As a pension fund our fiduciary objective is to meet our liabilities. As pension funds and plan sponsors we want to maintain or to safeguard the puchasing power of our benefits; that’s why the pension liabilities are - implicitly or explicitly - conditional or unconditional - linked to inflation.
The euro led to convergence of inflation rates as pricing inefficiencies disappear which will produce yet a lower inflation.
Due to global competition, companies are losing pricing power and a secular downtrend in global inflation supported very much this convergence running to a single monetary policy. Low inflation keeps defined benefits (DB) plan expenses under control and is safeguarding the purchasing power of defined contribution (DC)-accounts. On the other hand, real intrest rates are coming down which have multiple effects :
l The present value of our liabilities is increasing. A one per cent decrease in interest rates will increase our liabilities by 20% if their duration is 20. That means that the overfunding built up by some funds in recent years will disappear like snow in summer.
l Declining yields make our fixed-income investments more intrest sensitive which means that duration management is a more risky source of excess return than in the past.
l If we wish to deliver the expected rate of return which our liabilities demand or if we want to participate in the shareholder value of the company by decreasing pension expense in DB-plans, than one thing is for sure; greater risk taking will be required:
Well on the one hand, the absence of currency risk is reducing our home country bias meaning that we have access to broader and deeper and consequently more liquid capital markets without any currency risk in relation to our domestic denominated pension liabilities. In particular this is true for pension funds in countries like Belgium with a small, illiquid equity market concentrated in a limited number of economic sectors.
On the other hand, the diversification potential decreases because correlations in Euroland are increasing. Increasing return covariance of the different local equity markets wil rule out the diversification effect with consequently higher risk.
Active managers will have fewer decision variables to add value to the portfolios. Consequently, with reduced oppportunity sets it will be even more difficult in the future to separate skills from good or bad luck.
How should we adapt our asset allocation or strategy towards these events ?
The EMU acted as a catalyst to get European fund management to move from a home country-based to a pan-European, industry-based approach.
Relevance of national boundaries to corporate strategy, activity and profitability diminishes; companies, markets and economies become interdependent and valuations are dictated by international events.
That is in particular true for sectors like telecom, automobiles, chemicals and pharmaceuticals. Mergers and acquisitions are less Euro-focused than global-focused. But due to, for example, differences in accounting, tax policy and mentality “national” factors may not be excluded.
We think that due to that globalisation the world or the developed countries are more attractive than Europe and Europe is a lot more attractive than Euroland. To limit yourself to Euroland equity is giving you a poor market exposure to important growth sectors like, for example, health-care. It is better to anticipate future entrants in the EMU and choose a wider index. If you dislike currency exposure hedge the local currencies from the non-euro markets back into euro.
Global markets are less efficient and are less widely researched so active managers could exploit anomalies, but the problem is that you don’t find that many investment managers who have a truly “global” approach. Most investment managers have a regional or country bias in their research.
The impact of the EMU on our equity allocation was much smaller than the rebalance we executed in our bond portfolio. As a low cost effective pension fund we try to minimise transaction costs meaning minimising market impact and commissions by developing long term strategies.
During the last three years all new contributions are invested in international equity which diluted step by step the relative importance of our Belgian equity portfolio. The rebalance we do in our Belgian equity portfolio is more the consequence of mergers and acquisitions moving away important market capitalisations to other stock markets and an over-concentration to interest-sensitive stocks.
It is unlikely that large Belgian institutional investors such as insurance companies and pension funds will rapidly sell large amounts of domestic stocks because it will ruin their own performance.
In the bond portfolio we benefited from the convergence of interest rates by rebalancing our Belgian bond portfolio into its weight in our European bond benchmark in the first half of 1998. This opportunity incurred at no cost and indeed in that arbitrage we benefitted from yield pick-ups.
Because asset allocation is becoming more similar with the euro, as the domestic content is brought down and the investments in other countries are increasing, large European corporate pension funds in different European countries could easily concentrate the management of these funds in one place to reduce costs and improve the investment management quality. At the moment it is not possible to sell pension funds across borders, as national tax systems prevent greater flexibility but at least the euro will re-open that debate. These differences in tax systems unfortunately hinder the functioning of the single market as it prevents the free movement of people and services.
Today, we are all looking for diversification benefits from low correlations with a potential to add return. Low European bond yields limit long term return potential. The search for return enhancements will force us to diversify outside of EMU fixed income to benefit from further convergence opportunities (EMU round two, Eastern Europe or even global) or to take advantage from credit risk by investing in emerging corporate credit within Europe or by investing in large credit markets like the US.
Philip Neyt is managing director of the Belgacom Pension Funds in Brussels

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