metadata: authors: 0: author: Stewart,Fiona Elizabeth
1: author: Despalins,Romain
2: author: Remizova,Inna
count: World
docna: 0: docna: Pension funds, capital markets, and the
            power of diversification
docty: Policy Research Working Paper
subtopic: Non Bank Financial Institutions,Social Funds and Pensions,Capital Markets and Capital Flows,Capital Flows,Pensions & Retirement Systems,Economic Growth,Economic Theory & Research,Industrial Economics
teratopic: Industry,Social Protections and Labor,Finance and Financial Sector Development,International Economics and Trade,Macroeconomics and Economic Growth
abstracts: cdata!: The potential for pension funds to
            contribute to capital markets and thereby economic growth
            has been argued on a theoretical basis and demonstrated
            empirically. However, reforms fostering the development of
            funded pension systems have not had the economic impact
            hoped for in some countries. Pension fund portfolios in some
            cases have remained highly exposed to shorter-term assets,
            such as bank deposits and shorter-term government bonds.
            This, in turn, has led to relatively low investment returns,
            thereby potentially affecting income adequacy in retirement.
            This paper looks at the potential regulatory hurdles to
            long-term investment by pension funds, while also proposing
            international diversification and the creation of domestic
            investment opportunities to help portfolio diversification
            and ultimately improve the delivery of secure, adequate pensions.
repnme: repnme: Pension funds, capital markets, and the
            power of diversification
display_title: Pension funds, capital markets, and
            the power of diversification
listing_relative_url: /research/2017/07/27707774/pension-funds-capital-markets-power-diversification
topicv3: Pension Funds m1326066 611,Economic Growth m1326241 471,Capital Markets m1326967 332,Private Equity Funds m1327220 344,Retirement m1504007 2896
publishtoextweb_dt: 2017-07-05T00:00:00Z
historic_topic: Industry,Social Protections and Labor,Finance and Financial Sector Development,International Economics and Trade,Macroeconomics and Economic Growth
no_of_pages: 27
author_keys: 0: author_key: 1237818
1: author_key: 1491163
model_extractions: WPS8136 Policy Research Working Paper 8136 Pension Funds, Capital Markets, and the Power of Diversification _Fiona Stewart Romain Despalins Inna Remizova_ Finance and Markets Global Practice Group July 2017
Policy Research Working Paper 8136

# **Abstract**

The potential for pension funds to contribute to capital markets and thereby economic growth has been argued on a theoretical basis and demonstrated empirically. However, reforms fostering the development of funded pension systems have not had the economic impact hoped for in some countries. Pension fund portfolios in some cases have remained highly exposed to shorter-term assets, such as bank deposits and shorter-term government bonds. This, in turn, has led to relatively low investment returns, thereby potentially affecting income adequacy in retirement. This paper looks at the potential regulatory hurdles to long-term investment by pension funds, while also proposing international diversification and the creation of domestic investment opportunities to help portfolio diversification and ultimately improve the delivery of secure, adequate pensions.

This paper is a product of the Finance and Markets Global Practice Group. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The authors may be contacted at fstewart1@worldbank.org, romain.despalins@oecd.org, and iremizova@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# Pension Funds, Capital Markets, and

# the Power of Diversification

_Fiona Stewart Romain Despalins Inna Remizova_

## **JEL Code:**

**G110:** Financial Economics / General Financial Markets / Portfolio Choice; Investment Decisions

**G230:** Financial Economics / Financial Institution and Services / Pension Funds; Non-bank Financial Institutions; Financial Instruments; Institutional Investors

**G280:** Financial Economics / Financial Institutions and Services / Government Policy and Regulation

**F380:** International Economics / International Finance / International Financial Policy/ Financial Transactions Tax; Capital Controls

**_Keywords: Capital Markets, Financial Instruments, Pension Funds, Diversification, Portfolio, Asset Allocation, Capital Gain, Regulation, Capital Control_**
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<!-- Start of picture text --> 8 YEAR REAL RETURNS<br>#0 2009-2016<br>7.0<br>6.0<br>5.0<br>4.0<br><!-- End of picture text --> <!-- Start of picture text --> 3.0<br>2.0<br>1.0<br>0.0 S2séaeeeeeeags22sFA eee765s2zaos ég »ee2 ==Saeeseartaesrvz2seeeeeBeeTeez2 Be:zeaEEEo REEERPSERZ£2225uw B =z?F252er 3B2 =S33#2eeeoEB<br>2° 8 gs “ = 23<br>a<br><!-- End of picture text -->
10.0 12.0 4.0 -2.0 0.0 2.0 4.0 6.0 8.0 10.0 ooo.___<_l6le. nnn OOOO eee Russian F Boe —.Oo CO) TEE Macau, iwla S$jp[{—____—_—“—-oO—ooOoOoOCOCOCO—O—_— . indonesit —_—_—_—_—_o Bosnia raul CC and Herz faand |——Fn Bany ladesh e—_—_O_ e—_—_O_ Nauriti CoC Chile —_—__— —_—__— Mozart ue Se cc, — "Yanisia —_ —_ Paraguay —_—_—_— New Zealand|| 1 —_" ANA eon — ear ———— Basie ae “Bsn —_ Luxernbourg 7 Phiippines . Czech Gehan Rep i : : Taiwan, Cawwanl Puert

<!-- Start of picture text --> Bany ladesh e—_—_O_ e—_—_O_<br>Nauriti CoC<br>Chile —_—__— —_—__—<br>Mozart ue Se<br>cc, —<br>"Yanisia —_ —_<br>Paraguay —_—_—_—<br>New Zealand|| 1 —_"<br>ANA<br>eon —<br>ear ————<br><!-- End of picture text -->

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<!-- Start of picture text --> Real Return Colombiae Netherlands<br>» Canada<br>Romania »<br>5<br>Denmark<br>e.<br>Chile»<br>Norway » Peru<br>4 Iceland i<br>Slovenia Mexico Spain¢ * Latvia Auge° . States ° Australia<br>Estonia » Italy<br>2 ,<br>Greece ¢ Thailand<br>e slovak<br>Republic<br>Czech »<br>0 Republic a =<br>0 10 20 30 40 50 80 70 *<br><!-- End of picture text -->
<!-- Start of picture text --> 70.0 ; =e: : .<br>Diversification Vs. Sharpe Ratio<br>‘Canada<br>.<br>60.0 =<br>The Netherlands<br>.<br>50.0 Italy<br>* 6 Iceland<br>.? . Norway<br>.<br>40.0 . s<br>=<br>Sse=] . .<br><!-- End of picture text --> <!-- Start of picture text --> S 300<br>=yn” °<br>g Romania<br>GB 200 *_. * =<br>°<br>10.0 = . e Uruguay<br>© = Slovenia<br>0.0 °<br>0 0.5 1 L.5 2 2.5<br>Sharpe Ratio<br><!-- End of picture text -->
<!-- Start of picture text --> @ Share allocated in equities © Quantitative limit on equities<br>SS —————————<br>I<br>Finland eT<br>UnitedSSSStates —ESESSS~ECLEEL >>pSESESESESSSE<br>Switrerland ————)<br>Canada SaaS<br>Pore RRR<br>Mexico SS<br>Norway ees<br>ON<br>ete ga<br>$=<br>EE ————<br>CO<br>———————<br>Hungary _————————<br>Gemany ——————<br>a SS<br>0 0 20 30 40 #50 60 70 80 9 100<br><!-- End of picture text --> <!-- Start of picture text --> @ Share allocated in equities © Quantitativelimit on equities<br>Namibia<br>erg rong oe<br>Mauritius<br>sinhMalawi<br>Gibraltar<br>Armenia<br>Liechtenstein<br>Kenya<br>Romania<br>Bulgaria<br>Colombia<br>Ta<br>ee<br>Malta<br>ise<br>Maldives<br>Costa Rica<br>Kosovo<br>0 0 20 2% 4 5 6 7 8 80 100<br><!-- End of picture text -->
ultimately contributed to policy reversals in some of these systems since the financial crisis.<sup>19</sup> The paper also discusses how regulations could be adapted to incentivize long-term investment horizons by introducing outcomebased benchmarks.<sup>20</sup> Another form of regulation, which can distort pension fund investment and skews portfolios to short-term instruments, is switching. DC style, open pension systems, which allow members to switch between providers – often at will – have to hold more liquid portfolios to accommodate unexpected outflows. This again forces pension funds into shorter-term, more liquid instruments and does not allow for full diversification into longer-term asset classes, and prevents pension funds from having their potential impact on capital market development. Musalem and Pasquini (2012), examining the pension system in 27 countries from 1990-2007, find that: “ _occupational schemes tend to generate higher returns than do personal pension schemes and closed schemes tend to generate higher returns than do open schemes_ .” Evidence of such impact can be found in the United States in the difference between portfolio construction and investment performance of (closed) DB and (open) DC pension funds. There is also a difference in asset allocation between fund type in Australia – with open retail funds showing higher levels of cash and lower exposure to other/ illiquid assets than closed industry and corporate funds. As with US DB vs DC schemes, this translates into higher returns for corporate and industry vs. retail funds.

**Table 1: USA DB vs. DC Asset Mix + Performance**

|**Asset Class**|**Asset Mi**|**x % AUM**|**Returns( **|**see note)**|
|---|---|---|---|---|
|**(ranked by returns)**|**DB**|**DC**|**DB**|**DC**|
|Private Equity|4%|n/a|12.6%|n/a|
|Real Assets|5%|n/a|9.3%|n/a|
|Small CapStock|6%|7%|10.2%|8.4%|
|Employer Stock|0%|21%|n/a|8.6%|
|Fixed Income|31%|10%|6.8%|6.7%|
|Hedge Funds|2%|n/a|7.7%|n/a|
|Stock U.S. Large Cap|26%|30%|6.8%|6.1%|
|Stock Non U.S. or Global|23%|7%|6.7%|6.5%|
|Stable Value/GICs|n/a|17%|n/a|4.9%|
|Cash|2%|8%|2.9%|3.2%|
|**TOTAL**|**100%**|**100%**|**7.9%**|**6.9%**|
|No. of observations|3,083|1,995|||

Source: CEM<sup>21</sup> Notes: Asset Mix 17 years ending 2013 = arithmetic average of annual asset mix weight / Returns 17 years from 1997 to 2013. Returns are the geometric average of the annual averages for each asset class. Hedge funds were not treated as a separate asset class until 2000, so 60% stock 40% bond returns were used as a proxy for 1997-1999.

> 19 See Schwarz and Arias (2014), Price and Rudolph (2013) which raise these issues through also stress that the main driver behind the second pillar reversals was fiscal pressures.

> 20 Continuing the airplane analogy, without them Blake et at (2008) describe managing pension funds as the equivalent of worrying about air turbulence on a flight without considering whether the plane is actually going to reach its destination. 21 Data taken from CEM Database, as presented by Mike Heale, presented at the IOPS/AIOS International Seminar on Pension Systems, San Jose, Costa Rica, February 25, 2015.

9
**Table 2: Australia Fund Type Asset Mix and Performance**

|**Proportion of Assets %**|**Corporate**|**Industry**|**Public Sector**|**Retail**|**Total**|
|---|---|---|---|---|---|
|Australian Shares|30|29|22|26|26|
|International Shares|28|25|27|22|25|
|Listed Property|1|1|4|4|2|
|Unlisted Property|7|10|6|2|7|
|Australian Fixed Income|14|6|7|15|9|
|International Fixed Income|6|5|7|7|6|
|Cash|6|6|9|14|8|
|Other Assets|8|19|18|9|16|
|Total|100|100|100|100|100|
|**Rate of Return(2004-2013)**|**6.5%**|**6.7%**|**7%**|**4.9%**|**6%**|
|**Volatility**|**9**|**9.5**|**9.7**|**9.4**|**9.5**|

Source: APRA Initial evidence from a forthcoming paper<sup>22</sup> suggests that higher switching levels between providers in selected Latin American systems are correlated with higher levels of short-term investments. The analysis also shows that changes in regulation (such as making switching more difficult) can have a positive effect on portfolio turnover and construction.

**Table 3: Correlation between calendar-year returns and transfers**

||**Across Fund**<br>**Providers**|**With Fund**<br>**Providers***|
|---|---|---|
|LAC|||
|Chile|-0.46|-0.41|
|Colombia|0.15|0.04|
|Costa Rica|-0.23||
|Mexico|-0.41|0.71|
|Peru|0.18|-0.10|
|EEC|||
|Estonia|-0.28|-0.14|
|Romania|-0.03||

Source: Fuentes, Morales and Stewart (forthcoming) 22 See Fuentes, Moralez and Stewart (forthcoming).

10
<!-- Start of picture text --> = — Switches within Funds — - «Benefits + Payouts Transfers across funds<br><!-- End of picture text --> <!-- Start of picture text --> 23% Chile 2s Colombia<br>20% , Sy S - 20%<br>é ue<br>v<br>15%. i 15%<br>ee<br>fe N<br>10% f 10% \<br>é \<br>¢ \<br>5K ‘ 5K \ =<br>me ey -—— a<br>See te ee THe oe ae Sissy eee Se<br>O% mn<br>2005, 2006 oT 2008 2009 2010 2014 2012 2013 214 2015 2005, 2006 2007 20 2009 210 2011 2012 2013 mis 2015,<br><!-- End of picture text --> <!-- Start of picture text --> Costa Rica Mexico<br>25%. iss<br>20% Po<br>iss 15s<br>10% 10% e*<br>a Ney Fa ‘ 3<br>See ete<br>sy Sh<br>«, Seeee<br>2005 2006 oy 2008 2009 2010 2018 2012 2053 eee2014 2015 ag 2005,ne2006 eee2007 2008 2009 20 2011 2012 2013 Pony 2015,<br><!-- End of picture text --> <!-- Start of picture text --> Peru<br>35%<br>-<br>vt<br>30% é S<br>f \<br>e Fd \<br>25% ‘<br>\<br>20%. \<br>\<br>18%. ‘<br>\<br>10% seen el 3<br>ou a<br>- ee ae ee =<br>O%<br>2005 2006 207 2008 2009 210 2012 2012 2033 mi 2015<br><!-- End of picture text -->
we
stakeholders, the National Banking and Securities Commission (CNBV) has established specific regulation regarding CKD’s issuances, including shareholders’ rights and responsibilities. In addition, the CNBV has developed monitoring and surveillance processes according with best international practices.<sup>27</sup> The diagram below illustrates an issuance of CKDs in its simplest form. A fund manager, acting as a sponsor, creates a Mexican issuer trust, which in turn obtains the necessary approvals from Mexico’s securities regulator, the National Banking and Securities Commission to issue and publicly offer CKDs in Mexico through the Mexican Stock Exchange. The product of the placement of the CKDs is invested in the portfolio companies as an equity, debt or as a combination of both. The issuer trust then enters into a management agreement with a fund manager, who is responsible for finding and recommending investments. Once such investments are approved and made, the fund manager is responsible for managing them until their divestiture is completed. The performance of CKD is linked to the accomplishment of the portfolio companies in which the issuer trust invests.

**Figure 13: Illustrative Issuance of CKDs**

<!-- Start of picture text --> Fund Manager<br><!-- End of picture text --> <!-- Start of picture text --> Issuing Trust<br><!-- End of picture text --> <!-- Start of picture text --> CNBV<br><!-- End of picture text --> <!-- Start of picture text --> Portfolio<br>Companies<br><!-- End of picture text --> <!-- Start of picture text --> Issuance<br>of CKD<br><!-- End of picture text --> <!-- Start of picture text --> Proceeds<br>from CKD<br><!-- End of picture text --> <!-- Start of picture text --> Investment<br>in CKD<br><!-- End of picture text --> <!-- Start of picture text --> Mexican<br>Stock<br>Exchange<br><!-- End of picture text --> <!-- Start of picture text --> in CKD<br>Pension<br>Funds<br><!-- End of picture text --> <mark>Another contributor to the diversification of the pension fund portfolios was Mexican REITs (Real Estate Investment Trusts) or FIBRAs launched in 2011. Before the launch of these products, pension funds were not allowed to invest directly in real estate assets. FIBRAs are trusts the purpose of which is to issue investment type securities CPIs (Certificados de Participaciуn Inmobiliarios) and raise funds from their placement in the domestic and international capital markets, with the purpose of financing, acquiring and/or developing real estate projects (industrial, commercial or residential).</mark><sup>29</sup> <mark>The placement of the CPIs by the FIBRA on the Mexican Stock Exchange (or international capital markets) is backed up by the real estate portfolio comprising the trust assets (along with any lease rights and/or funds destined for the financing of the acquisition and/or development of real estate projects). Holders of CPIs are also able to trade them on the secondary market. Returns on FIBRA investments can be generated in three ways: dividends obtained through leasing less operating expenses (fixed income); performance, through the generation profits on the Mexican Stock Exchange; capital gains. FIBRAs are considered hybrid instruments (fixed and variable income), as holders receive periodic payments (from the lease) and can yield capital gains, as they can be traded on the capital markets. AFORES own the equivalent of 2.9 billion dollars in FIBRAs, or roughly 20% of all FIBRA issuance. The following is a diagram that illustrates an issuance of the certificates CPI in its simplest form.</mark>

> 27 OECD (2014): https://www.oecd.org/daf/fin/private-pensions/G20-OECD-Report-Annex-Effective-Approaches-LTI-FinancingSept-2014.pdf

> 28 http://www.iflr.com/Article/2660162/Mexico-Institutional-private-equity-emerges.html

> 29 As of March 31, 2016 Fibra Uno – the first FIBRA launched - had a portfolio of 511 properties that totaled approximately 76 million sq ft. Fibra Uno targets properties with the best locations, high-quality assets and diversification of geographies, segments and tenants

> <u>http://en.fibra-uno.com/wp-content/uploads/2016/06/One-Pager-FUNO-22-Jun-16.pdf</u>

13
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More initiatives are needed to create these long-term, domestic pension fund investment opportunities for pension funds. Pension fund regulators, capital market authorities and pension funds and their managers should be encouraged to work together to create secure financial instruments which meet institutional investors’ needs.

# International diversification

Developing investment opportunities is important to use these funds productively, but in many economies, particularly of smaller countries, it will not be possible to absorb all these savings domestically.

Though foreign investment means that pension funds’ will not be able to directly contribute to domestic economic development, some international diversification of assets will be required to fulfill the primary objective of the pension system, which is to deliver a secure income in retirement. Standard portfolio selection theory provides a fundamental justification for international diversification: by widening the pool of potential assets, investors can potentially increase returns while possibly even reducing risks through the selection of complementary assets with low correlations.

The benefits of international diversification are well documented, and there is a growing body of research, which argues that increasing international diversification improves pension funds’ investment performance – both by pension funds in developed<sup>32</sup> and developing economies. For example, Pfau (in numerous articles, alone and with colleagues), argues for international diversification, even concluding that: “ _on average, over half of the pension portfolios of emerging market countries should be in international assets in order to maximize the expected utility of moderate and conservative pension fund participants_ .”<sup>33</sup> The OECD (1998) also previously concluded that: “ _the benefits of global portfolio diversification apply particularly to developing-country pension assets because the volatility of asset returns is high while the risk tolerance of pensioners is low_ .”<sup>34</sup> Davis (2002), having studied both OECD and selected emerging market economies with funded pension systems, concludes that: ‘ _international investment allows superior investment performance in terms of risk and return_ .” Studies have also been undertaken looking at the impact of deregulation of international investment restrictions on pension funds individual countries. Pfau (2009) considered the impact of international diversification on the public pension system in Pakistan and concluded that: “ _international diversification could dramatically help to create sustainability for Pakistan's main public pension system available to private workers_ .” Hu et al (2007) conclude that allowing for international diversification, along with other deregulation of investment limits, would benefit Chinese pension funds. Swinkels et al (2005), in looking at the home bias in Latvian pension funds, note (using empirical analysis) that international diversification lowers investment risks for Latvian pension investors and that the high levels of domestic investment are suboptimal.<sup>35</sup> The OECD finds that in ten European countries and countries with small or no domestic capital markets, pension funds had a high share (over 30%) of investments abroad in 2015 – with Kosovo leading at 91.9%, the Netherlands at 81.3% and Estonia with 75.8%. The proportion of foreign investments in the portfolio of pension funds was higher in 2015 than 11 years earlier in several countries (e.g. Slovak Republic, Israel, Chile, Bulgaria, Peru and the Former Yugoslav Republic of Macedonia), with the trend in the Latin American countries attributed to the loosening of the regulatory limit for foreign investments that took place in recent years.

> 32 For impact on pension funds in developed economies, see, for example Vanguard (2013), Fadhlaoui et al (2009), among others. Didier et at (2013) discuss parallel evidence on unexploited gains from international diversification in the mutual fund industry.

> 33 See Ajantha and Pfau (2011), Pfau (2011) also quantifies the costs of prohibiting international diversification. 34 Musalem and Pasquini (2012) notes that lower volatility in pension returns is associated with restrictions on foreign investing.

> 35 Raddatz et al (2014) consider the impact on benchmarks on international asset allocation.

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outcomes, measuring performance and fees over a long-term period and reducing incentives for frequent switching etc. - can have an impact on pension fund portfolio construction, allowing for greater diversification and ultimately potentially higher pension fund returns. However, over and above investment restrictions, pension funds in emerging markets often have difficulties in diversifying their portfolios due to a lack of investment opportunities. This is compounded if overseas investment is restricted. A combination of the deliberate creation of innovative domestic investment instruments and reasonable overseas investment limits (based on the size of pension fund assets relative to macroeconomic and market factors) can help pension funds deliver the long-term investment returns which are needed.

Finally, improving the governance of pensions – particularly the large, public sector and social security funds which dominate many emerging markets – is key to improving security, diversification, and returns.

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