The primary objective of funded pension arrangements is to set aside funds during individuals’ working years so that money is available to support them during their retirement years. In essence, it is a very simple concept and saving for the future has been around for centuries.
When it comes to saving for retirement, there are only three possible sources to generate the required level of funds at retirement. They are contributions, whether paid by the employer, the employee or the self-employed; support from government, either through direct contributions or taxation concessions with reduced taxation rates, direct subsidies or rebates; and investment income received by the pension plans from interest payments, dividends, property rentals, other forms of income and capital gains. In fact, under normal economic circumstances, the investment return generated by a pension plan during an individual’s working and retirement years is by far the most important determinant in the provision of adequate retirement income. Indeed, more than 80 percent of an individual’s retirement income is normally generated by the investment income received due to the power of compound interest and the long term horizons. Such an outcome applies in respect of both defined benefit (DB) and defined contribution (DC) arrangements.
This result means that the asset allocation of pension plans is probably the most important decision made by the plan’s fiduciaries or trustees in their objective of providing adequate retirement incomes. It certainly has a direct effect on all defined contribution members. However, it can also have an effect on defined benefit members as a shortfall in funds, due to poor investment returns, can cause the closure or freezing of these arrangements.
The relative high value for the Other category in some countries is also caused by a range of additional items, including:
- Australia – the net equity of pension funds in life office reserves
- Canada – other mutual funds
- Italy and Korea – unallocated insurance contracts
- Japan – payable and receivable accounts and outward investments in securities
- Germany – loans and other mutual funds
- Estonia – private investment funds
Not withstanding the high value of Other investments in some countries, which include a variety of investments, it is apparent that there is great diversity in the asset allocation of pension plans around the world.
For example, when you allow for the Other category of assets, it is probable that the United States of America, Finland and Australia have at least half of their pension plans assets in equities and other growth assets. By comparison, several countries are likely to have at least 80 percent or 90 percent of the pension plans’ assets invested in bills, bonds, cash and deposits.
On an asset-weighted basis, the importance of equities is even more important than suggested by the graph on the previous page. That is, based on the OECD data, the assets in six countries (Australia, Canada, Japan, the Netherlands, the United Kingdom and the United States of America) represent 89 percent of all pension assets in OECD countries and, with the exception of Japan, all these countries are located in the top half of the graph.
This diverse asset allocation around the world highlights the following fundamental question for all funded pension arrangements:
Given the critical importance of investment return in providing adequate retirement incomes from funded pension arrangements, what is the most appropriate long term asset allocation for pension plans? For more information refer to Chapter 4 (page 17)