Pension Fund Economics and Finance

Efficiency, Investments and Risk-Taking

Jacob Bikker

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781317220831
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Pension fund benefits are crucial for pensioners' welfare and pension fund savings have accumulated to huge amounts, covering a major part of world-wide institutional investments. However, the literature on pension fund economics and finance is rather limited, caused, in part, to limited data availability. This book contributes to this literature and focuses on three important areas. The first is pension fund (in)efficiency, which has a huge impact on final benefits, particularly when annual spoilage accumulates over a lifetime. Scale economies, pension plans complexity and alternative pension saving plans are important issues.

The second area is investment behavior and risk-taking. A key question refers to the allocation of investments over high risk/high return and relatively safe assets. Bikker investigates whether pension funds follow the life-cycle hypothesis: more risk and return for pension funds with young participants. Many pension funds are rather limited in size, which may raise the question how financially sophisticated the pension fund decision makers are: rather professionals or closer to unskilled private persons?

The third field concerns two regulation issues. How do pension fund respond to shocks such as unexpected investment returns or changes in life expectancy? What are the welfare implications to the beneficiary for different methods of securing pension funding: solvency requirements, a pension guarantee fund, or sponsor support?

This groundbreaking book will challenge the way pension fund economics is thought about and practiced.

1 Introduction

Jacob A. Bikker

Pension fund efficiency and investment returns are crucial for pensioners’ welfare. Pension funds manage huge amounts of capital, constituting a major part of worldwide institutional investments. Pension systems also have a significant impact on national economies, especially in countries where the pension funds’ asset value exceeds that of the national product. However, the literature on pension fund economics and finance is rather limited, partly due to low availability of data on individual pension funds. This book contributes to the pension fund economics and finance literature with a number of relevant studies focusing on three important areas:

1.1. Pension fund efficiency

The first research field is pension fund efficiency. Inefficiency in pension fund administration and investment has a huge impact on final benefits, particularly when this accumulates over a lifetime. An increase in annual operating costs of 1% of pension fund assets may imply a cumulated reduction of 27% of final pension benefits or, equivalently, an increase of more than 37% in pension costs (see Bateman et al., 2001; Bikker and de Dreu, 2009). Economies of scale have a major impact on administration and investment costs of pension funds, and they rise over time, particularly as information technology costs are to some extent constant across the individual funds, which boosts economies of scale. Economies of scale may also imply the existence of an optimal pension fund scale, which is investigated in Chapter 2. This chapter estimates different functions for administrative and investment costs, which incorporate varying assumptions about the shape of the underlying average-cost function: particularly, U-shaped versus monotonically declining. Relationships between costs and scale that are more flexible than commonly used in the literature appear to be necessary to obtain meaningful estimates of economies of scale and their differences over the various pension fund sizes. Using unique data for Dutch pension funds, this chapter finds that unused economies of scale for both administrative activities and investment are indeed extremely large and yield a concave cost function, that is, huge and positive for small pension funds, but decreasing with pension fund size. A clear optimal scale of around 40,000 participants during 1992–2000 has been observed (pointing to a U-shaped average-cost function), which increases in subsequent years to an optimal size above the largest pension fund, pointing to monotonically decreasing average costs. The shape of the unit cost functions has changed over time.

Chapter 3 investigates how complexity of the pension plans and higher service levels may also contribute to administration costs. Administrative costs per participant appear to vary widely across pension funds in different countries. Using unique data on 90 pension funds, this chapter examines the impact of scale, the complexity of pension plans and service quality on the administrative costs of pension funds, and compares these costs across Australia, Canada, the Netherlands, and the United States. With the exception of Canada, large unused economies of scale have been found to exist. Higher service quality and more complex pension plans significantly raise costs. Administrative costs also vary significantly across pension fund types, with differences of up to 100%.

A different type of efficiency relates to the administration costs of pension provisions by pension funds in comparison to those offered by life insurers. Not all employers have access to pension provisions by a pension fund, and most self-employed people have no access to pension funds at all. On the other hand, enterprises may choose the kind of institution for the pension provisions of its employees. Chapter 4 makes such comparisons of pension provision costs. First, the differences across pension plans of pension funds and life insurers are discussed. Second, operational costs and profits across the types of institutions are compared over long periods, where life insurer products are split into four categories: individuals versus groups and, for both categories, investment portfolio-linked versus guaranteed amounts in euros. This allows for more detailed insight in pension provision costs of life insurers. Finally, the impact of economies of scale on the cost comparison has been investigated.

1.2. Investment behaviour and risk-taking

The second research area is on investment behaviour and risk-taking. Obviously, investment returns are key for a favourable (i.e. high) level of pension benefits. But investment returns are strongly linked to investment risks. A central measure of risk-taking is the allocation of investments over (i) risky assets, such as stocks, private equity and real estate, where expected returns are higher and (ii) relatively safe assets, such as bonds, with a priori lower returns. This book treats various aspects of this return and risk trade-off.

Chapter 5 studies the multi-period asset allocation problem – well-known in the finance literature – for pension fund investors with an emerging-market portfolio comprising stocks, bonds and bills. Two types of investors are considered: domestic ones who invest in emerging-market assets only (with returns in local currency) and international investors, who invest in both US and emerging-market assets (with returns in US dollars). The results show that emerging-market bonds with a maturity of one year and longer can provide attractive short-run and long-run investment opportunities for domestic and internationally investing pension funds with different risk preferences.

Chapter 6 discusses the implications of mean reversion in stock prices for long-term investors such as pension funds. It starts with a general definition of a mean-reverting price process and explains how mean reversion in stock prices is related to mean reversion in stock returns. Subsequently, it shows that mean reversion makes stocks less risky for investors with long investment horizons. Next, a mean-variance efficient investor has been considered to show how mean reversion in stock prices affects such an investor’s optimal portfolio allocation. Finally, the implications of the findings for the investment decisions of long-term investors are discussed.

Chapter 7 examines the impact of participants’ age distribution on the asset allocation of pension funds, using a unique dataset of Dutch pension fund investment plans. Theory predicts a negative effect of age on (strategic) equity exposures. This chapter observes that a one-year increase in the average age of active participants leads to a significant and robust reduction of the strategic equity exposure by around 0.5 percentage point. Larger pension funds show a stronger age-equity exposure effect. The average age of active participants influences investment behaviour more strongly than the average age of all participants, which is plausible as retirees no longer possess any human capital.

Many pension funds are rather limited in size, which may raise the question of how financially sophisticated the pension fund decision makers are: are they professionals or closer to unskilled private persons? Using investment policy plan data of 857 pension funds with a strongly skewed size distribution, Chapter 8 develops three indicators of investor sophistication. These indicators show that pension funds’ strategic portfolio choices are often based on rough and less sophisticated approaches. First, most pension funds round strategic asset allocations to the nearest multiple of 5%, similar to age heaping in demographic and historical studies. Second, many pension funds invest little or nothing in alternative, more complex asset classes, resulting in limited asset diversification. Third, many pension funds favour regional investments and as such do not fully employ the opportunities of international risk diversification. The indicators are correlated with pension fund size, in line with the expectation that smaller pension funds are generally less sophisticated than large pension funds. Using the indicators for investor sophistication, it has been shown that less sophisticated pension funds tend to opt for investment strategies with lower risk.

According to theory, institutional investors face both risk-management and risk-shifting incentives. Chapter 9 assesses the relevance of these conflicting incentives for pension funds and insurance firms. Using a unique and extended dataset, a significant positive relationship between capital and asset risk for insurers has been observed, indicating that risk-management incentives dominate the Dutch insurance industry. Risk-shifting incentives, however, also seem relevant, as stock insurers take more investment risk than their mutual peers. For Dutch pension funds, neither risk-shifting nor risk-management incentives seem to dominate in general. Interestingly, professional group pension funds take significantly less investment risk than other types of pension funds. This finding is in line with expectations, as in professional group pension funds potential incentive conflicts between pension fund participants and the employer are effectively internalized.

1.3. Risk-taking and regulation

The third main topic of this book is on risk-taking and regulation. The pension sector performs a key public task, highly important for its current and future beneficiaries but also for the current economy. Participants’ savings are held for decades to invest profitably in order to meet the future promised benefits. As a consequence, this sector is strongly regulated and supervised.

Chapter 10 investigates responses to changes in solvency by occupational pension funds using a unique panel dataset containing the balance sheets of all registered pension funds in the Netherlands over a period of 13 years. A fixed-discount rate for liabilities in the supervisory framework enables the measurement of the response of pension funds to solvency shocks. Pension rights appear to be expanded, by e.g. indexation, or limited, by for instance setting the pension premium over its actuarially fair price, in line with the funding ratio, but the pension funds’ response function exhibits two sharp and significant behavioural breaks, close to the minimum funding ratio of 105% and the target ratio of around 125%. Large funds and grey funds are relatively generous to current participants.

Adequate funding of occupational pension plans is key for security. Different methods of securing funding exist across countries: solvency requirements, a pension guarantee fund and sponsor support. The aim of Chapter 11 is to investigate the welfare implications to the beneficiary in a hybrid pension scheme. The chapter shows that the three security mechanisms can be made utility-equivalent by adjusting the pension contract specifications. The utility-equivalence approach could serve to strengthen the ‘holistic balance sheet’ approach, as advised by the European Insurance and Occupational Pensions Authority (EIOPA), a regulatory body of the financial sector in the European Union. It enables regulators to compare various pension systems across Europe in a single framework from a utility perspective instead of a valuation perspective.

1.4. Statements of aims

This books investigates topics which are of key importance for the following three groups: First, pension fund stakeholders, such as participants and employers. They can benefit from investigations on (i) efficiency with respect to scale, governance, organization, type of pension schemes and service level, and investment policy, where they can balance risk and returns with respect to their pension fund features and characteristics of their participants; (ii) policymakers from government and regulatory supervisors can benefit from knowledge on the most efficient structure of the pension sector, both in number of pension funds and their individual scale, as well as the legal organization, e.g. industry-wide funds versus company funds. Furthermore, information on investment behaviour and risk-taking are crucial for financial supervisors in developing regulation for solvency and financial stability as well as governance; (iii) all topics in this book are of great interest to academics, particularly because empirical research on these areas are generally hampered by a lack of detailed data on individual pension funds.

References

Bateman, H., G. Kingston, J. Piggott, 2001, Forced Saving: Mandating Private Retirement Incomes, Cambridge University Press, Cambridge.

Bikker, J. A., J. de Dreu, 2009, Operating costs of pension funds: the impact of scale, governance and plan design, Journal of Pension Economics and Finance 8, 63–89.

Part I

Efficiency

2 Is there an optimal pension fund size?

A scale-economy analysis of administrative and investment costs¹

Jacob A. Bikker

2.1. Introduction

After the credit crisis, pension funds all over the world have suffered from low returns on stocks, low interest rates and, particularly funds that offer defined-benefit plans, increasing life expectancy. The operating costs of pension funds may draw less attention, although persistent inefficiencies are seriously eroding (future) benefits. Ambachtsheer (2010) stresses the role of operating efficiency in optimal pension provision and indicates that more research is needed on institutional implementation. Comparing pension funds in the Netherlands, one finds that avoidable costs may cause a 10%–20% difference between benefits paid by the smallest and by the largest pension funds, a difference that may grow even larger as returns on investment decline. Here unused economies of scale are key, so that, considering only costs, consolidation is to be recommended.

The question arises, however, whether this advice should apply to pension funds of all sizes, including the very large ones. Economic theory typically assumes either a U-shaped average-cost function or continuously decaying unit costs. Theoretical arguments and empirical evidence for the...

Table of contents

• Cover
• Title
• Copyright
• Contents
• List of figures
• List of tables
• Notes on contributors
• 1 Introduction
• Part I Efficiency
• Part II Investment behaviour and risk-taking
• Part III Risk-taking and regulation
• Index