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Impact Investing

IPE special report May 2018

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Cutting the giants down to size

The argument in favour of compulsory membership of collectively organised pensions funds in the Netherlands is that their investment performance is superior to any private, individually organised arrangement.
It has become a commonly accepted fact that a collective pension arrangement is some 30% cheaper than a private, individual one. The thinking behind this is that a collective scheme has the opportunity or the means to generate higher returns by investing higher volumes of assets - something that is not available to the individual pension saver.
Yet how true is this commonly accepted fact? A number of people in the pensions sector have begun to question its veracity. Last year, Bibi de Vries, the Dutch Liberal Party’s pensions specialist, commented that “it needs to be assessed why it is necessary to have compulsory obligation to become a member of a pension fund if it is obvious that their respective performance is so much better than the rest”.
Put another way, if the performance of pension funds is so good, why should it be necessary to have compulsory membership? Surely people would be willing to join a top-performing pension fund without compulsion?
Laurens Blom, a pension analyst with Lanthos Consultancy and former financial director of securities brokers Financiele Diensten Amsterdam (FDA), has examined the evidence for the link between compulsory membership of pension funds and higher yields.
In his new book, ‘Compulsory pension funds discussed’ , he examines the performance of the 60 largest pension funds in the period 1945-2004. He finds no proof that pension fund investments are 30% more effective than private investment schemes.
Blom says he was looking for a substantial higher yield than the average yield from government bonds . Yet his calculations showed that between 1980 and 2004, the total yield, on average, has never exceeded that of government bonds.
He found that, in the period from 1995 to 2004, there were considerable differences between his own calculation of the yield on investment of the pension funds and the yields reported by the funds themselves.
His calculations show, on average, a 1% on average lower yield on investments than the yield reported by the 60 funds. In some asset classes, the difference was more than 5%. For the largest 20 Dutch funds, this represents an investment yield over 10 years that is e29bn lower than the reported yield.
Blom says the main difference between his calculations and those of the pension funds is that the pension funds take into account only the movements in value of the financial markets, whereas he takes into account changes in invested capital.
He also shows that the high yields on investments that were achieved by most pension funds between 1995 and 1999 were derived from relatively low investment volumes, while the negative yields reported between 2001 and 2003 occurred with far higher investment volumes.
Blom suggests that the calculation method used by the pension funds is helpful only in comparing one pension fund’s performance with another. In other words, it shows only their relative performance within their own peer group.
His own method shows the absolute return on investments, and provides, he says, a more effective financial analysis.
Blom also criticises the reporting method used by pension funds. They currently use the method used for commercial reporting, he says. Yet pension funds are not commercial operations.
Pension funds have a social function, and should recognise this in the way they report their returns, he argues. Their calculation of yields should show the exact financial situation and the respective results for the contributions.
The different methods of reporting produce differences in yield calculations. For example, reported yields from the Pension Fund Building Corporations are 1.9% higher than the yields produced by Blom’s method of calculation. Over a 10 year period this represents a difference of é380m in the reported yield.
In general, Blom discerns a lack of reporting and communication at most pension funds. In particular most funds do not report 10 year performance broken down into asset classes.
He is also critical of the pension funds’ portfolio management, and suggests that the main reason for current low yield on investments achieved by pension funds has been the wrong investment mix. The reason for this, he suggests, is that, since the current pension system was introduced, the entire sector has focused on security and safety. Pensions have been managed like insurance policies, he says.
This was particularly true in the years between 1945 and 1980, when most pension assets were invested in government loans. This investment strategy has been disastrous, since yield on government loans has never been able to counter inflation.
The effects of this strategy were a substantial increase of pension premiums and a tolerance of pension fund under-funding by the financial supervisory authority.
Investment in equities would have been highly attractive during the whole of that period, Blom says, and would have resulted not only in lower premiums but also higher economic growth. The total investment strategy followed by the pension sector has until 2004/2005 resulted in a loss of 2% of national income.
Since 1980, pension funds have given more attention to investment in equities. Yet Blom argues that the total returns on the latter have been below expectations, caused largely by the fact that equity investments have been made largely at the height of the market. The main reason for this has been the caution of most pension funds, a caution rooted in the belief that pension payments should be secured first and foremost.
Blom admits that the total Dutch pension sector has shown a remarkable resilience. Most pension funds have been able to counter, at least in part, the negative effects of the equity crash and the impact of high indexation costs. The supervisor (formerly the PVK, now the DNB) drawing on the lessons of the market downturn between 2000 and 2002, is urging funds to increase their capital position. The results have been cost-effective premiums, no indexation and overall lower pension arrangements.
Last year saw a strong recovery, which helped most pension funds to reach the coverage ratios set by the supervisor. Yet Blom suggests that most yields on investments will be eaten up by recovery measures related to the financial buffers and to counter missed indexation in the past. Before a real growth becomes apparent, he says, the financial situation of most funds still needs to improve dramatically.
The continuing negative impact of low interest rates should also not be underestimated. Blom predicts a capital market interest of below 4%, with an inflation of 2% - the European Central Bank target - which results in a real interest rate of 2%.
To support the real value of pension payments, pension funds should invest more in equities, he says, and the DNB should try to bring inflation down to zero.
The only alternative is a substantial increase of premiums, which would in turn put a damper on economic growth. Blom expects that, taking into account the immense impact of the nFTK, the current volatile financial markets and the situation of the respective pension funds, there will be growing pressure to remove the compulsion to participate in pension funds.
‘Compulsory pension funds discussed’ is published by SDU Tax & Financial Publishers price €22.50

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