This book, first published in 2004, presents an academic and a practical aspect on managing pension funds to clarify the global debate on social security. The authors establish the basic choices in designating any system to help policy makers develop the system that achieves their many objectives. They examine reforms in Latin America to highlight flaws and to estimate the true cost of these reforms and factors affecting these costs. The authors then discuss how the United States and Spain can implement robust systems incorporating many of the ideal features. The success of reforms depends on financial innovation to mitigate key risks and some innovations are discussed, which also demonstrates how pension reform choices affect the achievement of retirement objectives. Finally, the authors examine some proposed hybrid options to show how the beneficial features of these hybrids can be captured through good design in a single fund.
Practical applicationsMany practitioners focus on trying to maximise the information ratio of active assets for a given tracking error, as there is a perception that higher information ratios imply higher skill. This paper first demonstrates that higher information ratios may not transfer into higher confidence in skill and, more importantly, that a new class of risk-adjusted performance measures are providing invaluable advice on optimal portfolio construction. In short, for a given tracking error budget, the paper demonstrates that the correct approach is to maximise risk-adjusted return. Using performance measures such as the M-square or the M-cube to evaluate risk-adjusted performance also provides clients with invaluable advice on optimal portfolio construction; specifically, allocations to cash, the passive benchmark ('the beta') and the active strategy (which may include multi-manager portfolios). In short, a more effective way of creating optimal portfolios is to integrate the active-passive and leverage-deleverage decisions to achieve a desired risk budget (with certain constraints on volatility of the optimal portfolio) and not just maximise the information ratio on the active component.
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