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The World BankThe World BankSep 2001Sep 2001
Pension Fund Management
“IBRD’s experience”
Sudhir KrishnamurthiThe World Bank
Public Pension Fund Management, Washington, DC
24 September, 2001
The World BankThe World BankSep 2001Sep 2001
Road Map
Introduction
Governance of Pension Plans
Strategic Asset Allocation
Middle Office Issues Performance and Risk Measurement
The World BankThe World BankSep 2001Sep 2001
IBRD (World Bank) Investments
IBRD $55 billion liquidity Managed internally Many instruments
Pensions $10 billion for Pension and others Managed externally Many asset classes
Provide Financial Technical Assistance
The World BankThe World BankSep 2001Sep 2001
Financial Instruments
Fostered innovation in supporting services
IBRD Pensions
• Futures & Forwards
• Swaps Interest Rate Currency Structured
• Other Synthetic Products
• Bonds - issuance &
trading(incl. EMG)
• Equities US Non-US EMG
• Other Hedge Funds
• Private Equities (EMG)
• Real Estate
• Fixed Income
Global High Yield EMG
The World BankThe World BankSep 2001Sep 2001
Fund Governance
Macro Governance Oversight Structure Responsibilities
Micro Governance Delegation of Authority Conflict of Interest
Cost of Governance
Governance of country systems
The World BankThe World BankSep 2001Sep 2001
Governance Why Governance
Owner of assets PrincipalManager of assets Agent
In a principal/agent relationship, principal has to ensure agent is acting in his best interests
The World BankThe World BankSep 2001Sep 2001
Governance
Clear distinction between governing and governed bodies
Who needs to be Governed Pension investment groups, fund managers
Who does the Governing Ideally, the principals or pension beneficiaries Usually, a representative body like the oversight
committee or regulators
The World BankThe World BankSep 2001Sep 2001
Governance Organization Structure
The Regulators take role of Oversight Committee in DC plans
EquitiesEquities
oversight benchmark guidelinesmonitoring G
ove
rnin
g B
od
yG
ove
rned
Bo
dy
CurrencyCurrency Private EquitiesPrivate Equities
CashCash Real EstateReal Estate
Fixed Income
Oversight Committee
Investment Staff/External Managers
The World BankThe World BankSep 2001Sep 2001
Governance Macro Issues
Composition of Oversight Committee Selection method Size Representation Turnover Frequency of meeting
Responsibilities of Oversight Committee Select investment staff and external managers Set Investment Policy Oversee Investment Policy Implementation Monitor Investment Performance Overall Fiduciary Responsibilities
The World BankThe World BankSep 2001Sep 2001
Governance Macro Issues
Composition of Investment Staff Finance Professionals Accountants Quantitative Specialists Actuaries
Responsibility of Investment Staff Funding Recommendations Investment Management Risk Management Reporting
The World BankThe World BankSep 2001Sep 2001
Governance Micro Issues
Delegation of Authority Explicit and written Implementation of Investment Policy
Conflict of Interest Permissible and Non-permissible transaction Disclosures Code of Ethics
Responsibility for the Development of Investment Policy and its Implementation be separated
The World BankThe World BankSep 2001Sep 2001
Governance Cost of governance
Governance must be just right - not too little and not too much
Delays
False sense of comfort - especially if oversight committee is not paying attention.
Cost of providing adequate information to oversight committee/regulators.
Ensuring timely/appropriate feedback on decision to oversight committee/regulators.
The World BankThe World BankSep 2001Sep 2001
Governance Country Systems
Provident Fund (PF)
Individual
Provident Fund
Oversight Committee
NO
DefinedContributio
n(DC)
Individual
Fund Manager
Regulators
YES
DefinedBenefit
(DB)
Government
Government
Social Security Administration
YES
Agent
Oversight
Incentive compatibl
e
Principal
The World BankThe World BankSep 2001Sep 2001
Investment Decisions
Decision 1: Determining asset allocation policy mix
(Strategic Asset Allocation)
Portfolio construction &
manager selection
Tactical Asset
Allocation
Decision 2:
Decision 3:
The World BankThe World BankSep 2001Sep 2001
Importance Investment Decisions Sources of Long-Term Performance
As much as 91.5% of performance attributed to Strategic Asset Allocation
Source: Brinson, Hood & Beebower. “Determinants of Portfolio Performance” Financial Analysts Journal. May/June 1991.Note: Cross products account for 2.1% of the variance
Tactical Asset Allocation
1.80% Other Factors2.10%
Security Selection
4.60%
Strategic Asset Allocation
91.5%
The World BankThe World BankSep 2001Sep 2001
0
200
400
600
800
1000
1200
'80 '85 '90 '95
1980:$260 billion
0%
25%
50%
75%
100%
125%
150%
175%
'80 '85 '90 '95
1996: 104%($1.04 in assets for every $1 of liability)
1980: 123%($1.23 in assets for every $1 of liability)
1996:$1.13 trillion
Assets and Liabilities Liabilities are unique for every pension plan
Liabilities are the only reason for a pension plan to make investment choices
Pension fund assets,in $ billions, annually
Ratio of assets to liabilities,annually
Note: Figures include a majority of private pension plans (45,000)Source: Pension Benefit Guaranty Corp.
U.S. Pension Funds: 1980-1996
The World BankThe World BankSep 2001Sep 2001
Mean - Variance Efficient Frontier
Is standard deviation meaningful as risk tolerance measure for pension plans
6.00%
7.00%
8.00%
9.00%
10.00%
11.00%
5.00% 7.00% 9.00% 11.00% 13.00% 15.00% 17.00% 19.00% 21.00%
Risk - Standard Deviation
Ret
urn
- M
ean
Traditional approach to Strategic Asset Allocation
Market Portfolio
Capital Market Line
Asset Allocation
Risk Tolerance determines Asset Allocation
The World BankThe World BankSep 2001Sep 2001
The Pension Problem
Traditional asset allocation approach does not take liabilities into account
Asset and Liability matching problem
Yearly Outflows Current retirees
Future Outflows Future retirees
Yearly Inflows Contributions
Employees Employer
Return on Assets
Current Assets
LIABILITIES ASSETS
The World BankThe World BankSep 2001Sep 2001
Risk measures for Pension Plans
Pension Plan investors have many other risk measures besides standard deviation of expected returns.
The appropriate risk measures for pension plans depends on the parties that are involved in the decision making process.
The World BankThe World BankSep 2001Sep 2001
Different objectives Objectives of parties concerned with pension plans
Objectives dictates the risk measures and risk preference
PLAN SPONSOR
Low and stable contributions
PENSION FUND
REGULATING AUTHORITIES
Solvency requirements
EMPLOYEES
Maintaining pension scheme
CENTRAL GOVERNMENT
Reduction public pensions
RETIREES
Maintaining compensation cost of
living
Source: Ortec Consultant BV
The World BankThe World BankSep 2001Sep 2001
Objectives and Risk Measures
Risks: I. Low funded ratios II. High contribution rates
World Bank’s Pension Plan
Maximize Return(max. wealth of plan)
II.Avoid high
contribution rate levels
I.Avoid low
funded ratio levels
(ratio Asset to Liabilities)
The World BankThe World BankSep 2001Sep 2001
Mean - Variance Efficient Frontier
Risk
Ret
urn
- W
ea
lth
Asset Liability Management approach to Asset Allocation
Market Portfolio
Asset Allocation
Risk (as measured by st. dev.) determined by:
• Maximum Contribution Rate• Minimum Funded Ratio
Asset Allocation reflects risk bearing capacity of the pension plan
The World BankThe World BankSep 2001Sep 2001
Operationalize Risk Measures
5% Funded Ratio - at - Risk Minimum funded ratio that can occur in any year with a
5% probability
5% Contribution Rate - at - Risk Maximum contribution rate that can occur in any year
with a 5% probability
Variants of the value-at-risk concept
Use multiple years for calculation of these risks (in this example 10 years)
The World BankThe World BankSep 2001Sep 2001
Investment Decision Matrix Total allocation to risky assets
60% 60%60%
60% 70%70%
60% 80%80%
90% 80%85%
5% FUNDED RATIO - AT - RISK
19%
25%
22%
5% C
ON
TR
IBU
TIO
N R
AT
E -
AT
- R
ISK
Risk budget to these value-at-risk measures determines investment policy
The World BankThe World BankSep 2001Sep 2001
Investment Decision Example Budget: Funded Ratio-at-risk = 85% and Contribution Rate-at-risk = 22%
Shaded area shows investment policies which are conform with risk budget
5% Contribution Rate-at-risk
5% Funded Ratio-at-risk
92.5%14%
87.5%
82.5%
22% 30%18% 26%
90.0%
85.0%
60%
80%
70%
70% allocation to risky assets
The World BankThe World BankSep 2001Sep 2001
Middle Office Issues
For each external manager and entire portfolio
Contracts
standardized adequate protection
Guidelines
development compliance monitoring
Performance Measurement
frequency attribution
Accounting & Reporting
management internal Controls
risk management cash management local/global custody
The World BankThe World BankSep 2001Sep 2001
Why Risk Management and Performance attribution
Identify unsustainable downside risk.
Identify the sources of excess return
Support asset allocation by trading off risk and return.
The World BankThe World BankSep 2001Sep 2001
Sizes of Risks Value - At - Risk Tree
Asset Liability Risk is main risk and is taken by the oversight committee
Liabilities
Investment Benchmark
Extended Policy
1,809
128
168
192
1,776
Actual Portfolio
= -0.45
= -0.36
$, million
The World BankThe World BankSep 2001Sep 2001
TAA and Active Risk
Risk measured as tracking error against the strategic benchmark
177
TOTAL RISK
83
TAA - Risk
125
Active - Risk
40
Equity
45
Fixed Income
60
Others
100
Equity
20
Fixed Income
50
Others
10
US - Equity
120
Non US - Equity
15
High Yield
10
Global FI
0
Real Estate
50
Hedge funds
55
US - Equity
45
Non US - Equity
30
High Yield
7
Global FI
100
Hedge funds
15
Real Estate
The World BankThe World BankSep 2001Sep 2001
Monthly Performance Attribution
Performance in same format as risk enables evaluation of risk and returnof each investment decision
50
TOT. PERFORM
15
TAA-PERFORM
35
Active-PERFORM
20
Equity
5
Fixed Income
-10
Others
25
Equity
5
Fixed Income
5
Others
10
US - Equity
15
Non US - Equity
5
High Yield
0
Global FI
0
Real Estate
5
Hedge funds
15
US - Equity
5
Non US - Equity
0
High Yield
5
Global FI
-20
Hedge funds
10
Real Estate