Assumptions that a pension investor needs to make

2023-10-11 at 12:50 Timo Löyttyniemi

A pension investor is called upon to make several assumptions. They are necessary at the system-wide level, for investment activities as well as for determining pension liabilities. What are the key assumptions for a pension investor? What happens if they prove wrong? A panel discussion on this topic was held at a pensions conference in the Netherlands. Here are my own thoughts on this important topic.

Investment beliefs

Pension investors have developed and communicated pension beliefs for a long time. They serve the purpose of clarifying the criteria for investment activities for the investors themselves and others. Typically, investment beliefs tend to be shared by most investors. The beliefs can also be challenged because they are general by nature and do not necessarily hold true for the short term. As such, they usually serve as a guideline for long-term policies and investment allocations.

Investment beliefs are tested in practice by constantly making assumptions serving as a basis for various calculations, usually to optimise portfolio structures and the relative weightings of asset classes.

Promoting responsibility involves assumptions. One assumption could be the belief that a more sustainable company produces better returns or risks are lower. It can also be assumed that the carbon neutrality goals and schedules of governments and companies will be fulfilled. If these assumptions are not fulfilled, the investor can easily make wrong decisions and in that case investment returns may suffer. Of course, if there has been more talk than action in terms of responsibility, no damage has been caused by following the indices.

Pension system design, pension liability and discount rate

The creation of the pension system also includes other assumptions. One assumption is whether the system should be built on a collective basis or based on individual decisions and accounts. Also, the choice of funding is based on assumptions. These assumptions may change over time. Since the perspective is long, any calibration of the system will take a long time.

Pension liability calculations are extremely complex and involve a huge number of assumptions. They relate to age structure, retirement and mortality rates and are derived from a large number of sources. One of the key assumptions, however, concerns the discount rate. It may be a fixed rate or can be derived from market rates, in which case it varies in response to market rate fluctuations. In this respect, individual countries have made different choices. In Finland, the rate is fixed whereas in the Netherlands the discount rate is currently based on market rates.

What if the interest rate assumption proves wrong? If interest rates are sufficiently low, the risks of incorrect assumptions are probably lower as pension liabilities are higher in terms of current value and no false notions have arisen. Choosing a highly volatile market interest rate, on the other hand, forces you to invest at least partly in line with the corresponding interest rate behaviour.

Return expectation

The long-term return assumption, return expectation or return target is probably the main variable followed – and key assumption made – by a pension investor. To determine it, you need to make a wide range of assumptions concerning returns, volatilities and correlations in respect of the various asset classes. While the return assumption seldom hits the bull’s-eye in the short term, it often proves more or less accurate over periods exceeding 10 years. This means that while it is advisable to disregard it in the short term, it may well be used as a basis for the pension system in the long term. Reliability is not perfect but could be sufficient if other adjustment measures are available.

If the expected return turned out to be too low in the long run in comparison to assumptions, this would create a major problem for the pension investor. It would mean that the system was built on a false assumption and required corrective action. Short-term measures would be unfortunate if they were to affect pension benefits or contributions. The easiest solution would be to seek additional income from the market, but that would amount to an additional assumption about the future and in many countries this would not be enough to balance the pension system.

Risk premium

Underlying the return assumption are assumptions about the yields of each asset class above the risk-free rate. The risk-free rate is the short-term interest rate, which in the euro area is currently around 4 percentage points. When calculations are made, it is necessary to determine how much equity investments, corporate bonds, high yield loans, private equity, real estate investments and other similar asset classes will yield above said bond rate. When these are then weighted by asset class, we obtain the expected return for the entire portfolio. For pension investors today, it could be from 4% to 6%, or 2% to 4% in real terms over the long term (more than 10 years), depending on the pension fund, the composition of the portfolio and the assumptions used.

Changes in risk premiums?

The key question for pension investors right now is whether risk premiums are the same as they were a few years ago, when interest rates were much lower, or historically, when economic growth was much faster. Many expect returns to fall slightly in the coming years, but things change at a brisk pace. Interest rates were so low a couple of years ago that low return expectations had a real basis. Now that interest rates have risen by 2-3 percentage points, the key question is whether this rise in rates will be directly reflected in improved overall returns or whether risk premiums will be lower than before? The assumptions concerning these developments will be key questions to be pondered by many pension investors this autumn.

Risk premiums may vary depending on interest rates, the overall market sentiment and market prices. Even if the calculations were completely revised in response to these developments, the new assumptions could also prove wrong.

In conclusion

Pension investors do not modify their portfolios overnight. The assumptions described above may prove right or wrong in the short term. When changes to portfolio structures are made incrementally, the assumptions made or beliefs used in any given year do not result in undue risks or deviations. Small changes accumulate to transform into big ones. Many assumptions turn out to be more certain in the long term than in the short term but any correction to assumptions is also costly.

The writer is VER's CEO Timo Löyttyniemi.

TLö blogi 2020

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