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Doubts about using structured products

Almost 600 delegates attended the fifth annual IPE Awards in Berlin on 1 December 2005. The event began with a seminar programme that included the now customary asset allocation game, an expert panel, pensions address, CEO session and keynote address. It then went onto the awards gala dinner itself at the Ritz-Carlton hotel - which was followed by drinks and cabaret at the Kaisersaal.
There was a plenty of interesting high-level debate during the seminar session - with one or two revolutionary ideas emerging in some of presentations.
First off was the asset game (see panel). This was followed by an expert panel comprising three European pension fund managers: Thomas Stötzel of Airbus Deutschland, Silvio Vecchi of the European Patent Office and Henrik Gade Jepsen of Danish labour market scheme ATP. The three engaged in a wide-ranging discussion on investment strategy prompted by questions from the audience. Perhaps the most interesting thing to emerge from this session was a consensus on the use, or otherwise, of structured products.
They all revealed that they had no plans to invest in the asset class. “My motto is always: ‘Don’t buy what you don’t know’. We recognise that there is a possibility for higher returns for say CDO (collateralised debt obligations), but right now we regard them as too complex, kind of like a black box,” said Stötzel, who’s head of investments at the €600m Airbus scheme.
Stötzel also said another hindrance to investment was the fact that the European market for structured products was “still very young”.
“We have bought some mortgage-backed securities in the past, but if we want to go farther with other asset-backed securities, we have to go to the US market and that’s difficult for us, because we are European focussed,” he added.
Vecchi, who is head of investments at EPO’s €2.6bn fund, also noted that while accounting for CDOs investments was not a problem, as they simply were part of fixed income, doing so from a risk perspective, “is a nightmare”.
Henrik Gade Jepsen, of the €45bn ATP, agreed with his colleagues that investing in structured products was not possible currently because ATP simply did not understand them.
The Pensions Address was delivered by Sindo Oliveros of the €11.5bn World Bank Pension Plan. While the focus on alternative asset classes is warranted, pension funds need the right in-house structures before they can fully reap the rewards, Oliveros told delegates.
“Pension plans need adequate staffing/skill mix, robust risk management and long-term committed boards to absorb the value that alternatives can offer.”
According to Oliveros, the long-term challenges facing the industry are also spurring on major changes in asset management and the redefinition of traditional assets.
These challenges include global underfunding, the inversion of the population pyramid and stress of government pension insurers, such as the UK's Pension Protection Fund (PPF).
While Oliveros called bodies such as these a “well-intentioned response” and sensible for the long-term health of the industry, he added that they also add immense short-term pressures.
He stated that markets would be key catalysts for change. He explained that markets would “force change” against the need to bring in better returns.
Going forward, Oliveros added that pension funds needed to establish a “true” ALM framework, the unbundling of alpha and beta generation, and instil a long-term horizon into pension governance.
Three senior pension executives - Peter Norman of Sweden’s AP7, Peter Scales of the London Pensions Fund Authority and Joep Schouten of the Netherlands’ Cordares - took part in a CEO session.
Norman outlined AP7’s novel “pure alpha” approach to running its assets (see panel).
Scales explained how the LPFA, which is a defined benefit/final salary scheme, aims to hold contributions steady and maximise returns to finance pensions. The LPFA is split between an active sub fund and a pensioner sub fund, which were 74% and 92% funded as at the 2004 valuation - down from 103% and 99% three years earlier. The total fund was 82% funded, down from 101% in 2001.
With this in mind the authority has reorganised. The £1.8bn (e2.7bn) active sub fund now has 65% in global equities, down from 75% before. This allocation is split between 30% in one mandate, against a quantitative benchmark plus 1% and 35% in two equal mandates against a world index +2%. There is also currency overlay.
And instead of 10% in global bonds, the LPFA now has 20% of its assets in a two equal “total return” briefs - benchmarked against RPI plus 5%. The 15% allocation to other assets (property, private equity and cash) is the same.
The authority has also revamped the pensioner sub fund - mostly allocating to bonds. This section was formerly 15% in global equities, 20% in global bonds and 65% in index-linked gilts and cash.
Now the £1.4bn fund is 12.5% in global equities via an index tracker, with 87.5% in cash-flow matching bonds via three mandates targeting liability cash flows +1.5%.
Cordares’ Schouten’s presentation focused on liability driven asset management in the context of tighter regulation by the Dutch Central Bank and in an environment of falling pension fund solvency ratios.
The keynote address on ‘Solving the Pensions Puzzle’ was presented by Monika Queisser of the Social Policy Division of the Organisation for Economic Cooperation and Development (OECD) in Paris.
OECD countries have woken up to the need to adapt to an ageing society, and reforms have taken place, said Monika Queisser, principal administrator at the Paris-based body.
However, there was “limited scope” for further benefit cuts in much of Europe especially the lower end. This includes turning to options of saving more and working longer, she told the event’s attendees.
She outlined the organisation’s key findings regarding the redistribution of income towards low-income pensioners and the maintenance of living standards during retirement - pinned as the two primary objectives of pension funds.
The OECD has projected that the average gross replacement rate - a measure of pension entitlements as a share of individual lifetime average earnings - for OECD workers earning an average wage will be 57%.
However, there will be a “substantial variation” among the member countries, said the organisation’s Policy Brief of last March.
While workers in Denmark will enjoy a replacement rate exceeding 100%, Ireland, Belgium and Germany come close to the bottom of the table, and the UK is ranked in twelfth position among the EU15. Austria, Italy and Spain also top the table, while France rates around the roughly 50% mark.
“Reform is one of the biggest challenges of the 21st century,” says the OECD brief. Despite the fact that the report stated that pension reform is regarded as a difficult task, public opinion on pensions has been changing. “People are realising that a shrinking number of workers will have trouble paying for more and more pensioners.”
Her conclusions were that there are large differences in replacement rates across the earnings range in some countries. But there was limited scope for further pension benefit cuts in much of Europe, especially at the lower end.
And Queisser argued that closer links between pension contributions and benefits would put pressure on safety nets. Given the complexity of pension systems, financial education would be a crucial element of reform.

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