E/B/R ECONOMIC AND BUSINESS REVIEW | VOL. 15 | No. 2 | 2013 | 79-33 113 THE ROLE OF ASSET ALLOCATION DECISIONS IN PLANNING FOR A PRIVATE PENSION: THE CASE OF SLOVENIA ALEŠ BERK SKOK1 Received: 9 January 2013 MITJA ČOK2 Accepted: 2 September 2013 MARKO KOŠAK3 JOŽE SAMBT4 ABSTRACT: Current demographic dynamics driven by low fertility and increasing longev- ity requires adjustments of the traditional frameworks of providing pensions. In this ar- ticle we highlight three crucial issues policymakers should address by implementing those adjustments. First, fiscal limitations given the current and projected demographic dynam- ics will dramatically reduce PAYG pensions. Without sufficient savings during the active period, individuals will increasingly end up in poverty. Their savings will not be enough to support their desired consumption in old age. Second, we highlight the impact of the asset allocation decision and the general public's related lack of awareness on this issue. There- fore, we argue that financial illiteracy about both required savings and about decisions on appropriate asset class play a significant role in determining the well-being of masses in the not-so-distant future. Third, we argue that shift towards private pension away from the PAYG is expected to come with substantial benefits stemming from diversification among conceptually different sources of pension income. Key words: PAYG, private pensions, financial literacy, old-age income, risk diversification, transition economics JEL classification: J14, G11 1. INTRODUCTION Population aging requires that the traditional pay-as-you-go (PAYG) systems are downscaled. Projections of age-related expenditures from the European Commission (DG ECFIN) and Economic Policy Committee (AWG) (2009) point toward a signifi- cant risk to the sustainability of PAYG systems as a consequence of increasing demo- graphic shifts. Muenz (2007) argues that until 2050 demographic dynamics are pro- 1 University of Ljubljana, Faculty of Economics, Slovenia, Ljubljana, e-mail: ales.berk@ef.uni-lj.si 2 University of Ljubljana, Faculty of Economics, Slovenia, Ljubljana, e-mail: mitja.cok@ef.uni-lj.si 3 University of Ljubljana, Faculty of Economics, Slovenia, Ljubljana, e-mail: marko.kosak@ef.uni-lj.si 4 University of Ljubljana, Faculty of Economics, Slovenia, Ljubljana, e-mail: joze.sambt@ef.uni-lj.si 80 E/B/R ECONOMIC AND BUSINESS REVIEW | VOL. 15 | No. 2 | 2013 | 80-33 113 jected to result in a 10-year increase in the median age of the EU population, from 38 to 48 years old. Governments should build substantial funded pension systems as a supplement to the traditional PAYG (Du et al., 2011). More and more weight should be given to private pension systems, as under unfavourable demographic dynamics, they are far more efficient than PAYG systems (i.e., under realistic assumptions, they can deliver higher pension benefits with the same level of contributions or the same level of pension benefits with a lower level of contributions; Garrett and Rhine, 2005; Berk and Jasovic, 2007). This long-term shift toward funded private pensions should be based on sound second- or third-pillar5 frameworks, or both (Boersch Supan et al., 2008). Namely, trends in re- designing pension systems have during the past decade favoured the diversification of risks across all sources of old-age income as the coexistence of the three pillars positively effects benefits and consumption under various shocks, e.g. ageing population, inflation- ary shock, stock market crash etc. (World Bank Pension Conceptual Framework, 2008; Holzmann and Hinz, 2005; Lindbeck and Persson, 2003, Du et al., 2011). When a society is decreasing reliance on the PAYG and increasing reliance on private pension pillars, nature of co-movements between the drivers of pension benefits in both systems are of a great importance. Those co-movements can be measured with correlation coefficients between wages (predominant driver in the PAYG) and financial variables, i.e. stock and bond returns. Holzmann (2002) is the first published peer-reviewed research reporting very beneficial (i.e. low) national level correlation coefficients between wages and inter- est rates, and wages and capital return. Namely, he reports coefficients of correlation between wages and interest rates in the range between -0.197 and 0.238 and correlation coefficients between wages and capital return in the range between -0.077 and 0.202. Other authors in the area of diversification benefits report similar figures, in some cases even more beneficial (e.g. see Knell, 2010). Despite the evident shift toward private pensions, one should not expect overnight changes. Augusztinovics (2002) argues that countries, even though they redesign their pension system and move to strengthen individual pension accounts, will still deliver their pensions predominantly from PAYG systems for quite some time. Recent experi- ence of some countries in Central and Eastern Europe provide ample evidence of the budget constraint posed by high transition costs for cases of accelerated reform towards private pensions (Simonovits, 2011). Ferber and Simpson (2009) also argue that market meltdowns make shifts towards funded pillars less politically feasible. At the same time, private pensions should not be taken for granted, as only well-managed, efficient frame- works (e.g., competitive institutions and products, broad population coverage, sound governance mechanisms) can deliver the anticipated advantages (Pensions at a Glance, 2009; Bertranou et al., 2009). 5 Second pillar includes mechanisms through which employers make contributions for their employees and third pillar the ones through which employees make their own contributions, regardless of the level of obli- gation. A. BERK SKOK, M. ČOK, M. KOŠAK, J. SAMBT | THE ROLE OF ASSET ALLOCATIONS IN PLANNING .. 81 The resulting pension landscape will not only provide a more sustainable and efficient environment for managing inter-temporal consumption but also support domestic underdeveloped financial markets. Davis (2008) shows that pension-fund growth in the European Union is likely to lead to beneficial financial development with a broader range of instruments and a lower cost of capital, thus leading to higher welfare. He further argues that pension-fund growth has a significant effect on Eurozone finan- cial markets, by moving them partly toward the Anglo-American system, as well as promoting integration. Davis and Hu (2008) provide evidence that funding improves economic performance sufficiently enough to generate resources to meet the needs of an aging population and that the improvement is even greater in emerging market economies. However, the previously mentioned characteristics of private pension systems are by themselves insufficient to provide for society's well-being if people do not have suffi- cient financial knowledge, i.e. are only modestly financially literate. Financial illiteracy is a very important issue, and it has been reported even for the most advanced coun- tries (on the United States, see Lusardi and Mitchell, 2007; on the United Kingdom, see Gathergood and Disney, 2011; on Japan, see Sekita, 2011; on Germany, see Buchner- Koenen and Lusardi, 2011). Studies have found that many households are unfamiliar with even the most basic economic concepts in order to make savings and investment decisions. Financial illiteracy is lowest among women, young people, and individu- als with lower incomes and lower education levels. With respect to pension savings, financial literacy increases individuals' likelihood of having a savings plan for retire- ment, which has a very strong impact on their wealth levels at retirement (Lusardi and Mitchell, 2007a). We argue that very important aspect of financial literacy addresses knowledge about characteristics of various asset classes for their investments. Rooij et al. (2007) found that financially illiterate individuals are significantly less likely to invest in stocks. We show in this paper that this aspect has a very significant impact on the level of pension wealth, since choosing appropriate asset classes is extremely important. Strategic asset alloca- tion determines approximately 90 percent of portfolio performance (see Brinson et al., 1986; Ibbotson and Kaplan, 2000; Andreu et al., 2010). Overall, it is crucial that financial literacy campaigns address both topics: individuals' need to start saving for their pen- sion (e.g., in a pension savings account) and at the same time they also need to allocate savings into appropriate asset classes. We focus on Slovenia, a country with a combination of a significantly aging popula- tion and an underdeveloped private pension system. Exclusive dataset on the distri- bution of individuals' income in Slovenia is used in this article to support our three main points, which are particularly important for people in countries like Slovenia who are entering a career or are halfway into their professional career. We contribute to the literature with the model, which shows the required monthly savings under each of three asset allocation choices (i.e., stocks, treasury bonds, and treasury bills). We calculate the required savings during the active work period of individuals' life 82 E/B/R ECONOMIC AND BUSINESS REVIEW | VOL. 15 | No. 2 | 2013 | 82-33 113 under the assumption that they (together with the assumed long-term yield) can fill the gap between projected pensions from the PAYG system and the 70% net replace- ment rate suggest by the Organisation for Economic Co-operation and Development (OECD, 2009a). Different income levels (decile groups) are taken care of and insights into the potential outcome of a risk-aware individual allocating all of his or her pen- sion savings into a risky diversified stock portfolio and prepares for poorly perform- ing financial markets but actually achieving the long-term mean yield are offered. This case clearly favours investing in stocks over the long run. Finally, we address the issue of pension income diversification and show that benefits are greatest at the point, where private pension pillars only start to provide pension income. Our con- clusions are relevant in general, i.e. for many developed countries across the globe, as not many current pension systems have sufficient solutions regarding an increasing old-age dependency ratio. This article is structured as follows. In the second section, we briefly describe the exist- ing Slovenian private pension system and present pension funds in the context of the whole financial market. We also report the performance of Slovenian pension vehicles since their introduction nearly a decade ago and compare that with the performance of pension funds from developed markets. In the third section, we describe benefits from the Slovenian PAYG system and related taxation. The fourth section offers demographic projections up to 2060 and future public pension expenditures, which without changes, are expected to cause huge deficits in the pension budget. As those imbalances are unsus- tainable and cannot be financed through subsidies from the central government budget, we impose fiscal caps at various percentages of gross domestic product (GDP) that can be allocated to finance pensions. Those in turn pose further caps on the future levels of expected public pensions. The fifth section provides overview of three basic asset classes available for the allocation of private pension savings. Using historical data, we calculate real long-term yield and further assume that those returns are a reasonable approxima- tion of future long-term yields. We thus use historical returns as expected returns in our model, which we present in detail in the sixth section. In section seven we present the extent diversification benefits. 2. SLOVENIAN SYSTEM OF PRIVATE PENSIONS The pension reform enacted in Slovenia in 2000 introduced private pensions within the second pillar, which comes in two forms. The first form are pensions, which are compul- sory for employees in "health-risk" jobs. Employers must make special pension contribu- tions for all such classified workers, and those contributions are transferred to employ- ees' pension account at the special pension fund (managed by a government-sponsored institution). Second, for all other employees, participation in the defined contribution pillar is not compulsory but is promoted by a tax incentive. Namely, contributions to the second-pillar pension funds are subject to tax relief at the level of a payer. Either an employer or an employee can make a contribution, but the total amount of tax relief can- not surpass either the maximum of 5.844% of an employee's annual gross wage or a cap A. BERK SKOK, M. ČOK, M. KOŠAK, J. SAMBT | THE ROLE OF ASSET ALLOCATIONS IN PLANNING .. 83 that is set annually6 When an employer pays a second-pillar contribution for employees, it can deduct paid contributions from the company's corporate income tax base, while in the case that a second-pillar contribution is paid by an employee, it is deducted from her personal income tax base. Table 1: Size of the second pillar, average contribution to the second pillar and breakdown of total assets at the end of 2012 MPFs PCs ICs Total AUM (mln EUR) 839.0 655.0 302.6 1,796.6 Average annual contribution 450.72 466.92 381.47 422.53 Breakdown of total assets (%)* Deposits 22.2 22.7 n.a. n.a. Government bonds 28.1 37.4 n.a. n.a. Bonds: other 29.1 32.6 n.a. n.a. Stocks 1.1 5.3 n.a. n.a. Investment funds 19.0 0.0 n.a. n.a. Cash 0.5 2.0 n.a. n.a. Total assets 100.0 100.0 n.a. n.a. Note: MPFs = mutual pension funds, PCs = pension companies, ICs = insurance companies, and AUM = as- sets under management; * - PC breakdown of total assets at the end of 2011. Sources: Ministry of Labour, Family and Social Affairs (http://www.mddsz.gov.si), Report on financial mar- ket trends (2013); Report on insurance market trends (2012). There were 508 thousand participants in the second pillar by the end of 2012, which represents 60.7% of the total number of persons in employment7. Different second- pillar institutions manage the individual pension accounts: insurance companies (ICs), pension companies (PCs), and mutual pension funds (MPFs). At the end of 2012 total assets under management of the second-pillar institutions was only 1,797 mln EUR, as the average annual contribution is only about 400 EUR. Assets represented only 2.1% of the assets of the overall financial sector and only 5% of the GDP (Bank of Slovenia, 2013). A notable characteristic of the Slovenian private pension system is inappropriate asset allocation. Rules about guarantees in the private pension system (Pravilnik o izračunu..., 2005) force pension managers to reach a certain percentage (at least 40%) of the cumulative yield of long-term bonds issued by the Treasury of the Republic of Slovenia on a single-member contribution. Because pension asset managers must provide additional capital in the case that their products don't deliver the guaranteed threshold yield, they do not take much risk. As a result, they tend to invest less than 5% in stocks, even though participants in the pension fund might have investment horizons extending as far ahead as 40 years. Fixed-income instruments together with 6 The cap was 2,526.2 EUR in 2008, 2,604.5 EUR in 2009, 2,646.2 EUR in 2010, 2,683.3 EUR in 2011 and 2,755.71 EUR in 2012 (Tax Administration, 2012). 7 62% we obtain using the registry data on number of persons in employment. Using the definition of Inter- national Labour Organization (ILO) the share is even lower (54%). 84 E/B/R ECONOMIC AND BUSINESS REVIEW | VOL. 15 | No. 2 | 2013 | 84-33 113 deposits and cash represent at least 90% of total assets (see Table 1). Asset allocation in developed countries is dramatically different, as stocks represent roughly half of the total assets allocated.8 Of course, ultraconservative asset allocation can yield only meagre performance. When portfolio strategists set a conservative floor for the portfolio, the ceiling is not very high (Jensen and Sorensen, 2001). In the period 2003-2012 Slovenian pension funds recorded only 1.05% average real annual yield (mutual pension funds [MPFs]) and 0.87% (pension companies [PCs]).9 Pension vehicles as a group beat pension guarantee, as in real terms guarantee only amounted to -0.60%. Figure 1 shows the dynamics of the real yield of MPFs, PCs, the private pension system guarantee, and the best and the worst performer (in the entire 2003-2012 period) of all products in the market for the period 2003-2012 in Slovenia. If we compare same-period performance of Slovenian pension products with similar products in developed countries, we see that those countries did not have much bet- ter performance. However, there is a conceptual difference between Slovenian private pension products and those in the developed world. It is impossible to achieve long-run performance of 6-10% typical for countries with the developed private pension systems10 with the strategic asset allocations of Slovenian pension products, all of which are char- acterized by investment policy unification regardless of the age of their members and all of which are ultraconservative. Because Slovenia's private pension system cannot offer appropriate savings vehicles, it should change and pension products with less conservative exposure should be offered.11 Under a new system, individuals should have their choice of asset allocation—individu- als have different characteristics and needs, and not all of them need a guarantee. In the "Results" section, we point out the significant impact of the asset allocation decision on the outcomes of pension savings. 8 For the end of 2009, a Towers Watson study reported the following stock allocations: Australia, 57%; Can- ada, 49%; Hong Kong, 62%; Japan, 36%; Netherlands, 28%; United Kingdom, 60%; and United States, 61% (2010 Global Pension Asset Study, 2010). 9 Comparison of yields between MPFs and PCs must be taken with a grain of salt, as PCs are allowed not to mark to market all of their assets. 10 Antolin (2008) reports performance between 6 and 8 percent in real terms since introduction of private pension systems, measured in geometrical terms. 11 The legislation, which allows for asset-allocation investment policy design, became effective on Jan 1 2013 (Pension and Disability Insurance Act, 2012), but the second level rules and pension products are still being prepared. A. BERK SKOK, M. ČOK, M. KOŠAK, J. SAMBT | THE ROLE OF ASSET ALLOCATIONS IN PLANNING .. 85 F^uie 1: DyEamics of real annual yields of MPFs and PCs in the period 2003-2012 in Slovenia (in %) MPFs PCs "Guarantee 0Best performer 0 Worst performer 25,0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Reporton financial markettrends(2013), Repor toninsuraneematke0trinds(2012), MonthlyBul- letin (2005, 2 0S9( 22 withónMPts.PC categocies) . 3. OVERVIEW OF CURRENT BENEFITS FROM THE SLOVENIAN PAYG SYSOEM UnOei the peieipn Saw Keing io SO fores fsom 1 Jenwary 2053 the tTtsL aicsuol rate Nor sn SnOivEEuol wSSh Coll lE^K^mei^^ OGndSSSvns is EK.KL%l Ry asiumsng Nij wige ERAS gsow- Ssg Sn liso ts itÌR the aoorRAe waRO Sn CSovenia Tot rate amo uoAv toKA.EeV as wsll. The pensiwn b^^^ ^s CRSculfSiP ai tie peerage Krom tiso individual's valorised best consecutive 18 years (19 in 2013, 20 in 2014 and finally 24 in 2018 and onwards). Individual's gross wages by years are transformed to nominal wages with the ratio be- twE ew aww E EEE n E t an d g rw E E wage in that year. Those 'net' wages are multiplied with the vectorofvaloa isatlon noehOeients12 to calculate the pension base. Finally, accrual rate us apphnd Co the pnntion bane to cplnulotetheamountoffirsC penclon.Ancrtial rate for menamounCsto26%Ooa tdefirstl5workmgyears and furtanrC.20%0oe pfuhaddit-onat working year. Thus, for a man with 40 working years total accrual rate is 57.25% (26% + 1.25% * 25 years). For women the pension system is more generous with 29% for the first 15 years and, again, 1.25% for each additional working year. Thus, for women with 12 Calculation of those factors was based on the past growth of pensions relative to wages. After the pension law introduced with 1 January 2013 the set of factors will grow in line with the growth of average wage - thus, it will not depend on the growth of pensions any more. In the past factors were declining because the pension growth was lagging behind the wage growth. 86 E/B/R ECONOMIC AND BUSINESS REVIEW | VOL. 15 | No. 2 | 2013 | 86-33 113 40 working years the total accrual rate of 60.25% is applied. From 2013 to 2022 there is a transition period in which less than 40 working years is required for women and there- fore in this period for women even higher accrual rate is applied for 40 working years13. However, in our calculations we focus only on male with 40 working years. Slovenia, as other countries from Central and Eastern Europe, has undergone through several phases of pension reform; the last phase had passed the Parliament in 2012 and is effective from January 2013. Its most important element is a gradual increase of retire- ment age for both genders. The full retirement age (for old age pension) is thus increasing from 61 years (women) and 63 years (men) to 65 years (by 2016 for men and by 2020 for women). However, under both pension systems earlier retirement (up to several years) was/is possible with full benefits and without penalties if the person collects required number of working years earlier. Slovenia is also characterised by the fact that it has never implemented a compulsory second pillar14 compared for example with Slovakia, Hungary and Poland. However, the compulsory second pillar has been recently effec- tively abandoned in Hungary, while in Slovakia it is not compulsory any more since Feb- ruary 2013. The Czech Republic which initially also did not introduce mandatory second pillar is now opening the option for employees to divert part of their contributions from the first to the second pillar (Berk et al., 2013). 3.1. Financing the PAYG pillar Compulsory pension contributions for the PAYG pillar are set at the rate of 24.35% (em- ployees pay 15.5%; employers, 8.85%) out of a gross wage without any ceiling.15 The ag- gregate contributions total 3,348.9 million EUR, or 9.5% of GDP, in 2012. Because this is not sufficient to cover expenditures of the first pillar (which totalled 4,851.0 million EUR, or 13.7% of GDP, in 2012) in aiming to maintain the financial stability of the sys- tem, current legislation has stipulated that the central government budget cover the rest. In 2012 that transfer amounted to 1,416.2 million EUR, or 29.2% of total PAYG revenues (Ministry of Finance, 2013). 3.2. Taxation of Pensions Contributions for the PAYG pillar are entirely deductable from the personal income tax base, while pensions from the PAYG pillar are subject to personal income tax under 13 For 40 years of work women receive total accrual rate of 64.25% if they retire in 2013-2016 period, 63.5% in 2017-2019 and 61.5% for retiring in 2020-2022 period. Nevertheless, minimum and maximum pension base as of December 2012 are 551.2 EUR and 2,204.4 EUR, respectively. Taking into account that there is no ceiling for the PAYG contributions, such a pension base setting mechanism has a strong redistributive effect. 14 Exemptions are some selected professions, such as miner, or soldiers, where additional compulsory contri- butions paid by employers' are collected by special government owned pension fund. 15 The self-employed on the other hand pays the same rate of contributions from the base which is a function of annual income from self-employment with the ceiling equal to 2.4 average national gross wage. A. BERK SKOK, M. ČOK, M. KOŠAK, J. SAMBT | THE ROLE OF ASSET ALLOCATIONS IN PLANNING .. 87 an advantageous tax-credit system. As a result, most pensions (approximately 97%) are effectively tax-free, whereas the remaining 3% are taxed at a relatively low effective tax rate. On the other hand, the contributions to the second pillar are deductable from the personal income tax base up to the certain level. This tax relief is limited with the 5.844% of employee's annual gross wage or the nominal amount set annually (2,755.7 EUR in 2013) - whatever it is lower. Pensions from the second pillar are not entitled to the same tax credit as pensions from the first pillar. Instead, 50% of the second-pillar pension is subject to tax, without any special tax credit. As a result, these pensions are taxed more than the first-pillar pensions. Table 2 includes average gross and net wages in 2013, as well as the maximum amount of tax relief for the second-pillar contribution. One can observe that only taxpayers from the highest decile group can take full advantage of the nominal tax relief for second- pillar contributions. Table 2: Gross average annual wage, net average annual wage and maximum amount of tax relief for the second-pillar contribution in 2013 (in EUR) Decile group Average gross wage Average net wage Maximum tax relief (5,844 %) 1 9,671.5 6,455.4 565.2 2 10,760.0 7,140.1 628.8 3 11,939.4 7,875.8 697.7 4 13,190.8 8,642.1 770.9 5 14,563.9 9,445.3 851.1 6 16,288.2 10,417.1 951.9 7 18,546.8 11,661.9 1,083.9 8 21,740.3 13,385.6 1,270.5 9 26,755.5 15,872.7 1,563.6 10 47,663.8 24,743.2 2,785.5 Source: Authors' calculation based on data from Statistical Office (2013). 4. THE IMPACT OF DEMOGRAPHIC CHANGES ON BENEFITS FROM THE PAYG PILLAR The twentieth century experienced explosive population growth, but the twenty-first century is likely to see the end of population growth and instead population aging (Lutz et al., 2004). According to population projections, in the future there will be strong de- mographic pressures on public expenditures for pensions, health care, and long-term care (European Commission, 2012). Scholars began warning of this decades ago, but we have seen no changes, mainly because short-term-oriented politicians have as their ho- rizon only the next elections. They are not interested in projections for a distant future. 88 E/B/R ECONOMIC AND BUSINESS REVIEW | VOL. 15 | No. 2 | 2013 | 88-33 113 The situation, though, has become so aggravated that taking action cannot be further postponed. Many countries have already taken various measures. International organi- zations are pressuring countries to act in a timely manner to facilitate and accelerate change. PAYG systems are vulnerable to population aging. In our analysis, we apply Eurostat population projections from EUROPOP2010 for 2010-2060. They were prepared by the Eurostat for the European countries (EU27) and European Free Trade Associa- tion countries (EFTA)16. The projections assumed gradual convergence of countries' mortality and fertility, with the year 2150 set as the convergence year. However, the projections were prepared only until 2060, when only partial convergence has been reached. In Slovenia the life expectancy at birth is increasing rapidly. The past decade alone (from 2000-2001 to 2011) saw an increase of almost 4.5 years for males (72.1 to 76.6 years) and 3.3 years for females (from 79.6 to 82.9 years) (Statistical Office of the Republik of Slovenia, 2012, p. 79). Some developed countries already have a considerably higher, and still-increasing, life expectancy than Slovenia.17 The current population age structure is given. The baby-boom generations, born after World War II during times of high fertility, are now in their 50s and early 60s. Over the coming decade, they will be intensively entering retirement. At the same time, people born during the 1980s are starting to enter the labour market. During the 1980s and 1990s, fertility declined; in the first half of the 2000s, it stabilized at very low levels. In 1980 total fertility rate (TFR, or the average number of children a woman gives birth to, during her fertility period) was 2.1, which was still a replacement-level fertility. Since then, TFR declined until 2003, when it reached only 1.2 (Statistical Office of the Republic of Slovenia, 2008, p. 56). Consequently, the number of newborns decreased sharply in that period. In 2003 just 17,321 children were born in Slovenia, whereas the figure was 30,604 in 1979 (Statistical Office of the Republik of Slovenia, 2012, p. 78). Those reduced generations (they are only about one half of their parent's generations) will also determine fertility levels in the coming two to three decades. Even if fertility (TFR) were to increase, which the projections assume, the absolute number of new- borns is expected to fall considerably because there will be fewer women of reproduc- tive age. Sensitivity analysis (in which we variate fertility assumptions while keeping other assumptions unchanged) shows that, despite the impact of fertility on population size in the long run, we cannot expect increased fertility to considerably mitigate the process of population aging in Slovenia in the coming decades (Sambt, 2008). Further, from an economic point of view, increased fertility does not have positive economic 16 Iceland, Liechtenstein, Norway and Switzerland. 17 E.g., in Japan the life expectancy at birth in 2009 was 79.6 years for males and 86.4 years for females (OECD, 2011). A. BERK SKOK, M. ČOK, M. KOŠAK, J. SAMBT | THE ROLE OF ASSET ALLOCATIONS IN PLANNING .. 89 effects for about 20 years, as cohorts of newborns start to enter the labour market. In the meantime, the economic effect can even be negative, causing higher public expenditures in the form of education and other transfers like child allowances and health care. Immigration decreases the overall aging of the population, especially because most im- migrants are relatively young (Eurostat, 2011). However, without assuming unreasonable high immigration, the positive effect is only moderate. With time, immigrants are also aging and entering the age group of 65 and older (Bonin et al., 2000). Figure 2 presents the projected dynamics of the age structure of the Slovenian popula- tion by three broad age groups related to economic activity:18 0-19, 20-64, and 65 and older. According to EUROPOP2010 projections by 2060 the Slovenian population should slightly increase - by 11,000 people, which is 0.5% of the total population. However, the change in the age structure of the population is striking. The percentage of people age 65 years and older is expected to almost double in the 2012-2060 period, from 16.6% to 31.6%. In contrast, the size of the working-age population (age 20-64) is expected to shrink considerably - from 64.3% in 2012 to 49.8% in 2060. The combination of those two processes will have serious consequences for the long-term sustainability of pub- lic finance systems, unless adjusted accordingly. Sensitivity analysis reveals that those results are very robust for a broad range of assumptions about fertility, mortality and migrations since they are mainly driven by the increasing longevity, and especially by the given population structure (Sambt, 2008, Sambt, 2009). The unfavourable economic development with respect to the population age structure can be shown with the old-age dependency ratio, which is calculated as the ratio be- tween the elderly (age 65+) and the working-age population (age 20-64), multiplied by 100. An increasing old-age dependency ratio indicates an increasing demographic burden on the productive part of the population in order to maintain the pensions of the economi- cally dependent. According to the EUROPOP2010 population projections, the old-age dependency ratio in Slovenia will increase from 25.9 in 2012 to 63.4 in 2060 (see Table 3). A rapidly increasing old-age dependency ratio is not specific only to Slovenia. Practi- cally all developed countries across the globe face strong population aging. Therefore, the analysis we present here is generalizable. Table 5 presents projected future increases in the old-age dependency ratio for all EU27 member states, including Slovenia. In the new EU member states (EU12), the increase is expected to be somewhat stronger than in the old EU member states (EU15). 18 In demography traditionally defined dependency ratio compares population aged 65+ with population aged 15-64. However, in developed countries using 20-64 years in the denominator has been seen as more adequate from the economic point of view since not many individuals enter the labour market before age 20. 90 ECONOMIC AND BUSI NESS REVIEW| VOL.15 |No. 2|2013 Figure 2: Slovenian population in broad age groups: EUROPOP2010 projections for 2012-2060 (%) Source: Eurostat, 2011. Tabk3: OiVvagedepeDdsncyraSioinEUcountriesiEUROPOPNOlOproScstLons^for2002, 20CEVND2060 Old memOyr states(E U15) newmomU9is tale s dVi N 2030 2060 2012 2030 2060 Belgium 29.2 ekk ken Bilgaria ee.7 40.4 26.3 Denmark 29.6 46.7 48.0 CzecliRepublic 2ee 3C.6 rco.e Germany 33.a 21.0 65.1 Estonir 07.B 2 94 61.4 Spain 27.6 38.6 61.6 Greece 31.9 41.9 62.2 France 29.4 43.4 51.7 Latvia 27.4 39.4 74.3 Italy 34.0 44.5 64.5 Lithuania 26.0 38.8 62.3 Cyprus 21.7 33.7 48.7 Hungary 26.8 36.4 62.8 Ireland 19.9 31.2 48.5 Malta 25.8 42.8 60.5 Luxembourg 22.5 32.7 43.0 Poland 21.3 38.6 70.5 Netherlands 26.8 44.2 51.7 Romania 23.3 32.8 70.4 Austria 28.7 42.1 55.4 Slovenia 25.9 42.5 63.4 Portugal 29.9 40.9 59.7 Slovakia 19.0 34.2 67.4 Finland 30.6 47.3 54.5 Sweden 32.3 41.3 51.7 UK 28.6 38.6 46.5 Source: Eurostat, 2011. A. BERK SKOK, M. ČOK, M. KOŠAK, J. SAMBT | THE ROLE OF ASSET ALLOCATIONS IN PLANNING .. 91 4.1. Projecting Future Public Pension Expenditures Strong population aging translates into pressure on the public pension system. The mod- el that we use in the simulations rests on the age profiles from the base year. Therefore, we refer to it as the age-profiles-based model. Such models are standard approach in Generational accounting methodology19. This model is also used for projecting pension expenditures for Slovenia published in 'The Ageing reports' by the European Commis- sion (Ageing Working Group). In calculations we use three types of matrices. The matrix of pension age profiles (PENS) includes average pensions by years in the future. It builds on the pension age profile from the base year (2011). In particular, the PENS matrix consists of two matrices multi- plied with each other. The first one contains age profiles of average pension benefits per receiver, whereas the second one includes the share of pensioners in the total population by age group (i.e., retirement rates). This decomposition enables us to more easily, and more accurately, introduce future changes into the age profiles (e.g., increasing retire- ment age). Every year those age profiles are shifted up by the assumed growth of pensions. Before 2013 all pensioners with the same retirement conditions received the same level of pen- sion, regardless of the time of retirement ('horizontal equalization'), which strongly simplified the calculations. Horizontal equalization in Slovenian pension system was achieved through complex mechanism of valorisation that was abolished in 2013. Now growth of pension is in real terms20 60% indexed to the growth of wages. We follow each cohort of pensioners separately. We use the standard macroeconomic assumption that wages grow in line with labour productivity growth - we use the latest European Com- mission assumptions. The coefficient matrix (C) summarizes the effects of future departures from the basic age profile, assumed in the pension matrix. It contains the impact of the Slovenian pension system on pension age profiles in the future. The legally enforced, but gradually phas- ing-in parameters of the Slovenian pension reform are a typical such case. We obtained several inputs for the coefficient matrix (C) from simulations on microdata on pension- ers who have already retired. We simulate their behaviour under pension parameters that will be valid in future years. Weighted averages of those results (by age groups) enter the coefficient matrix. The population matrix (P) contains the EUROPOP2010 population projections present- ed earlier. 19 For review of Generational accounting methodology see, for example, the initial paper from Aurebach, Gokhale and Kotlikoff (1991) and comparative studies across countries (European Commission, 2000; Auer- bach, Kotlikoff, & Leibfritz, 1999). 20 Formally, the growth of pensions is 60% indexed to the nominal growth of wages and 40% to the growth of consumer price index (inflation). This is equivalent to 60% indexation in real terms. 9! ECONOMIC ANDBUSINESS REVIEW |VOL.15|No.2|2013 The amount: of p vnvion expendPsurer on ind mdi-iak aged! k in ye vr y is thu s c ekutó ed as follows (rnatrices are multi]vlieit in an element-by-eldmeni manneep PENSEXPat, = PENS^C^G^ (1) where G cN^Vo^nvc it^ff^ifS^ntvof ohe Efneivnilsnm tfin^^^ee^i^ae (here, 2ENNS io time t. Pplhc pvnion expc^itum] |f^kSfSEi^;ui iu: near f afe cakulateul as ste pum of gco-eeterl i^xaendiSuree -reaenuayt by aH age groups: D PENSEXPt = Y, PENSEXPat (2) a=0 where index a auns fnem 0 to D,and D Vnnel eethei^ax^^umietf Eh of hfv oia euo modol, tibi eye geoup fOO unii older). Finally, we employed the setoo ue aecoeeonvmin odsstmptions from ti^^ European Com- móvsion (se f 2ind in VN ti. i oi_giudi nag assnmp tine v on joeoduttf ioity gonilh, ND fp empi ef- mintl ost onenop1osrtnitnbeo^^s^1. In -he future theagrprRrüegf EmglovmentraOerisoroj evlnd^o^lfi^ iotohighni ages. Consic[ueietlu, alio -he ngi profilo pa retirement gntpe wlli withdraw inlu digOre ggsn Pith of titoli two eiOucir a.:ne efteflnn iulie made) huiirougE ^WIEiìS metEXt )ngi"eksinn ends ploedUEni aator (alio aecause olaurumaV dutviiie in vnrmp^ment rotili will hien Rise tioe imnsct silso uro OeDP sinee GDU oEawin in siso madri aouwets unlpO)our i]ro5luctlnd ity prowlh ani ohe eniEl^lim^nt gfavlfrl - thi some anpoooch sisns aSeo the nukOiieen Clmm-msion in i Eeiu eaiculotions. Fon axamuiv, ir^ the tranultioN giniod op to hi IO tino leadof yenoions will n^acluatiel deciinr disatio; io wsget beiaens oi gra2ual1y (01X1000 inn numnsr so poasr that ire (3001X11 i vie aocouni nhse CNicuiosi no PÌUsIu^ Naii itrom Oc isigf yiars in 0t(3 to 2S: in 20105t glris eife et eniens tei modeo throng) <2 m(lrig as wrü ar ophee 61:0x18 oi" lNa isttcion irgigigtion 5hg^ wove calcc iete ! unìng 1:1ÌU micro dato on Sì enfionfrr . Noneth chess , 1S iepenj ende nthaithr iol^l^cet^i^s^ls^n expenUltueeu asa ji ment age if GDP wiil iirong^ increase since the resu Its are mainly driven lay th e population egerng. In pnnsim' enOegjory acte igducCeoidiage, disagihty and eurvivor pnnsions eut ako pen- ciono of far mere, police officers e Wo rid War II veterano, siaie pmsioners and so cen. How- ever, payments to the health insurance that are paid for the pensioners by the pension fund are not included. Using the age-profiles-based model, we obtained the results pre- sented in Figure 3, labelled 'No limitation' variant. Without further changes to the cur- rent pension system, population aging would largely translate to rapidly growing public pension expenditures as a % of GDP. 21 To link employment rates with retirement rates, we used the submodel of the Institute of Macroeconomic Analysis and Development (IMAD; for a detailed description of the submodel, see Kraigher (2005). A. BERK SKOK, M. ČOK, M. KOŠAK, J. SAMBT | THE ROLE OF ASSET ALLOCATIONS IN PLANNING .. 93 Figure 3: Projections of public pension expenditures in Slovenia in 2012-2060 (% of GDP), scenario with no limitations and scenarios if limiting public pension expenditures to certain % of GDP te a as S O •p« se a a a u a 4= S a. 0 -I •No limitations -15% • 14% • 13% • 12% 11% i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i fN O tN O /") O fN VO >n o tN O © tN Year Source: authors' calculations. There are basically three solutions for mitigating rapidly growing pension expenditures. The first, usually considered preferable, is to increase the retirement age. This solution also provides the most straightforward response to increasing longevity. The second so- lution is to increase taxes, usually on labour income. In Slovenia labour is already highly taxed, which hinders its international competitiveness. Moreover, the tax burden has a negative impact on employment and incentives to work. The third solution is to reduce the level of pension benefits from the PAYG system. In our analysis we focus on the third option by introducing a simple assumption about future reductions of pension benefits. We assume the government will have to prevent further increases in public pension expenditure above some percentage of the GDP (i.e., capping expenditures) in a way that all pensions will be cut proportionally, regardless of the type and level of pension. Thus, we set the tolerated maximum percentage of public pensions of GDP at 11%, 12%, 13%, 14%, and 15% of GDP. Figure 3 shows projected pub- lic pension expenditures as a percentage of GDP according to these scenarios. 4.2. Expected Level of Pensions from the PAYG Pillar As already explained in section 3 in 2013 the statutory accrual rate for a man with 40 working years was set to 57.25% and according to the current pension law it will remain 94 E/B/R ECONOMIC AND BUSINESS REVIEW | VOL. 15 | No. 2 | 2013 | 94-33 113 at this level in the future ('No limitations' scenario in Figure 4). We also present results for different scenarios of assumed maximums to which government would tolerate pen- sion expenditures to increase; in those cases, the net replacement rate would fall to even (much) lower levels, as it is revealed in Figure 4. In the case that expenditures for pensions would be capped at 11% of GDP, the net replacement would thus decline to 37% by 2060. Figure 4: Projections of net replacement rate at retirement in the period 2012-2060 en s ie>n expend i - tures as 7fhrcentaye e f GDP fosÉe Cuteee . • The 130s GDP ucenario assumrttheproy7rf2Ugot PAYG GensConsnbenditufsrtobe cappee pS IDG of GDP. • Ih e 11% GDP ucena ret a^^umee the broporf2Ug dfPAeG peAsConrnendingta be cappey pf 10 °%o 0UGG G. Flg use 6 : A graphical illustration of the model PII PII PII PII r Pi Pi Pi Pi ACCU SAVINGS Vi V2 v3 v„ d *H •K working /saving period Yearof retirement period retirement Legend: r = investment rate of return; p = the growth rate of salaries and saving instalments; V. = monthly saving instalments; d = discount rate; P: = monthly PAYG pension; P = pension gap. 26 Calculations do not conceptually differ for female individuals, but we excluded those results from this paper for sake of keeping results as short and concise as possible. 98 E/B/R ECONOMIC AND BUSINESS REVIEW | VOL. 15 | No. 2 | 2013 | 98-33 113 Of course, by increasing restrictions on the pension-to-GDP ratio, the actual forecasted net replacement rate deteriorates gradually and the monthly pension gap increases ac- cordingly. Consequently, the additional pension savings that have to be accumulated through the private pension system must increase by increasing the level of public fi- nance restrictions, assuming that individuals target their individual total pensions at the 70% net replacement rate. In the next step the monthly pension gap values (PGAPt) for individual pension recipients are discounted using a 0.5% technical discount rate27 to the total amount of savings need- ed at the year of retirement (ACCUSAVINGS), which represents the target value an indi- vidual must accumulate over his working period through his monthly savings in the pri- vate pension pillar. In discounting, we use male life expectations at the age of 61 according to the Deutsche Aktuarvereinigung (DAV) tables. Again, we take into account the effect of the length of the savings period for typical individuals, and we simulate investment strategies that are consistent with three different asset allocation strategies. The simulated investment strategies rely on three asset classes, characterised by their distinct risk-return profiles: (1) stock strategy, (2) bond strategy, and (3) bill strategy. For simplicity, investors are assumed to stick to the selected asset class (i.e., risk-return profile) throughout the entire investment horizon, and they are assumed not to mix the three asset classes. In our results we present the amounts that must be saved by a male individual in the private pension system for a 20-year and a 40-year working period. We assume the start- ing annuity (At=1) to grow monthly by the expected average growth rate of salaries (g), which should be in line with productivity growth rate (we assume the average salary grows by 1.77% per year), and we assume those annuities to be invested at the constant investment rate r, which depends on the preselected asset class and related risk-return profile. Table 6 presents yields and volatilities for selected asset classes for selected 20- and 40-year investment horizons: A _ ACCUSAVINGS *(r - g ) _ (1 + r)n - (1 + g)n Table 5 displays a summary of the results. The results are presented for male individuals in three different decile groups (D1, D5, and D10) for selected years in the period 2035- 2060. Evidently, the pension gap (PGAP) is inflated throughout the projection period for all income groups (D1, D5, and D10), as the net replacement rate from the PAYG system is projected to deteriorate. In nominal terms the gap is becoming larger for individuals who belong to higher-income groups. This means that unless such individuals accumu- late greater savings until the end of their working period they will fall below the 70% net replacement rate. As previously explained, the discounted pension gaps represent the accumulated sav- ings that each individual pension recipient is expected to accumulate during his working 27 We use 0.5% discount rate as it reflect the need to minimize risk exposure once the individual is retired and it is consistent with annuity industry practice. A. BERK SKOK, M. ČOK, M. KOŠAK, J. SAMBT | THE ROLE OF ASSET ALLOCATIONS IN PLANNING .. 99 period until the end of his retirement year. Consequently, the volume of the required ac- cumulated savings determines the monthly savings contributions each male individual is expected to save until the retirement year. Table 8 presents the first annuity a male individual is expected to start saving under varying assumptions. First, we assume that individuals from different decile groups have to accumulate different savings volumes to supplement the regularly expected PAYG pension. Second, we assume that future public finance scenarios affect the monthly savings contributions. And third, the length of the expected savings period also affects the volume of the accumulated funds at the end of the working period. For simplicity, we present only calculations for 20 years and 40 years. Table 5: PAYG pensions calculated by the official net replacement rate in selected years and gaps to the 2035 pension, 70% net replacement rate pension, and gap to the forecast- ed salary in selected years to 2060 (in EUR) 2035 2040 2045 2050 2055 2060 Decile group Net replacement rate (%) 57.25 55.29 53.39 51.56 49.79 48.08 D 1 PAYG pension (M) 461 486 513 540 570 601 Gap to the 2035 pension 0 25 51 79 109 139 Gap to the 70% net replacement rate 103 129 159 193 231 274 Gap to the salary 344 393 448 508 575 649 Salary 806 879 960 1048 1144 1249 D 5 PAYG pension (M) 675 711 750 791 834 879 Gap to the 2035 pension 0 37 75 116 159 204 Gap to the 70% net replacement rate 150 189 233 283 338 401 Gap to the salary 504 575 655 743 841 949 Salary 1179 1287 1405 1534 1674 1828 D 10 PAYG pension (M) 1768 1864 1965 2071 2184 2302 Gap to the 2035 pension 0 96 197 304 416 535 Gap to the 70% net replacement rate 394 496 611 741 887 1050 Gap to the salary 1320 1507 1715 1946 2203 2486 Salary 3088 3371 3680 4018 4386 4789 Source: Authors' calculations. As it is evident from Table 8, the individual's decision for a particular type of investment (i.e., asset class) and the length of the savings period have a substantial impact on the size of the annuity that the individual saver is expected to start saving. So, a male individual in the D5 decile group who decides to invest in a portfolio of large- and mid-cap stocks (see section 5) is expected to start saving 54 EUR per month if he has a 40-year invest- ment period and 121 EUR per month if he has a 20-year investment period. If the same male individual were to decide to invest in a portfolio consisting exclusively of T-bills, he would need to start saving 149 EUR with an intended investment period of 40 years and 222 EUR per month with an intended investment period of 20 years. The differences in required monthly savings contributions are significant, and one can clearly observe 100 E/B/R ECONOMIC AND BUSINESS REVIEW | VOL. 15 | No. 2 | 2013 | 100-33 113 how important it is to decide on a proper investment strategy in terms of both portfolio structure and length of the savings period (i.e., individuals should start saving as soon as possible). All other accompanying aspects that also affect the final savings outcome (e.g., different public finance scenarios that directly affect the PAYG pensions) make the differences only more pronounced. The second set of results is based on simulations in which the investment yields were ad- justed to reflect the volatility of average historical returns of the preselected asset classes. Therefore, the three right-hand columns of Table 6 present the required monthly savings contributions for a risk-aware male individual who wants to avoid a case that investment yield deviates down to two standard deviations (-2 sigma) from the average historical returns of the individual asset classes. In this scenario all required monthly savings con- tributions are significantly higher, which reflects the sensitivity of the savings strategy to financial market volatility. Table 6: Required contributions under three different fiscal scenarios consistent with average real yield under three different asset class allocations (left) and consistent with -2 sigma real yield under three asset class allocations (right) 40 years 20 years SCI - STOCKS - AVERAGE Average yields D1 D5 D10 -2 sigma yields D1 D5 D10 1st contrib. under "no limit" 37 54 142 116 169 444 1st contrib. under 13% GDP 57 84 219 179 262 685 1st contrib. under 11% GDP 71 104 271 221 324 848 SC2 - BONDS - AVERAGE 1st contrib. under "no limit" 100 147 384 154 226 591 1st contrib. under 13% GDP 155 226 593 238 348 913 1st contrib. under 11% GDP 191 280 734 295 431 1130 SC3 - BILLS - AVERAGE 1st contrib. under "no limit" 102 149 391 120 175 459 1st contrib. under 13% GDP 157 230 603 185 271 709 1st contrib. under 11% GDP 195 285 746 229 335 877 SC1 - STOCKS - AVERAGE 1st contrib. under "no limit" 83 121 318 184 269 705 1st contrib. under 13% GDP 128 187 490 284 416 1089 1st contrib. under 11% GDP 158 232 607 352 514 1347 SC2 - BONDS - AVERAGE 1st contrib. under "no limit" 150 219 574 184 269 705 1st contrib. under 13% GDP 231 338 886 284 416 1089 1st contrib. under 11% GDP 286 418 1096 352 514 1347 SC3 - BILLS - AVERAGE 1st contrib. under "no limit" 152 222 582 174 255 667 1st contrib. under 13% GDP 234 343 898 269 393 1030 1st contrib. under 11% GDP 290 424 1112 332 486 1274 Note: D1, D5 and D10 represent first, fifth and tenth decile group of an individual's income distribution. Source: authors' calculations. A. BERK SKOK, M. ČOK, M. KOŠAK, J. SAMBT | THE ROLE OF ASSET ALLOCATIONS IN PLANNING .. 101 Finally, we compare accumulated savings (i.e., pension wealth), assuming that an indi- vidual would start saving monthly contributions adequate to the expected extreme mar- ket performance (i.e., -2 sigma) and at the same time it would ex post turn our that he could realise expected average market yields (mean yields). The results shown Table 7 are striking. Under this approach, one can easily grasp the advantages of allocating pension wealth into stocks over the long run. Table 7: Pension wealth at the moment of annuitizing of an individual who anticipated extreme market performance (-2 sigma real yield) but realized average performance under three different asset class allocations and three different fiscal scenarios D1 D5 D10 40 years SC1 - STOCKS - (-2 sigma) 1st contrib. under "no limit" 1st contrib. under 13% GDP 1st contrib. under 11% GDP SC2 - BONDS - (-2 sigma) 1st contrib. under "no limit" 1st contrib. under 13% GDP 1st contrib. under 11% GDP SC3 - BILLS - (-2 sigma) 1st contrib. under "no limit" 1st contrib. under 13% GDP 1st contrib. under 11% GDP 330,880 510,912 632,217 149,147 230,297 284,977 113,739 175,624 217,322 484,132 747,547 925,036 218,226 336,963 416,967 166,419 256,967 317,978 1,268,246 1,958,297 2,423,253 571,672 882,718 1,092,300 435,955 673,158 832,985 20 years SC1 - STOCKS - (-2 sigma) 1st contrib. under "no limit" 1st contrib. under 13% GDP 1st contrib. under 11% GDP SC2 - BONDS - (-2 sigma) 1st contrib. under "no limit" 1st contrib. under 13% GDP 1st contrib. under 11% GDP SC3 - BILLS - (-2 sigma) 1st contrib. under "no limit" 1st contrib. under 13% GDP 1st contrib. under 11% GDP 109,335 168,824 208,908 73,977 114,228 141,349 58,765 90,740 112,284 159,975 247,018 305,667 108,241 167,135 206,817 85,983 132,767 164,289 419,076 647,095 800,734 283,551 437,831 541,785 225,245 347,800 430,377 Note: D1, D5 and D10 represent first, fifth and tenth decile group of individual's income distribution. Source: authors' calculations. Figure 7 summarizes the effects of different investment strategies chosen by male indi- viduals. Stocks are a benchmark in this comparison (i.e., results are expressed in terms of ratio of stocks to other asset classes). First, individuals who choose stocks over a 40-year period are (according to the expected average yield) required to save about one-third the amount of individuals who choose bond or bills. According to expectations of extreme financial market performance, stock investors can still save about one-quarter less (ex- 102 E/B/R ECONOMIC AND BUSINESS REVIEW | VOL. 15 | No. 2 | 2013 | 102-33 113 actly 26% less over a 40-year investment horizon and 14% less over a 20-year horizon). Second, when risk-aware investors decide to save according to expectations that they close the gap despite extreme financial market performance, but those results turn out (most likely) to be average, a stock strategy would beat out a bond and/or bill strategy by a substantial margin. As Figure 8 shows, this margin is already very material at a 20- year investment horizon. Investors with a stock strategy accumulate 48% more pension wealth than those with a T-bond strategy and 86% relative to a T-bill strategy. Over the 40-year investment horizon, the respective differences are substantial: 121% relative to T-bond strategy and 191% relative to T-bill strategy. Figure 7: Stock-to-other-asset-class ratios of contributions and of pension wealth before annuitization for investment horizons of 20 years and 40 years ^Averageyield contribution ® - 2 sigma contribution • Wealth ratio (right scale) 11 3.om Stocks T-bonds 40 years T-bills 40 years T-bonds 20 years T-bills 20 years Source: authors' calculations. We argue that governments in countries with pension system facing similar issues to those of Slovenia should be interested in improving the financial literacy of the public in both aspects, i.e. improving an awareness to save and also knowledge about basic char- acteristics of financial asset classes. Doing so would prevent opportunity losses in terms of lower available pension wealth and old-age disposable income despite people being aware about the need to save for their pensions. A. BERK SKOK, M. ČOK, M. KOŠAK, J. SAMBT | THE ROLE OF ASSET ALLOCATIONS IN PLANNING .. 103 7. ADVANTAGES OF PRIVATE PENSION SAVINGS ALLOCATIONS OVER ORDINARY SAVINGS ALLOCATION In this section we present benefits that stem from the fact that separate pension pil- lars react differently to various economic shocks. We calculate the extent of benefits using common finance literature metrics of a standard deviation of a portfolio. In this approach coefficients of correlation among main assets take the central role. The co- movements that are reflected in the coefficients of correlation reduce the volatility of a combination of assets. We measure and show benefits of diversification that rise from combining exposures to homogeneous assets by the percentage decrease of standard deviation of the resulting portfolio compared to the standard deviation of the asset class alone. In order to be able to calculate standard deviation of a portfolio we have to define ho- mogeneous assets. Our analysis was based on the traditional financial market asset classes, i.e. stocks (EQ), 10-year government bonds (10yB), money market government bills (MM), and on wages, following approach of Holzmann (2002). We used data from Thomson Reuters Datastream database for France, UK, Germany and The Netherlands, for the period from 1971 to 2011. We calculated annual yields from total return index time series in nominal terms. We used the following stock indices: CAC 40 Total Return Index (France), FTSE 100 Total Return Index (UK), DAX 30 Total Return Index (Germa- ny), Amsterdam MIDKAP DS Total Return Index (The Netherlands), Benchmark 10-year Government Total Return Indices, and Benchmark 1-3-year Government Total Return Indices. For the time series of wages (we used two wage time series: Wage Rate - Private Sector and Wages and Salaries - Total Economy) we also used time series of aggregate wages in nominal terms. Our goal is not to define optimal investment strategy for pension portfolio but to show benefits of diversification that rise from the characteristics of each financial asset class by combining it with the pension income that is received from the PAYG. Therefore, we calculate bivariate correlation coefficients of stocks, long-term government bonds, and short-term government bonds with both measures of wage income that proxy for the dynamics of the PAYG. Table 8 reports our results. In general, correlation coefficients are low, which means that benefits of diversification are substantial. We see that correla- tion coefficients are smallest in the case of combining PAYG with stocks (cross-county average 0.0016), followed by long-term government bonds - 10yB (cross-county aver- age 0.0690) and finally by short-term government bonds - MM (cross-county average 0.2625), which means that benefits of diversification of PAYG pension income are the largest when this income is combined with pension income that derives from stocks investments. 104 E/B/R ECONOMIC AND BUSINESS REVIEW | VOL. 15 | No. 2 | 2013 | 104-33 113 Table 8: Divariate correlation coefficients between annual growth rates of aggregate wages and performance of financial asset classes for the period from 1971 to 2011 Stocks 10yB MM AVERAGE France 0.2657 0.2327 0.4169 0.3051 WR 0.3184** 0.2584* 0.4914** 0.3561 WS 0.2130 0.2071 0.3424*** 0.2542 United Kingdom 0.1931 0.2274 0.1488 0.1898 WR 0.2646* 0.1412 0.1577 0.1878 WS 0.1215 0.3136** 0.1400 0.1917 Germany -0.2038 -0.1649 0.3268 -0.0140 WR -0.2826* -.1693 0.4026*** -0.0178 WS 0.1208 -.1606 0.2510 -0.0101 Netherlands -0.2486 -0.0194 0.1574 -0.0369 WR -.1658 -.054 0.2776* 0.0193 WS 0.3313** 0.0153 0.0372 -0.0930 ALL 0.0016 0.0690 0.2625 0.1110 WR 0.0326 0.0441 0.3323 0.1363 WS -0.0294 0.0938 0.1927 0.0857 Notes: WR - Wage rate of the private sector, WS - Wages & salaries; 10yB - 10-year government bonds, MM - money market government bills; Performance of financial asset classes is expressed in terms of annual changes in total return indices. *** - significant at 1%, ** - significant at 5%, * - significant at 10%. Source: Thomson Reuters Datastream, authors' calculations. In order to be able to express diversification benefits we have to measure standard de- viations of separate time series (see Table 9) and then calculate standard deviations of portfolios comprising PAYG pension income and pension income that derives from a particular financial asset class. Table 9: Standard deviations of annual aggregate wages and performance of financial asset classes for the period from 1971 to 2011 Stocks 10yB MM WR WS France 0.2574 0.0845 0.0341 0.0487 0.0524 United Kingdom 0.1700 0.1120 0.0341 0.0583 0.0873 Germany 0.2512 0.0693 0.0339 0.0309 0.0358 Netherlands 0.3104 0.0792 0.0286 0.0471 0.0424 ALL 0.2472 0.0862 0.0327 0.0463 0.0545 Note: 10yB - 10-year government bonds, MM - money market government bills; Performance of financial asset classes is expressed in terms of annual changes in total return indices. Source: Thomson Reuters Datastream, authors' calculations. If we compare portfolio standard deviations with standard deviations of a particular financial asset class, we can directly measure the positive diversification impact of com- bining two sources of pension income, i.e. decrease of the standard deviation. Table 10 A. BERK SKOK, M. ČOK, M. KOŠAK, J. SAMBT | THE ROLE OF ASSET ALLOCATIONS IN PLANNING .. 105 and Figure 8 report such effects for pension income that derives in 50 percent from PAYG and 50 percent from the particular financial asset class. Table 10: Diversification benefits of combining traditional asset classes (50%) with PAYG (50%) Stocks 10yB MM STDEVp % efect STDEVp % efect STDEVp % efect FR (0.2574) 0.1376 -46.6% 0.0541 -36.0% 0.0359 5.2% WR 0.1384 -46.2% 0.0540 -36.2% 0.0360 5.4% WS 0.1367 -46.9% 0.0541 -35.9% 0.0358 5.0% UK (0.1700) 0.0985 -42.0% 0.0739 -34.0% 0.0425 24.8% WR 0.0969 -43.0% 0.0667 -40.5% 0.0360 5.7% WS 0.1001 -41.1% 0.0811 -27.6% 0.0490 43.9% GER (0.2512) 0.1234 -50.9% 0.0359 -48.2% 0.0274 -19.3% WR 0.1220 -51.4% 0.0355 -48.8% 0.0272 -19.9% WS 0.1247 -50.4% 0.0363 -47.5% 0.0276 -18.8% NL (0.3104) 0.1513 -51.3% 0.0451 -43.1% 0.0284 -0.6% WR 0.1531 -50.7% 0.0450 -43.2% 0.0308 7.7% WS 0.1495 -51.8% 0.0452 -42.9% 0.0260 -9.0% ALL (0.2472) 0.1235 -50.0% 0.0575 -33.3% 0.0402 23.0% WR 0.1265 -48.8% 0.0498 -42.2% 0.0325 -0.7% WS 0.1206 -51.2% 0.0653 -24.3% 0.0479 46.7% Note: WR - Wage rate of the private sector, WS - Wages & salaries; 10yB - 10-year government bonds, MM - money market government bills; Performance of financial asset classes is expressed in terms of annual changes in total return indices; STDEVp - standard deviation of a portfolio created by combining financial asset class with PAYG; %effect - Percentage decrease of standard deviation of an asset class due to diversifica- tion through PAYG. Source: Thomson Reuters Datastream, authors' calculations. As expected from the levels of correlation coefficients, decreases of standard deviation and thus benefits of diversification are the largest in case of combining PAYG income with investments into stocks, whereby standard deviation decreases to about one half of standard deviation of stocks. They are followed by investments into long-term gov- ernment bonds, whereby standard deviation decreases to about two thirds of standard deviation of long-term government bonds. Benefits are limited in case of short-term gov- ernment bonds, which is also a result of similar levels of standard deviations of wage income and short-term government bond yields. We see from Table 11 that standard deviations of short-term government bonds are generally lower than standard deviations of wage income. 106 E/B/R ECONOMIC AND BUSINESS REVIEW | VOL. 15 | No. 2 | 2013 | 106-33 113 Figure 8: Diversification benefits of bivariate combinations of financial asset classes (50%) and PAYG (50%), measured as a percentage decrease of standard deviation of a financial asset class 60,0% J- ^ jf Jf & ^ Jr ^ ^ J- ^ Note: WR - Wage rate of the private sector, WS - Wages & salaries; 10yB - 10-year government bonds, MM - money market government bills. However, diversification benefits depend on the weights in the standard deviation equa- tion, i.e. on the relative importance of each source of pension income. They are the high- est in situations when country makes the first moves towards private pensions from the PAYG and decrease with the relative importance of private pensions (see Figure 9). Figure 9: Impact of the extent ofrequiredprivatepension supplement on diversification benefits 90/10 80/20 70/30 60/40 50/50 40/60 30/70 20/80 10/90 Note: 10yB - 10-year government bonds; 90/10 - pension income generated in 90% through PAYG and 10% through private pensions, 80/20 - pension income generated in 80% through PAYG and 20% through private pensions, etc.. A. BERK SKOK, M. ČOK, M. KOŠAK, J. SAMBT | THE ROLE OF ASSET ALLOCATIONS IN PLANNING .. 107 8. CONCLUSION AND DISCUSSION With EU demographic dynamics, many countries are expected to face a situation where PAYG system will not be able to finance levels of pensions set out in current rules. In this article, we show that this is the case in Slovenia. Taking into account the current pension system and aging population, PAYG pension benefits as a percentage of GDP would increase to about 17%, which we believe is financially unsustainable. Cuts to the PAYG benefits thus are unavoidable. It is therefore the role of the private pensions to fill the gap between projected first-pillar pension and overall level of pension at the 70% net replacement rate suggested by the OECD. Improved private pension systems would not only solve pension issues but also help develop financial markets, which would in turn lead to higher savings, higher capital budgets of companies, economic growth, and most importantly, well-being of the population. Today Slovenia's private pension system is of minor importance. Second-pillar legisla- tion was enforced in 2000, a significant step forward, but evolution in the field has since been negligible. New legislation is now effective since January 2013, but secondary level acts are still being prepared. In general, people do not have enough knowledge to make proper decisions. Because a large majority of the population is only modestly financially literate, there is a real risk that many people will not have enough means to live through old age without financial difficulties. In this paper we have shown how much people should save and what kind of asset al- location they should choose. The government should try to address the issue of financial illiteracy and encourage people to save. In addition, government should conceptualise reasonable legislation on the available financial vehicles offered in the private pension system and work on ways to properly communicate the asset allocation decision. Name- ly, we have shown that if an individual saves over a period of 40 years and allocates sav- ings into a well-diversified stock portfolio, he can save far more than an individual who allocates savings into a well-diversified T-bond or T-bill portfolio for the same expected horizon. The differences are also significant over a 20-year period. However, story should not be based solely on returns but should also include risk. Name- ly, higher stock returns should also be more risky compared to bond and bill returns. That was why we checked the episodes of the worst historic financial market perform- ance. Average annual real yields at two standard deviations below the average value are 0.31%, -1.55%, and 0.10% for stocks, bonds, and bills, respectively. If a risk-aware in- vestor chooses to save amounts consistent with -2 sigma yields (which are higher than amounts consistent with average yield), the required amount for stock allocation is about 26% less than for T-bond allocation over a 40-year investment horizon. In addition, we have revealed the significant upside in yield potential with stock invest- ing, which is not the case for fixed-income investments. Namely, if risk-aware investor decides to save according to expectations that they save enough to achieve 70% net re- placement rate despite extreme financial market performance (but the investment result 108 E/B/R ECONOMIC AND BUSINESS REVIEW | VOL. 15 | No. 2 | 2013 | 108-33 113 turns out to be average, which is obviously the most likely), individuals with a stock strategy would beat individuals with a bond and/or bill strategy by a substantial margin. Investors with a stock strategy accumulate 49% more pension wealth than those with a T-bond strategy and 85% more than those with a T-bill strategy over a 20-year invest- ment horizon. Over a 40-year investment horizon, the stock allocation beats the T-bond portfolio by 119% and the T-bill strategy by 190%. We thus conclude that when people who save for their pension have a long-enough horizon, they should predominantly al- locate investments into stocks. The amount that people should save every month is in this setting where individuals choose asset allocation for the whole investment horizon determined by asset allocation choice, not income level, which is commonly assumed to determine individual's risk aversion. Governments should bring that finding into legisla- tion, and one way of doing so would be the life-cycle investment policy approach. According to the results presented here and the characteristics of Slovenia's current pen- sion system, the first thing needed is to give individuals a certain degree of free asset allocation choices and/or life-cycle investment choices for the automatic transition of aging individuals to more conservative asset classes (i.e., toward T-bill allocation). Even though this issue is sensitive, current guarantees set uniformly for all individuals are ill advised. We argue that besides a robust, strong, well-designed second pillar, individual retirement accounts should be introduced in the third pillar. Such accounts, when prop- erly tax-calibrated, would provide lower-income individuals with additional incentives to save for their pension. Over the long run, this would significantly increase chances that Slovenia's aging population will not slip into poverty. In this paper we also show that allocation of savings is less risky in the context of pen- sions compared to traditional allocation of savings. Namely, as pension income has to be combined from the PAYG and from the funded pension portfolio, and both depend on specific drivers having different sensitivities to various shocks, pension beneficiaries are protected by diversification benefits. 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