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  2. 2. I. Introduction 1. This note addresses issues relating to risk management of occupational pension funds in selected OECD and Asian countries. It was provided as background to the discussions on investment that took place during the third OECD/INPRS Conference on Private Pensions in Asia and the 2004 Asian-Pacific Regional INPRS Meeting Co-organised with the ADB to be held in Manila 30th March – 1st April 2004. 2. Risk management within pension funds was not widely discussed issue until the recent years. During the ‘golden decades’ of the 1980’s and 1990’s, when equities were delivering high returns, corporate pension funds continued to build up healthy surpluses and individuals (certainly in the developed world) did not to have to worry about retirement income. However, since the turn of the millennium, a ‘perfect storm’ has been brewing in the investment industry. Demographic concerns are becoming ever more pressing with governments attempting to spread responsibility for retirement saving more widely. At the same time as liabilities are rising, asset markets have also been proving less benign, with the ‘cult of equities’ being sorely challenged by recent market corrections, leaving many investors questioning whether these assets will be able to deliver adequate future returns. At the same time the low interest rate environment is ensuring that attractive alternative investments are not widely available in the fixed income markets. New attitudes to investment and risk arising from this challenging environment will be addressed in this document. 3. The paper opens with a brief overview of types of risk and types of pension plan, considering who bears risk in the different types of scheme. It then goes on to look at risk management at various stages of the investment process. Strategic asset allocation is first considered, whereby the broad investment policy of the fund is set, looking at how to match assets and liabilities in defined benefit schemes, and how to optimise returns most successfully in all funds, including defined contribution pension plans. Tactical asset allocation is then discussed, looking at the best way to achieve targeted returns, (passively, actively via derivatives), and ways to successfully diversify assets. Finally governance issues are examined, looking at ways to ensure that the investment process is both adequate and implemented properly, and limitations on current governance practices (in particular the prudent person rule and trustees) are considered. The paper finishes with a country survey, looking at risk management practices in selected OECD and Asian countries. -- Delegates are invited to comment on the regulation of investment and asset-liability management in their countries and in particular to answer the following questions: i. Does the regulatory framework address asset-liability matching? How is this matching defined? ii. To what extent is the use of ALM models required by regulation? Are these models assessed by the supervisory authority? iii. Is investment in alternative investments such as private equity, real estate and hedge funds permitted by the regulation? Does the supervisor pay specific attention to these less liquid investments? II Pension Fund Risk and Responsibility 4. Pension funds collect, pool and invest funds contributed by beneficiaries and sponsors to provide for the future pensions of beneficiaries. They are a means for individuals to accumulate savings over their working lives to finance their needs in retirement. Consequently, the ultimate risk for pension plans is that asset returns will not be sufficient to meet promised benefits and required household needs. The most basic decision to be made by a pension fund is regarding how to allocate funds amongst various asset categories and available financial instruments to assure sufficient investment returns over time and that unnecessary 2
  3. 3. volatility does not reduce asset values when liquidity needs arise. Risk management addresses these concerns. 5. Both the asset and liability side of the pension fund balance sheet can contribute to risk. Where liabilities are fixed, risks derive from ‘biometric’ factors (due to actuarial assumptions, notably on longevity) and financial issues (the greatest sensitivity being to the discount factor used in present value calculations). On the asset side, risks can involve both asset-liability mismatching (where assets are not adequately structured to meet benefits when they become due) and return related risks (where insufficient income is generated to cover liabilities). On top of these inherent risk factors, systemic risk can arise from a lack of governance for ensuring that a suitable investment process is in place and applied correctly. Different types of funds face different types of risk, and consequently have varying risk management control systems in place. Pension Fund Models 6. Pension funds operate under fiduciary mandates, but the nature of these mandates may not be the same across different types of plans that they support1. Pension schemes consequently fall into several categories, distinguished by their different types of liabilities and who bears responsibility for meeting shortfalls in these liabilities. The three main structures are: i. conventional defined benefit (DB) schemes: a pension scheme where the plan sponsor bears the investment, financial, longevity and other risks. This responsibility arises from the plan sponsor agreeing to provide plan members with a continuing flow of benefits upon retirement. There are several different types of structure within DB schemes, depending on how benefits are established. In ‘final salary’ schemes the pension benefit is based on the last salary achieved before retirement, whilst with a ‘final average earnings’ approach it is typically the earnings of the last few years prior to retirement that are used. The ‘flat rate’ system bases pension benefits on length of membership in the scheme and these benefits are not affected by earnings. In each case a contractual obligation is created on the part of the sponsor to make specific payments. Under these arrangements the sponsor assumes all the investment risk of generating sufficient income from plan assets to ensure that contractual funding obligations are met. Some risk may be shared with beneficiaries if employee contributions or benefits/accrual formulas can be altered. Only a small number of OECD countries (Canada, Japan, the UK, and USA) still make widespread use of defined benefit pension plans. ii. hybrid DB: funds which combine elements of defined benefit schemes with a return guarantee, by which beneficiaries get the either the higher of a DB or a DC benefit. Pension plans such as these have been introduced in the US and UK markets in the form of ‘cash balance’ schemes, by which the pension benefit takes the form of a specified percentage of salary at retirement received by the beneficiary as a lump sum. The sponsoring company therefore bears the risk of the scheme during the employee’s working career, whilst the risk passes to the individual on retirement (or to an insurance company if they choose to purchase an annuity). The new occupational plans in Belgium are also structured in this way. iii. defined contribution (DC) schemes: require the plan member to bear investment, financial and longevity risks, with the sponsor of the plan merely agreeing to invest the plan’s assets on behalf of the beneficiaries (in order to produce a stream of retirement income), thus having no specific obligation to generate a given investment result. Such schemes may be mandatory or voluntary. Beneficiaries may have a choice over how the funds are invested (such as in the 401k pension 1 From ‘Governance of and by Institutional Investors’. 3
  4. 4. system in the US), or may not (as is the case with Spain’s ‘single portfolio model’ which ignores the greatly different risk tolerance of members, arising from their differing ages etc.). Though individuals bear the risk in the case of defined contribution schemes, it should be noted that they do have the ability to further manage this risk themselves, (for example ensuring retirement needs are met by taking out insurance products such as annuities). iv. DC with guarantees: these are hybrid, sometimes called insurance style schemes, run in countries such as Denmark, Iceland, and to some extent in the Netherlands. Though defined contribution plans, (the employer’s liability is limited to making set contributions), they aim to provide benefits akin to those of defined benefit arrangements and contain an element of guaranteed return and sometimes also a guaranteed annuity rate. The employer’s obligation is limited to making contributions as stipulated in the arrangement, and the plan sponsor is not responsible for correcting imbalances between assets and liabilities. Households bear defined contribution style risk collectively in the form of changing parameters and even downward adjustments in benefits in order to keep liabilities in line with available assets. The type of guarantees offered by the funds varies, sometimes coming in the form of a guaranteed return handed over to the plan member in the form of a lump sum, whilst other schemes (such as those in Iceland) guarantee an annuity, which involves more risk for the pension fund. These funds are usually regulated as insurance undertakings. Responsible Parties Corporate Plan Sponsors 7. Corporate plan sponsors are the ones holding the ultimate responsibility for defined benefit pension plans, having to make up shortfalls from corporate cash flow if the fund is in deficit. Defined benefit schemes are subject to a wide range of risks including real labour earnings, interest rates, mortality risks, falling asset returns, changes in government regulation (such as indexation, portability, vesting and preservation), and the structure of the fund may determine which of these the plan sponsor is exposed to. For example, employers bear most risk with final salary schemes, followed by average salary and then flat rate arrangements, where the beneficiaries’ risk is highest (as they remain exposed to inflation). The nature of defined benefit schemes is changing, with structures tending to move towards a low base of benefits with a risk sharing approach. 8. The nature of defined benefit pension fund risk in relation to corporate plan sponsors, and how they perceive this risk, is also changing. This is partly due to the fact that, after a golden period of high investment returns, pension surpluses and contribution holidays, corporate sponsors are now facing, sometimes very large, deficits in their pension schemes2. These benefits have come about due to a ‘perfect storm’ within the investment climate. Liabilities are increasing (due to aging populations and early retirements) at the same time as contributions have been lowered (due to mergers, corporate downsizing). Meanwhile investment returns have also declined (due to the low inflation and interest rate environment, a decline of the equity risk premium and higher correlations between markets). After enjoying years of low pension contributions, corporate plan sponsors are now becoming aware of the risks and responsibilities posed by their DB pension schemes. Indeed they have realized that this risk is potentially ‘asymmetrical’, as plan beneficiaries argue that any surplus within the pension fund, like other assets, belongs to them, whilst corporate sponsors are required to cover any deficit. Is it any wonder they are shifting to DC plans and transferring the risk to individuals? 2 For example, according to the US Pension Benefit Guarantee Corporation ( the total deficit of US S&P 500 defined benefit schemes at around $350m. 4
  5. 5. 9. These problems faced by plan sponsors are being compounded by changes in accounting rules. These require corporations to publish details of these deficits at market value in their annual accounts, compared with the previous system where losses could be smoothed through the use of long-term, average valuations. These changes apply in the UK through the new FRS 17, which is mirrored by International Accounting Standard 19 (compulsory in EU countries by 2005-2007), with similar changes in US accounting regulations expected to follow in the coming years. Though such rules do introduce welcome transparency to pension accounting, there is great concern that where the pension fund represents a large percentage of the company’s market capitalisation, the firm’s share price will be driven by the inevitably increased volatility in the pension funds valuation, and ultimately could even force the bankruptcy of the company. Rating agencies have already warned that estimated deficits in company pension schemes are similar to debt, which has led to the downgrading of some firms. This new accounting is already having an impact on the risk appetite of plan sponsors, and on the investment decisions within their pension plans, with lower risk assets increasing as a percentage of the pension portfolio in order to reduce valuation volatility. Beneficiaries 10. Given the demographic changes faced by many regions in the world, most countries have seen their pension systems move from a defined benefit to a defined contribution model, shifting responsibility from corporations to individuals, with few new defined benefit schemes now being set up. However, it also seems that risk is being subtly shifted towards beneficiaries even within defined benefit schemes as plan sponsors seek to escape from the asymmetrical risk that they face. Though corporations cannot remove assets or surpluses from pension plans, they have been able to take contribution holidays during the bull market years of the 1990’s, which arguably allowed them to acquire the benefits of market upside rather than the plan members (through improved benefits). Likewise, when facing deficits, some corporations have cut benefit levels rather than increase contributions (which effectively shifts risk toward active scheme members as benefits remain fixed for retired beneficiaries), and in extreme cases firms have walked away from their liabilities all together (though this loop hole has now been closed in UK law at least). In such cases can it really be argued that the corporate sponsor bears the investment risk? 11. The issue of who ‘owns’ or benefits from pension plan surpluses is an important one as it affects the risk appetite of those in charge of the investment process – i.e. the pension fund trustees3. If the beneficiaries represented by the trustees take none of the investment downside (with deficits covered by corporate plan sponsors), yet gain any upside where there are excess investment returns, then surely they will be incentivized take on as much risk as possible. If, however, they do not get any benefit from surpluses and risk the ultimate bankruptcy of the sponsoring firm if excess deficits arise, they will become highly risk adverse. The latter situation is becoming more predominant in many markets, adding to the already cautious investment climate. 12. On a more positive note for beneficiaries, compared with the shifting of risk towards beneficiaries within DB plans, there is some evidence of increased willingness for corporate sponsors at DC funds to share more of the investment risk. This can be seen in the trend towards the use of ‘hybrid’ style, DC with guarantee schemes. There is some evidence of such moves within the UK industry at least, (for example through so called ‘CARE’ funds, where a lump sum is handed over to the plan member on retirement, the plan sponsor taking on investment risk during the member’s active membership, but they resume inflation and longevity risk on retirement). Given more uncertain times, the trend going forward maybe to move away from the extremes of risk bearing represented by the pure DB and DC models. 3 ‘Strategy Ideas: How should DB pension funds allocate assets?’ HSBC Strategy Ideas, author Jason James, Global Strategist 5
  6. 6. Government 13. In some countries the party who bears ultimate responsibility for pension fund liabilities is the government. When a company enters bankruptcy in the US, for example, the Pension Benefit Guarantee Corporation honours the liabilities of the firm’s pension fund, up to certain levels. The current pension’s shortfall crisis is, however, also affecting this insurance body, which has fallen into deficit4. A similar scheme is due to be introduced into the UK under the new Pensions Act, with an insurance body being set up to take over the pension funds of bankrupt firms. Though generally supported, controversy over the system focuses mainly on how it is to be funded with the debate ranging between flat rate fees and risk adjusted payments according to the financial worth of member firms. Though avoiding ‘moral hazard’, the latter type of payment has proven politically difficult to impose in other countries, and the UK is proving no exception. There are also concerns that the current unstable funding position at many companies could threaten the early life of this scheme (if a series of large bankruptcies were to occur before full funding levels had been achieved). III. Risk Management Techniques Strategic Asset Allocation 14. Strategic asset allocation is used to tackle the ultimate risk facing pension funds – i.e. that requirements in retirement cannot be met. For defined contribution funds this is a relatively straightforward process, involving the identification of ‘optimum’ portfolio constructions that generate the highest possible returns within set risk profiles. However, the process is more complex for defined benefit schemes (and for defined contribution plans with guarantees), which have to generate not only a set rate of return, but which must also ensure that these returns are available when liabilities become due (setting up contradictory objectives, requiring both adequate returns and low volatility). ALM Models 15. Asset-liability modelling is a financial risk assessment and asset planning tool, widely used by pension funds to help set long-term asset allocation strategies appropriate to the risk tolerance and liabilities of pension funds. Such mathematical models were developed by actuaries over the past 10 years or so and estimate the degree of investment and other risks faced by institutional investors. Pension fund trustees, certainly in more developed markets, now commission outside actuaries or consultants to estimate pension liabilities using such models on a fairly regular basis, (for example, every three years is currently standard practice in the UK). 16. With time the models have become more sophisticated, moving from the ‘static’ type to ‘dynamic’ models (covering multiple time periods), involving stochastic simulations of assets and liabilities (which run multiple ‘Monte Carlo’ simulations). Though dynamic models have proven a better fit for real world scenarios encountered by pension funds they do have their drawbacks, partly due to 4 ERISA Act of 1974 created the Pension Benefit Guaranty Corporation (PBGC) to protect pensions of participants in private DB pension plans. Guarantees are provided up to a certain limit (c$44,000 in 2003, the guarantee limit being revised each year) for the beneficiaries of insolvent companies with under-funded plans. Around 32,000 companies were insured in 2003 (down from 110,000 in 1985 – the fall coming from the shift to DC, particularly 401k vehicles). All single-employer pension plans pay a basic flat-rate premium of $19 per participant per year, with under-funded plans paying an additional variable rate charge of $9 per $1000 of under-funded vested benefits. Premium payments are segregated into Revolving Funds, invested in fixed-income securities. Assets received from terminated funds are placed in Trust Funds, which may be invested in equities. The PBGC uses external fund managers to invest these funds, with their oversight. September 2002 liabilities were $29bn whilst assets reached only $25.4bn. 6
  7. 7. becoming more complex making them harder for trustees to understand and interpret. Arguably investment oversight and trustee training have not been able to keep pace with improvements in the sophistication of mathematical modelling techniques. 17. Broader criticism these models centre on the fact that they are based on historical data and correlations and consequently are not necessarily reliable guides to the future. For example the UK Myner’s Review5 of the investment industry in 2001 claimed that: “Asset-liability modelling is a complex number-driven process, in which it is difficult to incorporate asset classes without reasonably long historic time series data. The outcome of such a process is unlikely to be investment in new or poorly researched asset classes, such as private equity. Yet according to investment theory, it is precisely among poorly researched asset classes that greater opportunities for enhanced return are likely to exist… More importantly, the outcome of the asset-liability modelling process depends crucially on a number of prior decisions and qualitative judgments, such as assumptions about rates of return, and other economic indicators, an the division of assets into classes (an imprecise art, with elements of arbitrariness).” 18. Furthermore, it has also been argued that these models have been misused within the pension fund process, with the focus being on generating efficient portfolios (as required by DC funds), rather than strictly for asset-liability matching (which is the real requirement of DB funds and the DC with guarantees)6. This is said to have led to a bias towards high-risk, high-return assets within pension portfolios (as discussed in the bond/equity debate below). Taking these criticisms on board, it would seem that the next development within the pension industry, (in developing countries at least), will be an improvement in the application of models, as opposed to great technical developments within the models themselves. Bond/Equity Debate 19. For defined benefit pension funds, a key part of ALM, and consequently the strategic asset allocation process, involves finding assets that suitably match the liabilities which it has been estimated that these funds face. This is currently an extremely hot investment topic in many countries, and focuses on the bond/equity debate. For many decades investors have been followers of the ‘cult of equity’, accepting the argument that, over the long-term, (the natural investment horizon for pension funds), equities deliver higher returns than bonds for limited extra risk, (equity volatility significantly declines if measured over a long enough period). Such an investment philosophy reached its zenith during the bull market of the 1990’s with funds in some Anglo-Saxon countries reaching around an 80% weighting in equities. Other countries followed the same trend, though never reached such dizzy heights (e.g. Dutch pension funds maintain around a 60% equity weighting, with Japanese pension schemes only 20-30% due to the troubles of their own equity market and the availability of a liquid government bond market). 20. Following the crash of global stock markets and the under-funding position that many corporate plan sponsors now find themselves in, this fundamental investment rule is being challenged. Much of the debate centres upon the ‘equity risk premium’ and whether equities really do deliver higher returns over the long-term; whether they will continue to do so; and whether the risk required to obtain these returns is 5 Complete review available at 6 See ‘Asset and Liability Modeling for Pension Funds’: paper by Jon Exley, Shyam Mehta, Andrew Smith, presented to the Joint Institute and Faculty of Actuaries Investment Conference June 2000 7
  8. 8. really justifiable for pension funds?7 Given the deficits faced by many firms, attention is also being refocused on the asset-liability matching question rather than the risk-return pay-off of assets. Defined benefit pension funds can be seen as simply a series of annuities for those who have retired and deferred annuities for those still working. It is therefore argued that these ‘bond-like’ payout structures make bonds rather than equities the best match for their liabilities. Such opinions have only been strengthened by recent accounting changes that make pension liabilities more transparent, allow them to directly impact the plan sponsor’s balance sheet, and which also increase the asset-liability mismatch from holding equities (given they use a corporate bond derived discount rate in valuing liabilities). The ‘pro-bond’ argument is further supported by the tax efficient nature of fixed income investing. 21. Equity holdings have certainly been declining at many major pension funds. The most headline- grabbing case being the UK pharmaceutical retail company Boots, which switched its entire 2.3bn sterling fund into bonds over an 18 month period during 2000 and 2001, despite this not being a particularly mature scheme (with around a 50% of the 72,000 members still active). John Ralfe8, fund trustee and head of corporate finance, has explained this decision as a risk reduction and cost saving exercise, allowing the company to lock in the healthy surplus built up during the bull market years, and reducing investment fees by 97.5% (to 250,000 sterling). Valuable management time was also freed up for operational matters. Though a supporter of the UK accounting changes affecting the disclosure of pension fund liabilities, Mr. Ralfe has claimed that these were not the main drivers behind the asset allocation move, despite the fact that the pension fund does represent a fairly large percentage of the firm’s market capitalisation (c40%). As a corporate financier, he was, however, conscious of the tax advantages of the switch, allowing both the corporate plan sponsor and pension plan members to benefit from the process of ‘balance sheet tax arbitrage’ (where the company issued debt and bought back company shares whilst moving the pension fund’s exposure in the opposite direction from equities to bonds). His views were heavily influenced by a controversial paper published by the Institute of Actuaries in 19979 which argued that there is no separation between the pension fund and the corporate sponsor and that the value of a defined benefit plan to employees is equal to the cost born by shareholders. They believe that equities cannot reduce the costs of a pension plan without adding risk simply because of the long-term and that pension fund investing should be about matching assets and liabilities and not about pursuing excess returns. The fund now holds exclusively AAA rated paper from a small number of quasi-sovereign sources (such as the World Bank), with maturity of 15 years upwards, 50% of which are index linked, (this level was increased from an initial 25% exposure during 2002). 22. Though the asset allocation move by Boots proved wildly successful (locking in a 250m sterling profit which it is estimated would have deteriorated into a 50m deficit if the prior equity weighting has been maintained in the subsequently years), both academic and practical concerns remain over this radical, 100% bond policy. To being with, no bonds are risk free, even AAA related paper, with significant 7 The argument centers on the equity premium paradox, according to which equity returns have historically exceeded estimates of the compensation investors require for taking on extra equity risk. This has been explained by an undervaluing of corporate assets, a benign period for equity investment and an over cautious approach by investors. A these factors have corrected, equity valuations have risen, so that the high returns of the previous decades are large are said to be due to a one off, multiple expansion which is unlikely to be repeated in future. Elroy Dimson, Professor of financial economics at LBS, further argues that the past return on equities has been flattered by good luck, biased index construction and too short a time horizon used in estimations as well as re-rating. Going forward it is estimated that the ERP will be 2.5-4%, much lower than 7-8% post war. Global surveys also come up with a lower number than the usual UK/US focus. For more on the ERP see ‘Note on Issues for the regulation of the Investment of Pension Fund Assets’. 8 See 9 ‘The Financial Theory of Pension Fund Schemes’: John Exley, Shyam Mehta, Andrew Smith, also available on 8
  9. 9. reinvestment risk remaining (though the average duration of the portfolio is 25 years this is still below the average pension fund 40 year life span). With the liabilities of even the most mature pension funds being to some extent uncertain (notably longevity risk), these cannot be 100% matched and all risk cannot be removed. Even given the high quality of the issuers the fund has invested in, some regulators have expressed concern that such an asset allocation breaks the duty of diversification laid down by the ‘prudent person’ rule (see later discussion). There is also the aspect of inflation risk to consider as with any bond investment, given the real nature of pension fund liabilities (which are affected by increases in wages). Thought the Institute of Actuaries’ paper argued that there is no academic evidence that equities are a greater wage-inflation hedge than bonds (citing the ‘stagflation’ period of the 1970’s as proof), others still argue that over the long-term a mixed equity portfolio is the best match for pension funds facing wage- related liabilities10. Jeremy Bell, partner of the consultant actuarial firm Lane, Clarke and Peacock which openly criticised Mr. Ralfe’s decision, summarized these doubts as follows11: “There is increasing pressure on finance directors to control the very real risks posed by defined benefit pension arrangements. This is being exacerbated by the imminent arrival of the new accounting standard FRS 17 as it will lead to more volatility in reported company results arising from pension provisions. However, we are not convinced that a decision to withdraw entirely from equity investments is in the best interest of either employees or shareholders. A 100% AAA bond strategy may appear sensible in terms of mitigating investment risk, but the company and its workforce may be assuming other risks as a result. Ultimately they may miss out on the superior long-term results that almost always accrue to long-term equity investors.” 23. Other aspects of concern regarding the Boots decision are of a more practical nature. To begin with, whatever the theoretical argument that beneficiaries and shareholders are symbiotically linked, many companies will not be willing to bear the higher contributions and costs which are a consequence of investing in lower return assets (the Boots fund now requiring a hefty 50m sterling annual contribution). The benefit may be found in other ways, such as in the higher credit rating that Boots now enjoys, but shareholders may not accept the more obvious impact on cash flow. A further practical constraint on other funds making such a dramatic allocation shift is that many are no longer in the luxurious position of having surpluses to secure but would be locking in deficits, a position which trustees and shareholders alike would undoubtedly regard with far less enthusiasm. 24. Even if it could be agreed that bonds are the best asset class for matching pension fund liabilities, another major hurdle to this ‘immunization’ process is found in the lack of sufficient indexed, liquid, government paper to meet demand that would be generated. In the US, aside from a liquid Treasury bond 10 Mirko Cardinale puts forward this argument in a technical paper for the consulting firm Watson Wyatt: ‘Co integration and the Relationship between Pension Liabilities and Asset Prices’. Summarized on the Independent Pensions Europe website: “The main finding is that, while shorter-run correlation evidence is less consistent, there is indeed a long- run link between the evolution of salary-linked liabilities and asset prices.” The study also finds that this link is consistent with economic theory, and that “no asset has historically been a perfect hedge for salary- linked liabilities.” The best historic hedge –“was a composite portfolio which included besides conventional and index-linked bonds, also domestic and foreign equities and property.” Such views are supported by Alistair Ross-Goobey, a highly respected industry figure and former chief executive of Hermes Pensions Management, speaking at the 2001 Pensions Institute Conference: “It is difficult to argue against the idea that, since most of the liabilities of a pension fund are real, most of the assets should be real too.” 11 Comments available on 9
  10. 10. market, there is a great deal of ‘agency paper’ with a high degree of government support, and deep markets for mortgage related securities exist. Some governments do remain committed to maintaining liquid bond markets whatever their funding requirements (notably Singapore and Hong Kong). However, most countries in continental Europe, for example, have a little high quality non-government paper, whilst fixed- income markets are extremely thin in Asia (with the exception of Japan’s JGB market). Any move towards restructured government debt to provide non-volatile instruments for increasingly self-managed retirement savings probably requires more deliberate public policy attention and debate than has occurred to date. Mr. Ralfe has argued that this market is deeper than many investors think, sitting, for example, the 100m sterling issuance of the World Bank, which Boots subscribed to exclusively. Yet it is not feasible to suppose that such paper could be found for the pension fund market as a whole12. 25. Academics and consultants have argued that investors could use derivatives as a synthetic way to overcome this lack of government paper. It is argued that it is possible for private financial sector intermediaries, through portfolio diversification and hedging, to provide the equivalent of indexed government bonds to satisfy potential demand. For example, if there is an insufficient supply of sterling denominated long term assets to satisfy demand from UK institutions, similar assets can be purchased overseas and the currency risk removed with derivatives. Similarly investment banks can create derivative securities with reduced credit risk through securitization and credit derivatives. The swap market is seen as another source of a ‘derived benchmark’ yield curve. This may be possible in theory, but many pension fund trustees and investment managers still lack the knowledge and sophistication to make use of such investment tools, as discussed below. 26. Weightings have undoubtedly become skewed over the past 20 ‘golden years’ towards equities, and strategic asset allocation has become focused on return optimization rather than asset-liability matching. Such allocations do need a correction in favor of bonds, but to move 100% in this direction with not be risk-free and would be impractical. The real driver behind the Boots decision, apart from the extremely forward looking and astute one of locking in its surplus around the peak of the equity markets, seems to be a belief that excess returns are impossible to capture. The fund has not simply been shifted into bonds but is barely being actively managed at all. Many other investors, however, believe that investment skill can unlock excess returns in markets. Consequently for these investors a broad allocation approach, more mindful of liabilities than previously and with a broader diversification of risks and returns, seems to be the best-practice approach which the industry is moving towards, and which has strong theoretical support13: “We favor holding stocks for the very long run. They are not a guaranteed superior performer over the investment horizon of most investors. They should be held as part of a diversified portfolio… Investors who fail to diversify efficiently and /or who overpay for asset management services can expect to erode their reward for equity risk exposure.” Alpha Returns 27. Aside from the ALM process affecting defined benefit funds, the strategic allocation process for defined contribution schemes has also come under heavy criticism and is likely to undergo a shift in direction in coming years. These funds will also be affected by the death of the ‘cult of equities’ and will require a dramatic overhaul in their investment process and risk management to cope with what is likely to be a far less friendly investment climate in future - a climate which poses challenges for all types of pension funds. Corporations facing deficits will no longer be able to rely on the external environment to ‘bail them out’ of their current under-funded position, and will have to make dramatic internal changes as a 12 For example, according to the Myner’s Review, UK pension assets amount to 800bn sterling. 13 ‘The Triumph of Optimism’: Dimson, Marsh, Staunton (2002) 10
  11. 11. consequence (events of this scale being unseen since the 1970’s). Funds with healthy surpluses (e.g. the US public pension fund CalPERS) and particularly acute deficits (such as that faced by US auto giant General Motors) are likely to lead the way, with others making small, opportunistic, but dramatic adjustments. 28. One major type of change is the move to seek out ‘alpha returns’ more consciously. Investment returns can be broken down into two parts: return attributed to market movements, known as beta, and residual returns, or value added over the market return, known as alpha. Strong equity performance during the 1980’s and 1990’s led to a preference for beta (index) risk over alpha (active) risk within pension plans. The old approach, which evolved over a period of 20 years and which pension consultants and academics based on ‘modern portfolio theory’, involved choosing between asset classes and a buy and hold strategy. The asset allocation decision was viewed as primary, with strategic weights based on long-term return and risk expectations. Alpha and active management were pursued, if at all, within an asset class and managers were judged relative to the asset class benchmarks (sometimes refined for style or capitalisation characteristics customised to managers). 29. This approach will need to be changed in a period of lower expected returns and bond return correlations. With lower beta returns available, investors will have to concentrate on extracting alpha returns. Active alpha investing builds on traditionally portfolio theory, desegregating sources of portfolio risk to identify additional return opportunities. Strategies with a low correlation to the largest current holdings (large-cap equities) and a high correlation to movements in liabilities will increase. These strategies rely heavily on products for managing index and interest rate exposure, and build on the growing availability of liquid index products, such as futures and exchange-traded funds (ETFs), and interest rate trading vehicles. Attention to alpha will require more short selling and short horizon strategies, with bottom-up investing replacing the macro approach. Strategic allocation is regaining in importance over tactical asset allocation, with categorisation by asset class developing into groups of similar strategies (such as delta-tilt, alpha, cross-market and overlay, flexible absolute returns, low liquidity and equity-tilt strategies, including index funds, long-only and long/short hedge funds). 11
  12. 12. Figure 1 Potential new pension strategy allocation framework Equity Tilt Flex ab rtn Cross-mkt overlay Low liquidity Debt-tilt Alpha strategies 14 Source Goldman Sachs Risk Budgeting 30. Complementing this new strategic allocation is a new approach to risk, know as ‘risk budgeting’. This involves the measurement of a portfolio’s potential risk exposure in each of several areas, followed by the allocation of a certain portion of the fund’s aggregate risk tolerance to each of these areas. The risk budget defines the extent to which the investor is willing to allow exposure to the portfolio to investment risk. As firms learn to juggle new objectives and target investments more accurately, risk will also come to be approached in a more forensic fashion. ‘Risk budgets’ will be drawn up, not simply looking at how much risk is tolerable and which assets are contributing to this risk, but delving deeper to analyse risk in more complex and interlocking formats and to see if it is being ‘spent’ for maximum return. Bob Litterman, Goldman Sach’s asset allocation guru, has described it as follows14: “The whole idea of risk budgeting is to manage your active risk. It is not about limiting risk, but about generating more return by managing it…Funds need to crank up returns from active risk and the only way to do that is by strategies that have large amounts of active risk per unit of capital.” Figure 2: Old and New style Risk Attribution 14 Table taken from Goldman Sachs report: ‘Equity Derivatives Strategy: The new pension paradigm’ January 30th 2004, authors Joanne M. Hill, Meric Koksal 12
  13. 13. Old-style risk attribution % of risk (variance) 100 80 60 40 20 0 Equities Bonds Manager Skill New-style risk attribution risk relative to liabilities 6 4 (units) 2 0 -2 Equity Risk Duration Liquidty Risk Credit Manager Skill Premium Premium -4 Source: Watson Wyatt 31. These new alpha investing and risk budgeting tools are required not only because pension funds are facing a more challenging investment environment, but also because the are being confronted with a broader range of investment objectives, over and above generating maximum returns for minimum risk. Funding requirements, for example, will also have to be taken into consideration, this not an being an issue until the last few years, as the bulk of the portfolios, equities, offered high returns, outperforming bonds. This implies an increased focus on minimizing both the present value and volatility of contributions to fund benefits as well as a heightened awareness of ‘tracking risk’ of pension assets to pension liabilities. More attention will be required on keeping funding ratios above100% and favoring policies that reduce risk of variability of funded status. Pension policy is likely to be co-ordinated with earnings and cash flow cyclically specific to companies themselves. These goals are all aimed at avoiding the negative impact on credit ratings, cost of capital, cash flow and earning volatility, and ultimately the bankruptcy of corporate plan sponsor. 13
  14. 14. Table 1: Comparison of past and future pension priorities Recent Priorities Futures Investment Priorities Maximise relative return and asset Increase focus on total return and allocation funded status Rebalance to strategic allocation Revisit strategic allocation – impact of lower equity risk premium Seek return from equity risk premium Tilt return to source alpha risk because (beta risk) of uncertainty of equity risk premium Slower growth in international Declining $ reason to reconsider investing international and global asset allocation Build process to improve risk Greater attention to addressing risk management and risk budgeting exposures – further equity market declines, credit, stock/bond correlation Source Goldman Sachs Quantitative Insights March 2003 32. Pension funds are already moving in this direction. In December 2003 PLANSPONSOR Magazine (in conjunction with Fidelity Research), as reported by Goldman Sachs15, published a survey of 233 defined-benefit plans in the US. As many as 90% of the respondents said they were considering new investment strategies to aid their funding situation. In terms of where asset allocations were headed, sponsors indicated that equity and fixed income holdings would be reduced in favour of non-US equity, real estate and alternative asset classes that reduce plan risk through diversification and low correlations with interest rate moves. Equities are, however, likely to remain the largest single asset class (over 85% of respondents saying that the risk premium benefit of equities justified these holdings). Extending the duration of fixed income holdings is being seriously considered (by around one third of sponsors) to reduce funded status risk. Strategies which favour both the objective of high risk adjusted returns and reducing risk relative to liabilities are amongst those being most interestingly examined – including those with a low correlation to equities and a high alpha quotient. The General Motors’ pension fund, one of the schemes with the worst funding positions in the US, is a particular example of a fund pursuing just such objectives: “Increased allocation to asset classes where active management had generated significant excess alpha… This indicated: − Increased commitment to ‘high alpha’ asset classes, such as emerging market equity and debt, domestic high yield, small cap equity, real estate and private equity. 15 Discussion taken from Goldman Sachs Equity Derivatives Strategy: Equity Indexes author Joanne M. Hill and Meric Koksal January 30th 2004 14
  15. 15. − Higher allocations to ‘absolute return’ strategies that include equity long/short, relative value and event driven strategies.” 16 33. To some critics, the biggest potential drawback to this new framework is that it builds on the belief that positive alpha exists and is exploitable.17 Academics have debated this issue for decades, with no clear conclusions. What is certain is that investment management is entering a new phase, with solutions required to drawn more upon investing skills as markets offer less in the way of embedded returns and liabilities loom with lower interest rates. The positive aspect is that new tools and outlets are increasingly available (from quantitative models, to swaps etc. – all made able through complex technical products). The pension’s CIO job has, however, become more difficult. Derivatives 34. The application of the new investment and risk strategies discussed above will depend heavily of the increased use of derivatives, another trend, which has been expected to rise within the asset allocation process of pension funds. These are financial instruments, (contracts between two parties), whose value is determined by reference to some other stock, bond, financial instrument or event. Academics and consultants have increasingly vigorously argued the benefits to funds, both in terms of risk reduction and return enhancement, alike18. These instruments can be used to provide insurance, hedging against currency or interest rate risk, to protect portfolios on the downside in case of extreme market moves, or to guarantee 16 Allen Reed, GM Asset Management’s CEO has elaborated further on the pension plan’s investment approach in interviews. He has indicated that 30-40% of the assets committed to the new investment program are going to ‘broad scope mandates’, where fund managers have discretion to allocate dynamically across a range of investment strategies offered by their organization which have been selected by the GM pension fund. The reminded of new funds will be directed towards diversified, high alpha and absolute return strategies by specialist managers. See GM US Pension Review 12/2003, available on the corporation’s website: 17 John Plender, writing on GM’s pension policy in the ‘Financial Times’ December 19 2003:‘Standards that encourage delusion’: “GM has now revealed that much of the new money will be invested in so-called alternative assets such as hedge funds, property, junk bonds and emerging market funds in an attempt to meet the demanding 9% return target. These are usually regarded as high-risk assets. Yet GM argues that its strategy does not involve higher risk because of the benefit of increased diversification and reduced volatility…The really big economic change, meantime, is in the increased risk that comes from borrowing to punt in markets, which is ultimately borne by shareholders and other stakeholders in GM, including the taxpayers who stand behind the Pension Benefit Guaranty Corporation, which underpins US employers' pension promises. Yet there is no escaping the fact that, by borrowing to invest in alternative assets, GM is no longer just a punt on the equity market. As John Ralfe, a British pension consultant, argues, it is also now a bet on the ability of its alternative asset managers to achieve superior, sustained performance without volatility.” 18 A study Cardano Risk Management and City University in London (see recently showed that options can be used to make defined benefit pension schemes more sustainable, and that properly constructed options can add substantial value to pension-fund management. It argues that the current pension’s crisis has focused more on cutting benefits or increasing contributions, rather than on the efficiency of the investment process and how to increase returns. The report points to ‘overwhelming’ evidence that active management adds only costs not value and that pension funds themselves are to blame for stubbornly sticking to traditional asset classes whilst ignoring newer management products. Vincent De Martel, AXA derivative product specialist from AXA Investment Management, backed this study: “The function of derivatives is to reshape the risk/return profile of an asset; in other words, they take the returns of an asset and modify them in a way which is suitable for the investor…As such they can be used by pension schemes, in order to adapt returns of equities and bonds to match the liabilities of the scheme.” 15
  16. 16. the upside and enhance income. They are also useful for facilitating efficient transactions within portfolios (e.g. management of cash flows to minimize market impact), to reduce trading costs and to improve liquidity. They can also, vitally, provide a closer match to pension fund liabilities than bonds (through interest rate swaps, synthetic indexation etc.). 35. Yet the use of derivatives has been slower to spread that theory would suggest, and opinion remains divided over the safety of their application. Two heavy weight economic figures, in the form of Alan Greenspan and Warren Buffet, represent the two sides of this argument. Mr. Greenspan believes that the growth of derivatives has allowed risk to be spread, making financial markets more stable, whilst Mr. Buffet worries about ‘linkage’ between these instruments with one contract failure potential causing the whole system to unravel. “Although the benefits and costs of derivatives remain the subject of spirited debate, the performance of the economy and financial system in recent years suggests that those benefits have materially exceeded the costs.” 36. Alan Greenspan – Chairman of the Federal Reserve Board Corporate Governance, remarks from the 2003 Conference on Bank Structure and Competition: “Derivatives are the financial weapons of mass destruction…the dangers are now latent – but they could be lethal.” Warren Buffet – Letter to shareholders, 2002 Annual Report of Berkshire Hathaway Inc. 37. Though Mr. Buffet’s caution stems largely from specific experiences within his own fund, and relates to OTC (unlisted) derivative instruments, he does reflect wider fears within the investment community, including those who think ‘Barings’, ‘Enron’ or ‘Orange County’ the moment the word derivative is mentioned. Yet it was not derivatives themselves but poor application and supervision that caused these scandals. Certainly, using derivatives requires greater understanding, training and more complex monitoring and risk management control than underlying instruments (as many are by their very nature incorporate leverage so that losses can accumulate more quickly). The Futures and Options Association has published a dossier, ‘Managing Derivatives Risk’, which acknowledges potential risks and helps users in their derivatives trading. One key recommendation is to create an effective policy for derivatives, including senior level risk management and audit programs across all products, consistent with the underlying strategy, objectives and risk appetite of the organization. Derivatives should be seen as a help rather than a hindrance in the context of pension portfolio management, and trustees and fund managers, rather than simply ignoring them, should look closely at where they might gain from their deployment. Individual Risk Budgeting 38. A further important consequence for the pension industry stemming from this ‘perfect storm’ of an investment climate is that the shift from defined benefit to defined contribution schemes is here to stay. As risk is shifted to individuals they should, in theory at least, be conducting their own strategic asset allocation process. Each individual should be conducting their own ALM survey, assessing their liabilities (i.e. retirement needs), their risk tolerance and subsequently investing in matching assets that will generate a sufficient return. Many academic papers have laid out how their portfolios should be adapted over time in a ‘life cycle’ investment pattern, (according to changing labour income, also known as human capital, levels of risk tolerance etc.) 19. However, there remains a woeful lack of financial education and even the 19 For example, ‘Consumption and Portfolio Choice’ Cocoo J.F., Gomes F.J., Maenhout P.J. May 2001 16
  17. 17. most advanced pension markets have failed to keep up increased demand for such services generated by the rise in DC funds. Individuals remain exposed to a greater and more complex pension risks than many still realize, with government action likely to be necessary in future to fill this gap. Furthermore, DC scheme members are accepting investment risk without making investment decisions. Where a choice of scheme is offered (though this is still not the case for around 25% of UK DC funds), the vast majority choose the default option (anecdotally 75% in the UK) – herd instincts clearly applying to individual as well as institutional investors. Concerns remain even when this choice is a so called ‘lifestyle option’ that gradually shifts from equities to bonds as the member matures, as expressed in the UK Myner’s Review (see footnote 5): “The review is concerned that the equity-bond switch which is the key feature of the lifestyle funds is often undertaken mechanistically, without adequately taking into account factors such as increased longevity rates and different risk appetites.” 39. The US pension market can offer other countries in transition from DB to DC valuable experience in striking the correct balance between choice and guidance for individuals. The average US DC plan now offers 13 investment options (having started with only 2). Caution does, however, have to be exercised, as can be seen from the fact that many of these new options in the US were technology funds, offered at the height of the ‘dot com.’ bubble. DC trustees need to ensure that beneficiaries are not seduced away from long term investing goals by the latest investment fad. Equally, they have to ensure that proper adjustments are made as participant’s age. It has also been shown in the US that if faced with too much choice plan participation rates fall. Trustees of DC schemes need to think of ways help individuals get around such behavioural investment errors20 Figure 3: Number of fund choices in US DC plans 30 % of funds 20 10 0 No 2 3 4 5 6+ choice No. of choices offered Source: Watson Wyatt 2000 Pension Plan Design Survey Tactical Asset Allocation 40. Once ‘strategic asset allocation’ has set out how to broadly match assets and liabilities, and what the structure of an optimal fund should be, ‘tactical allocation’ decides how to allocate pension fund assets within the various asset classes and financial instruments available. This is required both to ensure sufficient investment returns over time and to insure that unnecessary volatility does not result in a significant reduction in asset values at the time when the plan’s need for liquidity increases. Tactical allocation can be seen as process of reducing the return risk, using market timing and specialist research to take advantage of opportunities within and between the broad asset classes. Views on best-practice regarding tactical asset allocation have, however, also been changing. 20 One US scheme, for example, know as ‘Save More Tomorrow’ helps surmount the problem that people rarely increase their pension participation rates sufficiently by committing a certain percentage of future pay rises in advance. 17
  18. 18. Passive Investing 41. Within the tactical asset allocation process, issues related to alpha investing and excess returns are reflected in the debate over active Vs passive investing. Rather than an argument over whether excess returns actually exist, the question revolves around whether pension fund investors are able to obtain them. Those who believe not follow the passive investment route. ‘Passive’ investors are those who simply try to match the returns from a broad average of securities at the lowest possible management fee, (whilst active investors buy or sell particular issues which they estimate the market has under or over-valued). The increase in passive funds stems from increasing disillusion over investment performance Vs benchmarks. The rational for this type of investing is that it is extremely difficult to consistently out-perform any market, given that all fund managers cannot statistically do so, and that it has proven extremely difficult to select a successful active manager, as can be seen from the performance of fund managers pre and post a mandate handover. Past performance certainly does not appear to be a good guide to future returns21. Table 2: 10 year average return UK equity funds to 1998 Index Funds 16% p.a. Active Funds 15.6% p.a. FTSE All Share 15.9% p.a. Source: WM 21 Roger Urwin, a top actuary at Watson Wyatt, quoted in ‘The Economist’ magazine: “If you look at the top-performing fund managers in most asset classes in a recent period, 4 out of 5 will be there by chance rather than pure skill.” 18
  19. 19. Figure 4: Investment Performance during Manager Turnover UK 100 % of managers beating average 90 80 70 60 Old 50 New 40 30 20 10 0 -5 -4 -3 -2 -1 0 1 2 3 4 5 Years before and after handover 22 Source: Sloan Business School 42. The best strategy has therefore often been seen as one that simply replicates the broad market index. Also, as institutional funds have become larger, liquidity has become more of an issue also pushing many towards indexing, with technological advances making this move possible. US and other pension funds have increased their exposure to index funds dramatically over the past 20 years. Given the much lower fee structure, passive investing is a legitimate strategy for an investor who values the tangible cost advantages over the possibility of achieving additional returns through superior stock selection. The greater one’s belief in the efficiency of markets, the more convincing this argument is likely to be. Figure 5 Allocation to Indexed Funds (% of total US Pension Assets) 30 20 10 0 1981 1991 2001 Source: Goldman Sachs/ Pensions & Investments Hedge Funds 43. For those who believe that excessive returns can be captured, the approach has been the complete opposite, arguing that investors have, in fact, been too constrained by benchmarks to take proper active bets23. The answer has therefore been to free a certain percentage of funds from benchmark considerations 22 Sloan Masters Individual Dissertation submitted by Mark Fawcett (former CIO Amex Asset Management International): ‘Structural Problems in the UK Pension Fund Industry’ 23 See criticism in the UK Myner’s Review of quasi-benchmarking and hedging: “many objectives are set which give managers unnecessary and artificial incentives to herd. So-called ‘peer group’ benchmarks, directly incentivising funds to copy other funds, remain common. And risk controls for 19
  20. 20. and take a properly active, absolute return approach to equity investing. Such a style is represented by ‘hedge funds’ and pension funds continue to increase their exposure to these investment vehicles. A survey by Goldman Sachs24 shows the dramatic rise of hedge fund investment, the sharpest amongst all the new alternative investments measured. 40% of respondents worldwide said they were already using them, with the average allocation in the US along up 40%. This comes despite acknowledgement that the risk of this asset class is challenging to measure and monitor. Intended allocations continue to rise in all regions (with US funds, for example, having doubled their exposure between 2001-2003 from 2.5% to 5%, with the intention of rising to 7.5% by 2005). The rational for using hedge funds is a combination of risk and return. Median hedge fund returns over the past three years were reported by survey participants to be 5% and expected to be 10% over the next three. Their low correlation to other asset classes only serves to heighten their appeal. Figure 6: Allocation Alternative Investments (%) US Pension Funds and Endowments 10 % of total assets 8 2001 6 2003 4 2005 (est) 2 0 Private Equity Hedge Funds Real Estate Asset Class Source: Goldman Sachs / Russell Investment Group 44. In regional terms, Japanese funds maintain the highest exposure to these vehicles, which is consistent with the low returns in their equity and fixed income markets over the past 10 years. As expected returns fall in other markets, exposure is likely to rise to these levels25. Given many US pension plans are saying that they are becoming more like endowments, with steady cash flows to fund their obligations, this trend is only likely to continue, given that hedge funds represent a stable 10-12% of assets for such endowments. Pension funds using hedge funds are doing so across a wide range of strategies, in a diversified manner, spreading their alpha or ‘skill-based’ bets across a group of managers and styles (even more so than in general asset allocation). active managers are increasingly set in ways which give them little choice but to cling closely to stock market indices, making meaningful active management near-impossible.” 24 ‘Goldman Sachs Equity Derivatives Strategy: Equity Indexes’ January 30th 2004. Figures taken from survey published in PLANSPONSOR Magazine (with Fidelity Research) December 2003 25 The January 12th 2004 issue of Pensions & Investments confirmed this trend, identifying at least $6.4bn of additional expected contributions to existing hedge fund managers for 2004. However it should be noted that those investing in hedge funds are still in a minority (23% currently investing in these vehicles, 8% saying they are looking to in the next 2 years). 20
  21. 21. Figure 7: Regional Allocation to Hedge Funds 10 % total assets 8 2001 6 2003 4 2 2005 (est) 0 North America Europe Japan Region Source: Goldman Sachs / Russell Investment Group Figure 8: Hedge Fund Strategies in US (% funds using style) 100 90 80 70 60 50 40 30 20 10 0 TA t C A nt Mu rb ro ct Sta ral G Vo b en ed n rb lm b ne a l xe lon arb tr rt m t or co hor ar ba l ar & D sho r a ac m lti a ut Sh Ev ess M eut C tM B e ts d g/s / ng is kt kt lo in lo ity or u ua Eq Se Fi Q Source: Goldman Sachs/ Russell Investment Group Private Equity 45. Another increasingly popular form of active, absolutely return investing is via private equity – i.e. investing in companies not listed on public markets. This asset class offers potential attractive, risk- adjusted returns, with relatively low correlation to other traditional assets. The risk of these investments is largely in their long-term, illiquid nature, but given the long life cycles of pension funds, many are increasing their exposure. Investment is via closed-end private equity funds, or fund-of-funds which are proving increasingly popular, (particularly in Europe), as these allow pension investors to diversify their holdings and are an attractive way to achieve international exposure in the field. Commitments made are drawn down in tranches as investments are made by the underlying manager. As the companies which are invested in develop, funds are extracted and returned to the original investors either through sale or listing on public markets. Most funds are still directed towards venture capital and management buy-in/out type investments (through ‘special situations’ are increasingly popular in Australia). 21
  22. 22. 46. Following several years of spectacular returns, driven largely by the US ‘dot com’ phenomena, private equity returns have declined considerably in the past few years, and in some cases have turned negative. Yet pension funds in all regions remain committed to increasing their exposure to these vehicles, (even in Japan where only a small minority of pension funds as yet make such investments)26. Figure 9: Trends in Private Equity Allocation by Region 9 8 7 % total assets 6 5 4 3 2 1 0 1 1 t 01 t 1 st t es es se 0 0 0 e 20 20 20 20 05 05 05 5e n 20 pe 20 SA lia 20 0 pa 20 tra ro n U e SA Ja pa op Eu lia s Au U Ja tra r Eu s Au Source: Goldman Sachs/ Russell International Investment 47. As the bond/equity debate has shown, in previous decades tactical asset allocations have been heavily skewed towards equities. Major changes in asset allocation structure have consequently been within this equity category, with the most prominent being the move towards international diversification. This has been the major trend over the previous 20 years, following the relaxation of foreign exchange controls in the 1980’s. Financial theory argues for international diversification as a useful risk management tool, improving the risk-adjusted returns by investing in asset classes that are not perfectly correlated27. In reality, the level of diversification does still vary by country. For example, though foreign holdings have increased considerably at US pension funds, (from 4% of assets in 1981 to 14% in 2001)28, they still remain a smaller part of overall portfolios than in other countries, (partly due to the large scale and diversity of the US economy). They form a more important part of pension funds in other Anglo-Saxon countries, such as UK, Australia and in particular Hong Kong. 26 According to the Goldman Sachs / Russell survey: ‘Alternative Investing by Tax Exempt Organizations 2003’ almost 70% of respondents in the US and Australia invest in private equity, Vs 58% in Europe and only 12% in Japan. 27 International diversification has also been argued to be most beneficial when the whole portfolio of retirement assets are taken into account, including non-traded assets such as human capital, as these are highly correlated with domestic financial returns. See Baxter M., King R.G.: ‘The role of international investment in a privatized social security system.’ 1999 28 Figures taken from Goldman Sachs Asset Management Research: ‘Two Decades of US pension Fund Investing’. Authors Thomas J. Healey CFA, Rossen Rozenov, October 2002 22
  23. 23. Table 3: Asset Allocation (%) – Major Pension Markets Country Domestic Internat. Domestic Internat. Cash Real Other Equity Equity Bonds Bonds Estate Australia 38 25 16 5 5 9 2 Japan 36 19 29 11 3 1 2 Netherlands 9 41 17 26 2 6 0 Sweden 19 15 42 14 2 8 0 Switzerland 19 16 27 15 8 12 3 UK 46 25 10 3 3 6 7 US 48 11 35 1 2 2 2 29 Source: UBS Global AM estimates end 2001(government and industry figures) 48. Questions are now being raised as to how much further the international trend will go, particularly at US funds given these assets under-performed domestic ones at least through the 1990’s following only limited excess performance during 1981-1991 period. Increasing correlations between global equity markets are also raising questions in other pension markets, particularly as such correlations tend to rise most in periods of high volatility, reducing the benefits of diversification even further. It has also been speculated that US investors at least can achieve the benefits of international diversification through a portfolio of domestic securities. Such arguments will continue to reinforce the natural tendency for investors to maintain a ‘home country bias’. High weightings in domestic stocks have been explained by numerous factors, both practical (currency risk, inflation risk, costs and restrictions), though are probably now driven more importantly by psychological ones (‘comfort factor’, combined with the belief that domestic investors have better information and indeed proven ‘over confidence’ in the domestic market). The current weakness of the US dollar may, however, provoke further US overseas investment. Figure 10 29 Taken from ‘Pension Fund Indicators 2003: A long-term perspective on pension fund investment’ UBS Global Asset Management 23
  24. 24. Annual Average Returns on US and Int'l Stocks ($) 20 15 Int'l Stocks 10 % Large cap Stocks 5 0 1981-1991 1991-2001 30 Source Goldman Sachs: Ibbotson Associates Other Investment Trends 49. As well as diversifying amongst equity holdings, pension fund asset allocation has also shifted in recent years towards other asset classes. Real estate, which has always formed a core part of pension funds investment, has become more viable with the introduction of new investment vehicles. Outright investment has always offered liquidity and diversification problems, which can be overcome by indirect investment through listed property companies and investment funds, such as REITs. Long standing in the US market, these have been launched in Japan in recent years, as well as in several European countries, and it is hoped that a pan-European REIT market will follow soon. 50. As well as developments in such traditional asset classes, pension investors have also been carving new asset classes out of old groupings. For example, forestry investments, previous classed with property holdings, have become increasingly popular, as their long-term, stable returns offer a suitable match for pension fund liabilities31. Investing in currencies, independent from foreign exchange holdings that arise from investments in overseas equities or bonds, has also been increasing32. Governance Issues 51. Risk to pension funds also comes from systemic factors, including the conflicts of interest that always occur when there is a split between management and ownership, (i.e. the agent/ principle problem). Governance controls in the form of legal and regulatory measures to have been discussed at length in 30 Figures taken from Goldman Sachs Asset Management Research: ‘Two Decades of US Pension Fund Investing’. Authors Thomas J. Healey CFA, Rossen Rozenov, October 2002 31 Though grouped with property, forestry investment most resembles index-linked bonds, with predictable output and long-term price trends that have kept pace with inflation. Investment is most commonly via direct ownership, with limited partnerships being popular in the US, and unitized funds are becoming more widespread (offering liquidity, efficiency and reduced specific risks). Forestry also offers a low negative correlation with other asset classes and, due to renewable and sustainable characteristics, and fits well into socially responsible investment (SRI) portfolios. Comments taken from IPE paper on forestry investment 32 See IPE paper on currency investment Includes comments from Matthew Annenberg, global head of FX analytics and risk advisory with ABN AMRO in NY: “For the pension fund industry, currency risk management and the opportunity to generate alpha is increasingly important. Currency managers’ track records are long and favorable enough for most diligent studies. Total return currency mandates have come of age, and deserve consideration along side other alternative assets.” 24
  25. 25. previous OECD papers and therefore will not be repeated here.33 Analysis of governance controls in the form of the prudent person rule and the role of trustees do, however, follow. Prudent Person Rule 52. The broadest form of governance relating to risk management to which pension funds must subscribe is the ‘prudent person’ rule34. This applies in some form in most countries, and broadly states that a fiduciary (person with responsibility for the assets of another) must discharge his duties with the care that a ‘prudent person’ acting in a like capacity would use. Other specific duties, such as diversification, are also laid out in some interpretations, or are implicitly assumed to be an indicator of prudence. This rule has its origin in trust law, and its interpretation has developed over time. Historically, the reading of the rule was that investment should be undertaken on a highly cautious, risk avoidance basis. However, with developments in modern portfolio theory, focus shifted more to the investment process as opposed to investment outcomes, with the rule interpreted as requiring due care and diligence in investment decisions. 53. The rule is applied in different ways in different countries. The US investment industry, for example, is required (under ERISA legislation) to act in the manner of a ‘prudent expert’ arguably giving more scope that the ‘prudent person’ definition still used, for example, in UK pension regulation (though the 1991 Myner’s Review recommended changing to the US definition). The main difference between countries is as to whether the rule is applied in quantitative or qualitative terms. Rather than leaving discretion open to investment managers, requiring only that due care is taken in the investment process, some countries apply more concrete restrictions on investments and have strict diversification requirements. For example, some still limit the amount of equity investment that is possible, others the level of overseas holdings etc35. 33 Including ‘Portfolio Regulation of Life Insurance Companies and Pension Funds’ and ‘Governance of and by Institutional Investors’ 34 For more details on the prudent person rule see ‘“Prudent Person Rule” Standard for the Investment of Pension Fund Assets’ 35 For example the European Union applies quantitative restrictions (e.g. no more than 5% of assets in a single holding, no more than 30% in OTC securities, no more than 30% in external currency denominated assets), with a ‘prudent person’ overlay. See ‘Directive of he European Parliament and of the Council on the activities and supervision of institutions for occupational retirement provisions’, June 2003. 25
  26. 26. Table 4: Portfolio limits on OECD pension fund investment in selected domestic asset categories Country Equity Real Bonds Investment Loans Bank Estate Funds Deposits Japan No limit No limit No limit No limit No limit No limit Denmark 70% No limit No limit 70% No limit No limit gilts gilts gilts UK No limit No limit No limit No limit No No limit employer loans Source: Survey of investment regulation of pension funds Dec03 Table 5: Other Quantitative Regulations of Pension Fund Assets in Selected OECD Countries Country Minimum Self-investment / Other Ownership Diversification conflicts of quantitative concentration requirements interest rules limits Japan EPF (employee pension EPF: investment on none none fund): none, but securities with the pension legislation purpose of pursuing stipulates that each interests of someone pension fund should other than the pension endeavor to avoid fund is prohibited. concentration of investment on a specific asset category. Denmark Limits for any one Limits of 2% of the ‘High-risk’ assets Limit of 2% of the investment depending provisions for (domestic and foreign provisions for on the sort of assets investment in any one shares and unlisted investment in any enterprise (for securities) limited to one enterprise (for company pension 70%. company pension funds). Property and funds). investment-trust Prohibited to holdings limited to exercise a 70%. controlling Minimum 80% influence over the currency matching company in requirement. For EU question. currencies up to 50% of the liabilities can be covered by assets denominated in Euro. UK General requirement Yes, employer-related No quantitative None for diversification and investment limited to portfolio restrictions. suitability. 5%. Source: Survey of investment regulation of pension funds Dec03 54. The prudent person rule has, however, come in for criticism. Some argue that, though designed to reduce pension fund risk, the rule has actually done harm by limiting returns, particularly where quantitative restrictions are applied. These are said to make asset-liability matching and the immunization process more difficult (or even impossible), as well as limiting diversification and restricting the use of derivatives. In the words of the European Commission such restrictions are: 26