Shortfall risks and pension funds: Are future retirees at risk?
With life expectancy rising, it is expected to pose challenges for future retirees who may outlive their savings. How do we ensure a tension-free retired life for the world’s ageing population?
Investors frequently discuss market, liquidity and currency risks in financial assets. Simultaneously, market investors also face another type of risk known as shortfall risk – the risk that an investment will not be able to meet the returns provided by a benchmark, i.e., the risk-free rate. This risk is encountered by investors worldwide.
For example, suppose an investor places funds in pension funds and achieves an average return of 6% p.a., while the risk-free return during the same period is 7%. In that case, the investor experiences a 1% shortfall. This situation encourages investors to take unnecessary risks, possibly resulting in a lower return.
Many prefer locking all their money in fixed-income investments, considering it safer. However, in such cases, if the value of fixed-income securities starts declining, the value of pension funds can also decrease beyond the established shortfall limit.
Shortfall risks lead to a reduction in the nominal value of a portfolio. Unfortunately, many novice investors do not perceive it as a significant risk. Nevertheless, nominal wealth is less critical than real wealth for pension investors. The ultimate goal of pension funds is to ensure that investors possess sufficient real wealth upon retirement from active employment. If a shortfall occurs, investors often have to reduce their standard of living to compensate for it.
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The demographic transformation, with a growing life expectancy, is expected to pose challenges for future retirees who may outlive their savings. Providing monetary protection for the ageing population is a strategic challenge for most economies. Many economies concentrate their pension fund assets in traditional investment markets such as equities and bonds, heavily relying on volatile and dynamic markets.
It's crucial to remember that the global population is ageing rapidly. A report indicates that the number of elderly people is projected to exceed that of children under ten by 2030 and surpass 2.0 billion by 2050. Ageing negatively impacts the financial security of the older population, previously ensured by company pension plans and government pension funds.
In a defined benefit plan, the employer must guarantee pensioners a minimum benefit, irrespective of portfolio performance. This means the employer bears 100% of the downside risks, with limited benefits from upside potential. Consequently, employers are more concerned about avoiding downside potential than increasing fund returns.
Investing in equities increases the volatility of planned assets. The cost of insuring against shortfall risk (guaranteeing the minimum benefit) rises with increased volatility and the duration of the plan's liabilities. If management lacks superior investment skills, higher returns may not cover increased costs unless the employer can absorb 100% of any pension surplus. Equities are not responsive, even in inflationary periods, if the goal is to hedge the guaranteed benefit.
Since investments are made over an extended period, the risk of a shortfall is significantly reduced. Pension funds must consider their mean age while making investments. Provisions should be directed towards equity if a large percentage of investors are young. Even if there are losses in the short run, stocks provide a higher return in the long run compared to other benchmarks.
It's essential to recognise that shortfall risk should be a crucial consideration in investment decisions, as it doesn't afford investors an opportunity to recover. Failure to understand and incorporate shortfall risks into decision-making can profoundly affect pension fund investors.
National governments in most countries, including Bangladesh (which recently introduced a universal pension scheme), have schemes for their ageing population to provide income in their golden years. However, these plans predominantly favour traditional assets with a low-risk and low-return profile. As longevity increases due to improvements in healthcare and lifestyles, the drawdown period becomes longer. Conversely, as a larger portion of the workforce enters retirement, their contributions to pension plans stop while the drawdown begins.
Is suppressing fixed-income yields worsening pension shortfalls? Conventional pension plans invest in bond markets, a relatively safe bet, with lower profit rates and bond yields declining, resulting in a lower return on investment. Market conditions are not always promising; hence, there is no guarantee of returns, creating uncertainties for future retirees. Additionally, in Bangladesh, a proposed 27.50% tax on the profit of the provident fund of private sector employees could also initiate shortfall risk.
Several steps can be taken to address this challenge. Fund managers must diversify the asset portfolio and take calibrated risks to maximise returns on pension funds, which are declining rapidly. Although these investments typically have a low-risk appetite, a minimum transition period is needed to diversify and enter high-risk, high-return asset classes.
The allocation of funds needs to change, requiring in-depth research on asset classes and a thorough portfolio analysis. Provision and attribution analysis can be employed to scrutinise the portfolio and conduct a comprehensive analysis. Fund administrators' more vigilant and strategic approach involves broadening pension funds from low-risk, low-return to high-risk, high-return asset classes.
Md Harun-Or-Rashid works as a First Assistant Vice President at Social Islami Bank PLC. He is a Certified Finance Specialist and Certified Project Management Analyst.
Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.
