The World Bank Sep 2001 Pension Fund Management “IBRD’s experience” Sudhir Krishnamurthi The World Bank Public Pension Fund Management, Washington, DC 24 September, 2001

The World Bank Sep 2001 Road Map  Introduction  Governance of Pension Plans  Strategic Asset Allocation  Middle Office Issues  Performance and Risk Measurement

The World Bank Sep 2001 IBRD (World Bank) Investments  IBRD  $55 billion liquidity  Managed internally  Many instruments  Pensions  $10 billion for Pension and others  Managed externally  Many asset classes Provide Financial Technical Assistance

The World Bank Sep 2001 Financial Instruments Fostered innovation in supporting services IBRD Pensions Futures & Forwards Swaps  Interest Rate  Currency  Structured Other Synthetic Products Bonds - issuance & trading (incl. EMG) Equities  US  Non-US  EMG Other  Hedge Funds Private Equities (EMG) Real Estate Fixed Income  Global  High Yield  EMG

The World Bank Sep 2001 Fund Governance  Macro Governance  Oversight Structure  Responsibilities  Micro Governance  Delegation of Authority  Conflict of Interest  Cost of Governance  Governance of country systems

The World Bank Sep 2001 Governance  Why Governance  Owner of assets  Principal  Manager of assets  Agent In a principal/agent relationship, principal has to ensure agent is acting in his best interests

The World Bank Sep 2001 Governance Clear distinction between governing and governed bodies  Who needs to be Governed  Pension investment groups, fund managers  Who does the Governing  Ideally, the principals or pension beneficiaries  Usually, a representative body like the oversight committee or regulators

The World Bank Sep 2001 Governance Organization Structure The Regulators take role of Oversight Committee in DC plans Equities   oversight  benchmark  guidelines  monitoring Governing Body Governed Body Currency Private Equities Cash Real Estate Fixed Income Oversight Committee Investment Staff/External Managers

The World Bank Sep 2001 Governance Macro Issues  Composition of Oversight Committee  Selection method  Size  Representation  Turnover  Frequency of meeting  Responsibilities of Oversight Committee  Select investment staff and external managers  Set Investment Policy  Oversee Investment Policy Implementation  Monitor Investment Performance  Overall Fiduciary Responsibilities

The World Bank Sep 2001 Governance Macro Issues  Composition of Investment Staff  Finance Professionals  Accountants  Quantitative Specialists  Actuaries  Responsibility of Investment Staff  Funding Recommendations  Investment Management  Risk Management  Reporting

The World Bank Sep 2001 Governance Micro Issues  Delegation of Authority  Explicit and written  Implementation of Investment Policy  Conflict of Interest  Permissible and Non-permissible transaction  Disclosures  Code of Ethics Responsibility for the Development of Investment Policy and its Implementation be separated

The World Bank Sep 2001 Governance Cost of governance Governance must be just right - not too little and not too much  Delays  False sense of comfort - especially if oversight committee is not paying attention.  Cost of providing adequate information to oversight committee/regulators.  Ensuring timely/appropriate feedback on decision to oversight committee/regulators.

The World Bank Sep 2001 Governance Country Systems Provident Fund (PF) Individual Provident Fund Oversight Committee NO Defined Contribution (DC) Individual Fund Manager Regulators YES Defined Benefit (DB) Government Social Security Administration YES Agent Oversight Incentive compatible Principal

The World Bank Sep 2001 Investment Decisions Decision 1: Determining asset allocation policy mix (Strategic Asset Allocation) Portfolio construction & manager selection Tactical Asset Allocation Decision 2: Decision 3:

The World Bank Sep 2001 Importance Investment Decisions Sources of Long-Term Performance As much as 91.5% of performance attributed to Strategic Asset Allocation Source: Brinson, Hood & Beebower. “Determinants of Portfolio Performance” Financial Analysts Journal. May/June Note: Cross products account for 2.1% of the variance Tactical Asset Allocation 1.80% Other Factors 2.10% Security Selection 4.60% Strategic Asset Allocation 91.5%

The World Bank Sep 2001 Assets and Liabilities Liabilities are unique for every pension plan Liabilities are the only reason for a pension plan to make investment choices Pension fund assets, in $ billions, annually Ratio of assets to liabilities, annually Note: Figures include a majority of private pension plans (45,000) Source: Pension Benefit Guaranty Corp. U.S. Pension Funds:

The World Bank Sep 2001 Mean - Variance Efficient Frontier Is standard deviation meaningful as risk tolerance measure for pension plans 6.00% 7.00% 8.00% 9.00% 10.00% 11.00% 5.00%7.00%9.00%11.00%13.00%15.00%17.00%19.00%21.00% Risk - Standard Deviation Return - Mean Traditional approach to Strategic Asset Allocation Market Portfolio Capital Market Line Asset Allocation Risk Tolerance determines Asset Allocation

The World Bank Sep 2001 The Pension Problem Traditional asset allocation approach does not take liabilities into account Asset and Liability matching problem Yearly Outflows  Current retirees Future Outflows  Future retirees Yearly Inflows  Contributions  Employees  Employer  Return on Assets Current Assets LIABILITIESASSETS

The World Bank Sep 2001 Risk measures for Pension Plans  Pension Plan investors have many other risk measures besides standard deviation of expected returns.  The appropriate risk measures for pension plans depends on the parties that are involved in the decision making process.

The World Bank Sep 2001 Different objectives Objectives of parties concerned with pension plans Objectives dictates the risk measures and risk preference PLAN SPONSOR Low and stable contributions PENSION FUND REGULATING AUTHORITIES Solvency requirements EMPLOYEES Maintaining pension scheme CENTRAL GOVERNMENT Reduction public pensions RETIREES Maintaining compensation cost of living Source: Ortec Consultant BV

The World Bank Sep 2001 Objectives and Risk Measures Risks: I. Low funded ratios II. High contribution rates World Bank’s Pension Plan Maximize Return (max. wealth of plan) II. Avoid high contribution rate levels I. Avoid low funded ratio levels (ratio Asset to Liabilities)

The World Bank Sep 2001 Mean - Variance Efficient Frontier Risk Return - Wealth Asset Liability Management approach to Asset Allocation Market Portfolio Asset Allocation Risk (as measured by st. dev.) determined by: Maximum Contribution Rate Minimum Funded Ratio Asset Allocation reflects risk bearing capacity of the pension plan

The World Bank Sep 2001 Operationalize Risk Measures  5% Funded Ratio - at - Risk  Minimum funded ratio that can occur in any year with a 5% probability  5% Contribution Rate - at - Risk  Maximum contribution rate that can occur in any year with a 5% probability Variants of the value-at-risk concept Use multiple years for calculation of these risks (in this example 10 years)

The World Bank Sep 2001 Investment Decision Matrix Total allocation to risky assets 60% 70% 60%80% 90% 80% 85% 5% FUNDED RATIO - AT - RISK 19% 25% 22% 5% CONTRIBUTION RATE - AT - RISK Risk budget to these value-at-risk measures determines investment policy

The World Bank Sep 2001 Investment Decision Example Budget: Funded Ratio-at-risk = 85% and Contribution Rate-at-risk = 22% Shaded area shows investment policies which are conform with risk budget 5% Contribution Rate-at-risk 5% Funded Ratio-at-risk 92.5% 14% 87.5% 82.5% 22% 30% 18% 26% 90.0% 85.0% 60% 80% 70% 70% allocation to risky assets

The World Bank Sep 2001 Middle Office Issues For each external manager and entire portfolio Contracts v standardized v adequate protection Guidelines  development v compliance v monitoring Performance Measurement v frequency v attribution Accounting & Reporting  management v internal Controls v risk management v cash management v local/global custody

The World Bank Sep 2001 Why Risk Management and Performance attribution  Identify unsustainable downside risk.  Identify the sources of excess return  Support asset allocation by trading off risk and return.

The World Bank Sep 2001 Sizes of Risks Value - At - Risk Tree Asset Liability Risk is main risk and is taken by the oversight committee Liabilities Investment Benchmark Extended Policy 1, ,776 Actual Portfolio  =  = $, million

The World Bank Sep 2001 TAA and Active Risk Risk measured as tracking error against the strategic benchmark 177 TOTAL RISK 83 TAA - Risk 125 Active - Risk 40 Equity 45 Fixed Income 60 Others 100 Equity 20 Fixed Income 50 Others 10 US - Equity 120 Non US - Equity 15 High Yield 10 Global FI 0 Real Estate 50 Hedge funds 55 US - Equity 45 Non US - Equity 30 High Yield 7 Global FI 100 Hedge funds 15 Real Estate

The World Bank Sep 2001 Monthly Performance Attribution Performance in same format as risk enables evaluation of risk and return of each investment decision 50 TOT. PERFORM 15 TAA-PERFORM 35 Active-PERFORM 20 Equity 5 Fixed Income -10 Others 25 Equity 5 Fixed Income 5 Others 10 US - Equity 15 Non US - Equity 5 High Yield 0 Global FI 0 Real Estate 5 Hedge funds 15 US - Equity 5 Non US - Equity 0 High Yield 5 Global FI -20 Hedge funds 10 Real Estate