In the first of a series of articles on a new study, Amin Rajan argues that Europe's pension landscape is not fit for purpose post the credit crisis
Pronounced diversity in occupational pension arrangements across Europe has concealed the true significance of the crisis brewing up below the surface caused by successive seismic waves, according to a new study jointly carried out by IPE and CREATE-Research.*
The study is a call to arms. It highlights who needs to do what in order to ensure a comfortable retirement for current and future generations of employees.
This study's assessment is based on results from two separate postal surveys, jointly involving around 222 organisations: one covering 87 pension funds, the other covering 135 asset managers, collectively accounting for €22trn of assets in 15 countries - Austria, Belgium, Denmark, Finland, France, Germany, Italy, Ireland, the Netherlands, Sweden, Switzerland, Poland, Portugal, Spain and the UK.
A vicious cycle
At the end of a turbulent decade, European pension funds find that they no longer manage risk; they manage uncertainty. One relies on known probabilities of returns on different asset classes; the other on pure guesswork.
Many were overweight in equities in the raging bull market of the 1990s. The end of the tech bubble duly sparked a funding crisis. The resulting regulatory and accounting changes exacerbated it via their unintended consequences. The ensuing diversification into alternatives came at a time when their peak returns were history.
Asset values have dropped like a stone in today's bear market, as the new mark-to-market rules have turned the US sub-prime crisis into a global disaster. And recent falling interest rates have added to liability valuations, exacerbating under-funding and putting pressure on solvency levels."
Together, these events have triggered numerous discontinuities (figure 1): the risk-return features of most asset classes have become hugely volatile; the correlation between old and new asset classes has gone through the roof; strategic asset allocation looks like a casino game; and new products verge on financial alchemy.
On the accounting side, the mark-to-market rules have also injected an unpalatable degree of volatility into the balance sheets of defined benefit (DB) plan sponsors which are quoted companies. Undue short-termism as well as large cash injections is the norm, promoting further plan closures and accelerated buyouts. Covenant risk has emerged like a bolt from the blue. So has the reputation risk in defined contribution (DC) plans, whether managed individually or collectively. Plans where individuals bear all risks have been developing fault lines evidenced by low enrolment rates, low financial literacy, poor investment choices, a dearth of viable products and poor returns. Plans that pool risks or offer guarantees, too, suffered low returns before the current financial tsunami.
The emergence of these new risks has challenged the old certainties and exposed new weaknesses in different parts of the pension value chain. Pension funds can no longer count on their consultants and asset managers to help them navigate through uncharted waters: its time for them to up their game.
What do pension funds think of their consultants?
When asked to evaluate the contribution of pension consultants in meeting the unfolding challenges of this decade, pension funds in our survey convey a mixed but unfavourable picture (figure 2). On the whole, in every one of the activities in the chart, there are notable incidences of favourable ratings under the labels of ‘good' and ‘excellent' (on the right hand side of the chart). This is mainly the case in areas like asset liability modelling and performance monitoring.
At the other end, there are also notable unfavourable ratings under the labels of ‘poor' or ‘limited' (on left hand side) in vital activities like strategic asset allocation, manager selection, and strategy implementation.
As plan sponsors have raised the bar on their trustees, trustees have raised their expectations to levels to which consultants have not been accustomed.
The unfavourable ratings are indicative of the emergence of new urgencies as much as the prevalence of embedded weaknesses. But there are exceptions: consultants specialising over a narrow area have developed greater proximity to their clients, especially in continental Europe. They are perceived as adding greater value than their larger peers, with expertise across the entire waterfront. The key differentiator, however, is not size but the quality of the relationship with clients.
What do pension funds thinks of their asset managers?
When asked to rate the contribution of their asset managers in helping to meet the challenges of this decade, pension funds' assessment has been decidedly mixed once again (figure 3).
The favourable ratings are much more evident in activities such as stock selection, portfolio construction and risk management. But in the critical area of returns, 55% of the respondents rate them as ‘poor' or ‘limited'. Unfavourable ratings become more pronounced in other areas like strategic or tactical asset allocation, access to new asset classes and investor activism. They become most pronounced when it comes to pre-retirement, post-retirement and capital protection products.
Those pension funds that diversified did so because they either accepted the uncorrelated returns story from their managers as an article of faith; or they were enticed by the prospect of the much publicised ‘prime mover' advantage which has turned the Yale and Harvard endowment funds into world-class icons.
In hindsight, as the funding crisis unfolded over this decade, the response of asset managers was overly product-oriented. There was not enough understanding of the nature of either the crisis or the responses it required. Furthermore, returns in this decade have shown evidence of ‘fat tail' risks, casting doubts about the viability of the current generation of risk models used by managers. There have been more extreme events than are catered for by the backward looking nature of the models in use.
Finally, as in the case of consultants, the reported dissatisfaction has to do with the fact that the expectation bar for asset managers has been raised to a level to which they are not accustomed. It is also indicative of the disapproval of the ways in which many asset managers operate.
Understanding the systemic weaknesses
To chart the way forward, our study pursued three specific questions with pension funds, their consultants and their managers. First, we looked at what factors would feature strongly in pension funds' choice of their asset managers in the next generation of mandates; second, what do asset managers need to do to add more value; and third, what actions are needed by the three sets of players in the investment value chain.
To the first question, the answer was unanimous - good returns, backed by quality people with quality processes, and alignment of interest to ensure their sustainability into the future. The feast and famine mentality of the past has done credit to nobody.
On the second question also there was unanimity. Asset managers and pension consultants need to embrace their clients. The current arms-length approach is not conducive to understanding clients' dreams and nightmares. New uncertainties require more joined-up thinking.
On the third question, the predominant view was that this aloofness is the cause and the symptom of a cycle of shortcomings that prevails in each link in the investment value chain, as illustrated with respect to DB plans (see figure 4). Internal shortcomings have caused external disconnects and mutual misunderstandings.
Accordingly, pension funds need to tackle the prevailing skills and governance gaps that have for too long promoted herd instinct and rear view mirror decision-making.
On their part, pension consultants need to orient their professionalism towards fresh ideas and insights that create an edge, as new opportunity sets are desperately needed. They need to re-think their time-honoured approaches to asset allocation and manager selection, as no one gets the benefit of the doubt anymore.
Finally, asset managers must stop selling what they have and start selling what their clients need by creating products that are fit for purpose, not copycats, within a better value-for-money fee structure. Innovation should be about meeting client needs, not just revenue generation.
Above all, each party needs to interact directly with the others regularly to exchange ideas, review progress, do course corrections, and monitor outcomes. No one has the monopoly of wisdom. Consultants' current gatekeeper role pigeon-holes managers and retards creativity when it is most needed. Examples of best practices are there. But they are few and far between. The difference between the best and average is striking.
Tackling the root causes
The immediate cause of the current funding crisis is, of course, the bear market. When the markets recover, the crisis will ease but it will not disappear. Previous recoveries have merely concealed the deep-seated problems in every part of the pension value chain and postponed the root and branch reforms that have been long overdue.
Specifically, pension funds have identified 10 things that can have a material impact on their funding levels, either directly or indirectly. Some of them are about doing old things better. Others are about doing new things. Other articles in this series will explore them in detail.
At the end of a traumatic decade, the mounting crisis cannot be resolved at the same level of thinking as that which gave rise to it. Without fresh thinking, pension funds will continue to stumble from one crisis to another in an era where old certainties no longer hold.
*DB & DC Plans: Enhancing their delivery. Published on 20 November by CREATE-Research and available free from www.create-research.co.uk
Professor Amin Rajan is CEO of CREATE-Research
Too many ‘me-too' products
"Ten years ago, we were essentially in two asset classes: equities and bonds, both with a strong domestic orientation. Now, nearly 25% of our assets are diversified in search of uncorrelated returns. We were also advised to venture further afield to fish for alpha.
"One lesson from the current crisis is that the uncorrelated classes are few and far between. All that glitters is not gold.
"Also, funds marketed as uncorrelated have so far delivered returns no higher than traditional long only funds, yet they have attracted much higher fees for their managers. Some managers even attribute market driven beta to managerial skills. What kind of research process underpinned these funds that were meant to deliver good returns in good times and bad? How were these funds stress tested? Who provided the seal of approval? What was the quality assurance process that brought a bewildering range of new products on the market, without regard to their underlying risk return characteristics?
"Like car companies, asset managers need to push out only those products that are fit for purpose. There are too many ‘me-too' products rushed out in the name of innovation.
"Client interest attracts no more than lip service."
A Danish pension fund
Special insights key for consultants
"In the investment arena, we have seen the emergence of new asset classes, new markets, and new opportunity sets as the old asset classes are being combined with the new tools of hedging.
"Yet, we don't get the feeling that the models used by pension consultants are any different. Nor do we get the feeling that new tools of analysis are being created by them at a time when it is widely accepted that anywhere between 50-80% of returns stem from smart asset allocation choices.
"Nor do we see signs of special insights which help our trustees to understand the unfolding dynamics of the investment scene. As trustees, the bar has been raised for us by a combination of poor returns, new regulations, new accounting rules, financial statement volatility and large cash injections. Plan sponsors are no longer indulging their fund trustees, who are perceived as having got the sponsors into the mess in the first place.
"At a time when the risk premia of asset classes are so unstable, we need people with special insights to help us navigate through the uncertainty that has gripped the investment world in this decade."
A French pension fund
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