Investment strategies and risk management in pension funds
An Analysis of the Solvency II Regulatory Framework’s Smith-Wilson Model for the Term Structure of Risk-free Interest Rates (completed)
Title: An Analysis of the Solvency II Regulatory Framework’s Smith-Wilson Model for the Term Structure of Risk-free Interest Rates
Participants: Peter Løchte Jørgensen (Aarhus University)
Description: In the European Union the financial regulation requires life and pension (L&P) companies to use a specific model for the term structure of risk-free interest rates – the Smith and Wilson (2000) model – when valuing their liabilities and long term guarantees. Since the Smith-Wilson model is not one of finance theory’s standard term structure models we provide an introduction to this model and we describe how the European Solvency II regulation came to embrace this particular model. The paper moves on to document how the regulation also imposes quite detailed and tight restrictions on how this model should be parameterized and applied. We argue that many of these implementation instructions seem biased in the same direction and that they could thus indicate a systematic attempt to "lift" the term structure curve up and away from its true location. The result is not only significant undervaluation of L&P liabilities but also a peculiar contradiction of Solvency II’s overall objective of enhancing financial stability and of protecting policyholders via the promotion of economic valuation in accordance with market consistent principles. The paper’s analysis is accompanied by valuation illustrations based on data on the liability composition of an actual medium-sized Danish pension fund.
Title: Comparison of Variable Annuities between the Netherlands and Denmark
Participants: Anne G. Balter (Tilburg University), Malene Kallestrup-Lamb (Aarhus University) and Jesper Rangvid (FI, CBS)
Description: Both in the Netherlands and in Denmark regulators are currently revising the regulation of pension guarantees. Since the ﬁnancial crisis, pensions have been cut in the Netherlands. Therefore, relaxation of guarantees ﬁts the characteristics of a realistic future more. The embedded uncertainty is explicitly described in a variable annuity product, which is since September1, 2016 an allowed pension product in The Netherlands. And which always existed in Denmark but gained much popularity only recently. In this paper, we consider the differences between the Dutch and Danish variable annuity products and we describe the differences in the associated regulation and direction of the pension reform discussion. Consensus exists in the discussion that the pension system reform should adequately inform all participants about the risks and expectations. Moreover, in both countries the regulation that is currently under development, aims at a transparent system allowing for a comparison of different products.
Title: Efficiently Inefficient Markets for Assets and Asset Management
Participants: Lasse H. Pedersen (FI, CBS) and Nicolae Garleanu (Berkeley)
Description: We consider a model where investors can invest directly or search for an asset manager, information about assets is costly, and managers charge an endogenous fee. Informed managers outperform after fees, uninformed managers underperform after fees, and the net performance of the average manager depends on the number of "noise allocators."
Investors are small (retail investors) and large (institutional investors such as pension funds) and we analyze how their optimal strategies differ. Small investors should be passive, but large and sophisticated investors benefit from searching for informed active managers since their search cost is low relative to capital. Hence, managers with larger and more sophisticated investors are expected to outperform.
Further, the paper has predictions for the future of capital markets and asset management. Indeed, the efficiency of asset prices is linked to the efficiency of the asset management market: if investors can find managers more easily, more money is allocated to active management, fees are lower, and asset prices are more efficient.
Title: Life-cycle product designs: Pro et contra
Participant: Henrik Ramlau-Hansen (FI, CBS)
Description: The traditional pension product with guaranteed benefits is in rapid decline in Denmark. Instead, more and more pension schemes are based on various life-cycle products, which are unit-linked type products, where the proportion of the savings invested in risky asset is high when young and declining with age towards retirement. The aim of the study is to analyze pro et con for the various versions of life-cycle products, in particular the extent to which they deliver a predictable pension with a limited downside risk. The current environment with ultra low interest rates poses a particular challenge.
Title: Obligatory Defined Contributions Schemes Over Life
Participants: Michael Møller and Niels Chr. Nielsen (FI, CBS)
Description: The general rule in Denmark is defined contribution schemes where the contribution as a percentage of salary is age independent. There are several arguments against this. The ability to pay into a pension scheme grows with age, as young people need to pay back study debts and have some free savings to obtain home ownership. With rising interest margins the problems for young people borrowing at the same time as saving in obligatory pensions schemes have grown. Furthermore, changing circumstances (lower interest rates) can lead to the necessity of raising pension savings, but the necessary rise may not be age independent.
Title: What’s the expected return on stocks over the next decade?
Participant: Jesper Rangvid (FI, CBS)
Description: I consider methods to forecast stock returns over longer horizons, such as ten years, and I evaluate which methods seem more promising. I present estimates of what we should expect stocks to return over the next decade. News is sad: Stock returns over the next decade are expected to be considerably lower than historical returns. I discuss implications for long-term investors, such as pension funds.