Portfolio Preferences of Government Pensioners

Abstract

The study tests the Modern Portfolio Theory (MPT) with reference to optimizing the behavior of portfolios created by government pensioners; viz whether or not they adjust their portfolio in order to optimize market return against expected return? It finds that the portfolio choices of government pensioners indicate structural shift from pre liberalization period to the post liberalization period. Study is based on the primary data collected from 495 government pensioners who retired from the State, All India and Defence services and have settled in the four major cities of M.P. in pre (1967-1991) and post (1992-2002) liberalization period. Study pertains to the portfolios constructed out of the lump sum pension benefits received by them at the time of retirement. Reforms of early 1990s seem to have created a substantial effect on the investment opportunities available to an investor (pensioner). There has been a remarkable growth for financial assets market in India. It has grown in terms of amount raised from markets, number of stock exchanges and other intermediaries, the number of listed stocks, market capitalization, trading volumes and turnover on stock exchanges, and investor population. Along with growth, the profile of the investors, issuers and intermediaries have changed significantly. The market has witnessed fundamental institutional changes resulting in drastic reduction in transaction costs and significant improvements in efficiency, transparency and safety. Reforms in Indian economy have widened the investment opportunities for investors. Pensioners seem to be largely affected by the reforms in the money and capital markets. Pensioners who held their portfolios under constraints in the pre liberalization period now have greater choices of investment in financial assets. Study addresses the following three questions in the light of reforms in financial markets: 1. Shift : Has there been a shift from ‘X’ TO ‘Y’ in the portfolio preferences of the government pensioners between the pre liberalization and post liberalization period? 2. Diversification: Did the pensioners who retired in the post liberalization (on or after 01-01-1992) construct more diversified portfolios than those who retired before it? 3. Risk Return Characteristics : Have the risk and return characteristics of the portfolio of government pensioners changed from pre liberalization period to post liberalization period.? Answers to the questions mentioned above can be summarized as follows: 1. The government pensioners who retired in the pre liberalization period had opted for a different set of assets to hold in their portfolios from those who retired in the post liberalization period. This difference was found to be significant in the composition of portfolio, both in quality and quantity of the assets. The choice of assets in the post liberalization period was greater and more varied. 2. The government pensioners who retired in the pre liberalization period had a different level of diversification in their portfolios from those who retired in the post liberalization period. The number of assets in the portfolio of post liberalization pensioner was higher in quantity since a greater and varied choice was now available to him after the opening up of the Capital and Money markets. 3. The government pensioners who retired in the pre liberalization period had different risk return characteristics in their portfolios from those who retired in the post liberalization period. The Risk Return characteristics differed across all types of portfolios namely, low risk, medium risk and high-risk portfolios. The retirees of the last five years (post 1997) had lower returns despite a greater risk in their portfolios. Thus the study finds structural changes in the composition of portfolios of pre and post liberalization pensioners and confirms the shift as a consequence of reforms initiated in the 1990s. The average number of assets in the portfolio has increased from 3.84 security per portfolio in pre liberalization to 5.34 securities per portfolio in post liberalization period, yet there is no corresponding decrease in the risk component of the portfolio. Overall, the study finds that a vast majority of pensioners in the sample largely remain under-diversified in the pre liberalization period and naively diversified in the post liberalization period. They are found to have taken higher magnitude of idiosyncratic risk. Pensioners are aware of the benefits of diversification but they appear to adopt a “naive” diversification strategy where they form portfolios without giving proper consideration to the correlations among the equities and other securities. Cross-sectional variations in diversification across demographic groups suggest that pensioners in low income and high social liabilities category hold the least diversified portfolios. Overall, the results indicate that pensioners realize the benefits of diversification but they face a daunting task of implementing and maintaining a well-diversified portfolio. The study also compares the risk return analysis of the demand for financial assets of the household sector (as Market representative portfolio) in India from 1970 to 2002 with that of the pensioners’ portfolios. It was found that the pensioners who retired in the pre liberalization period outperformed the market, but those who retired in the post reform period failed to do so. Pensioners and small investors are usually advised to adopt the mutual funds route for investing, but mutual funds have not brought any glory to them in the short to medium term. It is therefore advisable to launch a mutual fund exclusively for pensioners and senior citizens. This may have a cross generation subsidy that can provide returns worth long term even in short or medium term. Thus short and medium term returns can be subsidized at the cost of steady long-term gains. Study also advises policy makers to come up with innovative instruments like inflation linked bond to help the pensioners beat inflation at one hand and make way for smooth living even when a few state governments have capped the dearness allowance. It is also recommended that the government should reduce the minimum holding period (lock-in period) for few government schemes like the NSCs, MIPs of the post offices etc. from the present six years to a minimum of two years and renewable thereafter for each single year. It is all the more significant to devise retirement benefit and investment policies for the retirees that would see them through their lives with an optimum level of consumption where they neither outlive their resources, nor under-spend it. The ceiling of the dearness allowances (DA) on pension by many states has adversely affected the finances of the pensioners. As found in the study, if pensioners diversify “naively”, they may falsely believe that they hold diversified portfolios and as a result the perception of market risk will vary across pensioners. Consequently, pensioners are likely to demand different amounts of risk compensation for holding securities, in accordance with their heterogeneous risk perceptions. If the degree of naive-diversification of portfolio of the sample pensioners is taken as representative portfolio of the pensioner population in India, asset-pricing models should be calibrated to take into account their investment needs.