Being long-term in a short-term world
How can pension funds make long-term investment plans in a short-term environment? Patrick Ferguson, chief executive of the Irish Construction Workers Pension Scheme; Henrik Olejasz Larsen, CIO at Sampension; and Patrick Groenendijk, CIO at Pensioenfonds Vervoer, share their views.
Patrick Ferguson, chief executive
Ireland's Construction Workers Pension Scheme
• Invested assets: €1.1bn
• Members: 25,000
• Hybrid - DB, but contributions are converted to pensions on a DC basis
• Solvency ratio: 110%
• Date established: 2006 (the original Construction Federation Operatives Pension Scheme was founded in 1965)
"Despite how much we fight it, from a board perspective we have an increasingly short-term perspective.
We do not invest for short-term results but if there is, for example, a significant dip in equities, a possible reaction to this is discussed at board level.
However, unless the fall in equities is going to continue for a significant amount of time, based on our long-term strategy we are unlikely to react to it.
The only parts of the asset allocation we review due to short-term pressures are the assets in our annuity or pensioner fund because they have a specific liability. Essentially, ours is a DB scheme but it is operated on a DC basis for active members; it is the pensioner fund that makes it a DB scheme.
We initially moved the assets in the pensioner fund from a pooled, passive fund into an active, segregated fund because all of those assets would be in euro-zone bonds, and we started moving our bonds from peripheral to core European bonds.
The issue of euro-zone bonds and the euro have created worrying negative sentiment, which has been driving the markets recently.
But short-termism just adds to investors' volatility and it can be very costly moving around when the market changes, or when there are big changes in the return of certain asset classes.
The return-seeking assets in the active members fund are all long-term strategies, which we will continue to diversify to have, for instance, absolute correlation in alternatives versus equities.
The other issue, which pushes us into a short-term strategy, is that every three years we have to obtain a funding certificate of our solvency ratio for the Pensions Board. This clearly influences what we do on a short-term basis because - although we have never been underfunded - we have to convince trustees and others involved that we invest for the long term. But, in our experience, consultants have always shared the long-term view with us.
The trend to short-termism stems from mark-to-market accounting and DB schemes where people have to fund for their liabilities in the short term, particularly if they are underfunded and trying to recover. But if the regulator did not press the fund for a recovery in the short term, there is a good chance the underfunding would not be dealt with."
Henrik Olejasz Larsen, CIO
• Danish common management company for three pension funds
• Net invested assets: DKK140bn (€18.8bn)
• Members: 270,000
• Defined contribution scheme with guaranteed life annuities
• Date established: 1945
"Over the last decade the shift to more market valuations on both assets and, in our case also on liabilities, has changed the way we look at our portfolio.
The traditional Danish pension fund has had a tendency of buying very illiquid assets with a buy-and-hold strategy, which has its advantages but also disadvantages. The benefit of market valuation is that we gain information from the market and instead of just sitting on a portfolio, we can act on new market environments.
But it is important to get the strategic asset allocation right and not pay too much attention to short-term market movements - we look at our portfolio in the light of our chosen long-term asset allocation.
By communicating on the effect of negative market movements on our portfolio in advance we try to manage the expectations of our members and board.
Forced selling is always destructive to portfolios, which is why we try to construct our portfolio in a way to avoid having to reduce risks when markets are stressed. This can be in conflict with the illiquidity premium of certain assets - the solution is to make the liabilities robust enough to be able to maintain our asset allocation in stressed market environments.
To deal with the value destruction as a result of being forced sellers in stressed markets, Danish pension funds like us have moved away from hard guarantees to either no guarantees or softer, conditional guarantees. We have also put more emphasis on our ability to manage risks in the short term. As part of that, we require a substantial part of our investments to be liquid.
Although market valuation is the only form of accounting that is robust to manipulation we should allow for the fact that markets are not well-functioning at all times. In other words, where market values are irrelevant or misleading we should have an environment where the regulators have some leeway to make extraordinary provisions.
It would be prudent for the new Solvency II regulation, for example, to formulate this in order to have some counter-cyclical working measures at the outset that we can build into our own risk management operations."
Patrick Groenendijk, CIO
Pensioenfonds Vervoer of the Netherlands
• Invested assets: €12bn
• Participants: 600,000
• Solvency ratio: 100%
• Date established: 1964
"With the Dutch regulator forcing us to adopt so-called recovery plans - which have a horizon of five years - our previously long-term horizon of 15 or 20 years in asset liability management studies has automatically shortened to five years to enable us to meet the requirements of the recovery plan.
In fact, the focus is on an even shorter time horizon because the recovery plan sets out certain milestones that have to be achieved every year.
And because the regulator is under pressure from the general public and politics, which by its definition is short-term, it is highly unlikely that we will see the trend revert to a more long-term outlook.
The other reason for the greater focus on the short term compared to a few years ago is that today everything is discounted mark-to-market. There is much more information available now and with more emphasis on how we are doing in the short term, people look at the solvency level every day. In the past we were given a longer-term horizon, which meant we could afford some short-term volatility.
It is generally not easy dealing with the short-term versus long-term conflict. The main challenges we face in this conflict lie in the asset allocation. How can we, for example, pick up a long-term illiquidity premium while at the same time satisfying the people with a more short-term view? Within our portfolio construction and asset allocation, we try to keep both sides happy simultaneously by emphasising the short as well as the long-term horizon. In other words, we have some investments that are more of a long-term nature but also try to design the portfolio in a way that ensures we meet the goals set out by the short-term recovery plan.
Investment banks have come up with various structured products - such as downside or solvency protection - that can help us achieve the required milestones or solvency ratings by year-end. A whole industry has grown out of this short-termism.
The only benefits deriving from a focus on the short-term concern risk. Some focus on short-term risk is useful to avoid volatility and drops in funding - however, an exclusive focus on the short term would be deadly for the long-term viability of pension funds and the pension fund system."
This article first appeared in the March issue of IPE magazine.