The Neyt legacy
The only guide to managing our pension fund assets are our liabilities – these are the raison d’être of pension funds. Never think asset only
You must not manage a pension fund like an investment fund. Your asset allocation is based on your liability characteristics. So if they are index-linked – as Belgacom’s are – the mix is going to be different to that if they are not linked. It depends on the duration of the liabilities to determine the extent of bonds or equities. As we have 16–17 years’ duration, we can have significant equities in the portfolio.
The only returns to compare with are the needs of your liabilities and the factors affecting these. In our case, for example, our membership is a closed group, so our average age increases each year.
Generating a return on the assets while not controlling your liabilities is just a drop in the ocean
Asset returns are volatile and values are not locked in, but your liability side is locked in. So when you promote people, you take on the back service, which is all locked in. Similarly with indexation – your liabilities are increasing all the time. You must control firmly your liabilities. For your active population your returns should be higher than your nominal salary increase, otherwise your liabilities will be increasing at a faster rate than your assets. In an underfunded situation especially, you do not want that gap to increase!
In our plan, most members have 20 years of service on average, so any salary increases mean a back service liability. We introduced a ‘market premium’ concept, so when we promote people the salary increase is not pensionable. This premium is pensionable, but only in respect of future service years in a separate pension fund we established.
Real interest rate risk is the largest risk for our pension fund
We don’t pay pensions with relative returns – you have to make a real return on assets. Our net real return after inflation is very important. For all pension funds, whether it is an explicit guarantee or not, what you want to do is to safeguard the real purchasing power of your pensions. As it is a replacement income, it should follow the living standards of the economy.
Inflation is risky, but deflation could be the end of pension funds
In the past decade we have had annual real returns of over 5% net, which is historically very high. While the last three years have been tough on the asset side, the liability side has been very much more under control, particularly with developments on the telecom staffing side.
What is happening on the asset side is not a catastrophe, with low inflation. Now high inflation would be a killer, as it works on both sides. But the most drastic scenario would be deflation. We are looking at covering the inflation risk through index-linked bonds or some kind of reinsurance. But if we do this, we should also do it for deflation, as the economic activity would be decreasing. But would governments be willing to reduce pensions? Index-linked pensions should go down with deflation. But I don’t think this is realistic. In the long run, if it is not possible to make a real return on assets any more, over the longer term, say 10 years, it could be the end of pension funds. We need real returns on assets.
Any money plan sponsors make returns on is less money they have to put into pensions, which is why funds exist. It is also why funds need to be much more closely integrated with the corporate finance department of sponsoring employers. Pension funds must not jeopardise the financial stability of the sponsor.
While the pension fund is a buffer in some ways, it is important to create other buffers to manage the equity volatility risk, in order to avoid affecting the stability of the employer. You need to create excess funds to avoid calling on the plan sponsor, usually at the worst time for them.
Risk in a pension fund is downside risk: the shortfall risk versus the liabilities
The Belgacom fund has always been underfunded, starting out at a 12% funding ratio, seven years ago and ending 2002 at 78% of PBOs. On insurance authority ratio requirements, the fund is almost 140% funded.
When I get calls about our funding position, I reply, “I do not have a problem”. I am sticking to my philosophy and my strategic allocation. I meet my minimum funding requirements. While I am underfunded against my liabilities, I know in the long term I need equities to make my returns and without jeopardising the P&L position of my sponsor.
The only measure of risk is not mean variance or standard deviation, but the magnitude of the shortfall, the downside versus the liabilities – and also downside risk versus the P&L of the company. We are quite risk-averse, so we know we will never come out with the highest return, but we will never be the worst. All we want is a reasonable return per unit of risk we take. This is not just risk on the pension fund but also on the corporate itself as to how we affect its P&L. Companies and pension funds are going to come much more closely together, as they move away from the local accounting GAAPS.
Asset trends among pension funds are homogeneous in spite of very heterogeneous liability streams
The continental pension funds in the last decade increased their equity allocations from under 20% to over 40%. This helped fuel the rise in equity markets, we must not forget. And this was despite the fact that we all have different durations and liabilities streams. Even the growth in DC plans was driven by this as a result of investor choice. The big danger with DC is that along with stock options, we expose employees to excessive market risk. As pensions are part of HR, this is not wise.
Investors in the the US and the UK who had been exposed to equities since the 1980s have still made money, despite what has happened in the markets. In continental Europe the problem is, they all came in when the market was at the top at the end of the 1990s and they lost a lot of money. Markets should be led by economic factors, but they are more and more led by behaviour, probably the irrational behaviour of over-confident and over-optimistic people, such as daily traders. But so were pension funds, to a certain extent. We all moved in the same direction at the same time.
The Belgacom fund decided not to rebalance during last year. When we were at 42% equities and the benchmark said 55%, we saw that the correlations within the market were going up and said the only asset which could protect us from further downside risk was government bonds, which had a negative correlation with other asset classes. We saw our buffer was decreasing, which means that you have to be very careful with the risks you take, since you have less degrees of freedom to take risk.