Weathering the storms
More emphasis on alternative investments. That’s how the World Bank’s pension fund succeeded in weathering the stock market storm last year and hopes to resist future tough times.
“During the last two years we consistently pushed an increasing portion of our assets into alternative investments,” says John Gandolfo, acting pension finance administrator and secretary in Washington DC. “We thought and still think they offer better value in the current situation. We particularly focused on the hedge funds, which are able to short stocks and which offer an absolute return strategy. Our choices have protected us quite well.”
The annual report for 2000 is not available yet, but the World Bank pension fund’s secretary believes that the fund lost around 2–3% of its value, which is quite a dramatic shift from the 22.9% performance in 1999. But Gandolfo shows no signs of panic: “We’ve been affected by the stock market’s downturn, but only slightly and we are still very well funded and we are confident in our strategic asset allocation.”
The World Bank staff retirement plan became effective on May 31, 1948. It is managed by two committees: the pension finance committee is responsible for the investment and actuarial activities of the plan; the pension benefits administration committee is responsible for administering the plan’s benefits. Active members are around 11,000; retirees and beneficiaries around 5,000.
The fund is a defined benefit pension plan. Its scheme was reshaped in April 14, 1998. For participants entering before that date, contributions are fixed at 7% of the gross pensionable salary and the pension benefit is based on years of service and highest three-year average gross pensionable salary. For participants entering on or after that date, benefits are based on a traditional defined benefit component and a cash balance component. The latter is based on the accumulated value of both the bank’s credit of 10% of net salary and the participant’s contributions of 5% of net salary, and deemed earnings credited to the account.
The cash balance component of the plan has four investment options: ‘real 3%’, which guarantees a 3% return above the US inflation rate; ‘S&P 500’ with a return indexed to the US stock market performance, adjusted for investment management fees; ‘EAFE’ with a return indexed to the performance of the European, Australian and Far East stock markets, adjusted for investment management fees; and ‘bonds’, with a return equivalent to a bond market index, which is the State Street Global Advisor Daily Government and Corporate Bond Strategy, also adjusted for investment management fees. Participants may choose to allocate their account balances among any one or more of the options and reallocate quarterly.
“Until the first half of 2000 the ‘S&P 500’ option was the most popular among our members,” says Gandolfo. “Now a lot of them have reallocated in favour of the ‘real 3%’.” He points out that the plan’s staff give the members a lot of information and tools to make investment decisions. There is a team that holds seminars on these subjects and manages the World Bank intranet, where members can find – among other things – the ‘retirement planner’: a calculator for projecting the plan benefits for each participant, highlighting any gap between his estimated retirement income needs and his income sources, reviewing strategies for closing the gap.
The plan’s total assets were around $11bn (e12.4bn) at the end of 2000. “Our size is not sufficient to justify the internal management of our investment,” explains Gandolfo. “Buy and sell stocks or other financial instruments require a lot of research and infrastructure, which are too expensive for us. But we do have the skills to establish our strategic asset allocation, select external managers and monitor the risks without the help of any consultant.”
The finance committee revises the strategic asset allocation at the end of every year, according to the outlook for the financial markets and to the plan funding ratio. Compared with many similar plans, the World Bank’s pension fund has a higher share of equities and alternative investments.
“At the end of 2000 we decided to put a bit more into alternative investments, as a defensive move,” says Gandolfo. “We diminished a bit the equities and left unchanged the fixed income share of the portfolio.” In 1999, other US pension funds had increased their commitment to alternative investments, but later in 2000 this trend slowed down. Not so the World Bank’s plan. On the contrary, Gandolfo points out that, thanks to falling valuations, nowadays venture capital investments look more attractive than one year ago.
The current strategic allocation is 60% in equities (35% US equities, 25% European and Japanese); 20% in global fixed income; 20% in alternative investments (10% private equities, 5–6% real estate, 5–6% hedge funds).
Stocks and equities traded on public markets are managed by something like 40 external managers, while alternative investments are managed by more than 80 different managers. “Due to the illiquidity of these investments, we give a very small amount of money to each manager, to avoid any unnecessary risk,” says Gandolfo.
The plan appoints passive managers more than active ones for the large cap US equities portfolio and similar assets, “because we think the market is very efficient in this case,” explains the plan’s secretary. “We use both indexation and enhanced indexation.” The two managers that have the largest share of the plan’s assets are passive: State Street Global Advisors and Barclays Global Investors. According to the plan’s 1999 report, at the end of that year $1.1bn of assets were invested in the State Street Flagship Fund and $1.5bn in the BGI S&P 500 Fund.
For small cap equities and similar assets, the plan also appoints active managers, which can provide more value.
The plan selects, monitors and fires the external managers, using in-house tools. “We have a very sophisticated risk management system, which was developed by our staff,” says Gandolfo. “The major risk we look at is the plan becoming underfunded. Then, monthly, we look at the risks the managers take compared with the benchmarks we choose for our portfolio. For example, our benchmark for the US equities is the Russell 3000, which is very broad and representative of the US stock market.”
The annual rate of replacement of external managers (not including alternative investments) is roughly 10%, which means four to five managers are usually fired and replaced every year. “We fire external managers only if they don’t follow the strategy we had chosen them for.” adds Gandolfo, “and if their performance is not consistent with that strategy.”
In 1999 the plan achieved a gross return of 22.9%, outperforming the policy benchmark by 160 basis points. This strong performance and the slower growth of liabilities resulted in the continued improvement in the plan’s funded status. The funded ratio – the market value of assets divided by liabilities – in 1999 increased to 1.23 from 1.04. The lowest level was 0.75 in 1990. Now the funded ratio has decreased a bit, “but we are still very comfortable with it,” stresses the plan’s secretary.
Based on the annual valuation and recommendation from the plan’s actuaries (the only external consultants), the finance committee determined that the suspension of the bank’s contribution to the plan would continue in 2001 for the fourth year in a row. In fact, the bank’s contribution rate varies from year to year, with the highest at 19% of gross pensionable salaries, down to zero in 1998 and subsequent years, because of the plan’s sound financial conditions.
In 1998 the actuaries conducted a review of the plan’s funding method, including the principal financial assumption, the real rate of return. On the basis of this review, the finance committee decided to lower the assumed real rate of return from 4% to 3.5% – reducing the assumed nominal rate of return on investments from 9% to 7.5% and the underlying inflation rate from 5% to 4%. “We wanted to reduce the risk incorporated in the calculation of liabilities and to reflect changed perceptions of long-term returns and inflation rates,” explains Gandolfo. Since liabilities increased on account of the lower rate of return, the change reduced the funded ratio from 1.13 to 1.04 as of December 31, 1998. But the extraordinary 1999 performance again lifted the ratio to a very strong level.