Capital preservation and current spending with sovereign wealth funds and endowment funds : a simulation study

We simulate the future performance of the Norwegian Government Pension Fund Global as a leading example of sovereign wealth funds intended both to preserve wealth and provide regular budget contributions. Withdrawals are limited to the fund’s expected real returns; however, deviations are allowed to fund automatic stabilizers as well as discretionary fiscal policy. It also allows smoothing to avoid abrupt changes. Except for the fiscal policy part, many endowment funds are subject to similar rules. The main findings are: (i) Even if withdrawals matching expected returns maintain the fund’s value in expectation, the fund will be depleted eventually. (ii) Because the fund is invested in foreign currency, long-run purchasing power parity introduces an element of mean reversion and hence a negative serial correlation in the rates of return, so that the fund’s value is not even preserved in expectation. (iii) The use of the fund for fiscal policy introduces a substantial risk of depletion in finite time. (iv) Smoothing raises the risk of depletion after large negative financial returns, though only modestly so. Risk reduction and withdrawal rates below expected returns are explored as remedies. Risk reduction postpones the eventual depletion but does not eliminate it. Lower withdrawal rates help sustainability more fundamentally, but bounds on fiscal policy are needed for depletion risk to be eliminated.