Looking for some breathing space
Pension funds are quite different from other institutional investors because of their long term liabilities. This was the robust and unequivocal response from readers to this months survey.
This may seem a statement of the obvious, but increasingly, regulator and accounting bodies appear to want to squeeze pension funds into the straitjacket of day-to-day asset management. One sign of this is the insistence that companies mark to market the value of their pension funds assets.
Pension fund managers complain that regulators take far too static a view of the equity markets. This is the main objection to the application of FRS17 and IAS 19 to pension fund assets – companies are forced to make a ‘snapshot’ calculation of the market value of their pension fund assets each year. They call for a more dynamic view which takes more account of the way assets interact with liabilities over the longer term.
This ‘straitjacketing’ is particularly apparent in times of stress. In the current conditions, falling equity markets could provide pension funds with the opportunity to build holdings in undervalued companies. However, some European regulators not only prevent European pension funds from buying into a falling market but insist that they sell.
Regulators may insist that pension funds meet certain resilience or stress tests. A stress test requires funds to be able to meet regulatory solvency requirements if equity prices fall by a certain percentage – say 25% or 35%.
If the funds cannot meet these requirements, the supervisor can insist that they reduce their risk profile by selling equities. The effect of this forced selling is to provide a downward spiral whereby the more equities that funds are forced to divest, the lower equity prices are driven.
In this way, the need to reduce risk to maintain prudent levels of capital can lead to sub-optimal investment strategy. Funds are prevented from going into the market at precisely the moment when they would profit from doing so.
In this month’s Off The Record, readers were asked whether the prudential strategies that supervisors require of funds and their insurers are appropriate to the risks they face. In particular, do supervisors take too short a view of pension fund liabilities?
The response suggests that European pension funds would strongly resist any regulatory interference with either their investment strategy or risk management. Three quarters (76%) of the fund managers and administrators who responded to the survey say that regulators should not be able to compel pension funds to reduce their equity holdings to improve their risk profile.
The corollary of this is that pension funds should be able to decide for themselves when and whether equities are undervalued in a falling equity market. Perhaps not unexpectedly, a large majority (79%) agree with this proposition.
Regulators who insist that pension funds that fail a stress test must calculate the market value of their equity holdings every day get little support. Two thirds of respondents (65%) think this is unnecessary. Now a significant minority say this is reasonable. One Austrian pension fund comments that “pension funds should be able to do this anyway”.
Some regulators are softening their approach to stress tests. In the UK, the Financial Services Authority (FSA) has conceded that its resilience test it imposes on insurers is not sensitive enough to the effect of past changes in equity market prices and can, in certain circumstances, cause perverse asset allocation.
The FSA’s new test, introduced in June takes account of past price changes over the past three months. This sort of move gains considerable approval from our respondents. A large majority (83%) say that stress or resilience tests should take more account of past changes in equity prices.
However, most people think the averaging should be done over a longer period than three months. A substantial majority (72%) suggest that market prices should be averaged over a year. Only 16% suggest three months, while 6% prefer six months and 6% one month. Among other possibilities are rolling one year periods over five to 10 years, and a 10 year averaging period. This would certainly allow for a more dynamic, less static view of the state of a pension fund’s portfolio.
It is no surprise, therefore, to find there is overwhelming support (92%) for the proposition that the long term horizons of pensions funds set them apart from other institutional funds. One UK pension fund points out this is especially true in a situation where contributions exceed pensions in payment, and the fund is not a forced seller of assets at depressed prices.
Yet, an Austrian fund, though agreeing, strikes a note of caution: “What is more important than the time horizon is the investment risk the funds can bear – and this again is related to existing reserves”.
If pension funds are different, should they be treated different for accounting purposes? Should the pension fund assets of a company be covered by the same accounting rules (for example, IAS 19 internationally) as other company assets? Here, opinion is more divided than one would expect, with only 59% saying that pension funds should be treated differently.
Perhaps the furore that FRS 17 has raised in the UK – and the pressure it has supposedly put on company pension schemes – is atypical at a European level. The fuss about the application of the Swiss accounting standard FER 16 to Swiss pension funds two years ago suggests that dissatisfaction with accounting rules is fairly widespread.
Generally, pension funds would like more flexibility from regulators, and be allowed to slip below the minimum funding level occasionally without incurring the wrath of the regulator. Three quarters of respondents say that pension funds should be allowed to operate below the required solvency margin, at least temporarily. Most suggest a breathing space of a year.
However, the manager of a Belgian pension fund suggests two years: “The first year could serve as a ‘wait and see’ measure – a cooling down period for both market and pension fund nerves. If things did not turn around substantially, the supervisor would then be able to compel the pension fund to take measures over the following year.
Regulators themselves have come in for some criticism, mainly because of the rigidity of their regimes. However, the respondents to our survey take a tolerant view, with 69% saying that they think supervision in their home country is “about right”. Only 26% feel that regulators are inflexible while 5% see them as too flexible.
The proposed IORP directive allows home country supervision of investment. Is this likely to change anything? Will it provide European pension funds with sufficient freedom to pursue an optimal investment strategy, or will it perpetuate the rigidities of different national regulatory regimes?
Here opinion is evenly divided, with 53% of respondents saying that the new directive will give pension fund the investment freedom they need, and 47% saying that it will not.
A Portuguese pension fund manager warns: “It is possible to achieve a global equilibrium on ALM but due to local restrictions it seems very likely to create unbalanced portfolios”. And a Belgian pension fund manager suggests it runs the risk of concentrating too much investment decision power in one part of Europe: “Based on the local conditions, such as inflation, and DB/DC preferences among workers, it is very possible that the investment process for the pension fund of a Spanish subsidiary in a German multinational will be totally different from a Swedish subsidiary. Concentrating everything in Germany – and implementing a uniform investment model for all funds – would be counterproductive.”
Overall, it seems that, for pension funds, real investment freedom – like freedom itself – is elusive, and still some way off.