Worldwide Country Bonds Overview

Country Bond Rates are decreasing. As global debt is still increasing, trust is declining. 'Counterparty Safe Cash'  is what's becoming more and more important. Prepare for getting used to negative interest rates!

BTW: If you can't hold your breath, go to the end of this blog and click one of the tabs to get an updated worldwide overview of actual country bond interest rates.

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What's up?

Countries with a high inflation (e.g. Brazil, India, China) or countries (e.g. Portugal, Ireland, Spain) that can't control and therefore have to finance their increasing debt at high interest rates, still show optical interesting interest rates for investors... So it seems, as these relative high interest rates are in fact 'compensation for inflation' or 'hidden default premiums'.

And of course we have countries (e.g Greece), who's interest rates show that they have in fact gone broke.

Unfortunately non of the EU countries dares to pull the plug...  From a risk management perspective: Living in a nuclear financial death zone, apparently is a better option than pulling the trigger in the knowledge that not only your Greek brothers but also YOU will be 'financial dead' for sure.....

Still the Greeks get away with this non compliance strategy, let's call it:

Greek Risk Management

Last but not least we have the strong countries like Denmark and Germany with low interest rates. These countries have to carry and finance their weaker brothers short term. So it all comes down on cash and counterparty risk.

The rhetorical question in this European business case is:

Can Germany finance a Europe that fails to restructure their debts in a sustainable way?

Country Bond Interest Rates in alphabetical order

Let's examine those interest rates as reported by Bloomberg, at the end of July 2012 in alphabetical order:

It's clear that country bonds interest rates vary widely across countries.

White spots in the table imply, there's no (Bloomberg) data available.

Let's bring some order in this bond-muddle, by ranking the countries on basis of their 10Y Bond yield.

Country Bond Interest Rates sorted by '10Y' Bond Rate

From the above chart it is clearly visible that

• Germany, Denmark and The Netherlands already enter the negative interest rate zone for 1 and 2 year bonds.
• Greece, with a phenomenal interest rate, is is completely burned up
• The Eurozone is split up in good and bad performing countries
• A strong, sustainable and relatively independent country like Switzerland has 'low short term', as well as 'low long term' interest rates.
  This must for sure be a warning to every investor to estimate long term interest for other countries  much higher on the long term. Perhaps the relatively higher long term interest rates of other countries resembles the implicit (extra) inflation expectation on the long run.

Mattress Money

As debt keeps increasing, economic growth in western countries is limited and modest inflation continues, short term interest rates will stay low for the near future (until the end of time inflation beast is released).

With an increasing 'cash demand' from weak performing countries, we have to learn to get used to negative interest rates in relatively more strong performing countries.

In other words, consumers and professional investors have to pay to put their money in the bank. Why not keep your money under the mattress?

For consumers this might perhaps be a risky (theft) solution  to consider. Professional investors however, have to reduce counterparty risk which demands first class collateral assets.

Therefore "mattress money" is no option for professional investors and (increasing) negative interest is the price these investors will have to pay for keeping more and more cash as debt and risk keep rising.

Desperate advice ;-)

Perhaps - just like World War II was financed by War Bonds - we should appeal to private investigators and consumer to fund the government in their desperate war against debt.... government debt ...

 But then.... who would be willing to invest?

Actual Country Bonds Interest Rates

Are you interested in following the actual country bonds interest rates, than bookmark this blog or the special Actuary-Info Actual Country Bond Rates Page, and come back once in a while to view the latest bond interest developments by clicking on one of the next tabs (have a few seconds patience, loading 150 (!) bond rates takes some time).

Actual Country Bond Interest Rates (Alphabetical)

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Actual Country Bond Interest Rates ('10Y' Sorted)

Update 2013 
Bloomberg stopped publishing a lot of bond rates. That's why several bond rates are missing. Sorry.

Hope you enjoyed this holiday blog...

Related Links/Sources

- View & Download 'Google Country Bond Rates Spreadsheet'
- Actuary-Info Actual Country Bond Rates Page

- View Google Country Bond Rates (Alphabetical)HTML and Bookmark!

- View Google Country Bond Rates ('10Y' Sorted)HTML and Bookmark!

- Bloomberg, Worldwide Best Financial Data Supplier 

- IS - LM Model Wikipedia

- On Negative Interest Rates (2012)

Humor: Actuarial Marriage Advice

It's an intriguing topic: Do you indeed live longer if you marry a younger woman?  Or is this kind of party talk total nonsense?

This time an 'actuarial marriage counseling blog' that gets serious  about this hilarious topic of age differences and mortality......

Research speaks...

While it had long been assumed that women with younger husbands also live longer, in a 2010 study Sven Drefahl from the Max Planck Institute for Demographic Research (Rostock, Germany) has shown that this is not the case.

Some interesting an remarkable conclusions from Drefal's study:

• A woman's life expectancy is shorter the greater the age difference from her husband, irrespective of whether she is younger or older than him.
• However, the younger his wife, the longer a man lives. 
• Women marrying a partner seven to nine years younger, increase their mortality risk by 20% compared to couples where both partners are the same age. 
• But the mortality risk of a husband who is seven to nine years older than his wife is reduced by 11%.
   

Drivers

It's strongly doubtable if this mortality advantage of a man marrying a younger wife, is the reason why, according to Okcupid, a man - as he gets older - searches for relatively younger and younger women.

In general a man of age X searches a women with a lower limit age Y of :

Y = 0.5X + 7

Men, don't search a woman beneath this lower limit age border, unless you want to end up as sugar daddy........


What about women?
For women it's quite different:

In general women search for an older man. But as they grow older this effect shrinks.

Conclusion

Actuarial marriage advice is rubbish...
Don't follow statistics if you want to marry someone, follow your heart! ;-)

Related Links & Sources:
- Max Planck Institut: Marriage and life expectancy (2010)
 - OKCUPID: The Case For An Older Woman
- CBS News :Age gap Deathly (2010)
- Sugar daddy diagram ;-)

How to Stretch 'One Point Estimates'

So called 'One Point Estimates' (OPEs) fill up our lives, but are useless without context. What can we do?

Some common real live OPE examples: 'Speed Limit 100', 'Temperature 70° ', 'Post Stamp 33', etc....

To give 'estimates' meaning, we have to put them in context:

• To define a post stamp value, just a simple number on a post mark isn't enough. We need more information, like currency, country, date, uniqueness and 'stamped' or 'not-stamped' information to determine a more precise value of a certain stamp.
• A speed limit of 100 has only meaning if you know if it's measured in Mph or Km/h.
• If you measure the temperature it's important to know whether you measure in ℃ or in ℉.

Stretching Technique

From now on if you're confronted with a 'One Point Estimate' in life, ask yourself the next question:

How can I stretch a one dimensional One Point Estimate
into a two dimensional graphic in more than one way?

The way to stretch a point, is to stretch your mind.
Let's tak a look at a simple example.

Application:Pension Funded  Ratio

Level 1: Your pension fund reports a 90% Funded Ratio

Just reporting a 90% Funded Ratio (FR) is in fact no-information. It's what I call a 'One Point Estimate' (OPE) that hardly adds any relevant information to you as a pension fund member.

At the best, it only raises questions.

More likely, this information leads to misunderstanding, confusion or even panic.

Level 2: The Funded ratio reported on a time scale

Reporting values on a 'time scale' is often the first attempt to stretch information in order to enable pension fund members to gain insight into the (future) development and direction of the funded ratio.

This kind of reporting gives pension fund members an idea about the short term variance and direction of the funded ratio, but still lacks information about 'how' and 'why'.

Level 3: Reporting values as function of their dependent variable(s)

On this level the added value of stretching an OPE becomes really visible.
Key question you have to ask yourself is:  what are the main variables that influence the outcome (funded ratio) most?
As the expected future return and/or discount rate is one of the most relevant variables, it's illustrative and clarifying to express the funded ratio as a function of for instance the discount rate.

By doing so, every pension fund member can conclude that (in this case) the pension fund needs a future return of at least 4% p.a. to meet its obligations and that the 'solution area' (triangle 'A'), gives visible information about the 'space' or room for future indexation or pension-improvement at higher return rates.

Level 4: Adding additional information 1:Future Longevity Effect

Our two-dimensional diagram is now enriched with additional information of other vital variables that influence the pension funded ratio outcome.
We start with the estimated effect of future longevity development.

As pension fund members can note, the solution triangle area 'A' is now substantially reduced and a minimal return of (in this case) 5% is needed to fund pensions in a sustainable way.

Level 5: Adding additional information 2: Confidence level (CL)

Next, several confidence levels, based upon (future) regulatory demands, are plotted in the diagram.
For example, we may plot:

•  the 97.5% confidence level (CL) as current risk appetite of a specific pension fund (is it enough?)
• the 99.5% CL European insurers have to meet in Solvency II demands. As Solvency demands will probably also apply for pension funds in the near future, this level becomes relevant in a proactive approach.
• The 99.5% CL that's applicable in Basel III demands for Banks.

In this case it becomes visible and clear to every pension fund member (and probably also every pension fund board member!), that 'more secure confidence levels', as well as 'future upcoming regulatory confidence levels' demand unrealistic high returns of this pension fund under study. As the confidence level increases, the solution area 'A' stepwise shrinks to zero.

In this specific case the pension fund has no other choice than to lower its future pension rights or to accept a higher risk of not meeting its pension obligations.   

Key Question
Key question for YOU: Have you done the above exercise with your pension fund?

Pleas answer this question Honestly...
If the answer is NO, just keep on hoping things will turn out for the best......

By the way, you don't need to be an actuary to ask your pension board to inform you by means of the above formulated simple diagrams. I hope you get clear answers...

What's the difference between 'Pension Board' and 'Pension Bored'?

Practice Check: NYSCRF

Let's reflect  the above approach on the third-largest public pension fund in the United States, the New York State Common Retirement Fund (NYSCRF)

First, just watch the next video in which New York State Comptroller Thomas P. DiNapoli tries to explain that based on the fact that NYSCRF has 'worked' for more than 90 years, it will continue to work for many years to come. 


Although Thomas DiNapoli probably does his utmost best and tries to reassure us that  NYSCRF is fully  under control, communication and taken measures unfortunately do not underline this standpoint:

NYSCRF Communication Fact Findings

• Annual reports and additional communication mainly report about the asset side of the balance sheet and not about the liability side
   
• No Mission Statement or Strategic plan can be found on either the NYSCRF-website or in the annual report (how to steer without a general target?)
   
• No risk appetite is communicated and no confidence levels are publicized, communicated or mentioned in the annual reports.
   
• 
  Merely a level-2 kind of information about the 'Funded Ratio' is given in the NYSCRF annual 2011 report, without any consequences.
  
  Although the Funded Ratio is rapidly declining, the annual report does not transparently explains 'why' and 'what can be done about it'.
   
• No mentioning of the possible effects of available PEW information that the Governmental Accounting Standards Board (GASB) is considering new rules that would decrease the funded ration substantially

Redefine Pension Fund Governance
It's clear that not only communication about state pensions needs to be improved (complete, balanced and structured), but also 'pension governance' has to be redefined to  a more general and strategic level where a vision, mission statement and a strategic plan are defined and where responsibilities and power of the comptroller are set  'in line' with these documents.

Until now, Comptroller Thomas DiNapoli 'is responsible for making sure the CRF meets its annual performance benchmarks'.

It's clear that this definition does not cover an overall responsibility to ensure a healthy sustainable pension system in the future.

Comptroller DiNapoli must be given 'full control' in order to do his job well. His responsibilities and targets must not be limited to the performance of just the asset side of the balance sheet.

Last but not Least

If the upcoming GASB rules are adopted, as expected, retirement plan funding ratios would drop dramatically. The Center for Retirement Research (CRR) found that if the new rules had been in effect in 2010, funding levels would drop from 76% percent funded to 57%.

In short the CRR-Report sets (in summary) the new pension tone:

• Under the GASB standards, state and local plans generally follow an actuarial model and discount their liabilities by the long-term yield on the assets held in the pension fund, roughly 8 percent.
• Most economists contend that the discount rate should reflect the risk associated with the liabilities and, given that benefits are guaranteed under most state laws, the appropriate discount factor is closer to the riskless rate.
• The point is not that liabilities should be larger or smaller, but rather that the discount rate should reflect the nature of the liabilities; the characteristics of the assets backing the liabilities are irrelevant

In case of the New York City Employee Retirement System (ERS) new GASB rules would imply a decrease in funded ratio from 77% to 50%.......

Final Conclusions:

1. Take adequate measures before its too late
2. Get realistic and Honest, with ourselves and to others

I guess it all comes down on Honesty, as Billy Joel already stated..




Used Sources & Related links:
- NYSCRF 2011 Comprehensive Annual Financial Report (PDF)
- PEW Report (2012)
- Interactive ' funding of pensions and retiree health care' (2010)
- Wisconsin proves the lie of Pew pension numbers (2012)
- CRR Report: How would GASB affect pension reporting? (2012;PDF) 

Gold as Investment

Financial institutions have to optimize ‘Risk – Return’ and diversify their portfolio. This (strongly interactive) presentation by CEO and Actuary Jos Berkemeijer, supports the power of Gold as the best asset class to optimize ‘Risk – Return’ in a given portfolio.

Just widen your knowledge about monetary gold by examining  the next  presentation given on June 19 2012 as a 'Johan de Witt Lecture' before 60 in gold interested actuaries of the Dutch Actuarial Association (Actuarieel Genootschap, AG), the professional association of actuaries and actuarial specialists in the Netherlands.

With the help of a button (""ACTuary NOW" ), Jos Berkemeijer calls for action by actuaries on several main issues . 

Gold as InvestmentGold as Investment

Default Risk at Risk

What's the default rate of Europe?
Let's try to answer this question by examining the (spread on) 10 year Government Bonds for different European countries.

Some simple observations:

• A Diverging Europe
  The above chart clearly shows that EU-country interest rates are diverging. The 'spread' between relative financial healthy countries and their weaker brothers is increasing.
   
• A strong EU Base?
  Key (rhetorical) question  is whether the low interest rates of countries like Denmark, Sweden and Germany are the result of their strong economic performance or the effect of fact that other EU-countries are in real trouble...
   
• Rewarding Debt
  The current real interest rate of  relatively 'healthy' countries (interest rates less than 2%) is negative at long term inflation levels between 2% and 4%.
  Negative real interest rates imply a non-sustainable  debt rewarding economic system for governments and banks. Perhaps most important: in a negative real rate economy financial institutions like pension funds, lose their rationale for existence!!
  
  
• Risk Free Rate?
  Also remarkable is that these low interest rates are far under what was once qualified as risk free rate (3%-6%, whatever.....)

Risk Free Rate In order to be able to calculate a country's default probability, we need to estimate the so called 'risk free rate'. As I've Illustrated earlier (how to catch risk)  the idea of a 'risk free rate' is an illusion: Every asset has some kind of risk Relative Risk However risk could be relatively defined from one country to another. In order to do so, let's analyze a more worldwide picture (table on the right) of 10-y bond rates on June 1 2012. From this table we may conclude that the best risk free country 10-year  bond rate is the 0.55% Swiss rate. As we know that even this rate is not completely free of risk, let's not settle for the traditional  mistake of  'one point estimates', but calculate a country's default risk on basis of different risk free rate levels, varying between 0% and +1%. Calculating Country Default Risk A country's semiannually paid default risk (dh) can be calculated from a country's 10-year (semiannually paid) Bond Rate (semiannually paid coupon rate = ch ) and a semiannually paid Risk Free Rate (semiannually rate = rh) on basis of the next relationship: leading to: Expressed in the yearly semiannually paid coupon rate (c=2.ch) and risk free rate (r=2. rh): Finally resulting in a formula (1) regarding the one year default risk (d):

Country 10Y Bond (%) Greece 30.83 Pakistan 13.27 Brazil 12.55 Portugal 12.03 Hungary 8.71 India 8.5 Ireland 8.21 South Africa 8.2 Colombia 7.6 Peru 6.76 Spain 6.56 Indonesia 6.51 Mexico 6.04 Russia 6 Italy 5.92 Poland 5.45 Israel 4.46 Thailand 3.78 South Korea 3.69 Malaysia 3.55 New Zealand 3.54 China 3.38 Czech Republic 3.27 Belgium 2.94 Australia 2.9 Norway 2.38 France 2.36 Austria 2.12 Canada 1.76 Netherlands 1.61 United States 1.58 United Kingdom 1.57 Finland 1.49 Singapore 1.46 Sweden 1.29 Germany 1.2 Denmark 1.03 Hong Kong 1 Japan 0.82 Switzerland 0.55

Now, let's calculate the default risks for the top-5 worrisome EU countries given a risk free rate of 0%:

	Greece	Portugal	Ireland	Spain	Italy
10Y Bonds	30.8%	12.0%	8.2%	6.6%	5.9%
1YR Default Risk , r=0%	24.9%	11.0%	7.7%	6.3%	5.7%
1YR Default Risk , r=1%	24.2%	10.1%	6.8%	5.3%	4.7%

As is clear from this table, in practice there's no substantial impact-difference between a 0% or a 1% risk free rate, with regard to calculating a one year default rate.

This helps us to define a really simple rule of thumb to translate a 10Y Bond rate (c) into 1 year default rate (d) at a 0% 'free interest rate level' :

Examples

• 10Y Bond rate = 30% =0.3
  d= 0.3 -0.3*o.3/2 = 0.3 - 0.045 =0,255 ≈ 25%
   
• 10Y Bond rate = 10% =0.1
  d= 0.1 -0.1*o.1/2 = 0.1 - 0.005 =0,095 ≈ 9.5%
   
• Higher risk free rates  (r>0%)
  At higher than 0% risk free rates, simply subtract the risk free rate from the default rate, to find the default rate at that higher risk free rate.
  Example: Risk free rate = r =1%, 10Y Bond Rate = 30% : d ≈ 25%-1% ≈ 24%
   
• Compare country relatively default rates
  10Y Bond Rate Ireland = 8.21%
  10Y Bond Rate Greece = 30.8%
  Probability (d) that Greece defaults relatively more than Ireland:
  d ≈ 0.31 -0.5*0.31^2 -8 ≈ 0.18 ≈ 18% (more exact formula 1: 18.62%)

Of course we have to realize that all this hocus-pocus 'default math' is only based on strongly artificial managed market perceptions.... Probably the real default rates of Greece are much higher than 25%. In other words:

                               Default Risks are at Risk

N-year default probability
For those of you who still believe that financial Europe will survive, let's calculate default probabilities for more than one year. In formula the N-year default probability (d_N) can be defined as:  d_N = 1-(1-d)^N

Conclusion

There's no hope for a Greece Euro-survival. Main problem is that even if Greece's debts would be covered by the stronger EU countries, Greece is not in the position of realizing a financial stable and positive economy.

Other financial weak and 'temporarily more or less out of the spotlight' countries like Portugal, Ireland and Spain will follow. No matter the development of default rates, it's an illusion to think that Germany is financial able to carry Europe through this crisis. Perhaps it's time to introduce country linked euros like the DE-Euro.......

Related Links
- Download Excel Spreadsheet used for this blog
-  On line Bond Default Probability Calculator
- Greece’s bond exchange
- Actual 10Y Government Bonds (all countries)
- The Greek debt crisis and the hypocrisy of the EU bureaucrats (2010)

Risk Manager Test

Risk Manager is THE profession of the future.

For all (young) actuaries, econometricians and other talented whizzkids who are considering to become a Risk Manager, here's the ultimate test...

Find out if you really have more risk management talent than an average Duck Risk Manager.

Perhaps even some more experienced Risk Managers dare to risk their reputation by taking the test as well........ 

Risk Manager Test 

Imagine you're a risk manager during World War II...

Allied pilots are bombing targets in Germany. Most bomber airplanes come back with heavy damage, some even don't come back at all. Therefore it is considered important to protect bombers with extra armor.

As there is only very limited supply of retrofitting armor, you as a risk manager are hired to determine where this extra armor is best placed on a plane.

In order to find out the vulnerable parts of the plane, you mark every bullet hole of every plane that comes back from a bombing mission as a red dot on a plane-bullet-hole diagram.

After having observed more than 50 planes coming back, you end up with the next diagram:

Instruction
Please point out in detail the most important places where you as a risk manager, would put the armor on the plane.

READY?.......

To find Out if you passed the Risk Manager Qualification Test please press on the answer button.

ANSWER

Aftermath

The risk manager in this test actually exists. During WWII, the Hungarian-born mathematician Abraham Wald undertook a study with the British Air Ministry to use statistical analysis to help protect bombers flying over enemy territory. The data to be crunched included the number and location of bullet holes on returning aircraft, and the goal was to use this information to determine where to best add armor to the plane's structure.



Sources & Related Links
- Abraham Wald : original Report
- Abraham Wald's Work on Aircraft Survivability by Marc Mangel 
- The hole story: What you don't see will kill you 
- UK Bombers in WWII (pictures)

Strategy Outsourcing

Most Pension Fund Boards are sincerely convinced they define their strategy on basis of their own insights.....

In practice, the leading Investment Consultant - as trusted advisor - often has a strong influence on the board.

Very often the authority of the Investment Consultant is so dominant that it's "not done", permitted or 'seen as wise' to discuss the advice of the consultant. Nor is a second opinion seen as appropriate, as it might be regarded as a matter of distrust in the trusted advisor relationship.....

Unfortunately in these situations it is quite often the Investment Consultant, instead of the Pension Find Board, who implicitly defines the Strategic Plan, Risk Appetite and Asset Mix......

Of course this doesn't apply for YOUR Pension Fund....

In this case DON'T view or download the next power point presentation 'On how Strategic Advice got Outsourced'....
Strategy Outsourcing

Scroll through the presentation by pressing the right arrow button.

Confidence Fallacy
Last but not least: As most Investment Consultants advice more than one pension fund, it is not unlikely that a lot of pension funds get more or less the same kind of advice. This might give pension fund board members a false notion of confidence with regard to their (own) chosen investment strategy.

All the more reason to be extra vigilant that the chosen strategy is finally YOUR strategy and not that of your consultant......

Remember.....  Never Ever Outsource your Strategy!

Related Links 
- Download PDF: On how Strategic Advice got Outsourced
- Donald Duck Search Images 

Standard Deviation, a Poor Measure of Risk

As actuaries and/or risk managers we've been professionally brought up with some deep-rooted assumptions about what 'risk' is....

Difference between Science and Religion
One of my favorite statements is that there is no fundamental difference between a religion (believe) or science. Both depend on a number of axioms, the basic assumptions. Assumptions, we 'believe' or 'take for granted' on basis of our intuition and/or personal experience. Only by means of those axioms we're able to 'prove' other theorems in our system or model.

So what we have to conclude is that what we prove in our our statistical models, is as strong as the foundation (assumptions) on which our models are based.

Main problem is that the assumptions in our models are so trivial and often so frequently implicitly used, that we don't realize their impact. We've developed a blind spot.......


Risk Axioms
With regard to 'risk' I'll just discuss two of the most dangerous (risky ;-) ) assumptions on which most of our investment risk models are build:

1. Risk = Standard Deviation (SD)
2. Mean Reversion
   The theory that a given value will continue to return to an average value over time, despite fluctuations above and below the average value.

Explication

Risk is a much wider concept than just 'standard deviation'.
First of all there's an 'impact difference' between a downside risk and an upside risk. In general, what we perceive as risk is more in terms of downside risk. But yet..., we keep measuring and concluding  about risk on basis of 'standard deviation'.

Why SD Fails as a measure of risk
To illustrate the failure of Standard deviation (SD) as a measure of risk, take a look at the next example in which we compare the performance of two different asset classes, AC-I and AC-II, with the next characteristics:

• AC-I and AC-II have the same average (compound) return of 2.5% per year
• AC-I has a Standard Deviation of  13,9% and AC-II a SD of 27%
• AC-I has a maximum deviation of minus 40.0% and AC-II of 76.3%

By definition AC-II is more risky than AC-I.....

However.., a two year old child will point out AC-I as far more risky than AC-II. First, downside deviations are  more risky than upside deviations and secondly, the 'incremental downside risk' of AC-II can be 'managed' much more effective than the 'crash downside risk' of AC-I.

Conclusion
The times of modeling risk on basis of Standard Deviation are over. We need more sophisticated models that describe and measure risk multidimensional and with respect to downside risk and not upward potential.

Let's conclude with a final question to test your 'stock crash insight'.

What was the worst performance of the S&P 500 and in which year?

Click on 'answer' to find out!

ANSWER

Read more about the S&P 500 performance on: S&P 500 Five Worst One Year Performances (in %)


Related Links
- Actuary-Info: Equity Returns and Mean Reversion (2010)
- Risk is more than standard deviation (2005)
- Our Monetary Blind Spot
- Black Ducks Comic Strips

Why Life Cycle Funds are Second Best

Life Cycle Funds (LCFs) are seen as the ideal solution for pension planning. Unfortunately they aren't..... They're Second Best....

Pension Funds solutions (PFs), are far more superior to LCFs, as will be shown in this blog with regard to the performance of a pension plan.

Life Cycle

A Life Cycle approach presumes that, while your young and still have a long time before retirement, you can risk to invest more than an average pension fund in risky assets like stocks, with an assumed higher long term return than bonds,

As you come closer to the retirement age, you'll have to be more careful and decrease your stock portfolio incrementally to zero in favor of (assumed) more solid fixed income asset classes like government bonds.

A well known classic life cycle investment scheme is "100-Age", where the investment in stocks depends on your age. Percentage stocks = 100 -  actual age.
E.g.: If you're 30 years old, your portfolio consists of 70% stocks and 30% bonds.

Here's what the average return of a life cycle '100-Age' investment looks like when you start your pension plan at the age of 30 and assume a long term 7% average yearly return on stocks and 4% on bonds.
The return of this life cycle fund is compared to a pension fund with continuously 50% in stocks.

Key question is however, is the younger generation also risk minded and the older generation risk averse?

As often in life and also in this case, what would be logical to expect, turns out just to be a little bit more complicated in practice....

Misunderstanding:Younger people have a high risk attitude
Research by Bonsang (et al.; 2011) of the University of Maastricht and Netspar shows that on average 25% of the 50+ generation is willing to take risk.

 The research report shows evidence  that  the  change  in  risk  attitude  at  older age  is driven by 'cognitive decline'.  About 40 to 50% of the change in risk attitude can be attributed to cognitive aging.

Unfortunately other recent research also shows that only 30% of people under age 35 say they're willing to take substantial or above-average risks in their portfolios (source:Investment Company Institute).

This implies that -  although they would theoretically be better of on the long run - younger people will certainly not put all their eggs in one basket, by investing all or most of their money in stocks.

Pension Fund Investment Horizon
In contrast to individual pension member investors, a pension fund has a long term perspective of more than 20-50 years as new members (employees) keep joining the pension fund in the future. Therefore a pension fund can keep its strategic allocation in stocks relatively constant over time instead of decreasing it.

This implies that a pension fund on the long term has an advantage (longer horizon) above a life cycle fund. Let's try to find the order of magnitude of this difference.


Comparing a Life Cycle fund with a Pension Fund
First of all, we have to take into account that younger people will not over invest in stocks.

Let's assume:

• A 30 year old 'pension plan starter', retiring at age 65
• Contribution level   (€, $, £, ¥,): 1000 a year
• A long term 7% average yearly return on stocks and 4% on bonds
• Life Cycle Investment scheme
  A modest 50% stocks, with a yearly 2% decrease as  from age 50
• Pension Fund Investment Scheme
  A constant 50% investment in stocks (and 50% in bonds)
• Inflation 3%, Pension and Contribution indexation: 3%

 This leads to the next yearly return of these portfolios, as follows:

To find out the overall difference in return between LCF en PFS, we calculate the Return on Investments (ROI) of both investment schemes with help of the:

Pension Calculator

The outcome looks like this:

As you can see the ROI outcomes (left axis) on the investments (yearly contribution) from 'dying age' 65 to age 69 are negative as the cumulative payed pensions (compared to your contribution) didn't (yet) result in a positive balance. Or to put it in another way, if you die between age 65 and 69, you died too early to have a positive return on your paid contribution.

Overperformance
The right axis shows the difference between the LC ROIs and the PF ROIs.
As you may notice,  the pension fund has a structural yearly overperformance of more than 0.3%  and an average overperformance between 0.4% and 0.5% per year.

Overperformance expressed in pension benefits
Expressed in terms of yearly pensions the differences are as follows:

Investment Scheme	Pension at 65	Relative
LC 55year -2% p/y	11673	83%
LC '100-Age'	12304	93%
PF 50% stocks	13172	100%

For a 40 year old pension plan starter, the differences are:

Investment Scheme	Pension at 65	Relative
LC 55year -2% p/y	5359	82%
LC '100-Age'	5578	92%
PF 50% stocks	6040	100%

Conclusion

Investing in life cycle funds ends up in a 7% to 18% lower pension than investing in a pension fund with 50% investment in stocks.


So..., Be wise and choose a pension fund for your investment if you can!


Aftermath
Of course, every pension vehicle has its pros and cons ... So do Life Cycle AND Pension Funds.....

Related Links/Sources
- CNNMoney:The young and the riskless shun the market (2011)
- Cognitive Aging and Risk Attitude (2011)
- America’s Comm. to Ret.Security: Investor Attitudes and Action (2012) 
-  “Saving/investing over the life cycle and the role of pension funds” (2007)
- Excel Pension Calculator Blog
- Benny AND Boone Comic Strips
- Study: Public employee pensions a bargain (2011)

Investment Herding Risk

What was suspected, has now been proved:

Investment Herding Exists!

Dutch Pension Funds are active Traders
In a 2011 research document called "Herd behavior and trading of Dutch pension funds", researchers Rubbaniy, Lelyveld and Verschoor of the Dutch Erasmus University in Rotterdam, provided evidence that repudiates the popular belief that - in specific - Dutch pension funds are long-term passive institutional traders.

De facto Dutch pension funds are active traders and trade about 8.5%  of their portfolio on a monthly basis!

Conclusions

Main conclusions of Rubbaniy (et al.) are:

• Significant feedback trading strategies, both momentum and contrarian
• Robust herding behavior in investments of Dutch pension funds
  Overall (LSV) herding level of 8.14% (significant at 1% level !!)
  On average if 100 PFs are active in the same security in the same month, there are 8.14 more PFs trading on the same side of the market than what would be expected under null hypothesis of random selection of securities.
• Herding asymmetry in buying and selling of securities
  Across asset classes there is a higher degree of herding in less-risky assets.
• Recent financial crises have a positive impact on both turnover and herding while it negatively affects feedback trading.

Explanations
Possible explanations of these herding effects are:

• Possibly outsourcing of portfolio management and small PFs imitation of large PFs’ lead to the same kind of asset allocation strategy.
• Many small Dutch PFs often hire the same large and reputed asset management firms for their portfolio management and are likely to have same asset allocation of their portfolios. 
• Even if they do their own portfolio management, small Dutch PFs may mimic the investment behavior of large PFs - a widespread belief about the small investors - and thus, add to (LSV) herding measure.

Remarks

Let's conclude with some remarks....

• Dangerous Big Brother Hedge
  Although large PFs (investors) have some 'economics of scale' and budget for experimenting on a small scale with (alternative) non-conventional investments, their investment strategy probably strongly differs from a small PF, as liabilities, sponsor obligations and pension benefits conditions are often are fund specific. 
  
  Therefore, following a large PF asset strategy as a small PF, is extremely dangerous and will eventually not turn out to be the 'big brother hedge' the fund was aiming at.
   
• Unfounded First Mover Risk
  Key question remains if all this herding, hedging and active trading results in an outperformance above a long term sustainable asset-location strategy.
  
  Probably not. But although investors pretend tot act on a rational basis, in reality irrational and conformist behavior take the upper-hand. Small investors often don't dare to formulate a unique fund specific asset allocation strategy because of 'first mover risk'.

Keep care and formulate yur own specif pension fund strategic asset mix!

Related Links & Sources
 - "Herd behaviour and trading of Dutch pension funds" (2011, PDF)
 - Momentum or Contrarian Investment Strategies:
    Evidence from Dutch Institutional Investors (2011)
- Momentum and Contrarian Stock-Market Indices