Handling the mismatches
When you invite a group of pension funds to a gathering at the moment there is only one question in delegate’s minds.
And Karel Stroobants, head of the Belgian Pension Fund Association and chair of the event, expressed it clearly opening the 2003 Pension Summit in Noordwijk in the Netherlands last month, organised by FundPartners and sponsored by PGGM, Mn Services and IPE.
“The thing we are asking ourselves at the moment is “What are we going to do to make pension funds safe in the current environment?”
It might seem strange, however, to think that an answer could hail from the US.
Nonetheless, out on the Dutch coast facing west, it was perhaps appropriate that a rethink on the whole structure of pension plans and equity investment should blow in from the first speaker of the day – Professor Zvi Bodie of Boston University.
Bodie began by asking some big-picture questions, citing the need for any society to ask itself what its future policy options were for pensions in terms of defined benefit (DB), defined contribution (DC), risk sharing and guarantees.
“We have to ask ourselves what kind of guarantees we are looking for and what the correlation is with living standards. The difficulty lies not in whether we want guarantees, but in making sure that what is promised will be delivered.”
As an example of a mismatch between pensions expectation, delivery and end product, he pointed to the US 401k market, noting: “What has become clear is the lack of training and information needed to make the types of investment decisions for 401k plans.
“We don’t expect people to make such difficult decisions about their medical health and I would argue that asset allocation was as hard as most medical surgery!
“Currently I would say the 401k system is a disaster – no-one knows the risk of their pensions, and even financial planners can’t really tell anyone. The last three years have been a rude awakening in the US.”
Bodie’s next major point went to the heart of a discussion that is taking place in many of Europe’s pension markets right now. Is there a risk-free asset class for pension funds and do inflation-linked bonds fit the bill?
“I know that this issue of inflation-linked bonds is being discussed in the Netherlands at the moment, but it is an issue that has been resolved in the US, UK and France with the issue of US TIPS, UK Linkers and French OAT’s.”
However, he noted that the range of return on these bonds has not really moved beyond 3%.
The question then, he said, was whether pension guarantees could be met in the long-term by investing in equities. Somewhat surprisingly, Bodie argued that the pension scheme mantra that equity investment was less risky in the long-term was “fallacious” thinking.
He added that this belonged to a general sense of “wishful thinking” that had contributed to the myth of equity investing.
“The first is that equities are safe in the long run. Investment professionals tend to believe this as a ‘matter of faith, but it is a false proposition. If you invest $100,000 and you let it sit for a long period of time and you want some insurance against a shortfall relative to what you would have earned had you invested in risk-free bonds, you should observe that the cost of insuring against a shortfall for a long horizon should be a lot less than insuring for a short horizon.
“Well, as it turns out this shortfall insurance exists – it’s a put option where the exercise price is equal to the floating price of the underlying index.”
Bodie, however, showed that the price correlation actually increases over the period: “This tells a very different story than that of decreasing risk with a lengthening time horizon.
“You can ignore this, but you will find that in some scenarios the shortfall could be huge.”
He then argued that actuarial calculation had allowed this misnomer to flourish by permitting pension funds to report expected rates, not actual rates of return on equity.
“This was a disastrous decision. It enabled everyone to pretend that equity risk had gone away, when in fact it had not.”
Many ALM studies, he opined, had also furthered the problem by providing pension funds with a flawed measure of risk based on the volatility of average compound rates of return and the ‘probability’ of a shortfall.
“This is flawed because it does not include the severity of a shortfall, just the probability.”
As if that wasn’t enough heresy for the audience, Bodie then argued against the notion that equities were a good inflation hedge.
“The clear example against this was in the 1970s in the US when there was high inflation and stocks were performing at their worst level for decades.”
Thirdly he challenged the wisdom that equities lowered the cost of providing benefits. This was not the case, he said, if costs were computed on a risk-adjusted basis.
Lastly, he questioned whether the best discount rate for pension funds to use was the expected rate of return on pension assets, claiming: “That is how you make it seem as if the cost of providing benefits can be reduced by investing in equities.”
If Bodie left the audience with food for thought, the next speaker, Professor Udo Reifner at the Institut für Finanzdienstleistungen in Hamburg, reminded them that such questions about pension reform were far from mere talking points.
Reifner spoke of what he called the “design failures” in the German government’s Riester pension reform, pointing out that subscription rates to the new plans had flailed with a take-up rate of just 17%. I do not believe that this has been a big success and nor does anyone else.”
On the question of low participation, Reifner believed there were three main reasons: “Firstly there is no comparative advantage with social security. Secondly there is not very much transparency in the reform and few people have enough knowledge about what has happened. Thirdly there is little consumer confidence in this type of approach.”
With this in mind, Jeroen Tielman, CEO of Fundpartners, argued that there was an “urgent need for change” around Europe.
Tielman noted that there while there were problems with DB plans such as cost and transparency, there was also pain with DC arrangements : “Knowledge levels are low, there are insufficient levels of contributions and advice can be costly.”
The issue of DC underfunding, however, he pointed out, was potentially the most damaging.
The answer, he argued, was to find the right balance between reliability in terms of contributions and liabilities, while accepting a certain liability in both.
“Could there be a hybrid DB/DC system based on this concept, which we would call ‘defined risk’?”
The floor was then open for a panel of pension professionals to give their views on the topics discussed.
Roderick Munsters at PGGM commented that inflation-linked bonds were on the agenda at the fund with investment in the UK, US and France up to 2-3% of assets.
But, he added: “Personally we would rather invest in Royal Dutch equities which earn 5% dividend with a sound balance sheet and are inflation adjusted.
“This serves the pension fund better than the return we can get on inflation-linked bonds. For diversification, yes some inflation-linked bonds, but not too many please!”
Professor Stan Beckers from the University of Louvain, added his belief that there was a huge mismatch between the investment products being offered and those actually needed by pension funds. “Financial/product engineering is trying to package existing financial instruments into something that suits pension funds. I’m not sure how successful they can be. The natural long-term default position of a pension fund should be into inflation-linked or better still personal income linked instruments. Doing anything but this is just gambling with people’s money to try and increase returns and get a pension holiday for the company.”
After a day of top-level debate, it remained for summit chairman, Karel Stroobants, to bring everyone down to earth by reminding the audience that we can only manage risk, not eliminate it. “We have to be careful not to panic, to not make the same mistakes again, to explain risk to people and be more honest with our clients.
“On top of that the answer might just be that we have to work harder, save more and consume less!”