Asset Allocation Considerations for Pension Insurance Funds: Theoretical Analysis and Empirical Evidence

405 Pages·2013·8.73 MB·English

by  Christian Hertrich (auth.)

Asset Allocation Considerations
for Pension Insurance Funds
Christian Hertrich
Asset Allocation
Considerations for
Pension Insurance Funds
Theoretical Analysis
and Empirical Evidence
Christian Hertrich
Fachbereich BWL
Universität Stuttgart
Stuttgart, Germany
Dissertation University of Stuttgart, 2013
D93
ISBN 978-3-658-02166-5 ISBN 978-3-658-02167-2 (eBook)
DOI 10.1007/978-3-658-02167-2
Th e Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografi e;
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V
Foreword
Social Responsible Investments (SRI) have benefitted in the last few years from
double-digit growth rates. In many European countries, SRIs have also reached
high-digit market shares in terms of assets under management. An exception to
this trend is the German capital market, which lags the European growth trend.
Strikingly, main driver of European SRI growth are institutional investors, in par-
ticular occupational pension schemes. Prevailing regulation is in many Europe-
an countries the predominant reason for the rapid SRI expansion (e.g. Pension
Act from 2002 in the UK). In Germany, on the other hand, occupational pension
plans remain cautious in terms of their SRI asset allocation. The lack of a com-
pulsory regulation to include SRI strategies in the investment process, concerns
with respect to underperformance in comparison to conventional asset classes
as well as a perceived unfavourable risk capacity of SRI assets have impeded a
more pronounced expansion so far.
This is the starting point of Christian Hertrich’s dissertation. One of his funda-
mental research interests is to investigate the investment flexibility German
Pension Insurance Funds have for SRI strategies within the prevailing regulato-
ry as well as supervisory framework in Germany. The author uses hereby con-
ventional SRI asset classes, e.g. equities and bonds, as well as established and
common investment methods. He then expands his investment universe to in-
clude alternative investments and completes his empirical analysis by simulat-
ing new investment models that do not adhere to existing German regulation.
He chooses as benchmark the British as well as Dutch pension models given
their high asset allocation into equities and alternative investments as well as
the flexible nature of the regulation in those countries. Furthermore, an inflation
hedge model and credit risk hedging considerations are simulated and as-
sessed for their suitability for Pension Insurance Funds. To evaluate the risk-
return profiles of different risk management instruments (derivative overlays)
applied and underlying investment models used, Christian Hertrich uses a set of
shortfall risk measures based on Lower Partial Moments.
Empirical SRI studies exist for close to 35 years, with the majority of them fo-
cusing primarily on performance measurements. Analyses that are primarily
VI
risk-oriented remain rare in academia to date. The present dissertation, howev-
er, pursues a strong risk emphasis. It is thereby the first research work that of-
fers a risk-focused econometric analysis for highly regulated German Pension
Insurance Funds. Christian Hertrich’s research is highly innovative in terms of
how SRI assets can be implemented by this type of occupational pension plan.
Moreover, his dissertation implements methods and parameterisations that
have been rarely used in the context of financial econometric studies applied to
SRI. It is laudable that the author’s studies are not limited exclusively to the ex-
isting German regulatory framework, but also includes alternative investment
scenarios of occupational pension systems that pursue (partially) contrary in-
vesting philosophies, e.g. the British as well as the Dutch pension models.
The innovative approach of Christian Hertrich’s dissertation is that it operates
between the rigid regulations of Pension Insurance Funds in Germany and the
latest findings of modern empirical capital markets theory in terms of SRI. The
simulation of different asset allocation strategies combined with the calculation
of adequate risk-return parameters relevant for Pension Insurance Funds offers
valuable conclusions. While the dissertation is primarily focused on empirical
analyses in the field of financial econometrics, it includes nonetheless practical
considerations as well as regulatory aspects of Pension Insurance Funds. The
author’s thesis is therefore also a valuable reference for practitioners involved in
the asset allocation of Pension Insurance Funds. Christian Hertrich presents
hereby for the first time the options available within SRI investing by applying a
risk-focused quantitative analysis. The empirical methods used as well as the
results obtained in this book might not only draw the attention of academics, but
also receive the recognition of practitioners.
Stuttgart, February 2013 Univ.-Prof. Dr. Henry Schäfer
VII
Preface
A few words of gratitude cannot express how much the completion of this thesis
is due to the support I have received during the last few years.
Running the risk of excluding some people important to me, I owe a special
thank to a small group of individuals: to my supervisor Prof. Henry Schäfer for
his continuous advise and guidance during the dissertation, to my sister Isabel
for her positive attitude to life and her inspirational character, to my brother
Markus for our numerous discussions on econometrics as well as his strong be-
lief in my project, to my mother for emphasising the importance of education in
life and for teaching me to be the person I am today, and to my beautiful wife
Ainura for the enormous support she gave me over the last few years and all
the sacrifices she had to make during my studies.
This book, however, is dedicated to my little son Arman, for bringing love and
joy into our lives. His birth and the first few months together during the final
phase of my thesis were incredible.
London, March 2013 Christian Hertrich
IX
Table of Content

Foreword ............................................................................................................ V
Preface ............................................................................................................. VII
Table of Content ............................................................................................... IX
List of Figures ................................................................................................ XIII
List of Tables ................................................................................................ XVII
Glossary Translated Terms .......................................................................... XIX
Glossary Abbreviations ................................................................................ XXI
Abstract ........................................................................................................ XXIII
Zusammenfassung .................................................................................... XXVII
1. Introduction ................................................................................................. 1
1.1 Research Framework ...................................................................................... 1
1.1.1 Relevance of Pension Insurance Funds ...................................................... 1
1.1.2 Future Challenges ....................................................................................... 2
1.1.3 Investment Allocation Aspects .................................................................... 3
1.1.4 SRIs and Alternative Investments in the Pension Fund Sector ................... 4
1.2 Problem Definition ........................................................................................... 6
1.3 Research Objectives and Contributions ....................................................... 8
1.3.1 Research Objectives ................................................................................... 8
1.3.2 Research Contributions ............................................................................. 11
1.4 Methodology .................................................................................................. 12
1.5 Existing Research Studies and Delimitation ............................................... 13
1.5.1 Existing Research Studies ........................................................................ 13
1.5.2 Delimitations .............................................................................................. 15
1.6 Thesis Outline ................................................................................................ 17
2. Insight into the German Pension Insurance Fund ................................ 19
2.1 Objectives ....................................................................................................... 19
2.2 Overview of the German Pension System ................................................... 20
2.2.1 Historical Context ...................................................................................... 20
2.2.2 Institutional Structure ................................................................................. 25
2.2.3 Major Challenges and Outlook .................................................................. 29
2.2.4 Conclusions ............................................................................................... 34
2.3 Pension Insurance Funds as Integral Part of the Occupational Pension
Scheme .................................................................................................................... 36
2.3.1 Definition Occupational Pension Scheme ................................................. 36
2.3.2 Types of Occupational Pension Plans ....................................................... 37
2.3.3 Rationale for the Sponsoring Company .................................................... 44
2.3.4 Conclusions ............................................................................................... 45
2.4 Principal Elements of the Pension Insurance Fund ................................... 46
2.4.1 Economic Relevance ................................................................................. 46
2.4.2 Definition ................................................................................................... 49
2.4.3 Insured Risk Categories ............................................................................ 51
2.4.4 Pension Benefits and Contribution Alternatives ........................................ 52
2.4.5 Regulatory Supervision ............................................................................. 59
2.4.6 Conclusions ............................................................................................... 60
2.5 Investment Management Considerations .................................................... 61
2.5.1 Regulatory Investment Framework ........................................................... 61
X
2.5.2 Asset Allocation in Practise ....................................................................... 68
2.5.3 Considerations on Solvency II ................................................................... 72
2.5.4 Conclusions ............................................................................................... 74
2.6 Summary ........................................................................................................ 75
3. SRIs and Alternative Investments: Expanding the Efficient Frontier? 78
3.1 Objectives ....................................................................................................... 78
3.2 Social Responsible Investments (SRI) ........................................................ 79
3.2.1 Definition ................................................................................................... 79
3.2.2 SRI Investors Types and Investment Motivations ..................................... 86
3.2.3 Investment Strategies ................................................................................ 96
3.2.4 Asset Class Considerations .................................................................... 103
3.2.5 Performance vs. Conventional Asset Classes ........................................ 107
3.2.6 SRI Market Size ...................................................................................... 114
3.2.7 Relevance of SRIs for European Capital-Funded Pension Schemes ..... 121
3.2.8 Motivation for German Pension Insurance Funds ................................... 124
3.2.9 Conclusions ............................................................................................. 130
3.3 Alternative Investments .............................................................................. 133
3.3.1 Definition ................................................................................................. 133
3.3.2 Strategic Asset Allocation Considerations ............................................... 134
3.3.3 Pension Funds in the Alternative Investment Sector ............................... 138
3.3.4 Performance, Portfolio Diversification and Inflation Hedging .................. 141
3.3.5 SRI Considerations in the Alternative Investment Space ........................ 148
3.3.6 Conclusions ............................................................................................. 155
3.4 Summary ...................................................................................................... 156
4. Theoretical Foundation .......................................................................... 159
4.1 Objectives ..................................................................................................... 159
4.2 Vector Error Correction Modelling Technique .......................................... 160
4.2.1 Stochastic Time-Series Model Selection ................................................. 160
4.2.2 Rationale for VEC Models ....................................................................... 170
4.2.3 Identification ............................................................................................ 172
4.2.4 Estimation ................................................................................................ 180
4.2.5 Diagnostic Checking ................................................................................ 182
4.2.6 Conclusions ............................................................................................. 187
4.3 Bootstrap Simulation .................................................................................. 188
4.3.1 Definition ................................................................................................. 188
4.3.2 Rationale ................................................................................................. 189
4.3.3 Implementation ........................................................................................ 190
4.3.4 Conclusions ............................................................................................. 191
4.4 Strategic Asset Allocation Strategies ........................................................ 192
4.4.1 Overview ................................................................................................. 192
4.4.2 Main Assumptions ................................................................................... 194
4.4.3 Outright Strategies .................................................................................. 196
4.4.4 Derivative Overlays ................................................................................. 198
4.4.5 Conclusions ............................................................................................. 202
4.5 Performance Measurement ......................................................................... 204
4.5.1 Asymmetric Risk-Return Measures ......................................................... 204
4.5.2 Downside Risk Performance Indicators .................................................. 206
4.5.3 Conclusions ............................................................................................. 209
4.6 Summary ...................................................................................................... 210
5. Empirical Analysis .................................................................................. 212
5.1 Objectives ..................................................................................................... 212
5.2 Description of the Investment Portfolios .................................................. 214
5.2.1 Matching Principle ................................................................................... 214
5.2.2 Descriptive Statistics ............................................................................... 217
XI
5.2.3 Conclusions ............................................................................................. 223
5.3 Vector Error Correction Modelling ............................................................. 224
5.3.1 Identification ............................................................................................ 224
5.3.2 Estimation ................................................................................................ 232
5.3.3 Diagnostic Checking ................................................................................ 235
5.3.4 Conclusions ............................................................................................. 238
5.4 Simulation of Investment Management Strategies ................................... 239
5.4.1 Modelling Assumptions ........................................................................... 239
5.4.2 Outright Strategies .................................................................................. 243
5.4.3 Hedging ................................................................................................... 247
5.4.4 Bond-Call Option Strategy ....................................................................... 255
5.4.5 Yield Enhancement ................................................................................. 258
5.4.6 Performance Comparison by Portfolio .................................................... 262
5.4.7 Benchmarking Across Investment Strategies .......................................... 269
5.4.8 Conclusions ............................................................................................. 271
5.5 Alternative Investment Scenarios .............................................................. 274
5.5.1 Objectives ................................................................................................ 274
5.5.2 Equity-focused Approach: UK- and Dutch-Model .................................... 276
5.5.3 Inflation Hedge Model ............................................................................. 281
5.5.4 Credit Risk Hedging ................................................................................ 291
5.5.5 Benchmarking Across All Strategies and Portfolios ................................ 298
5.5.6 Conclusions ............................................................................................. 300
5.6 Summary ...................................................................................................... 302
6. Conclusion, Criticism and Outlook ....................................................... 308
6.1 Conclusion ................................................................................................... 308
6.1.1 General Observations ............................................................................. 308
6.1.2 Specific Research Questions .................................................................. 311
6.2 Criticism ....................................................................................................... 324
6.3 Research Outlook ........................................................................................ 326
Bibliography .................................................................................................. 329
Appendix A: Reforms of the German Occupational Pension System ..... 369
Appendix B: Description Indices ................................................................. 375
Appendix C: Empirical Results .................................................................... 381