The best of both worlds
A successful occupational pension scheme depends on the relationship between the sponsoring company and the scheme itself. Operating as two separate legal entities, they nonetheless serve the same workers and former workers. A solid sponsor-pension fund relationship will be built on mutual trust and they share a common goal: to ensure the best possible pensions deal for members. But there are often other factors that highlight the different interests of each party, and the recent liability matching revolution is a prime example.
Belgium's KBC pension scheme, small but innovative, understands the changes recently introduced pension laws have on how a company values its pension scheme. It knows this places demands on the scheme to find a solution that will ensure the sponsor can control the risks the scheme poses to its finances and the scheme can continue to be solvent.
KBC was not about to lie back and let the law dictate how it set its investment strategy to accommodate the new laws, which effectively oblige the employer to place the scheme on its balance sheet, so that it is aware of how much it costs to run each year.
In the past, long-term investments largely in equities and the long-term perspective of the scheme's composition allowed both the scheme and sponsor to take a more holistic approach to covering liabilities.
But now the accounting standards demand that the scheme's liabilities match the value of bonds in the market and that the company and scheme account diligently for the liabilities year in, year out. This is no easy task and many schemes have panicked and bought up large amounts of bonds.
But KBC is a clever little scheme that knows that any law can be interpreted in many ways and, while it is ready to help control the volatility the liabilities can create on its sponsor's balance sheet each year, it is not ready to sacrifice its return objective of 6% from the investment of its assets.
In essence, the Belgian regulator now demands that the discount rate that the scheme uses to forecast its liabilities should be directly linked to the returns on the assets. In the past a fixed discount rate of 6% was used. This places the KBC scheme in a unique position and this is another reason it is determined to keep a 6% target, for if the markets fail, it is not only the scheme that suffers. Its sponsor is active in the financial sector and stands to lose as well in downward markets. The scheme does not have the luxury that others do to go cap in hand and ask for more. So retaining the level of returns on its assets is paramount as well as ensuring the liabilities are sufficiently matched each year.
The first thing the KBC needed to ascertain with the changes to the law was whether or not the company wanted to continue to sponsor a defined benefit arrangement. With that confirmed, the scheme was able to go away and put its thinking cap on.
The question it need to answer was, how can a scheme reduce the volatility the liabilities create without abandoning the returns on its investments?
Answering this question gave it a unique insight into the mismatch between the assets and the liabilities and how this can be overcome. Firstly, it realised that with only 40% of its portfolio allocated to bonds, this created an imbalance with respect to the new accounting practice. But it was unwilling to change that percentage. Secondly, how did it solve the problem that the average duration of the pension liabilities was 12 years whereas the average duration of the bonds portfolio was only seven years?
A mere increase of the fixed income allocation or a lengthening of the duration of the bonds would not do the job. A more substantial intervention was required. The pension fund's portfolio was thus restructured and split into three parts:
The matching portfolio which saw the fixed income part of the portfolio replaced by structured LDI maturity buckets. To do this, KBC Asset Management created a Luxemburg UCITS III with a full range of constant duration sub-funds covering periods such as 0-5 years, 5-10 years, 10-15 years and so on. These are with or without a link to inflation. Next the scheme began using interest rate swaps to create a kind of leverage that allows the fixed income part to hedge more liabilities with less money.
The return portfolio which contains the scheme's equity investments and a small private equity allocation which have not been altered. The scheme continues to split its equity investments equally between Euro-zone stocks and rest of the world mandates.
The matching and return portfolio which was created to take care of a restructured real estate policy. Overall, property accounts for 10% of the scheme's investments but was initially limited to quoted real estate securities. But other real estate instruments such as non-quoted funds, infrastructure funds - which KBC says function in much the same way as property funds - and government leases showing less correlation with the equity markets. In addition, they enjoy a long-term investment nature and are linked to inflation. KBC realised it can use them as a much better means of supplementing the matching portfolio, rather than having to exchange its return-seeking equities for more bonds.
All schemes want the benefit of a strong employer covenant to help it as it grapples with the problems of spiralling liabilities and volatile markets. But with employers now obliged to place the value of their pensions scheme's liabilities on their balance sheet each year, this has placed extra strain on its support for the support they can offer a scheme. Pension funds have therefore had to become inventive in the way they invest their assets to match their liabilities and help control the risk this poses to the sponsor.
Not willing to forego its treasured equity investments or create to much upheaval in its investment strategy, KBC has come up with a solution which allows it to avoid the trap others have fallen into by selling off equities to buy bonds that offer less return in the long run but will match liabilities in the short term.