The effectiveness of smoothed bonus portfolios for mitigating investment risk in defined contribution pension funds

Abstract

The aim of this study is to investigate whether smoothed bonus portfolios (SBPs) are effective at managing the investment risk that members of a defined contribution pension fund are exposed to. Investment risk arises from the uncertainty of the performance of the assets invested in by the fund during the accumulation phase. This creates uncertainty for a member as to what the outcome at retirement will be. It is measured as the value at risk as well as conditional tail expectation, calculated on a member's simulated savings at retirement. The effectiveness of an SBP is investigated through applying three methodologies, namely 1) a return/risk analysis where the contribution of each of the features of an SBP to its return and return/risk ratio is analysed; 2) comparing the simulated outcome at retirement of an SBP with the outcome of two types of notional benchmark portfolios that apply simpler investment strategies, but are set up to have the same level of risk as the SBP; and 3) applying first-order stochastic dominance (FSD) rules. On a risk adjusted basis, the guarantee and smoothing mechanism of an SBP make positive contributions to its performance. However, when comparing the outcome of the notional benchmark portfolios with that of the SBPs, the former consistently outperform the SBPs modelled. Applying FSD rules, the notional benchmark portfolios are found to be preferred to a greater extent than the SBPs.