Pensions in Europe:Strategic transitions ininvestment governanceKees Koedijk
Structure of the presentation• The need for change in the European pension market• Macro economic & institutional pension ...
The world is complicated enough as it is...
… while pensions as an issue loom in the background• Pension expenditure set to rise in European Union• Wide diversity bet...
Increase in old-age dependency ratio in the EU countriesconstant factor for years to come 55 50 45 40 35 30               ...
The change in old-age dependency ratio and the situation in 2050                                   is spread unevenly thro...
Public pension expenditure as a share of GDP set to rise further between 2004 and 2050              14              13    ...
Countries deal with pensions in different waysThird pillar:private pensionSecond pillar:collectivelyorganized pensionFirst...
Size of pension liabilities overshadows government debt600500400300                                         Implicit publi...
Structure of the presentation• The need for change in the European pension market• Macro economic & institutional pension ...
Transition agenda•   Pension sector set to transform in the coming years on a macro    economic/institutional and organiza...
Macro economic transition            • Separate implicit pension claims from explicit government Create       claims Priva...
Organizational transition                      Principal                     Agent issues       Complexity                ...
Organizational transition – Complexity financial industry                                                          Princip...
Organizational transition – Principal agent issues   • Increasing awareness: principal (pension                          P...
Organizational transition – Shifting investment paradigms• Challenges up ahead; aging on asset pricing                    ...
Structure of the presentation• The need for change in the European pension market• Macro economic & institutional pension ...
A new investment framework has to deal with a lot of unresolved    questions•    Is the equity premium dead or alive?•    ...
Questions…•   … pension funds and investment managers deal with day in day out•   Answers…     • Are difficult to give. In...
Unresolved, because finance & investments are youngdisciplines•   Humans get in the way (Gray, 1997)        • No “hard” sc...
But…•   If investment results influence the success or failure of pension funds•   And investment choices are (partly) bas...
Just as any other organisation would do•   Strategic Management Similarities     • Companies communicate their vision and ...
Strategic management rationale     Best practice funds: “WHY”                          Muddling through: “HOW”1.   Clear f...
Upward potential  •   Upward potential for good governed pension funds, best governed      pension funds focus on coherenc...
Investment beliefs                Financial markets beliefs               Investment process beliefs     •Risk premium    ...
Focus on a number of beliefsTo be publishedin the AnthologyProject, AP2Fonden
Best practice investment process      Investment Belief                 Theory                Investment Strategy         ...
Governance approach  • Identify basic beliefs  • Make consequences explicit  • Check if the governance is in place to unde...
A starter’s set of investment beliefs1. Strategic asset allocation is the most important choice in the   investment proces...
Structure of the presentation• The need for change in the European pension market• Macro economic & institutional pension ...
Going forward•   The European pension sector is embarking on an ambitious agenda for change•   Macro economic changes unde...
More background on investment beliefswww.investmentbeliefs.org. Blog posting insights andgovernance related researchKoedij...
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Strategic Transitions in European Investment Governance

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Kees Koedijk, at P&I's 5th annual Global Pension Symposium, addressed strategic transitions in investment governance in European pensions, macro economic and institutional pension changes.

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Strategic Transitions in European Investment Governance

  1. 1. Pensions in Europe:Strategic transitions ininvestment governanceKees Koedijk
  2. 2. Structure of the presentation• The need for change in the European pension market• Macro economic & institutional pension changes• Micro economic & organizational changes• Digression: investment beliefs as case study in organizational change• Assessment
  3. 3. The world is complicated enough as it is...
  4. 4. … while pensions as an issue loom in the background• Pension expenditure set to rise in European Union• Wide diversity between countries in • pension expenditures • pension buildup (first, second, third pillar)• Unfunded pension liabilities: long-term challenge economic stability • governments already under strain to manage government deficits and kick start economic growth• Changes necessary, and underway
  5. 5. Increase in old-age dependency ratio in the EU countriesconstant factor for years to come 55 50 45 40 35 30 EU15 25 EU25 20 EU10 15 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 Old-age dependency ratio: 65+ age group as a share of 15-64 age group Source: Eurostat
  6. 6. The change in old-age dependency ratio and the situation in 2050 is spread unevenly throughout the European Union 70 ES IT 65Elderly dependency ratio 2050, % BG 60 EL PT DE SI 55 CZ AT RO PL SK 50 BE HU FR UK FI 45 LT IE LV EE CY SE MT 40 DK NL LU 35 30 30 50 70 90 110 130 150 170 190 210 Percentual change of elderly dependency ratio 2004-2050, % EU-25 average Source: Eurostat
  7. 7. Public pension expenditure as a share of GDP set to rise further between 2004 and 2050 14 13 12 11 % of GDP 10 EU15 9 EU10 8 7 6 5 4 2004 2010 2015 2020 2025 2030 2035 2040 2045 2050Source:EPC/AWG-calculations 2006
  8. 8. Countries deal with pensions in different waysThird pillar:private pensionSecond pillar:collectivelyorganized pensionFirst pillar: publicpension
  9. 9. Size of pension liabilities overshadows government debt600500400300 Implicit public debt related to future costs of aging, %200 GDP100 Offical public debt, % GDP 0
  10. 10. Structure of the presentation• The need for change in the European pension market• Macro economic & institutional pension changes• Micro economic & organizational changes• Digression: investment beliefs as a case study in organizational change• Assessment
  11. 11. Transition agenda• Pension sector set to transform in the coming years on a macro economic/institutional and organizational/pension fund level• Macro economic level • Creating private pensions • Embedding longevity • Absorbing financial risk• Organizational / Pension fund Level • Pension funds come to grips with new financial complexity • Working with new changing investment paradigms
  12. 12. Macro economic transition • Separate implicit pension claims from explicit government Create claims PrivatePensions • European division: Netherlands, Sweden, UK, Norway, Denmark have capital based systems, Southern Countries PAYGO • Link retirement age to longevity Embed • More or less implemeted in European countries Longevity • Question: how to stimulate labour participation for older workers • Shift from DB to (Collective) DC Absorb financial • European employers: stability and shocks predictability pension contributions key
  13. 13. Organizational transition Principal Agent issues Complexity Shifting financial investment industry paradigms New investment frameworks
  14. 14. Organizational transition – Complexity financial industry Principal AgentFinancial sector is highly innovative issues• However, most innovations have been Complexity Shi ing financial investment supply based; industry paradigms• focus on diversfiying balance and income of financial institutions New investment frameworksComplexity has created new interlinkagesthat transform accepted investmentparadigms:• correlation between assets have been rising, creating the need for new investment “shelters”Regulators, suppliers, pension funds asbuyers have to strike a new, sustainablebalance in product innovation
  15. 15. Organizational transition – Principal agent issues • Increasing awareness: principal (pension Principal Agent issues fund board) not always the same agenda Complexity Shi ing as the asset manager (agent) financial industry investment paradigms • New, more assertive role of pension funds New investment underway frameworks Risk diversification Inefficiencies Risk premiums Focus ActivePension fund management Asset manager Responsible Impact Investments Teams and staff Risk man. Goals Koedijk and Slager (2006, 2008)
  16. 16. Organizational transition – Shifting investment paradigms• Challenges up ahead; aging on asset pricing Principal Agent issues (cf. Working paper Elod Takats, Bank of International Setttlements) Complexity Shi ing financial investment industry paradigms • “Disinvesting”, retiring generation increases in importance relative to “investing”, working New investment generation frameworks • Negative effect on stock markets and house prices?• Challenges existing beliefs that the only way is up, such as positive long term equity risk premium• Funds have to develop new investment frameworks to deal with these debates
  17. 17. Structure of the presentation• The need for change in the European pension market• Macro economic & institutional pension changes• Micro economic & organizational changes• Digression: investment beliefs as a case study in organizational change• Assessment
  18. 18. A new investment framework has to deal with a lot of unresolved questions• Is the equity premium dead or alive?• What is risk to us or our participants?• How long should long term horizon be?• Does active management pay off?• What is real diversification?• How much faith do I place in emerging markets?• Is mean reversion a true “constant” in financial markets?
  19. 19. Questions…• … pension funds and investment managers deal with day in day out• Answers… • Are difficult to give. Investing is not a hard science despite the econometric advances • Depend on what you believe and matters for you
  20. 20. Unresolved, because finance & investments are youngdisciplines• Humans get in the way (Gray, 1997) • No “hard” scientific laws, parameters • Humans are not monotone in their behavior • Humans influence predictions• We fit behavior into models, instead of the other way around (Taleb)• We have not yet found a way to reach firm conclusions about the major debates in finance • Neither should we expect it in the near term • Embedding behavioral finance promising avenue• We have therefore to articulate the investment beliefs behind the debates and choices
  21. 21. But…• If investment results influence the success or failure of pension funds• And investment choices are (partly) based on beliefs• Then thinking about, embedding and evaluating the consequences of investment beliefs are important to pension fund governance
  22. 22. Just as any other organisation would do• Strategic Management Similarities • Companies communicate their vision and strategy (USPs; proposition) for their clients, articulating why certain choices are made • Especially in markets where different visions co-exist• If not • It becomes difficult for trustees to evaluate new developments, and whether to embed them in their own strategies • More likely to “join the herd”, increasing costs and opportunity costs along the way
  23. 23. Strategic management rationale Best practice funds: “WHY” Muddling through: “HOW”1. Clear framework based on investment 1. Implicit dependance on financial beliefs to guide investment choices structuring to deliver the expected results2. Disciplined investment process to counter/minimize behavioral biases 2. Leaning on external advice, following the herd – what are my peers doing?3. Management of the investment process as a tightly knit supply 3. Poorly developed managerial chain, instead of assembling parts framework to assess which strategies after delivery will (not) work, how, and under what circumstances they help achieving add4. Clear understanding and organization value to the fund’s goals of needed skills and resources for the required governance level Authors: Ellis, Ambachtsheer, Rajan, Koedijk and Slager
  24. 24. Upward potential • Upward potential for good governed pension funds, best governed pension funds focus on coherence, process and people • Urwin & Clark: long term performance differential between well- governed and less well-governed funds amounts to 1-2% per year • Committees investigating pension funds in several European countries after the financial crises: ample room to improve investment governance
  25. 25. Investment beliefs Financial markets beliefs Investment process beliefs •Risk premium •Impact, focus on management decisions •Risk diversification •Risk management •(In)efficiencies in financial markets, •Investment management style asset pricing •Costs •Horizon Organizational beliefs Sustainability and Governance •Teams, role of investment managers •Role Sustainability and corporate •Out vs. insourcing governance in asset pricing •Experience •Role in investment process •Implementatiion / execution
  26. 26. Focus on a number of beliefsTo be publishedin the AnthologyProject, AP2Fonden
  27. 27. Best practice investment process Investment Belief Theory Investment Strategy Organization •Observes behavior in •Theoretical basis behind •Describes how the •Organization to successfully the financial the investment belief. investment belief can be exploit the investment strategy. marketplace •What is it about that practically put to use. •Links the exploitation of the •Frames why the mechanism investment beliefs to organization deals •Is it a structural, performance measures. with this in a repeatable phenomenon sophisticated way. Belief: Investors Theory: Stocks that have Investment strategy: Organization: overreact had bad news •Buy (sell short) stocks •Trading strategy with short announcements will be after bad (good) term horizon. under priced relative to earnings •Good versus bad news stocks that have good announcements. announcements have to be news announcement. •Alternatively, buy (sell identified. short) stocks after big stock price declines (increases).
  28. 28. Governance approach • Identify basic beliefs • Make consequences explicit • Check if the governance is in place to understand and manage it • Create environment to challenge assumptions; adaptation to new realities is key
  29. 29. A starter’s set of investment beliefs1. Strategic asset allocation is the most important choice in the investment process2. Active management does not pay off3. Costs determine net return4. There are only a select number of risk premiums worth pursuing5. Simplicity pays off: we match governance and strategies6. We only invest if we agree on when to exit7. Sustainability is an opportunity, not a necessity
  30. 30. Structure of the presentation• The need for change in the European pension market• Macro economic & institutional pension changes• Micro economic & organizational changes• Digression: investment beliefs as a case study in organizational change• Assessment
  31. 31. Going forward• The European pension sector is embarking on an ambitious agenda for change• Macro economic changes underway or envisaged • Private Pensions • Longevity • Reallocating financial risk• Micro economic change at the fund level challenge for management and trustees • Pension funds will professionalize further to act as the right counterparty and partner of financial institutions • Simultaneously the need for flexible investment frameworks to incorporate uncertainties in the financial markets increases: investment beliefs help
  32. 32. More background on investment beliefswww.investmentbeliefs.org. Blog posting insights andgovernance related researchKoedijk and Slager, 2010, Investment Beliefs, PalgraveMacmillan. Fleshing out the investment debates in moredetail.c.koedijk@tilburguniversity.edu
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