RESTRICTIONS ON RESTRICTIONS ON PENSION FUND PENSION FUND INVESTMENT – A COST INVESTMENT – A COST ASSESSMENTASSESSMENT

E Philip DavisE Philip Davis

Brunel University and NIESRBrunel University and NIESR

LondonLondon

e_philip_davis@msn.come_philip_davis@msn.com

www.ephilipdavis.comwww.ephilipdavis.com

OverviewOverview

Background – optimal investment Background – optimal investment for pension fundsfor pension funds

Distinguishing between QAR and Distinguishing between QAR and PPR regulatory approachesPPR regulatory approaches

Weighing up the argumentsWeighing up the arguments Tests of the benefits of PPRTests of the benefits of PPR Conclusions and issues for Conclusions and issues for

discussiondiscussion

Background – Optimal Background – Optimal Investment for Pension FundsInvestment for Pension Funds

Defined contributionDefined contribution– mean-variance approach to maximize replacement mean-variance approach to maximize replacement

ratio at retirement, subject to members’ risk aversionratio at retirement, subject to members’ risk aversion Defined benefit (subject to additional risks):Defined benefit (subject to additional risks):

– Real labour earnings, interest rates, mortality risks, Real labour earnings, interest rates, mortality risks, falling asset returns, risks of changes in government falling asset returns, risks of changes in government regulationregulation

Warrants asset-liability management (ALM) Warrants asset-liability management (ALM) approach:approach:– ImmunizationImmunization– Asset driven approachesAsset driven approaches– Liability driven approachesLiability driven approaches

Benefits of international for both DB and DCBenefits of international for both DB and DC– avoid unnecessary systematic riskavoid unnecessary systematic risk

Defining Quantitative Asset Defining Quantitative Asset Restrictions (QAR)Restrictions (QAR)

QAR – limits on holding of particular QAR – limits on holding of particular classes of assets and notably classes of assets and notably international assetsinternational assets

Considers prudence equal to safety, Considers prudence equal to safety, where security of assets is measured where security of assets is measured instrument-by-instrument.instrument-by-instrument.

Typically limits holdings of assets with Typically limits holdings of assets with relatively volatile nominal returns, low relatively volatile nominal returns, low liquidity or high credit risk, even if liquidity or high credit risk, even if mean return relatively high.mean return relatively high.

Defining Prudent Person Rule Defining Prudent Person Rule ((PPR)PPR)

““A fiduciary must discharge his or A fiduciary must discharge his or her duties with the care, skill, her duties with the care, skill, prudence and diligence that a prudence and diligence that a prudent person acting in a like prudent person acting in a like capacity would use in the conduct capacity would use in the conduct of an enterprise of like character of an enterprise of like character and aims” and aims”

(OECD definition)(OECD definition)

Test is of the behaviour of asset Test is of the behaviour of asset manager, institutional investor and manager, institutional investor and process of decision-making. process of decision-making.

Example, whether “due diligence” Example, whether “due diligence” investigation undertaken in investigation undertaken in formulating strategic asset formulating strategic asset allocation, whether coherent/explicit allocation, whether coherent/explicit statement of investment principles. statement of investment principles.

Prudent Investment is What Prudent Investment is What Someone Would Do in the Someone Would Do in the Conduct of Their Own Affairs Conduct of Their Own Affairs

Polar Extremes Rarely Polar Extremes Rarely AdoptedAdopted

PPR typically accompanied by a QAR on PPR typically accompanied by a QAR on self investmentself investment

Some QAR countries introduce concepts Some QAR countries introduce concepts of maximising safety and profitability to of maximising safety and profitability to their investment laws their investment laws

Commonly in PPR restrictions on large Commonly in PPR restrictions on large exposuresexposures

QAR rarely extended to require specific QAR rarely extended to require specific methods and targets for maturity methods and targets for maturity matching matching

The Case for QARThe Case for QAR

Limits overall risk of a pension portfolio, allows Limits overall risk of a pension portfolio, allows sponsors to be as competitive or low-cost as sponsors to be as competitive or low-cost as possiblepossible

May protect beneficiaries against insolvency of May protect beneficiaries against insolvency of operators and investment risks; ensures operators and investment risks; ensures diversification diversification

Reduces need for an insurance fundReduces need for an insurance fund Protects governments from need to bail out Protects governments from need to bail out

individuals from imprudent investments in DC individuals from imprudent investments in DC productsproducts

Compliance more readily verified and monitored Compliance more readily verified and monitored than for PPR. Lowers cost of running regulatory than for PPR. Lowers cost of running regulatory agencyagency

Canadian case – “government rules are necessary Canadian case – “government rules are necessary for the proper allocation of resources”for the proper allocation of resources”

The Case for QAR (cont’d)The Case for QAR (cont’d)

Difficulty with PPR - court judgements (or desire to Difficulty with PPR - court judgements (or desire to avoid litigation) can lead to narrow interpretations of avoid litigation) can lead to narrow interpretations of risk and safety, possible focus on indexationrisk and safety, possible focus on indexation

Case for QAR stronger in EMEs, where managers and Case for QAR stronger in EMEs, where managers and regulators inexperienced, markets volatile and open regulators inexperienced, markets volatile and open to manipulation by insiders, investors may need to to manipulation by insiders, investors may need to be prevented from taking excessive risksbe prevented from taking excessive risks

Issues regarding internal controls in institutions, Issues regarding internal controls in institutions, industry’s capacity for self-regulation and related industry’s capacity for self-regulation and related governance structures. governance structures.

If securities markets not yet developed, possibly If securities markets not yet developed, possibly need for initial investment in government bonds, need for initial investment in government bonds, corporate loans and corporate bondscorporate loans and corporate bonds

Further issues in context of capital outflow controls Further issues in context of capital outflow controls in EMEs that may be needed to avoid currency crisesin EMEs that may be needed to avoid currency crises

The Case for PPRThe Case for PPR

Allows free market to operate throughout Allows free market to operate throughout investment process while ensuing, along investment process while ensuing, along with solvency regulations and with solvency regulations and contributions policy, adequacy of assets contributions policy, adequacy of assets and appropriate riskand appropriate risk

Presumption diversification of investments Presumption diversification of investments is key indicator of prudence, in line with is key indicator of prudence, in line with finance theory finance theory

Entails wider degree of transparency for Entails wider degree of transparency for the institutions the institutions

May be delegated to industry self May be delegated to industry self regulating bodiesregulating bodies

Weighing the Arguments: Weighing the Arguments: Finance Theory Argues Finance Theory Argues Strongly Against QARStrongly Against QAR Likely to enforce holdings of a portfolio Likely to enforce holdings of a portfolio

below the efficient frontier, (high below the efficient frontier, (high proportions of bonds and domestic proportions of bonds and domestic assets)assets)

Limits diversification benefits of Limits diversification benefits of international investment, also exposing international investment, also exposing policy holders to currency riskpolicy holders to currency risk

Focuses unduly on risk and liquidity of Focuses unduly on risk and liquidity of individual assets and ignore risk reduction individual assets and ignore risk reduction via diversification, and liquidity risk via diversification, and liquidity risk depends on the overall liquidity positiondepends on the overall liquidity position

Weighing the Arguments Weighing the Arguments (cont’d)(cont’d)

May prevent account being taken of May prevent account being taken of the duration of the liabilities and the duration of the liabilities and related changes in risk aversionrelated changes in risk aversion

Renders difficult or impossible the Renders difficult or impossible the application of appropriate application of appropriate immunisation or ALM techniques for immunisation or ALM techniques for maturity matchingmaturity matching

Encourages national governments to Encourages national governments to treat pension funds as means to treat pension funds as means to finance budgetary requirementsfinance budgetary requirements

May impose higher administrative May impose higher administrative costs on pension fundscosts on pension funds

Weighing the Arguments Weighing the Arguments (cont’d)(cont’d)

If limits use of derivatives, force the institution If limits use of derivatives, force the institution either to hold low-yielding assets or expose either to hold low-yielding assets or expose itself to unnecessary risks itself to unnecessary risks

Inflexible and cannot be changed rapidly for Inflexible and cannot be changed rapidly for changing conjunctural economic circumstances changing conjunctural economic circumstances and market movementsand market movements

Incentivizes asset managers to hold proportions Incentivizes asset managers to hold proportions of risky assets which fall well short of the limits, of risky assets which fall well short of the limits, to avoid breaching themto avoid breaching them

May encourage low levels of surplus assetsMay encourage low levels of surplus assets Strategies likely to conform with legal Strategies likely to conform with legal

restrictions rather than attaining good returns, restrictions rather than attaining good returns, reducing risk and other desirable objectivesreducing risk and other desirable objectives

Impacts on the Asset Impacts on the Asset Management Industry and Management Industry and the Economythe Economy Less incentive to nominate skilled Less incentive to nominate skilled

investment managersinvestment managers Competition among asset managers Competition among asset managers

discourageddiscouraged Development of asset management Development of asset management

industry set backindustry set back QAR may lead to inefficient allocation of QAR may lead to inefficient allocation of

capital, via limiting capital to small firms capital, via limiting capital to small firms and pension funds’ corporate governanceand pension funds’ corporate governance

Increase costs for employers providing Increase costs for employers providing pensionspensions

Tests of the Benefits of PPRTests of the Benefits of PPR

Limited amount of empirical work – often using Limited amount of empirical work – often using quite short national return datasets and not quite short national return datasets and not allowing for riskallowing for risk

Other influences on pension fund portfolios Other influences on pension fund portfolios typically not taken into account in studies, such typically not taken into account in studies, such as:as:– RegulationRegulation– LiabilitiesLiabilities– TaxationTaxation– Corporate governance of pension fundsCorporate governance of pension funds– Competition in asset managementCompetition in asset management– Inefficiencies in international capital marketsInefficiencies in international capital markets– Financial structure in terms of bank or market Financial structure in terms of bank or market

dominancedominance

Davis 2002Davis 2002

Compared pension fund returns between Compared pension fund returns between QAR and PPR countries in aggregate QAR and PPR countries in aggregate pension fund sector for 7 OECD countries pension fund sector for 7 OECD countries using data from 1980-95using data from 1980-95

Used flow of funds data on pension fund Used flow of funds data on pension fund sector and overall market indices for returnssector and overall market indices for returns

Found both higher returns and in most Found both higher returns and in most cases lower risk in PPR on averagecases lower risk in PPR on average

Similar result if comparing with benchmarksSimilar result if comparing with benchmarks Problem – small sample of countries and Problem – small sample of countries and

short dataset. Some results differ over short dataset. Some results differ over 1970-951970-95

Estimated Returns on Pension Estimated Returns on Pension Fund PortfoliosFund Portfolios

AverageAverage Prudent Prudent PersonPerson

RestrictionsRestrictions

Nominal ReturnNominal Return 11.511.5 11.911.9 10.610.6

Standard DeviationStandard Deviation 9.49.4 8.78.7 11.111.1

Real ReturnReal Return 7.27.2 7.87.8 5.85.8

Standard DeviationStandard Deviation 10.010.0 9.59.5 11.411.4

1970-1995 Real 1970-1995 Real Returns (memo)Returns (memo)

4.64.6 4.84.8 4.04.0

1970-1995 Standard 1970-1995 Standard Deviation (memo)Deviation (memo)

10.010.0 10.210.2 9.59.5

Comparing Pension Fund Real Comparing Pension Fund Real Returns with Benchmarks Returns with Benchmarks

Real Return on Real Return on Pension Funds LessPension Funds Less

AverageAverage Prudent Prudent PersonPerson

RestrictionsRestrictions

50-50 Domestic 50-50 Domestic Bonds and EquitiesBonds and Equities

- 2.2- 2.2 - 1.8- 1.8 - 4.6- 4.6

Global 50-50 Bonds Global 50-50 Bonds and Equitiesand Equities

- 2.7- 2.7 - 1.9- 1.9 - 4.1- 4.1

Real Earnings Real Earnings GrowthGrowth

6.46.4 6.96.9 4.94.9

Hu 2007Hu 2007

Assessed pension asset allocation in 39 countries, 17 Assessed pension asset allocation in 39 countries, 17 emerging markets and 22 advanced countriesemerging markets and 22 advanced countries

Investigated rate of change in the Sharpe ratios Investigated rate of change in the Sharpe ratios comparing mean variance optimal portfolios with comparing mean variance optimal portfolios with foreign assets to those confined to domestic assets foreign assets to those confined to domestic assets

Positive values for pension funds in both OECD Positive values for pension funds in both OECD countries and EMEs, with a larger effect on the lattercountries and EMEs, with a larger effect on the latter

Widely differing optimal portfolio – higher proportion Widely differing optimal portfolio – higher proportion of pension funds optimally allocated to foreign assets of pension funds optimally allocated to foreign assets in EMEs than those in OECD countries in EMEs than those in OECD countries

Results not based on actual investment performance Results not based on actual investment performance of funds or sectorsof funds or sectors

Sharpe Ratio SSharpe Ratio Shifting From hifting From the QAR to PPR (percentage)the QAR to PPR (percentage)

OECDOECD Exclude Exclude OutliersOutliers

EMEsEMEs Exclude Exclude OutliersOutliers

MinMin 24.724.7 7.27.2 108.0108.0 36.936.9

MaxMax 43.543.5 15.215.2 184.3184.3 75.475.4

MedianMedian 34.034.0 10.310.3 134.2134.2 50.350.3

MeanMean 34.034.0 10.610.6 138.2138.2 52.652.6

SDSDaa 5.85.8 2.52.5 30.830.8 15.515.5

Davis and Hu 2008Davis and Hu 2008

Analysed returns and risks on Canadian Analysed returns and risks on Canadian pension funds vis and vis those in UK and pension funds vis and vis those in UK and US, in light of residual QAR aspects of US, in light of residual QAR aspects of Canadian regulationCanadian regulation

Used both aggregate and individual fund Used both aggregate and individual fund datadata

Found Canadian funds underperform in risk Found Canadian funds underperform in risk and return relative to benchmarks and also and return relative to benchmarks and also relative to a mean-variance optimal portfoliorelative to a mean-variance optimal portfolio

Data period covers period of Canadian Data period covers period of Canadian foreign asset restrictions so does not show foreign asset restrictions so does not show solely current rulessolely current rules

Sectoral Real Returns and Sectoral Real Returns and Benchmarks: UK and CanadaBenchmarks: UK and Canada

Canada

Actual Portfoli

o

50-50 Domesti

c20%

Foreign40%

Foreign GlobalDiversifie

d

66-06

Mean 5.4 5.7 5.8 5.9 6.2 6.0

S. Dev 8.0 9.9 9.4 9.3 11.6 8.6

Ratio 0.7 0.6 0.6 0.6 0.5 0.7

90-06

Mean 8.3 9.2 8.6 8.0 6.2 8.1

S. Dev 7.1 9.3 8.6 8.3 9.6 8.1

Ratio 1.2 1.0 1.0 1.0 0.6 1.0

United Kingdom

Actual Portfoli

o

50-50 Domesti

c20%

Foreign40%

Foreign GlobalDiversifie

d

66-06

Mean 7.7 7.2 6.8 6.4 5.2 6.9

S. Dev 15.0 16.3 14.5 13.3 13.6 13.5

Ratio 0.5 0.4 0.5 0.5 0.4 0.5

90-06

Mean 7.0 7.0 6.6 6.1 4.8 6.5

S. Dev 9.8 9.1 9.1 9.4 11.8 9.4

Ratio 0.7 0.8 0.7 0.7 0.4 0.7

Optimisation for 1978-2006Optimisation for 1978-2006

High Risk Mean Variance Portfolio (100% Risky Portfolio)Risky Portfolio

Overall Return

Overall Risk

Sharpe Ratio CB GB EQ PR FA

Fund Return

Fund Risk

Sharpe Ratio

Excess Return on

Fund

Canada 7.9 5.7 1.4 0.231 0.034 0.112 0.460 0.163 7.6 7.8 1.0 -0.3

UK 7.9 6.7 1.2 0.070 0.189 0.303 0.437 0.000 8.5 8.9 0.9 0.6

US 7.2 6.0 1.2 0.000 0.030 0.271 0.658 0.042 7.5 9.9 0.8 0.3

Medium Risk Mean Variance Portfolios (80% Risky Portfolio)

Risky Portfolio

Overall Return

Overall Risk

Sharpe Ratio

Risk Fraction CB GB EQ PR FA

Fund Return

Fund Risk

Sharpe Ration

Excess Return

on Fund

Canada 6.6 4.0 1.7 0.8 0.111 0.164 0.087 0.510 0.129 7.6 7.8 1.0 1.0

UK 6.4 4.8 1.3 0.8 0.018 0.378 0.183 0.421 0.000 8.5 8.9 0.9 2.1

US 5.5 4.0 1.4 0.8 0.198 0.000 0.122 0.667 0.013 7.5 9.9 0.8 2.0

Real Return for Top 20 Funds Real Return for Top 20 Funds In UK and Canada: 2000-2006In UK and Canada: 2000-2006

2000-2000-20062006

CanadaCanada AverageAverage

Mean Fund ReturnMean Fund Return 5.25.2

Benchmark (40% foreign)Benchmark (40% foreign) 6.46.4

Excess Over BenchmarkExcess Over Benchmark -1.2-1.2

Standard Deviation Across FundsStandard Deviation Across Funds 4.04.0

UKUK

Mean Fund ReturnMean Fund Return 1.71.7

Benchmark (40% foreign)Benchmark (40% foreign) 2.42.4

Excess Over BenchmarkExcess Over Benchmark -0.7-0.7

Standard Deviation Across FundsStandard Deviation Across Funds 11.111.1

Other StudiesOther Studies

Queisser 2000 cites study for European Queisser 2000 cites study for European Federation for Retirement Provision Federation for Retirement Provision – Data for 1984-1993 shows pension funds Data for 1984-1993 shows pension funds

from PPR European countries had 9.5% from PPR European countries had 9.5% average real rate of return, compared to average real rate of return, compared to 6.9% for QAR6.9% for QAR

OECD 2007 – extent to which different OECD 2007 – extent to which different regulatory regimes impact on the regulatory regimes impact on the performance of privately managed performance of privately managed pension funds over 1990-2005 pension funds over 1990-2005 – Most country pension funds underperform Most country pension funds underperform

when compared to the hypothetical optimal when compared to the hypothetical optimal portfolio, and investment restrictions have a portfolio, and investment restrictions have a damaging effect on performancedamaging effect on performance

ConclusionsConclusions

Overview of literature shows PPR superior Overview of literature shows PPR superior to QAR in theory and also in empirical to QAR in theory and also in empirical workwork

Some limitations on latter, such as small Some limitations on latter, such as small samples, other influences on portfolios, samples, other influences on portfolios, but overall outturn is clearbut overall outturn is clear

Warrants pressure on regulators to ease Warrants pressure on regulators to ease outstanding restrictions such as those in outstanding restrictions such as those in CanadaCanada

Logic has been followed in IOPR Directive Logic has been followed in IOPR Directive in Europe and recent shifts to PPR in in Europe and recent shifts to PPR in countries such as Japancountries such as Japan

Issues or DiscussionIssues or Discussion

Are there any stronger arguments for QAR?Are there any stronger arguments for QAR? How could the testing of effects of regulation be How could the testing of effects of regulation be

improved? improved? For countries where QAR holds, how restrictive are the For countries where QAR holds, how restrictive are the

regulations considered to be in practice?regulations considered to be in practice? Are they more serious for DC or DB schemes?Are they more serious for DC or DB schemes? Is their impact worsening in the context of the increasing Is their impact worsening in the context of the increasing

sophistication of strategies?sophistication of strategies? Is there a detectable impact on competition in asset Is there a detectable impact on competition in asset

management?management? Are governance structures adequate for PPR in all cases?Are governance structures adequate for PPR in all cases? Does the sub-prime crisis tell us anything about the Does the sub-prime crisis tell us anything about the

effectiveness of PPR or QAR?effectiveness of PPR or QAR?

ReferencesReferences

Davis, E. Philip (2002), “Prudent person rules or Davis, E. Philip (2002), “Prudent person rules or quantitative restrictions? The regulation of long term quantitative restrictions? The regulation of long term institutional investors’ portfolios”, Journal of Pension institutional investors’ portfolios”, Journal of Pension Economics and Finance, 1, pp157-191 Economics and Finance, 1, pp157-191

Davis E Philip and Yu-Wei Hu (2008) “Are Canadian Davis E Philip and Yu-Wei Hu (2008) “Are Canadian pension plans disadvantaged by the current structure of pension plans disadvantaged by the current structure of portfolio regulation?” paper prepared for OMERS, Marchportfolio regulation?” paper prepared for OMERS, March

Hu, Yu-Wei (2007), “Pension fund investment and Hu, Yu-Wei (2007), “Pension fund investment and regulation”, in “Three essays on pension funds and regulation”, in “Three essays on pension funds and pension reform”, Doctoral Dissertation, Brunel University, pension reform”, Doctoral Dissertation, Brunel University, May 2007 May 2007

OECD (2007OECD (2007), “Pension fund performance”, committee ), “Pension fund performance”, committee meetings document, Working Party on Private Pensions, meetings document, Working Party on Private Pensions, Paris.Paris.

Queisser, Monika (2000), “Pension reform and Queisser, Monika (2000), “Pension reform and international organisations: from conflict to convergence”, international organisations: from conflict to convergence”, International Social Security Review, 53(2). International Social Security Review, 53(2).