In their report, the researchers simulate the performance development of four different portfolios containing different proportions of shares and bonds, the one being a pure equity portfolio with a 100 per cent equity component, and the other a mixed portfolio with 50 per cent shares and 50 per cent bonds; a variant adapted to the lifecycle is also considered for both portfolios, which involves a shift from shares to bonds at the age of 52. The basic model assumes a 45-year savings phase between the ages of 22 and 67. With an average gross salary of 3,880 euros and three per cent annual nominal wage growth, employees pay four per cent of their gross wage into the portfolio each month.
Depending on the investment strategy and the median values for pension payments in an average capital market trend, such a savings model would result in quite considerable amounts: between 2,400 and 1,220 euros in today’s purchasing power.
The report is based on a simulation with 10,000 yield progressions from historical data. “Generally, the pure equity portfolio achieves the highest return in most of the simulated cases. During a bad market trend, however, the equity portfolio adapted to the lifecycle becomes the better choice,” says Tabea Bucher-Koenen, head of the ZEW Research Department “International Finance and Financial Management” and professor at the University of Mannheim.
Financial crises hit particularly hard close to the time of retirement
In order to test the crisis resilience of investment strategies, the researchers simulate a one-year financial crisis with a severity corresponding to that of the financial crisis of 2007 to 2009. If such a crisis occurs in the first year of contribution, the total value of the portfolio falls by an average of one to two per cent for all investment strategies. The effects of a crisis in the last contribution year, however, are much more massive: the pure equity portfolio loses on average around 30 per cent of its value, the lifecycle model around 16 per cent. For mixed portfolios, losses are lower at 14.5 per cent, and 7.5 per cent for the lifecycle model.
For the pension phase, the researchers consider a withdrawal plan with residual payments at the age of 90 onwards and, alternatively, an immediate payment annuity. With the withdrawal plan, the portfolios in question remain invested on the capital market even after retirement, meaning that monthly pension payments fluctuate depending on the chosen investment strategy and the current capital market trends. The withdrawal plan is designed in such a way that the payments are neither zero nor negative. Financial crises during the withdrawal phase can also have an impact on monthly pension payments, in principle potentially causing the greatest damage during the transition from the contribution to the payout phase, since the capital value of the portfolio is at its highest during this time. “The equity portfolio with a lifecycle can counteract the risk of losing considerable assets due to a strong shock on the capital market at the time of retirement, which is why it’s recommendable as the standard option,” says ZEW Research Associate Professor Martin Weber from the University of Mannheim.
In order to take into account the multitude of possible living conditions, the researchers included various deviations from their basic model. They considered what impacts payment interruptions due to unemployment and parenting had on the value of the lifecycle equity portfolio. The effects of payment periods of different lengths and of a one-off payment in the case of inheritance were also simulated. As a general rule, the later employees start making contributions, the lower the portfolio value at the start of the pension phase. Beginning to save later also means giving up interest and compound interest.
The findings of the report can be applied to state and occupational, as well as private pension schemes.