Risks and Rewards of International Investing for Retirement Savers

Historical Evidence

Gary BurtlessThe Brookings InstitutionThe Brookings InstitutionWashington, DC USA

August 2006 RRC Conference, Washington, DC

Can retirement savers benefit from cross-national diversification?

Defined-contribution pension contributors

Worker control over investment portfolio

Conversion of savings to level annuity at retirement (age 62)

Pension replacement rates at retirement– Alternative portfolios– With and without overseas investments

Source of concern: Excess sensitivity of pension to late-career returns

5%

6%

7%

8%

9%

10%

11%

12%

13%

1 4 7 10 13 16 19 22 25 28 31 34 37 40

Year in career with -50% return

Rate of return on contributions

40%

50%

60%

70%

80%

90%

100%

110%

120%

Pension replacement rate

IRR on contributions (left axis)

Replacement rate (right axis)

Geometric mean return over career = 7%.

In exactly one year during career:

Return = -50%.

In other 39 years:

Return = 9.1%.5.6%

114%

53%

9%

Geometric mean return (in US $)

4.3%

8.5%

7.0%

9.2%

6.0%

7.7%7.0%

7.8%

5.7%

0%

2%

4%

6%

8%

10%

U.S.A. Australia Canada

1926-1948 1949-1973 1974-2005

Source of concern: Persistence of bad returns

Stock returns

… although not in these 3 countries

Source of concern: Persistence of bad returns

Geometric mean return (in US $)

-6.3%

5.4%

12.5%

6.3%7.5%

6.5%

3.5%

-1.2%

0.0%

-8%

-4%

0%

4%

8%

12%

France Ger. Italy

1926-1948 1949-1973 1974-2005

Stock returns

Source of concern: Persistence of bad returns

Geometric mean return (in US $)

15.1%

-10.2%

-2.9%

-15%

-10%

-5%

0%

5%

10%

15%

20%

1926-1948 1949-1989 1990-2005

1926-1948 1990-2005

-10.2%

-2.9%

Japan: Stock returns

… big time

Standard deviation of real stock returns (in US $)

19 19

31 3128

32

21 20

0

5

10

15

20

25

30

35

Australia Canada France Germany Italy Japan U.K. U.S.A.

Another source of concern: High variability of overseas returns

International investing:Portfolio allocation / country weights

In target-retirement-year funds– Vanguard– T. Rowe Price– Fidelity

In proportion to countries’ market weights In proportion to countries’ GDP weights

– 1980 – 2005 “Optimal” portfolio on the efficient frontier

Assumptions

40-year career

Predetermined portfolio allocation– Fixed asset allocation– Life-cycle asset allocation

Take account of fund management costs

Conversion to single-life annuity at age 62– Long government bond rate determines annuity price

Worker’s goal: Highest possible replacement rate

Pension replacement rate (% of final pay)

0%

20%

40%

60%

80%

100%

120%

140%

160%

1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Year pension begins

100% US stocks

50% stocks / 50% bonds

100% US bonds

Results:100% Allocation to U.S. assets (1872-2005 returns)

All stocks

All bonds

Pension replacement rate (% of final earnings)

0

20

40

60

80

100

120

140

160

0 25 50 75 100

Percentile

100% US Stock

Vanguard target-year portfolio

50% US Stock / 50% US Bond

Results:Vanguard life-cycle portfolio (based on 1927-2005 returns)

Vanguard life-cycle

100% US stocks

100% US bonds

Pension replacement rate

0

50

100

150

200

250

300

350

50 55 60 65 70 75 80 85 90 95 100Percentile

100% Foreign

50% U.S. / 50% Foreign

100% U.S.

Allocation of portfolio across foreign and domestic assets:

Results: The good newsVary percent of equities allocated to foreign stock

50% for. / 50% US

100% foreign stocks

100% US stocks

Pension results in good years

Pension replacement rate

0

20

40

60

80

100

0 5 10 15 20 25 30 35 40 45 50Percentile

100% Foreign

50% U.S. / 50% Foreign

100% U.S.

Allocation of portfolio across foreign and domestic assets:

Results: The bad newsVary percent of equities allocated to foreign stock

50% for. / 50% US

100% foreign stocks

100% US stocks

Pension results in bad years

Pension replacement rate

0

20

40

60

80

100

120

140

160

0 10 20 30 40 50 60 70 80 90 100

Percentile

0

20

40

60

80

100

120

140

160

Results:Conservative and aggressive “efficient” portfolios

Aggressive int’l portfolio ___

100% US stocks ___

Conservative int’l portfolio ____

Conclusions

In theory: International should help Compared to 100% US stock portfolio –

– Life-cycle fund reduces average pensions– Increases risk of low pensions– Result due to high allocation to bonds

Naïve international diversification –– Improves average and best pensions– Increases risk of very low pensions

“Efficient” international portfolios can –– Increase median and top-end pensions– Without harming pensions in worst years