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Risks and Rewards of International Investing for
Retirement Savers
Historical Evidence
Gary Burtless
The Brookings Institution
Washington, DC USA
August 2006
RRC Conference, Washington, DC
Can retirement savers benefit from
cross-national diversification?

Defined-contribution pension contributors

Worker control over investment portfolio

Conversion of savings to level annuity at
retirement (age 62)

Pension replacement rates at retirement
–
–
Alternative portfolios
With and without overseas investments
Source of concern:
Excess sensitivity of pension to late-career returns
Rate of return on
contributions
13%
Pension replacement
rate
120%
114%
12%
Replacement rate (right axis)
11%
9%
110%
IRR on contributions (left axis)
Geometric mean return
over career = 7%.
100%
10%
90%
9%
80%
In exactly one year
during career:
8%
70%
Return = -50%.
53%
7%
6%
60%
50%
5.6%
5%
1
4
7
10
13
16
19
22
25
28
31
Year in career with -50% return
34
40%
37
40
In other 39 years:
Return = 9.1%.
Source of concern:
Persistence of bad returns …
although not in these 3 countries
Geometric mean return (in US $)
10%
1926-1948
1949-1973
1974-2005
9.2%
8%
8.5%
7.8%
7.0%
6%
4%
7.7%
7.0%
6.0%
5.7%
4.3%
2%
0%
U.S.A.
Australia
Stock returns
Canada
Source of concern:
Persistence of bad returns
Geometric mean return (in US $)
1926-1948
12%
1949-1973
1974-2005
12.5%
8%
7.5%
6.5%
6.3%
5.4%
4%
3.5%
0.0%
0%
France
-4%
Ger.
-6.3%
-8%
Stock returns
-1.2%
Italy
Source of concern:
Persistence of bad returns … big time
Geometric mean return (in US $)
20%
15%
15.1%
10%
5%
1926-1948
1990-2005
0%
1926-1948
1949-1989
-5%
-10%
-2.9%
1990-2005
-2.9%
-10.2%
-10.2%
-15%
Japan: Stock returns
Another source of concern:
High variability of overseas returns
Standard deviation of real stock returns (in US $)
35
30
31
32
31
28
25
20
15
19
19
Australia
Canada
21
20
U.K.
U.S.A.
10
5
0
France
Germany
Italy
Japan
International investing:
Portfolio allocation / country weights

In target-retirement-year funds
–
–
–


In proportion to countries’ market weights
In proportion to countries’ GDP weights
–

Vanguard
T. Rowe Price
Fidelity
1980 – 2005
“Optimal” portfolio on the efficient frontier
Assumptions

40-year career

Predetermined portfolio allocation
–
–
Fixed asset allocation
Life-cycle asset allocation

Take account of fund management costs

Conversion to single-life annuity at age 62
–

Long government bond rate determines annuity price
Worker’s goal: Highest possible replacement rate
Results:
100% Allocation to U.S. assets (1872-2005 returns)
Pension replacement rate (% of final pay)
160%
140%
120%
100% US stocks
All
stocks
50% stocks / 50% bonds
100% US bonds
100%
80%
60%
All
bonds
40%
20%
0%
1910
1920
1930
1940
1950
1960
Year pension begins
1970
1980
1990
2000
Results:
Vanguard life-cycle portfolio (based on 1927-2005 returns)
Pension replacement rate (% of final earnings)
160
100% US
stocks
100% US Stock
140
Vanguard target-year portfolio
50% US Stock / 50% US Bond
120
Vanguard
life-cycle
100
80
100% US
bonds
60
40
20
0
0
25
50
Percentile
75
100
Results: The good news
Vary percent of equities allocated to foreign stock
Pension replacement rate
350
100%
foreign
stocks
Allocation of portfolio across foreign and
domestic assets:
300
100% Foreign
50% U.S. / 50% Foreign
250
100% U.S.
50% for. /
50% US
200
150
100% US
stocks
100
50
0
50
55
60
65
70
75
Percentile
80
85
Pension results in good years
90
95
100
Results: The bad news
Vary percent of equities allocated to foreign stock
Pension replacement rate
100
50% for. /
50% US
Allocation of portfolio across foreign and
domestic assets:
100% Foreign
80
50% U.S. / 50% Foreign
100% US
stocks
100% U.S.
60
40
20
0
0
5
10
100%
foreign
stocks
15
20
25
30
35
Percentile
Pension results in bad years
40
45
50
Results:
Conservative and aggressive “efficient” portfolios
Pension replacement rate
160
160
Aggressive int’l portfolio ___
140
100% US stocks
120
140
___
120
Conservative int’l portfolio ____
100
100
80
80
60
60
40
40
20
20
0
0
0
10
20
30
40
50
Percentile
60
70
80
90
100
Conclusions


In theory: International should help
Compared to 100% US stock portfolio –
–
–
–

Naïve international diversification –
–
–

Life-cycle fund reduces average pensions
Increases risk of low pensions
Result due to high allocation to bonds
Improves average and best pensions
Increases risk of very low pensions
“Efficient” international portfolios can –
–
–
Increase median and top-end pensions
Without harming pensions in worst years