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Investment Risk and Pensions: Measuring Uncertainty in Returns

Listed author(s):
  • Anna Christina D'Addio


  • José Seisdedos


  • Edward R. Whitehouse


This paper explores how uncertainty over investment returns affects pension systems. This issue is becoming more important because of the dramatic spread of defined-contribution pension provision around the world. It has also been highlighted by the recent financial crisis: the OECD estimates that pension funds lost 23% of their value in 2008, worth a heady USD 5.4 trillion. The scale of investment risk is measured in this paper using historical data on returns on equities and bonds in major OECD economies over the past quarter century. The results show a median real return of 7.3% a year on a portfolio equally weighted between equities and bonds (averaging across the countries studied). It might be expected that, over a very long period, the degree of uncertainty in investment returns is small. After all, a few bad years in the market are likely to be offset by boom years. Nevertheless, the degree of uncertainty, even with the relatively long investment horizons of pensions, is found to be large. In 10% of cases, an annual return of less than 5.5% would be expected, while in 10% of cases, this should exceed 9.0%. Compounded over the time horizon for pension savings of 40 years or more, such differences in rates of return amount to enormous sums of money. However, there is a series of reasons why returns achieved by individuals on their pension funds are less than the market return (as measured by conventional indices). These factors include administrative charges, agency and governance effects and demographic change, depressing investment returns below the high levels recorded over the past two decades. As a result, a more conservative assumption for future investment returns than the record over the past quarter century is appropriate. Settling on a median of 5.0% annual real return net of charges implies that 80% of the time, the investment return on pension savings should be between 3.2% and 6.7% a year. Ce document mesure l’impact de l’incertitude des rendements d’investissement sur les systèmes de retraite. Ce sujet devient de plus en plus important en raison de la propagation spectaculaire des systèmes de retraite à cotisations définies. Le degré du risque d'investissement est mesuré à l’aide de données historiques sur le rendement des actions et des obligations dans un nombre de pays de l’OCDE au cours du dernier quart de siècle. Les résultats montrent, en moyenne dans les pays étudiés, un rendement réel médian de 7,3 % annuel d’un portefeuille composé en parties égales d’actions et d’obligations. On pourrait s’attendre à ce que, sur une très longue période, le degré d’incertitude du rendement des investissements soit faible. Après tout, quelques mauvaises années sont susceptibles d’être compensées par des années de prospérité. Néanmoins, le degré d’incertitude, même en prenant le très long horizon temporel sur lequel se fait l’investissement des pensions, se trouve à être grand. Dans 10 % des cas, on devrait s’attendre à un rendement annuel de moins de 5,5 %, tandis que dans 10 % des cas, il devrait dépasser 9,0 %. Les calculs des rendements composés de l’épargne-retraite sur une période de 40 ans, montrent que de telles différences sont équivalentes à d’énormes sommes d’argent. Toutefois, il existe une série de facteurs qui peuvent expliquer pourquoi les rendements obtenus par les individus sur leurs fonds de pension sont inférieurs aux rendements du marché (tels que ceux mesurés par les indices classiques). Ces facteurs qui incluent les frais administratifs, les effets d’agence et de gouvernance et ceux liés au changement démographique, ont contribué à la baisse des rendements en dessous du niveau élevé enregistré au cours des deux dernières décennies. Par conséquent, une hypothèse plus conservatrice sur le rendement des investissements futurs est appropriée. En fixant la médiane du rendement annuel net de charges à 5 % implique que dans 80 % des cas, le rendement sur l’investissement de l’épargne-retraite devrait se situer entre 3,2 % et 6,7 % par an.

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Paper provided by OECD Publishing in its series OECD Social, Employment and Migration Working Papers with number 70.

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Date of creation: 09 Jun 2009
Handle: RePEc:oec:elsaab:70-en
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