Consider a state pension fund that needs to generate a series of fixed payments for its...

Consider a state pension fund that needs to generate a series of fixed payments for its retires. Assume that the compensation of the fund’s portfolio managers is tied to the return earned on the investments each year. What a short essay that explains how the compensation plan might lead to investment strategies that do not serve the needs of the retirees

Expert Solution

Retirees usually want a fixed cash flow to finance their post retirement expenses month on month. They do not want excess returns and don't want to take any kind of risk with their principal. A state pension fund with the objective of generating fixed cash flows should focus on those products which ensure safety of capital and offer an interest slightly higher than the risk free rate. The return on debt instruments will be slightly higher than the risk free rate. One cannot expect to earn the kind of returns that are generated in equity market in a low risk debt instrument. If the pension fund's manager's compensation is tied to the investment returns i.e. the higher the returns higher the compensation, this may lead to a biased investment strategy which may not be in sync with the investment objective.

The manager may try to invest in those assets which may be risky for a pension fund. If the manager sets the primary objective of managing the fund as his desired compensation he will not be able to serve the objective of the pension fund. Risky assets may erode the capital of the fund and this may lead to no cash flows for retirees.

To keep the retirees investment safe, only those products should be part of the portfolio which can generate a consistent return. A fund manager's compensation should not be tied to such a fund. This will help avoid any unnecessary losses.

jeff jeffy answered 1 year ago

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