Jean Frijns discusses the way ahead with Fennell Betson
The day to visit ABP's offices, located in the rolling farmlands at the southernmost tip of the Netherlands, is when the countryside is bathed in spring sunlight and afloat with blossom. Then you might forgive the architects who designed the building for Europe's, if not the world's, largest pension fund. The office presides incongruously over the distinctive inter-war period town houses making up the suburbs of the market town of Heerlen.
Size is not ABP's only characteristic of note. Chief investment officer Professor Jean Frijns points out that the fund is one of the country's oldest. Its venerable 77 years are testimony to its ability to survive the 20th century cataclysms that felled many other European institutions. We survived the Great Depression, we survived the War, all of which was quite exceptional for continental Europe," he says.
It is also testimony to the strength of the underlying concept of being a funded scheme. From the outset, ABP was a funded arrangement for Dutch public servants. This makes it a pretty unique specimen, as pay-as-you-go systems are the norm for civil servants, even in Anglo-Saxon countries. "There was some discussion after the war as to whether funding was appropriate or not, but it was decided to continue."
The biggest challenge of all to its funded status was the heavy inflation of the 1970s, when the funding ratio of assets to liabilities dropped sharply. "The benefits of the approach were reconfirmed, and we returned to being fully funded even though it meant increasing the contribution rates to over 20%," he says. "We were determined to safeguard the funding idea."
The fund then had what Frijns calls its "golden era" during the 1980s, when high interest rates and reducing inflation meant excellent real returns, particularly when combined with the continuing high contribution rates. The funding ratio improved dramatically - a fact to which the government as main contributor reacted. In fact, it over-reacted. "In the late 1980s and early 1990s, the government tried to reduce the contribution rate too aggressively," he maintains.
The upshot was an examination of the fund's place within the governmental apparatus, leading to the 'privatisation of ABP'. "This was really a 'big bang' that was done under the name of privatisation," Frijns says. "We used to be a government agency, where the government set the contribution rate, where it set the investment constraints and appointed the board of trustees. The decision was to solve all these questions in one swoop." The change in status gave ABP all the freedoms that a private sector fund has, but no more than that, with responsibility for its own funding, investment strategy and setting the contribution rates. Since impact day in 1996, the fund has had its own board with representatives from the different employer organisations, including the civil servants, local government employees, teachers, university staffs and others, and from the six different unions.
Frijns, who also lectures at the Free University of Amsterdam, has been with ABP for over 10 years. In that time, he has seen the investment side become increasingly predominant. "When I joined, investment income was roughly of the same order as the annual contributions. Now it is three to four times as high." Before privatisation, he has been active in building up the fund's professional investment expertise, but it was not until then that the fund was able to take advantage of the liberal investment regime Dutch funds have. With over 90% in fixed interest and mostly Dutch treasury bills the scope had been limited.
"The first thing we did after privatisation was to devise a new investment strategy, once we had put in place a multi-year funding system to ensure the fund would be solvent at all times." At the core of the fund's overall strategy is an asset/liability model built by ABP's actuaries and financial experts. "With asset liability management, you have to decide about the way that you fund - either you are in a system with a short-term horizon and the obligation to maintain a target funding ratio, but with the consequence of enormous volatility in the contribution rate, or you go to the other extreme and you adopt a very long time horizon and the contribution rate is stable, but you can have big swings in your funding ratio."
ABP went, in fact, for something in between. "Ours is a synthesis of a system that looks very much at a target funding ratio and also looks as an anchor at the long-term contribution rate, which is the actuarially fair contribution rate assuming a funding ratio of one." The system is targeted on a three- to five-year time horizon. "We started with funding ratio, which was slightly above the target ratio, but only slightly."
The second element in the AL model is the benefits side. In ABP's case not only are the pensions final-salary-related, they are also fully inflation-proofed, including those for early leavers. Frijns observes: "Our system is generous compared with the US and the UK." And its 77 years means that it is a mature scheme. "Our risk profile is high on the liability side, given both the benefits structure and the age profile of participants. With such a risky liability structure, we cannot afford a big fall in earnings."
The outcome had to be a cautious investment strategy, as Frijns sees it. "I am often asked about moving to a much higher percentage in equities. I agree that we have to invest more in equities as it is the only way to make our generous pension package affordable. But, in the meantime, you run a lot of short-term risk by equity investment."
The plan is to increase the equity exposure gradually over the next few years, but "building buffers to smooth the short-term equity risk". "In the meantime, the downward risk in equities has to be controlled. If we were heavily into equities and the market drops, our funding ratio would fall substantially below the target ratio and contribution rates would have to increase dramatically."
Frijns dismisses the idea that its size prevents ABP moving more quickly into equities. "As global investors, even on our scale, it is quite possible to invest successfully, especially for a professional investment organisation such as ours. The only reason is to build our defences against short-term equity-risk."
The equity proportion has moved dramatically from around 8% before privatisation to 17% at the end of 1996 and over 20% last year. Originally, the focus was on indexed portfolios and in 1996, the ratio of active to indexed was 20:80. There always has been a significant Dutch portfolio amounting in 1996 to around 50% of the equity portfolio, with holdings of around 3.5-5% in most listed Dutch companies. With the fund's commitment to corporate governance issues, the investee companies are increasingly aware of what it means to have such a powerful shareholder. But the Dutch proportion is scheduled to decline, while the US, rest of Europe and Asia will each account for between 20 and 25% of equity holdings.
The fixed interest holdings are approaching the $100bn mark. Since privatisation, the drive has been to exceed the benchmark of the return on treasury bills but without increasing risk. One active area is Dutch private placements by mainly public sector bodies. Mortgages are scheduled for growth (up to 10% of the portfolio by 2000) and a relatively new activity has been making loans to Dutch corporates. At the end of 1996 only 10% was invested abroad through external managers and this has risen to 12% by the end of 1997.
On the real estate side, the big switch for the fund has been to put its Dutch holdings into three separate property funds for residential, office and retail properties, with the aim of eventually reducing ABP's stake to a minority. Another target is to spread its holdings worldwide, with 50% outside the Netherlands by 2000. The lion's share will go to the US as it has a well developed real estate fund sector, both listed and non-listed, and where it also has joint activities with Rodamco, the property fund arm of the Robeco group.
Currently, the fund invests more than 30% in real assets, but this is not enough, Frijns acknowledges. "But we are on course to where we want to be by the year 2000. We looked at our financial position at the end of 1997, and we proposed to the board a more ambitious target to increase the equity proportion to 40%, with another 10% in real estate, but with the freedom to shift between real estate and equities."
This 50/50 split between real assets and fixed income is a reasonable target for ABP, given its maturity, he reckons. "While we are financially healthy, we are not very rich - some pension funds are really rich, with funding ratios of 130 and 140%!"
The shift to equity has involved forming a new investment focus called 'structured investments', which includes real estate, private equity and structured finance. This will be run from the new Amsterdam office. "These are all products which are illiquid and long term, comprising a portfolio of individual deals. Often the investment is the result of a complicated process, requiring investment bank people for such a group." A large pension fund can invest in these areas long-term, provided it invests in the human resources, while a mutual fund cannot, he points out.
"The arrival of the euro strengthens our determination to diversify our international equity portfolio, which has already been happening." Eschewing the term "passive", Friijns says: "We manage market portfolios in-house for the Netherlands and for Europe as a whole. An in-house structured investment process is being set up to manage enhanced market portfolios with small tracking errors relative to the market index, with active tilts based on sectoral weightings or the outcome of quantitative factor models." He adds that the same process can be used to manage market portfolios. "We do not have the resources nor the ambitions to set up a purely active stock-picking process."
Of the Dutch fixed income market, where ABP is such a colossal investor, Frijns observes categorically: "This market no longer exists!" A redefined strategy for the euro has resulted in the US credit risk approach being adopted. "We see the European fixed interest markets becoming more liquid and this will enable us to diversify our credit risks much more effectively than we could in the Dutch market alone. This is a great advantage. We have invested in sophisticated credit risk management programs and are expanding our capacity in Heerlen to handle European fixed income."
The eventual aim is to handle the increased US exposure in-house out of the New York office. Other areas being developed include the corporate debt market and redemption-free mortgages, which will act as a swing portfolio. The fund has long provided mortgages for the Dutch market.
The run-up to the euro has meant it not been worth hedging the currency risk for other Emu currencies. Otherwise the question of currency hedging is "a never-ending debate with the trustee board". "If we have the choice between taking more market risk or equity risk and currency risk, we prefer to take on more equity risk, as we feel that in the longer run we will be better off." But even if the currency risk is not worth taking, there is a limit: "It would be useless to hedge 100%, as then we would not benefit from diversifying the currency risk." So the policy is to hedge 50% of equity exposures and 80% of foreign fixed income exposures.
"We want to be the best provider of investment management services for ABP and related funds and the participants." As a non-profit organisation, ABP has no intentions to be an independent investment manager. "We would only become a third party asset manager, if we were a profit-driven organisation."
Frijns emphasises the group's commitment to us-ing outside managers where appropriate. "Our ap-proach is not to do everything in-house. While we will continue on the equity side to concentrate on the core European and US markets, we will continue to hire outside managers for Pacific, emerging and other peripheral markets. The idea of co-investing with outside managers is also something we want to do." But the shift to more equities means ABP will use more outside managers. Here Frijns sees the core mandates shrinking and the specialist increasing.
"We have learned a lot from outsourcing mandates, but we have never and never will copy the investment strategy of any particular manager. What we learned is not copying specific tricks, but that we are better off implementing a structured process. You cannot attract the right people and tell them that the only thing they need do is look at what someone else is doing and copying it. People have to take their own responsibility, it is far too dangerous to rely on someone else's black box or process. You have to do your own analysis and to build your own decision systems." The investment process has to be well structured and if the disciplined approach slackens, the results will deteriorate.
Like other Dutch pension funds, ABP is coming under increasing pressure to offer more individual choices to members, such as financial products which are integrated with the scheme. "There is a lot of competition in respect of these additional products and we face insurers and other providers head-on." But he resists strenuously any attempt to drift from the advantages of providing benefits on a collective group basis. "People are better off with such a funded scheme, with a steady time horizon and solidarity between the generations, with investment being done by professionals." He points to the enormous efficiencies of providing benefits on such a basis. "Our management costs are not more than 10 basis points, you can easily face 100-150bps annually on individual arrangements."
On the question of results, the fund has outperformed its strategic asset allocation benchmark for the last four years, he says. This means that ABP will not be caught by the recently legislated under-performance provisions, which give individual employers freedom to withdraw from industry-wide schemes.
But the fund faces its own future challenge in this direction - the ABP 2001 discussions. When it was privatised, the five sectoral schemes agreed on one fund and one scheme for a minimum of five years.
"The ABP 2001 was started to discuss this idea to see if there should differentiation within schemes, whether or not there should be different schemes, whether or not different funds, and whether or not there should be individual choices." The government, the employers' associations and the trade unions are involved in these discussions with ABP. "The discussion is being done in a very objective and constructive way, aimed at arriving at the best outcome for us all," says Frijns.
In this discussion, but also from a wider perspective, he has no doubts about the advantages size confers on ABP. "The financial world is in a very turbulent state. You see the making of giant financial powerhouses as a result of enormous mergers. There are reasons why that is happening: internationalisation, the economies of scale, the huge investment required in IT systems, and the desire of the best performing professionals to work in large houses. In our view, these are good reasons for ABP to be a large, powerful player."
Frijns remains totally an advocate of the group approach to funding pensions. He says that, based on the Dutch and UK experience, the concept of one uniform pension scheme for all employees is still highly attractive. "It is simple, it can be produced cost-effectively and it has a lot of risk solidarity. However, it is not the best-selling product. So it will have to be modified to give more choices to employer groups and the individual members."