CS sets sights on Dutch market
Credit Suisse is the latest international asset manager to show an interest in the Dutch pensions market, in particular the market for fiduciary management. This reflects the growing demand from pension funds for more complex and comprehensive services, says Paul Bourdon, head of the bank's European Pension Solutions Group.
"Dutch pension funds are diversifying their portfolios and they need a wide range of services and a lot more advice on how to construct them - diversified portfolios, liability driven investment concepts, traditional risk management investment banking type products and skills in the use of derivatives and the separation of beta from alpha in portfolio construction,"
The market in the Netherlands is different in that it has an insurance-based regulatory environment and therefore changes in regulations have a greater impact on schemes when compared to UK pension funds, he points out.
"Regulatory and accounting rules have put a lot of focus on using current interest rates to discount liabilities, introducing unrewarded risks around interest rates falling. As interest rates fall 1% the present value of pension cash flows rises by about 20% - which is a significant impact when the returns required from a pension fund's assets are considered."
A portfolio of bonds and equities is no longer enough to give the diversification benefits that can be achieved with lower-correlated assets within a portfolio, he says. "With equities on their own, the average volatility is between 16-18%, but with a well-diversified portfolio, including alternatives such as commodities, hedge funds, real estate and private equity, similar returns can be achieved with roughly two thirds of the risk or lower.
"Over 20 years you can be more or less certain that the equity risk premium will be delivered in a portfolio. The problem over the next five years is that equity holdings could be plus or minus 50%. There's huge volatility over a short period of time," he says
Diversification into new, alternative classes makes the composition of portfolios much more complicated, he says. "The expertise required to have a thorough understanding of all the assets makes the challenge of introducing them and managing issues, such as tail risks, much greater. This has been a phenomenon of the last two to three years, brought upon by the changes in regulation and accounting rules and adverse market movements.
"The Dutch have seen that the skills and time required to manage the portfolio process have grown significantly. Some pension funds have realised that they are just not able to deliver on the whole investment process so they've outsourced the chief investment officer role to experts such as fiduciary managers."
Although pension funds retain the final say on the type of risk the fiduciary manager is taking and set the constraints within which the manager has to operate, they can delegating to people who have the right skill sets and, importantly, the necessary time and focus to commit to managing the portfolios, he says.
"We feel strongly that this is certainly a viable way of taking pension fund management forward and aligning the skill and expertise to the job in hand while retaining the overall responsibility that pension fiduciary trustees and corporates have. They can then focus on other aspects of the pension fund. This just doesn't affect small and medium schemes where there are more pressures, but even bigger schemes.
However, handing over the running of pension scheme funds to a third party will not appeal to everyone, he says. "I'm not sure that the majority of schemes will go this way because there's still a very strong emotional tie in pension fund trustees and managers running their own funds, particularly when there are a lot of in-house skills available and people feel they can do the job better themselves. But not everybody is a large pension fund with a very large expert team on the spot."
ourdon feels that costs should not dissuade pension funds from fiduciary management, and notes
that some substantial Dutch schemes - notably Philips and SBZ - have outsourced this function without being put off by the fee structures.
"The important thing is to align the interests of the fiduciary manager with the interests of the fund through the performance fee. The big pension funds that have taken this decision view the potential improvement in scheme risk/return management as a reward for taking the decision to go with a fiduciary. They see the logic in aligning the complicated management of the scheme with someone who has the time and expertise to engage fully with the task in hand."
If a performance fee was based only on returns then the manager could simply load the portfolio with risky assets, and the interests of the scheme and fiduciary manager will not be aligned, he says. "If the basis of the fee includes allowances for risk and return then you have a much more powerful alignment of interests."
Pension funds also have to take into account that a 1% reduction in returns on a portfolio could mean a 15-20% difference on benefits over the long-term, he warns. "Lower returns have a big impact on future contribution levels, a factor which is rarely mentioned when de-risking is suggested as a solution.
"People say you don't need fiduciary management and you can lock-down all the risk and put it into bonds so they match liabilities exactly, with government bond returns or maybe better using credit. If you do this, you're taking a hit on your returns, which means you've locked in your current level of contributions at the very least and that's expensive," he says.
"You also haven't necessarily locked down all the risk because the liabilities at the next valuation in three years time may well have changed by 10% to 15%, with mortality changes and scheme population variance. It is slightly illusionary to think you're completely hedged because these liabilities will change."
The cost of locking-down risk and putting a portfolio into non-return seeking assets is high, he says. In the UK indexation is written into the contract, but in the Netherlands pension increases are not given until the fund can afford them.
"If you look at it from the corporate point of view, what really is important is the level of current contributions and the likelihood of having to make extra future contributions. A number of UK schemes, which are perceived to be in deficit, are going through that specific funding discussion with the trustees on how they are going to reduce this over the next 10 years by increasing contributions over and above the ones they are already making.
"In the Netherlands, however, you have to maintain certain levels of funding otherwise the sponsor has to make good on the underfunding."
The free cash flow of the company is the critical factor for the finance director, he says, since pension contributions could be used in the business to produce a greater return.
"In a company where the pension contributions relative to the free cash flow are small, then the financial director is a lot less concerned. However, there are a number of firms where the pension contribution isn't insignificant and is a major percentage of those free cash flows. This is where you need to manage risks carefully," he concludes.