33383 World Bank Pension Reform Primer Portfolio limits Pension investment restrictions compromise fund performance T he value of funded pensions can depend criti- This briefing focuses on the last of these: quanti- cally on the funds' investment performance. tative restrictions on pension funds' portfolios. To try and protect people's savings, governments often regulate pension funds strictly, particularly Why regulate pension portfolios? when contributions are mandatory. For example, Consumers in countries that have introduced the new funded pension systems in Latin America mandatory funded pensions often had little experi- and Eastern Europe are more stringently regulated ence of investing. Many had little, if any contact than private pensions in OECD countries, which with financial services and providers before the are mainly voluntary. pension reform. In addition, financial services industries were rarely well developed. The lack of These pension fund regulations take three experience of investment--in particular, of different forms: managing risk--might lead to poor portfolio Restrictions on industry structure. Reforming decisions. Indeed, investing in emerging governments in Latin America and Eastern economies is more risky than investing in more Europe have tended to establish a new pension developed countries. Capital markets can be fund management industry, separated from fragile, lacking both liquidity and transparency. other financial institutions. Regulation of pension funds' performance. Countries with better-developed capital markets These guarantees sometimes specify an abso- where the population has more investment lute return that funds must earn, but more experience may require only a light regulatory usually, they are related either to the industry's touch. Voluntary retirement savings also put less average performance or to the returns on a responsibility on the government than mandatory benchmark portfolio. pensions, again suggesting less need for strict Limits on investments allowed. Quantitative regulation of fund investments. Finally, many restrictions on the share of particular types of countries have funded defined benefit pensions assets held by the fund limit the dispersion of provided by employers. These schemes raise many outcomes, particularly for defined contribution regulatory problems with protecting people's rights schemes. In most mandatory schemes, this and fund assets. But because employers stand leads to a `single portfolio' environment where behind the promised pension benefit, there is less members of the scheme are forced to hold need for detailed regulation of portfolios than in basically the same portfolio. Most common defined contribution pensions, whose value are limits on risky assets such as shares and depends more closely on fund performance. corporate bonds. Often, foreign investments are curtailed. This briefing is part of the World Bank's Pension Reform Primer: a comprehensive, up-to-date resource for people designing and implementing pension reforms around the world. For more information, please contact Social Protection, Human Development Network, World Bank, 1818 H Street NW, Washington, D.C. 20433; telephone +1 202 458 5267; fax +1 202 614 0471; e-mail socialprotection@worldbank.org. All Pension Reform Primer material is available on the internet at www.worldbank.org/pensions 2 Portfolio limits Effects on the public finances as a prudent professional, experienced and Because of explicit public guarantees of pension educated in financial matters. values or pension fund returns, the government's finances might be imperiled if pension funds make Many countries do not use common law and tend excessively risky investments. The sustainability of to rely on extensive codification and detailed the whole reform might even be jeopardized. regulations. Most do not have long traditions with Also, should a fund fail or under-perform its peers private pension funds. In a mandatory system, it consistently, the government might feel obliged to may be difficult for many countries to depend on step in to protect pensioners: a kind of implicit prudent people, at least until the concept was well- guarantee. Portfolio limits, if they succeed in re- defined and understood. ducing the riskiness of investments and limiting the dispersion of outcomes, might help prevent Portfolio limits in practice such calls on the public purse. Prudent person rules of this sort are the main source of legal protection for pension fund mem- Another motive for encouraging investment in bers in around a third of OECD countries. These government bonds through portfolio limits is to governments impose few, if any, rules on pension ease the transition from a pay-as-you-go pension funds' asset allocation (beyond basic prudential system to funding. During this transition, workers' restrictions, such as concentration of holdings). pension contributions are partly diverted into their These are the English-speaking countries-- own pension accounts, meaning another source of Australia, Ireland, New Zealand, the United revenues is needed to pay for existing public pay- Kingdom and the United States--plus Austria, as-you-go pension liabilities. Spain and the Netherlands. Encouraging pension funds to buy public bonds Figure 1 summarizes asset allocation restrictions. can smooth the transition to a funded system in These regimes are often complex, with limits ap- the short run. But continuing this policy into the plying to dozens of different asset classes. We medium and long term undermines the beneficial focus here on the ceilings on direct holdings in effects of the switch to funding (on aggregate sav- equities of listed companies and on total foreign ings, economic growth and capital market assets (including bonds, equities and other assets). development, for example). The OECD countries are at the top of the chart, the Latin American pension reformers at the Prudent person rules bottom. The alternative to quantitative investment limits is a `prudent person' rule. This approach gives Domestic restrictions, on the left-hand side of the pension fund managers more flexibility but relies chart, take two different forms in the OECD heavily on legal precedents and accepted local countries. First, Denmark, Germany, Japan and standards of prudence. For example, the United Switzerland, for example, have a ceiling on the States requires fund managers to invest amount that can be invested in equities. The limit is typically 30 or 40 per cent of total assets. `with the care, skill, prudence and diligence Poland, too, will restrict equities' portfolio share in under the circumstances then prevailing that its new mandatory pension system. (Note that the a prudent person, acting in a like capacity and ceiling shown for the Netherlands is an informal familiar with such matters would use in the one.) conduct of an enterprise of a like character and with like aims'. Secondly, Belgium, Denmark, France, Japan and Portugal, impose a minimum investment in public The Employee Retirement Income Security Act of sector bonds. This minimum is more variable-- 1974 goes further than common law. It is not suf- between 15 and 50 per cent--but has the same ficient to be a careful amateur: managers must act effect in restricting equity investments. Portfolio limits 3 Restrictions in the Latin American countries, at the from an outright ban on foreign investment to 30 bottom of the chart, are generally tighter than in to 40 per cent ceilings. OECD countries. The most relaxed regimes are Chile, Colombia and Argentina, which allow 30 Four of the Latin American countries allow for- per cent or more in shares. (Peru, however, allows eign investments, ranging from a 5 per cent an additional 20 per cent in workers' shares, giving maximum share in Peru to 12 per cent in Chile. a 40 per cent total equity ceiling.) The situation in Finally, maximum investments in public bonds are Bolivia--not shown in the chart--is complicated. also common in Latin America. The reasoning On paper, investment is more lightly regulated seems to be a mix of requiring funds to diversify than in the rest of Latin America. But a high and preventing future governments from minimum investment in government bonds has appropriating pension funds to finance deficit swallowed up most funds in the first few months spending. of the system. Mexico and Uruguay's relatively tight regimes are also supposed only to be International investments temporary, as in Bolivia. The second common restriction on pension fund managers is on the amount they can invest abroad. Pension fund portfolio limits 1 One economic rationale is that the pension funds' liabilities are domestic and so, by investing at no limit Finland no limit home, assets and liabilities are denominated in the Canada no limit Czech R zero same currency. Investing abroad, in contrast, in- curs exchange rate risk. Although hedging against Denmark currency movements is possible, this can be costly Poland and even sophisticated investors have got their Switzerland fingers burned with the complex financial instru- Japan ments that hedging can involve. (The case of Germany Long-Term Capital Management in the United Netherlands no limit States is just one example among many.) Norway no limit zero Italy no limit A second motive is to limit capital flows, whose volatility has been blamed for economic crises in bond minimum Portugal the emerging economies of East Asia and Latin not available Greece America. Reducing capital flight by limiting over- mainly bonds Sweden seas investment might also help deepen domestic bond minimum France zero (insured funds) capital markets. Chile Chile's gradual liberalization Argentina Chile had a restrictive investment regime for the Colombia first few years of the new scheme. Between 1981 Uruguay zero and 1985, pension funds could only hold public Peru and corporate bonds, mortgage-backed securities zero (preference shares: 10%) Mexico zero or fixed-term deposits. Equity investments-- 0 10 20 30 40 0 10 20 30 40 equities foreign assets initially up to 30 per cent of the portfolio , now up limit, per cent of portfolio limit, per cent of portfolio to 37 per cent--have been allowed since 1985. Mutual fund investments were permitted in 1990. Foreign assets came next, in 1992. The limit, first Turning to foreign investments, on the right-hand set at 3 per cent, was increased to 9 per cent in side of the chart, the limits in Latin America are 1995 and 12 per cent in 1997. Finally, the funds again tighter than in the OECD. Twelve OECD have been allowed to use hedging instruments countries restrict overseas investments, on average, since 1995. to 16 per cent of total pension assets. This varies 4 Portfolio limits Chile's regime, illustrated in the second chart, is A final explanation is the effect of other regulatory therefore best characterized as one of gradual lib- controls. Pension funds, for example, are only al- eralization of investments as fund managers and lowed to own 7 per cent of a single company's consumers have become more confident in, and total share issue. The larger funds push against more experienced with, the new pension system. this limit well before they reach the 37 per cent total equity ceiling. Another rule requires equities, Chile's pension portfolio limits 2 as well as bonds, to be risk rated. Pension funds could only invest in companies rated BBB or bet- 80 per cent of portfolio venture capital ter. In practice, this meant just 30 blue-chip 70 hedging companies out of the total 300 stocks listed on the 60 foreign market. Since 1997, however, this rule has been 50 relaxed, and over 200 companies are now eligible property 40 for pension fund investment. mutual funds 30 20 equities Pension fund portfolios in Chile 3 10 35 per cent of portfolio 0 zero 1982 1985 1990 1992 1995 1996 1998 30 equity 25 limit 20 Portfolio limits and asset allocation equity 15 Staying with Chile, Figure 3 looks at how pension share foreign funds responded to their newly granted asset allo- 10 assets cation freedoms. By 1992, Chile's pension funds limit 5 had moved 30 per cent of their assets into equities. share But the switch into equities was very slow, and it is 0 natural to ask why. 1982 1984 1986 1988 1990 1992 1994 1996 Looking at other parts of the pension funds port- folio offers some answers. Government bond OECD countries holdings have remained steady since 1983 at Chile's pension funds, until recently, invested around 40 per cent of total assets. Equities have much less in equities than they were allowed. And tended to substitute for mortgages and, to a lesser this pattern is common to many other countries. extent, deposits rather than for government bonds. The fourth chart shows the difference between the The fall in mortgages' portfolio share--from over regulatory ceiling and the actual share in pension half in the early 1980s to 17 per cent--might be funds' portfolios. driven by supply rather than the regulatory change. Pension funds owned more than half of Chilean The shortfall in Chile and Argentina is, in fact, mortgages in 1997. Managers might have wanted lower than in many OECD countries. In Den- to invest more in mortgages, but, prevented by mark, Germany and Switzerland, for example, their short supply, searched for other investments. pension funds' equity investments are 20 percent- age points or so below the statutory limit. Secondly, rapid portfolio shifts can change asset prices. Chilean pension funds, now worth 43 per Pension funds are always likely to allow for some cent of GDP, are by far the largest investors in the gap between actual share and the ceiling because economy. Reducing bond or mortgage holdings equity values can be volatile. A sudden increase in rapidly would drive prices downwards, and buying share prices would force managers to liquidate part equities shift prices upwards. A more gradual of their pension portfolio immediately. Some dif- switch would be less likely to have such an effect. ferences might be explained by other prudential Portfolio limits 5 controls, as in Chile, but this is less likely in the full 40-year lifetime of contributions by 20 or 30 well-developed capital markets of Western Europe. per cent. Portfolios and limits 4 Equity portfolio share 5 equities foreign assets United Kingdom no limit Canada United States Japan Ireland Australia Netherlands no limit Belgium Argentina Brazil Peru Chile Canada Portugal Chile Sweden Switzerland Argentina Denmark Denmark Netherlands Germany Luxembourg -20 -10 0 -20 -10 0 Malaysia Switzerland average portfolio relative to limit, per cent of total assets France Hungary Austria Greece The most convincing explanation is that fund Finland managers in continental European countries are Portugal Germany innately conservative. Equity holdings are gener- Italy ally lower than statutory limits and than in other Spain Singapore countries (Figure 5). In English-speaking coun- Mexico tries, such as Australia, Ireland, the United Uruguay 0 10 20 30 40 50 60 70 80 90 100 Kingdom and the United States, pension funds equities, per cent of total portfolio hold 40-80 per cent of their assets in equities. In Austria, France, Germany, Italy, Spain, Switzerland To show the impact of investment restrictions, and others, the share is typically 10 per cent or so. Figure 6 compares pension funds' actual returns These countries lack what is often termed an `eq- with the return on a `balanced portfolio'. This uity culture'. So regulatory restrictions cannot benchmark is based on a fund invested half in alone explain conservative, bond dominated equities and half in bonds. portfolios. The reforming countries of Latin America lie between these two groups of OECD Pension funds in the four countries at the top, economies. In fact, Argentina, Chile and Peru's with relatively liberal investment regimes, earned pension funds invest more than the average in 9½ per cent a year between 1984 and 1996 (the equities of the 28 countries shown in the chart. bars on the chart). In the six countries that restrict asset allocations, returns were around 6½ per cent Asset allocation and returns a year. The main reason for concern with portfolios with small equity holdings is that shares have histori- There are many possible explanations for this dif- cally offered a higher rate of return than bonds. ference. One important reason for differences in Equity returns are, of course, more volatile than pension fund performance might be differences in bond returns. But pensions are long-term invest- financial market performance. But we can reject ments, and much of equities' volatility is smoothed this conjecture. The lines in the chart show the out over a long investment period. Furthermore, returns on a balanced portfolio. This measure of any shortfall in returns is very important for the the market return is actually lower on average in value of the pension. A one per cent increase in the countries with fewer investment restrictions: annual returns increases the pension value for a 3½ per cent compared with 4 per cent a year. 6 Portfolio limits A second reason for the differences is that this larger return but at the expense of greater volatil- simple comparison ignores risk. The portfolios of ity. In Chile, for example, equity returns averaged equity dominated pension funds are more volatile. 18 per cent over a 16 year period compared with As a result, the standard deviation (a simple meas- 7½ per cent a year for bonds. But the standard ure of variability) of the returns on a pension deviation for equities was over 40 per cent fund's average portfolio in countries with liberal compared with just over 1 per cent for bonds. investment regimes is 11 per cent, compared with 8 per cent in more restrictive systems. So some of Chile's pension funds have delivered lower returns the extra return is being bought at the price of (11 per cent a year) than a balanced equity-bond greater risk. But only investors extremely adverse portfolio (15 per cent a year). They have, how- to risk would choose to forego returns three per- ever, delivered consistent returns: the standard centage points a year better for this comparatively deviation--9 per cent-- is less than could be small increase in volatility. achieved by an equity-bond mix. Pension and benchmark returns 6 The risk-return trade-off 7 Prudent person balanced portfolio actual 40 risk equities Ireland standard deviation Chile 1981-97 35 of annual returns United Kingdom United States 30 Netherlands 25 Argentina 1994-97 balanced Asset limits equities Belgium 20 balanced Sweden 15 bonds Germany 10 Chilean pension funds Japan Denmark 5 Argentine pension funds Switzerland bonds 0 0 2 4 6 8 10 0 5 10 15 20 annual average real return, per cent return annual return, per cent There are many other factors that might be at The performance of Argentine funds is better in work--macroeconomic policies, taxation etc.--but the short, three-year period since they were intro- the chart offers some compelling evidence that duced than in the longer period Chile's funds have investment restrictions do compromise pension been in operation. The annual return is nearly one fund performance. percentage point higher and the standard deviation nearly half the figure recorded in Chile (5 com- Chile and Argentina pared with 9 per cent). But these results must be The final chart compares the risk and return of treated with caution. A quarter of Argentina's pension funds and different benchmark portfolios funds are held in an `investment fund', which al- in Argentina and Chile since they introduced man- lows them to avoid counting any losses incurred datory funded pensions (Figure 7). The chart plots during the economic turmoil following the Mexi- the average annual return against the standard de- can peso devaluation of 1994. This crisis measure viation of returns. Points to the right of the chart means that `returns' are probably overstated. have higher returns; moving up the chart implies more variable returns. Latin American pension funds have delivered high absolute returns: 11 per cent or more, compared Three indices of market returns are used: bonds, with 5 per cent or so in OECD countries (Fig- equities and a balanced portfolio, combining the ure 6). But what matters is returns relative to two. As might be expected, equities deliver a investment alternatives, and benchmark portfolios Portfolio limits 7 combining stocks and bonds have often done at the safe end. `One-size-fits-all' portfolios of- better. fered in Latin America mean that people cannot switch their investments to take account of their Adverse effects of portfolio limits own, individual circumstances. We have looked at two types of portfolio restric- tions. The first either limits investments in In the United States, members of employer-run equities either directly or indirectly (by requiring defined contribution schemes (called 401(k)s after minimum investments in public bonds). The the relevant clause of the tax code) vary their in- second constrains investment abroad. vestments with age, from equity dominated portfolios when younger to safer assets when they Equities have generated higher long-run returns near retirement. Pension providers in the United than bonds. And pensions are a long-term in- Kingdom have begun to offer `lifestyle' plans that vestment. We have shown that returns in automatically adjust the risk profile of investments countries where pension funds have sizeable equity with the member's age investments have been higher than countries where bonds dominate portfolios, with only a International diversification small increase in risk. Portfolio limits could, there- Spreading assets across countries can reduce the fore, have a high cost in terms of reduced benefits volatility of investment returns. (Again, we will for pension members. look in more detail at these issues elsewhere in the Pension Reform Primer.) For example, the corre- There is one potential caveat. Many countries' lation between returns on equities in the United pension funds invest far less in equities than any States with those in emerging markets is just 40 portfolio restrictions allow. It does not necessarily per cent. Stockmarkets in the larger industrialized follow that freer investment rules lead to more di- economies (Germany, United Kingdom, and the versified portfolios. But circumscribing portfolio United States) are, however, more closely linked: limits is a necessary condition for diversification, the correlation is around 60 per cent. But even even if it is not sufficient. this degree of linkage allows for substantial benefits from international diversification. One objective of moving towards a funded pen- sion system is to enhance individual's Few funds take advantage of their freedom to in- responsibility for their own retirement income vest abroad. The most international funds are in planning. Individual choice of pension fund man- Belgium, Ireland and the United Kingdom, which ager provides an essential element of choice, and is have 30 per cent or so of assets overseas. In the an important spur to competition between funds United States, this proportion is just 10 per cent in both service and performance. Portfolio limits, and elsewhere, usually lower. There are many po- along with regulations of industry structure and tential explanations for this effect, called `home fund returns, substantially reduce individual bias', and portfolio restrictions are probably only a choice. These rules interact to produce almost small part of the story. identical pension fund portfolios and performance in Latin America. (This so-called `herding' behav- So, again, freer investment rules are necessary for ior is investigated in detail in the Pension Reform pension funds to reap the rewards in lower risk Primer briefing on guarantees of fund returns.) and higher returns from international diversifica- Competition between funds is not on investments tion of their assets. But they are not sufficient to but on service and sometimes even on gimmicks. ensure this outcome. A related point is that pension fund members are diverse. For example, the best portfolio for a younger worker is one with high risks and high returns while older workers are better off invested 8 Portfolio limits Further reading Conclusions and recommendations Srinivas, P.S., Whitehouse, E.R. and Yermo, J. governments have a responsibility to (2000), `Regulating private pension funds' ensure that pension funds earn decent structure, performance and investments: cross- returns for their members, especially country evidence', Pension Reform Primer when contributions are mandatory series, Social Protection Discussion Paper, explicit and implicit guarantees of World Bank, forthcoming. pension values mean governments also Vittas, D. (1998), `Regulatory controversies of pri- have a financial interest in promoting vate pension funds', Policy Research Working good pension fund performance Paper no. 1893, World Bank. (Internet: this responsibility has been used to www.worldbank.org.) Shah, H. (1997), `Towards better regulation of pri- justify strict regulation of pension funds' vate pension funds', Policy Research Working portfolios, the fund management Paper no. 1791, World Bank. industry's structure and investment World Bank (2000), `Guarantees: costs and conse- returns quences of guaranteeing funded pension but these restrictions have a cost:: benefits', Pension Reform Primer Briefing. pension funds have often under- Laboul, A. (1998), `Private pension systems: regu- performed benchmark portfolios of latory policies', Ageing Working Paper no. 2.2, stocks and bonds in Latin America OECD, Paris. (Internet: www.oecd.org.) and OECD countries with liberal Blommenstein, H.J. and Funke, N. (eds), Institu- investment regimes have had better tional Investors in the New Financial Landscape, pension fund returns OECD, Paris. (Particularly chapters by K. De different types of regulations interact to Ryck and D. Vittas.) ensure that Latin American funds have European Federation for Retirement Provision similar portfolios and almost identical (1996), European Pension Funds: Their Impact on performance European Capital Markets and Competitiveness, liberalizing the pension fund market London. should offer better returns, increased competition between funds and allow workers to choose a portfolio that matches their individual circumstances restrictions at the time of the reform might be necessary to bolster confidence in the new system but the medium-term goal should be to move to freer portfolios and pension funds' fiduciary duty to their ent members should eventually be set out in r `prudent person' regulation N r - pe´nsion n. 1mad . pee on riodicretirespecifie paymment od age above PENSPRIMER equipmer n pr person. 1with information IOREFORM of imperfectimby removal o etc.) beftoter r´ ons, faults ormrerrors v.t. & i. 1. ake (in . elementary book to abandostnment itution, procedure