28. In order to build these benchmark portfolios, first an independent body (independent from government and separate from the fund management industry) needs to establish the target objective for the pension funds.<sup>19</sup> This is usually expressed in terms of a replacement rate – i.e. the expected pension income express as a percentage of final salary. A target replacement rate for average individuals is usually in the 50-70% range. For reference, the average replacement rate from mandatory pensions is the OECD is 55%,<sup>20</sup> while the International Labor Organisation (ILO) recommends a minimum 40% replacement rate from the public pension systems.<sup>21</sup> It should be noted that this is the target for the pension system as a whole. The amount comes from a funded second pillar individual account will vary (for example, this is the bulk of the pension in Chile, but a small part of the overall system in Sweden).

29. Given this target replacement rate and the level of contributions into the fund, a target return can be set (assuming these inputs are internally consistent). A benchmark portfolio can then be established with the maximum probability of achieving the desired return with the minimum amount of risk, based on the projected returns, volatility and correlations of various asset classes. This benchmark portfolio should be low cost, allow for adequate diversification and based on passive index investments.

30. The difficulties of achieving this in practice, particularly international diversification, are noted. In many countries second pillar pension systems were set up with one of their goals being to develop the local capital markets and therefor requiring funds to invest domestically– though the evidence of this working in practice has been mixed. The examples of the reserve funds from Canada and New Zealand demonstrate the need for international diversification to make portfolio optimization work, with the Armenian case showing the difficulties of applying this approach where local capital markets are not yet mature.

31. Alternatively, Viceira outlines<sup>22</sup> that the benchmark could be made up of a portfolio of riskless assets which would generate the targeted replacement rate at the relevant investment horizon.<sup>23</sup> The performance of pension funds would be measured against the performance of such a benchmark.<sup>24</sup> 19 For a discussion of target outcomes see forthcoming work from the IOPS and OECD.

20 (OECD 2013) 21 The World Bank publication (Hinz et al 2010 ) notes that these benchmarks should consider the following factors: The presence of other sources of retirement income, including the income from public pensions; the age of individuals; the rate of contributions; the target replacement rate and its downside tolerance; a matrix of correlations between labour income and equity returns; the expected density of contributions for different categories of workers; the type of retirement income in the payout phase, in particular the risk tolerance of pensioners in the payout phase (e.g. real fixed annuities, variable annuities, and phase withdrawal); a parameter that reflects the risk aversion of policy makers.

22 (Rudolph et al 2010).

- 23 For example, a portfolio of inflation-indexed bonds with a duration that properly reflects the investment horizon of the population of plan participants could be used, but Viciera stresses that this would only deliver a limited pension income. An additional issue is that in practice there is a lack of such long-dated, indexed bonds, not only in developing but also some developed economies, making it difficult to apply this ‘replicating’ portfolio approach extensively.

> 24(Blake et al 2008) and (Impavido et al 2009) also discuss a similar concept of target annuitization funds.

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