Shortfall risks and pension funds: Are future retirees at risk?

Md. Harun-Or-Rashid :

Market risk, liquidity risk, and even currency risk are more frequently discussed when investors invest in financial assets.

At the same time, market investors also face another kind of risk called the shortfall risk (investment which will not be able to meet the returns provided by a benchmark i.e. risk-free rate) faced by investors all over the world.

For instance, if an investor invests in pension funds and averages a return of 6% p.a. whereas the risk-free return during the same period is 7%, the investor has faced a shortfall of 1% which makes investors take unnecessary risk earning for him a lower return.

Many of us are locking all our money in fixed-income investments and very little money is invested in equities (a safer approach).

However, in such cases, if the value of the fixed-income securities starts going down, then the value of the pension funds also starts decreasing beyond the shortfall limit.

Also, shortfall risks do lead to shrinkage in the nominal value of a portfolio. Subsequently, many apprentice investors do not consider it to be a risk at all.

Though, nominal wealth is not as important as real wealth to pension investors.

The uncut objective of pension funds is to ensure that investors have sufficient real wealth when they retire from active employment.

This is because investors receive pensions when they are no longer earning.

If there is a shortfall, investors often have to reduce their standard of living in order to make up for it.

As we are aware that transformation in demographics with growing life expectancy is anticipated to produce problems for future retirees, who are expected to save their savings.

And one of the strategic challenges is to provide monetary protection for the grown-up population as the population of the globe is aging promptly.

Most economies focus their pension fund assets in orthodox investment markets like equities and bonds and thereby, depending mostly on markets that are explosive and vigorous.

Remember, populations of the globe are aging at an increasing pace.

A report shows that the number of ageing population is estimated to exceed that of children under 10 years old by 2030, and surpass 2.0 billion by 2050.

And aging pessimistically impacts on financial security of the older population so far ensured by company pension plans and government pension funds.

In a defined benefit plan, the employer has to provide the pensioners with a minimum guarantee (pensioners will receive minimum benefits notwithstanding of the performance of the portfolio).

This means that the employer has to bear 100% of the downside risks.

However, when it comes to upside potential the employer can only benefit from obtaining a percentage of the benefits.

As a result, the employers are more concerned about avoiding the downside potential than they are about increasing the returns of the fund.

Volatility of planned assets will increase if investors invest in equities.

The cost of insuring against shortfall risk (guaranteeing the minimum benefit) will increase with increased volatility and with the duration of the plan’s liabilities.

If management does not possess superior investment skills, this increased cost will not be covered by increased returns unless the employer can be considered to down 100% of any pension surplus.

Since the investment is made over a longer period of time, the risk of shortfall is greatly reduced. Pension funds must therefore take their mean age into account while making investments.

Provision needs to be persuaded towards equity if a large percentage of investors are young.

And even if there arises losses in the short run, in the long run, stocks provide a higher return as compared to other benchmarks.

It is important to realize that shortfall risk should be considered a very important factor while making investment decisions as shortfall risks do not provide investors with a chance to recover.

Failure to understand shortfall risks and unite them in the decision-making process can have in-depth effects on pension fund investors.

National governments in most countries including Bangladesh (recently introduced universal pension scheme) have schemes for their ageing population to provide them with an income in their golden years.

However, these plans are largely skewed toward traditional assets that have a low-risk and low-return profile.

As longevity increases amid improvements in healthcare and lifestyles, the drawdown period is becoming longer.

Reversely, as a larger portion of workforce enters the retirement age, their contributions to pension plans stop, while the drawdown starts.

Are suppressing fixed income yields worsening the pension shortfalls? Customary pension plans invest in bond markets, a relatively safe bet. With lower profit rates, yields on bonds decline, resulting in lower return on investment.

Market conditions are not always promising, and, hence, there is no guarantee of returns and could create uncertainties for future retirees.

Additionally, in Bangladesh, a proposed 27.50% tax on profit of provident fund of private sector employees can also initiated shortfall risk.

A few steps can be taken to address the challenge. Fund managers must diversify asset portfolio and take calibrated risk and needed to maximize returns on pension funds which are sinking fast.

Although these investments usually have a low risk appetite, a minimum transit period is needed to diversify and enter high-risk, high-return asset classes.

Allocation of funds needs to change, and in-depth research on asset classes and scrutiny of the portfolio is prerequisite. A factor of provision and attribution analysis can be employed to scrutinize the portfolio and conduct thorough analysis.

(The writer works at Social Islami Bank PLC. )