developed, but initial costs may be very high thus eating into pension asset returns and generating dissatisfaction from workers.

19. Default Portfolios and Financial Literacy
Most employees do not have the financial acumen to make optimal investment choices. Therefore a default or automatic portfolio should be offered.
Default portfolio can be assigned based on regulation, a special agency, or a pooled fund. It can be used for the investment/accumulation stage as well as the payout/annuities stage.
A default portfolio should not be risk free as this would be a disservice to workers (low r.o.r.’s).

20. Default Portfolio Design
The default portfolio should thus be globally diversified to give good returns, but not risk free with close to zero returns. A default portfolio is thus a ‘managed choice’ using a moderate to high return & a moderate to high risk strategy.
The Swedish and Danish systems as well as the Russian funded system have default choices. Surprisingly, most people invest in the default portfolio. Does this imply more trust in the wisdom of the State than the market?

21. Funded Pension Systems
The End
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