An ageing population, low birth rates, a decreasing workforce and fundamental changes in the workplace are threatening the financing of the pay-as-you-go (PAYG) system in developed countries. To ease this challenge, leading European pension systems have emphasized capital-funded, private pension schemes as a substitute for the statutory pension system. In particular, the UK and the Netherlands have adopted social responsible investment (SRI) strategies as well as alternative investments in the asset allocation of the pension funds. However, Pension Insurance Funds (Pensionskassen) in Germany hesitate to do so. Their asset allocation is highly regulated and very risk-conservative. This book provides detailed theoretical analysis and empirical evidence that German Pension Insurance Funds should consider SRIs as well as alternative investments as part of their strategic asset allocation.
The first chapter outlines the aim of the book, to assess the suitability of SRIs, alternative investments and derivative outlays as part of the strategic asset allocation and find suitable alternative asset allocation models for German Pension Insurance Funds. The author introduces the pension system in Germany and the role of SRIs as well as alternative investments in the pension fund section of German and other European countries, which motivates the consideration of the pros and cons of adopting SRIs in Germany. The author performs his investigation through a multi-step process, including a stochastic time series model, multivariate bootstrap simulation, dynamic portfolio allocation strategies and value distributions.
Chapter 2 provides a thorough review of the overall German pension system. The history of occupational pension plans in Germany is as long as 180 years. However, they used to play only a subsidiary role in the pension system. The recent deterioration in the funding viability of statutory pensions has made Germany promote private sector pension plans, including occupational and individual ones. Among the five occupational pension scheme alternatives, German Pension Insurance Funds are the most important, due to their historic role, size and market share. Insured pension members benefit from retirement, death or disability via different pension benefit structures. The author then reviews the legal and regulatory framework of the investment management of German Pension Insurance Funds.
The third chapter is devoted to discussing the suitability of SRIs and alternative asset classes for the strategic asset allocation of Pension Insurance Funds. The author first provides a definition for the broad term ‘sustainable’ and ‘SRI’ investments and compares the differences among the various understandings of the same concept. In common terms, SRIs can be considered as investments and investment strategies ‘to create positive social change, minimize environmental damage and incorporate religious or ethical beliefs’, where the so-called ‘ESG factors’ (environmental, social and governance standards) will influence the investment decisions of the investor. Then the author introduces SRI investor types, investment motivations, investment strategies, asset classes, investment performance and SRI market size. The experience in the UK and US market indicates that SRI strategies perform at least as well as traditional asset classes, which might motivate German pension funds to invest in SRIs. Finally, the author discusses the suitability of alternative investments for the asset allocation of Pension Insurance Funds, with a particular emphasis on hedge fund assets and commodities.
Chapter 4 provides the theoretical foundation of the empirical analysis. The author introduces the Vector Error Correction modelling technique, including basic models, statistical tests and estimation methods to be applied to capture the underlying data. Depending on different asset classes, a Vector Error Correction Model (VECM), a Vector Autoregressive Model (VAR) and an ARMA model might be used for fitting. Then the bootstrap simulation technique is reviewed, which will be used to generate future return paths of the target assets. Both outright strategies (buy-and-hold and constant-mix) and derivative overlay strategies (hedging, bond-call option and yield enhancement) will be tested in the simulation study. Owing to the risk-averse investment profile of German Pension Insurance Funds, the traditional mean-variance performance measures are not adequate to assess the suitability of SRIs. So other performance measures, such as lower partial moments (LPMs) and downside risk performance indicators, are defined.
The fifth chapter is the core part of the book. The author applies the matching principle to compose a Standard Portfolio, a SRI Portfolio and an Alternative Portfolio and calculates the descriptive statistics of those portfolios. Then, various test and estimation methods are used to establish cointegration relationships among assets used in all three portfolios. The bootstrap simulation reveals a lot of interesting results, for example, (1) all three portfolios achieve their objectives in all strategies used; (2) taking into account the inflation rate, the performance of these portfolios are still sufficient to offer capital guarantee in real money term; and (3) the Alternative Portfolio with up to 10% of the total asset allocation in alternative investments performs on average better than the SRI Portfolio. Further investigation of alternative investment scenarios show that alternative strategic asset allocation models can provide effective inflation hedging and credit risk hedging for Pension insurance funds.
In summary, this book provides empirical evidence that SRIs and alternative assets are suitable for the strategic asset allocation of German Pension Insurance Funds. However, the historical average returns of equity assets are lower than those of fixed-income securities. This is abnormal since it is widely accepted that equity assets are more risky than fixed-income securities. Such abnormality in historical data may lead to arbitrage opportunities. Another shortcoming is the use of the Black-Scholes pricing formula. The Geometric Brownian Model assumption in the Black–Scholes pricing formula is not realistic. It fails to incorporate many important stylized features of assets returns, such as asymmetry and heavy-tailedness of the distribution of returns, time-varying conditional volatility, sudden jumps, and others. The Black–Scholes pricing formula also cannot explain some important empirical behaviour of option prices, namely, the implied volatility smile or smirk.
