fundamental risks of defined contribution pension …fundamental risks of defined contribution...
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Fundamental Risks of Defined Contribution Pension Plans
Tapen Sinha, PhD
ING Chair Professor, ITAM, Mexico
Professor, University of Nottingham
Director, International Center for Pension Research
SOMMAIRE/ SUMMARY
We examine different kinds of risks in the defined contribution plans either government sponsored or private
We discuss investment risks, longevity risks,policy risks, agency risks and transition risks both in developed and developing countries
These risks are substantial especially in developing countries where capital markets are not very well developed
Risks of moving to defined contribution system
There are five fundamental risks
1. Investment Risks2. Longevity Risks3. Policy Risks4. Agency Risks5. Transition Risks
We shall discuss them in turn
Investment risks
Investment risk: The portfolio of investment has inherent risk as the asset prices vary
There is also a risk of inflation
In defined contribution plans, the risk is borne directly by theaccount-holder
In defined benefit plans the risk is borne by the plan sponsor
It could be the government or employer depending on how the plan is run
If the government has promised a minimum pension guarantee (as it happens in many countries), this risk can become part of the government risk too
Bad investment advice versus no advice
If an investment decision is taken and it turns out bad, who is responsible?
Mertens et al. v. Hewitt Associates 1993 US
It made a distinction between investment advice and investment education
It becomes advice if the the advisor makes allocation of money
Bottom line: You cannot sue your accountant for making bad calls
It has been used in other cases
Investment risks in developing countries
In addition to the above investment risks, developing countries have a special problem
The markets (stock market, bond market, markets for synthetic instruments, market for annuities) are not well developed
They are typically not deep (not enough transactions) so that a few traders (especially pension funds) can move the markets
They are not wide – so that there are not enough instruments to play with (e.g., in 1995, the most active bond in Mexico was 7 day T-bills)
Additional risks
In many (developing) countries, the benefits have a guaranteed floor value which in turn is tied to minimum wage (MW)
Minimum wage is not necessarily adjusted for inflation
For example, in Mexico, between 1970 and 2000, the minimum wage has fallen 85%
Thus, unless retirees get full inflation offset, inflation might eat up benefits
Mexico: 60% under the new system will have MW!
0
50%
100%
25%
75%
5 MW3 MW
10 MW 25 MW
1 MW
0
0.2
0.4
0.6
0.8
1
Probability of NOT having enough after 25 years
Risk of low density of contribution can be large
Longevity Risk
Longevity risk refers to the uncertainty surrounding the length of retirement
The time between retirement and death of the retiree or survivor
For defined contribution plans, it shared between the retiree and annuity provider
Experiments show that most people consistently underestimate the length of life
Annuity providers can hedge this risk through mortality bonds (UK Government & Swiss Re)
Annuity buyers versus programmed withdrawal
In many systems, it is not necessary to buy a contingent annuity
The retiree can make programmed withdrawal
For the retiree, such withdrawals are risky:
Market risk (portfolio goes bad)Credit risk (default of elements in portfolio)Biometric risk (lives too long)Business risk (political instability)Operational risk (fraud)
Policy risks
Policy risk arises from interference by policymakers in the operation of a pension system
Arbitrary changes in plan rules (e.g. benefits, tax treatment). In some countries, systems had started with EEE to TEE or to TTE at the stroke of a pen
Strict investment rules that do not permit adequate diversification of investment risk
Most Latin American countries require huge investment in government bonds, very few allow foreign investment significantly
Latin American government mandatedPrivately managed pension funds
Government Corporate Financial Foreign Liquid TotalArgentina 62% 15% 12% 10% 2% 100%Bolivia 67% 24% 6% 1% 1% 100%Colombia 49% 20% 21% 10% 0% 100%Chile 19% 24% 30% 27% 0% 100%El Salvador
84% 0% 10% 6% 0% 100%
Mexico 85% 14% 0% 0% 1% 100%Peru 27% 37% 27% 8% 0% 100%Uruguay 79% 5% 7% 0% 8% 100%
Agency risks
Agency risks: risks arising from private management of pension plans
Misappropriation of assets or outright fraud
Conflict of interest (pension fund manager engages in an investment transaction with a related party)
Negligence or ignorance on the part of the pension provider (oops factor)
The last element can be extremely damaging to the retirees
Expense risks
Charges
It can be at the accumulation phase
It can also be at the annuitization phase
How high? Depends on how you ask!
Bottom line: comparing 30 year without any charges and with charges – most developing countries with DC have 20% to 35% lower accumulated values
Additional charges at the annuitization phase
Risks of miscalculation in Bolivia
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
Pension transition cost as a percentage of GDP
Projected 2.8% 2.6% 2.4% 2.2% 2.0%
Actual 4.0% 4.2% 4.3% 4.4% 4.5%
1998 1999 2000 2001 2002
With and without reform in Mexico
-
0.2
0.4
0.6
0.8
1.0
1.2
2004
2006
2008
2010
2012
2014
2016
2018
2020
2022
2024
2026
2028
2030
2032
2034
2036
2038
2040
2042
2044
2046
2048
2050
2052
2054
per
cen
t o
f G
DP
Without reform reform
With reform
Which is more expensive?
Discount rate Without reform With reform
0% $10,679.41 $4,462.17
3% $1,965.85 $1,984.38
6% $776.09 $1,338.12
10% $361.55 $690.01
Risks of bad legal judgementIn Mexico, you put in 6.5% of the salary in a
pension fund (minus charges)In additon you put in another 5% in a housing
accountGovernment is allowing transition generation to
choose the old or the new systemThe assumption was that if you choose the old, the
government will keep the money from both accounts
ALL calculations were based on this additional saving by the government
In January 2006, the Supreme Court has ruled that housing is a separate account
Additional transition cost: Another 9% of GDP
