This paper explores how uncertainty over investment returns affects pension systems. This issue is
becoming more important because of the dramatic spread of defined-contribution pension provision around
the world. It has also been highlighted by the recent financial crisis: the OECD estimates that pension
funds lost 23% of their value in 2008, worth a heady USD 5.4 trillion.
The scale of investment risk is measured in this paper using historical data on returns on equities and
bonds in major OECD economies over the past quarter century. The results show a median real return of
7.3% a year on a portfolio equally weighted between equities and bonds (averaging across the countries
studied). It might be expected that, over a very long period, the degree of uncertainty in investment returns
is small. After all, a few bad years in the market are likely to be offset by boom years. Nevertheless, the
degree of uncertainty, even with the relatively long investment horizons of pensions, is found to be large.
In 10% of cases, an annual return of less than 5.5% would be expected, while in 10% of cases, this should
exceed 9.0%. Compounded over the time horizon for pension savings of 40 years or more, such differences
in rates of return amount to enormous sums of money.
However, there is a series of reasons why returns achieved by individuals on their pension funds are
less than the market return (as measured by conventional indices). These factors include administrative
charges, agency and governance effects and demographic change, depressing investment returns below the
high levels recorded over the past two decades. As a result, a more conservative assumption for future
investment returns than the record over the past quarter century is appropriate. Settling on a median of
5.0% annual real return net of charges implies that 80% of the time, the investment return on pension
savings should be between 3.2% and 6.7% a year.
Investment Risk and Pensions
Measuring Uncertainty in Returns
Working paper
OECD Social, Employment and Migration Working Papers
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