Built to fit
In the recent past, much has been written on the looming European pension crisis. In this article we will elaborate on the implications (both direct and indirect) of this crisis for the investment policy of corporate pension funds throughout Europe. A changing regulatory environment, is expected to have direct implications for the asset allocation chosen by the pension funds. Given the fact that the new regulatory environment is about to be implemented, we expect pension funds to make their asset allocation changes soon.
As the new regulatory environment implicitly requires investment portfolios to have characteristics that can not always be delivered by investments in traditional securities, structured products are expected to play a significant role in the new asset allocation of pension funds.
Changes in regulatory environment
In relation to Europe’s rapidly ageing population, the health of the European pension funds has been the subject of debates for more than a decade. However, as long as pension funds in countries such as the UK and the Netherlands were able to benefit from strong equity markets, the urgency of this problem was not visible. This issue has been receiving more attention lately as the result of:
o Corrections in valuations of equity markets (and the associated impact on funding levels of pension funds);
o Limited capacity of some corporate sponsors to fulfil their role as a sponsor of the pension fund in future.
The emerging problems in relation to the future affordability of pension funds are now high on the agenda of corporate sponsors, politicians as well as regulatory bodies. As a result of this we see a number of planned changes in regulations that can be expected to impact the pension fund industry directly.
Implementation of IAS19
This international accounting standard aims to clarify the impact of corporate pension fund arrangements on the financial health of the sponsor. Any obligations or benefits that relate to the corporate pension fund will ultimately be reflected in the balance sheet and profit and loss of the sponsoring corporate.
As a consequence the corporate sponsors can be expected to be more interested in the financial health of the pension fund than they used to be and they will be keen not to be confronted with sharp fluctuations of the surplus of the pension fund as they can have a major impact on their annual results.
The local regulators of the pension fund industry aim to safeguard short term solvency as well as long term continuity of the pension funds. The impact of lower valuation levels of assets on funding rates has been significant and the regulators received the criticism of doing too little too late. In an attempt to be more pro-active, regulators now come up with frameworks to limit short term underfunding risks and they force pension funds to make plans to improve their financial health whenever their financial health turns weak. In the Dutch market, for example, the regulator (PVK) has introduced the so-called FTK framework to assess and monitor and control the financial health of pension funds.
Implications for pension funds
Although each of the regulatory changes as referred to above has different objectives, it is interesting to see that the actual impacts on pension funds have actually great similarities. There are two major implications for pension funds:
Valuation of assets and liabilities will have to be based on market values (Fair value accounting)
Historically, pension funds in several countries used fixed discount rates to value their future liabilities while using actual market rates to value their assets. In this situation the impact of interest rate movements on the funding rate of the pension fund is therefore limited to the interest rate sensitivity of the assets. Holding cash leads to the lowest level of interest rate induced funding risk. When changing to fair value accounting, this situation changes drastically. The impact of interest rate movements on the funding risk will be a function of the difference in interest rate sensitivity between the assets and the liabilities of the fund. The lowest level of interest rate induced funding risk is achieved by exactly matching future liabilities of the pension fund with fixed income assets. As the liabilities of a pension fund typically have a long duration, this requires the pension fund to keep fixed income instruments with a long duration. As a consequence of this, we expect pension funds to change their asset allocation in such a way that they immunise the interest rate risk associated with their liabilities.
Increased pressure to minimise the risk of underfunding, while ensuring the long term continuity of the fund
The regulator’s attempts to minimise short term underfunding risks are actually strongly aligned with the corporate sponsor’s aim to minimise the risk of significant negative impacts on the corporate’s P&L. Both the regulator and the sponsor have clear asymmetrical risk/return preferences. Although funding risks are probably best controlled by large investments in safe instruments, it is also understood that the long term costs of the pension fund will increase to unacceptable levels when no risks will be taken. This will be an incentive for pension funds to look for investments in instruments with option like pay-off functions. Enabling the fund to create leveraged exposure to asset classes while limiting the associated downside risks.
Need for structured products
Where a pension fund would like to limit the changes in the portfolio, it can decide to maintain its existing asset allocation and change the interest rate sensitivity of its existing fixed income portfolio in order to minimise interest rate risks. This can be done in such a way that the money weighted interest rate sensitivity of this fixed income portfolio will be close to the money weighted interest rate sensitivity of the liabilities of the pension fund. This will not lead to a full elimination of interest rate induced funding risks, but has the advantage that it will leave funds available to create exposure to other (more aggressive) asset classes with attractive expected returns (such as equities).
Exposures to these asset classes are traditionally believed to provide a good hedge against inflation and can help the pension fund to meet its indexation needs, lower its pension premiums or improve the benefits for the participants. The major drawback of this approach is that short term underfunding risk remains high as a result of the exposure to more aggressive asset classes and the interest rate sensitivity of the funding rate.
As an alternative, it is also possible for a pension fund to eliminate interest rate risk on its funding rate to a greater extent, by allocating a larger percentage of its portfolio to a fixed income portfolio that closely matches its liability structure – the so called ‘cash flow matching fixed income product’. Although such a solution might sound rather trivial, the practical implementation of this strategy is more complicated. It requires the use of over-the- counter derivatives, which require amongst others an approach to manage counter party- and liquidity risk. The benefit of this approach is that interest rate risk can be fully eliminated, but the drawback is that it requires a significant allocation to fixed income instruments and leaves little room to invest in other asset classes that aim to provide opportunities for future indexation.
The pension fund therefore needs to find ways to increase its exposure to these more aggressive asset classes while minimising the risk of underfunding in the short run. The pension fund can solve this issue by taking up an additional loan. The proceeds of this loan can than be used to invest in the other asset classes (such as equities). This approach is from an economic perspective similar to an investment in an interest rate swap while maintaining the original asset allocation of the fund. The benefit of this approach is that interest rate risks are eliminated, while the fund has at the same time the opportunity to meet its indexation needs. The major drawback of this approach is that short term funding risks will increase significantly. The pension fund effectively invests in risky assets with borrowed funds.
Alternatively the pension fund can increase its exposure to more aggressive asset classes by investing in instruments that provide leverage to these asset classes with a limited downside risk (call option like pay–out profiles). These leveraged instruments with a limited downside risk are far more suited to pension funds as they accommodate asymmetric risk preferences The risk of short term underfunding is actually minimised , while a significant exposure can be created to the more aggressive asset classes.
As a result of the changing regulatory environment defined benefit pension plans can be expected to change their asset allocation significantly. We expect to see an increased use of synthetic fixed income instruments in fixed income portfolios (particularly cash flow swaps with long maturities) as well as an increased need for access to a whole range of lowly correlated leveraged asset class exposures with limited downside risks.
Arjen Soederhuizen is co-head structured asset management at ABN AMRO Asset Management in Amsterdam