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Ontario Teachers’ Pension Plan: Asset Allocation Decision. Evolving Retirement Systems. The Extended Family Working members share income with retirees Defined benefit pensions Workers accept lower salaries Retirees receive relatively fixed payments Defined contribution pensions
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Evolving Retirement Systems • The Extended Family • Working members share income with retirees • Defined benefit pensions • Workers accept lower salaries • Retirees receive relatively fixed payments • Defined contribution pensions • Workers save to provide benefits for their own retirement years
The Extended Family • Workers sacrifice consumption to provide consumption for retired Parents • Bad times are shared by retirees and workers • Retirees have an equity claim on economic output
Defined Benefit Pensions • Workers sacrifice consumption through lower wages to pay for retirement benefits • Retirees are paid amounts that are • fixed in currency terms, or • fixed in real terms • Retirees have relatively fixed claims on economic output • Formally, claims are fixed • But terms may have to be revised in adverse times • Implicit partial equity characteristics
Defined Contribution Pensions • Worker and/or employer make contributions to a retirement account • Amount received by the worker in retirement depends on • Amounts contributed • Actuarial factors • Investment returns
The Swedish Pension System • The Notional Defined Contribution System • 16% of salary contributed • Partially funded • Investment return based on • Increase in an index of average income, or • Approximate rate of return in the system • The Financial Defined Contribution System • 2.5% of salary contributed • Fully funded • Individual can choose as many as 5 of 500 investment funds
Defined Contribution Pensions • Workers and retirees typically have some discretion over types of claims purchased (fixed, equity or both) • Growing use in both private and public retirement systems • More amenable to risk-sharing between workers and retirees
Demography and the Growth of Defined Contribution Pensions • Ratio of retirees per worker increasing • With fixed claims for retirees, worker claims would be highly leveraged • Allocation of risk would be suboptimal • Defined contribution plans can • Provide equity characteristics • Allow workers to choose levels of risk • Facilitate a more optimal allocation of risk among workers and retirees
Risk-sharing in a Simple Economy Economic Output Retirees Workers
Risk-sharing with Few Retirees Economic Output Retirees: 10% Debt Workers: 90% Equity
Risk-sharing with Many Retirees Economic Output Retirees: 25% Debt Equity Workers: 75% Equity
Risk-sharing in the Swedish Pension System • Notional Defined Contribution • Characteristics of both debt and equity • Accumulation phase • Rate of return based on index of average income or approximate rate of retun in the system • Retirement • Annuity amount varies with index of average income or approximate rate of return in the system • Guaranteed minimum pension • Financial Defined Contribution • Accumulation phase • participant can choose debt, equity or combination • Retirement • Participant can choose fixed annuity or variable annuity
Demographic Trends:Disappearing Population Pyramids • Population by age cohort • 0-4 • 5-9 • …. • Males on the left • Females on the right • Source: U.S. Bureau of the Census, International Database
Increasing life expectancies mean more retirees to support Future retirees will live years longer than today’s 65-year-olds, and collect thousands more in benefits.
In the future, fewer workers will support more retirees. As a matter of simple math, when the ratio of workers to retirees falls, each worker must bear a greater financial burden. 2030: 2.1 to 1 Today: 3.4 to 1 1960: 5.1 to 1
Social Security taxes are already high… • The Social Security payroll tax is 12.4 percent of wages. That’s… • An eighth of the average worker’s total wages… • The biggest tax the average household will pay. • That’s enough to pay… • Six months rent on a $700 per month apartment, or… • A full year of student loan payments at $350 per month, or… • A keg of Budweiser every weekend (plus chips!). • And if today’s payroll tax seems high, wait ‘til it rises to 18 percent or more!
…and without reform, they’ll only go higher: by 2030, costs will top 17 percent of payroll.
In that context... • What are key objectives of OTPPB? • Who are key stakeholders? • What conflicts can you envision?
Trends: • People live longer • People work less... • Inflation is low • Wage increases are high • Problems with CPI
Asset side • Efficient frontier analysis • How sensitive is it? • What should be taken into account in diversification strategy?
How to do it? • Let us consider fund’ surplus=Assets-Liabilities, S=A-L • Today S0=A0-L0 • Tomorrow S1=A1-L1 • Pension fund problem is to max S1 • Or..
