Facing up to a harsher future
New financial legislation generally means a business opportunity for product providers, and the Dutch FTK pension law is no exception.
The new framework is expected to come into force on 1 January 2007, and fund managers are already reporting increased interest from Dutch pension funds in liability- driven investment (LDI)-type solutions.
“Pension funds have to become more professional in managing risks which include fund liabilities,” says Bart Heenk, managing director, Benelux and Nordic region, SEI Investments. “They are more likely to manage their portfolios in the light of liabilities, so LDI will be used to capture a wide variety of solutions, focusing on assets and liabilities.”
Every investment house has their own set of solutions, says Heenk.
“So as there are almost as many LDI strategies as investment funds, it is not very easy for pension funds to sift through them,” he says. “Coupled with anticipated interest rate increases, this means there is therefore a tendency to postpone the investment decision.”
Heenk says the advent of FTK has highlighted the need to distinguish between the risk management and the return parts of the portfolio, using tailored solutions for each, such as hedge funds and absolute return products. He says there is also an increased demand for long-dated bonds, for inflation-linked products and cash flow swaps.
“FTK does present a business opportunity in terms of demand for LDI-type products, although we are a bit sceptical as to whether the law will actually be passed,” says Reinoud van den Broek, head of institutional sales, Robeco Investment Management. “Not all pension funds are ready for the new law, so there is a lot of demand for LDI-driven products. Pension funds are asking managers to create a portfolio within an LDI framework or with an overlay, at the current level of interest rates.”
Van den Broek is also seeing a rise in demand for fiduciary asset management and for compliance-type products.
Fiduciary management allocates different assets between specialist managers with the lead managers taking the risk management and ALM reporting into account.
Theo van der Meer, head of institutional business for Benelux, Fidelity, says: “There is a new trend, moving away from a core and satellite approach towards a split in the portfolio between liability matching (predominantly with fixed interest stocks), and a concentration on high alpha, including uncorrelated assets so that the risk is as low as possible.”
Van der Meer says that fiduciary managers such as Fidelity can then be hired to manage a portfolio on the basis of a liability-driven benchmark, and to fill in the gaps with building blocks such as real estate, private equity, on a best-in-class basis.
Hessel van Beijma, principal, strategic clients, Benelux, Barclays Global Investors, says: “Roughly the 25 largest Dutch pension funds - worth e1bn plus — are mostly doing direct deals such as swaps with brokers, in a so-called structural form, while smaller funds are looking for partners such as ourselves. We can offer them liability solution funds in sterling and euros.”
Two years ago, BGI Netherlands had the first very large mandate arising out of its LDI business. “There is/was, for the majority of pension funds a gap of approximately 11 years between the average duration of assets and liabilities,” says van Beijma. “This could be resolved by using pooled liability solution funds. At the moment, BGI has 13 euro liability solution funds and over 25 in the sterling family.”
Jan Lodewijk Roebroek, chief executive officer, Netherlands, Fortis Investments, says: “With the deadline for the new regulatory framework, as well as higher interest rates in the past few years, there has been increased interest from pension funds - particularly medium-sized funds - in finding appropriate solutions for acquiring funding cover. Over the next couple of months, pension funds will have to make the decision as to whether to fully or partially hedge.”
Roebroek said that there is a wide range of options for pension funds to deal with the new regulations. For example, funds can move the liability side into a collective DC-type of environment, although not many are going down that route at present.
“There are alternatively a number of pension funds who are considering reinsuring the whole of the pension scheme, but that means they would no longer be independent,” he says. “At this stage, most medium-sized pension funds are actively looking at solutions which leave their current status unchanged. This could involve reinsuring, which is suitable for smaller pension funds, as the regulatory requirements do not apply to the same extent to them as they do to independent pension funds. Another option is to be taken over by industrywide pension funds.”
Roebroek says that he thinks the relaxation in FTK (from a one-year to a four-year restitution period) may have some impact on the appetite for LDI, but that medium-sized funds will still be keen to use this type of solution.
UK asset manager New Star has entered the Dutch market in order to expand its international business, focusing on institutional clients.
Cobus Kruger, director, mutual funds, New Star, says: “The FTK regulations create great opportunities to manage assets differently, and with a much bigger emphasis on DC rather than on DB schemes, more opportunity will be created for smaller players. DC schemes have been great for boutique asset managers, as they allow us to highlight the importance of being alpha managers. Our goal is to deliver absolute returns and to make money for clients.”
Karin Roeloffs, head of institutional clients, ABN Amro Asset Management, says: “We are seeing an increasing number of pension funds acting in anticipation of FTK coming into force. On the liability side, some pension funds are looking for swaps, long bond portfolios and swaptions. For the return part of the portfolio, we have absolute return products with a target of Libor plus return.”
She says there is also increased interest in diversification. “Some pension funds have taken this route - they need additional returns, so they go into emerging markets or multi-strategy hedge funds,” she says.
IFRS has been cited by some managers as a driver behind the switch from DB to DC schemes or collective DC schemes. But it is also having an effect on investment strategy.
Roeloffs says: “IFRS introduces some fair value issues for pension funds, and will reinforce the demand for LDI products, as pension funds will be looking to match assets/liabilities much more.”
Van der Meer considers that IFRS is having two major influences on pension funds.
“First, there is the legal effect, which means that pension funds require a short-term buffer under FTK,” he says. “Secondly, there is a long term requirement to sell the duration of your portfolio. But FTK says that if you have enough of a buffer, you can leave a gap open.”
According to van der Meer, this results in investment partners creating products in the form of matching portfolios, with some investment managers creating duration pools of, say, one, five or even 50 years.
“The pension fund can then put a small percentage of its portfolio in one of these pools, giving it strong leverage, and leaving the rest of the portfolio intact,” he says. “Other partners offer derivatives-based solutions.”
“The fact that our clients are small to medium-sized pension funds has more to do with the fact that they have been affected first, in the sense that they are mostly corporate pension funds and therefore have already been affected by IAS 19 [ the international accounting standard for pensions] rather than just FTK,” says Marc Van Heel, director of business development Benelux, Pimco Europe.
“That is the over-riding factor, in my view. CFOs in particular, and others within the company, have been thinking about how they can cope with this problem, and have therefore urged their pension funds to look into these solutions. For them, IFRS is a much bigger factor than FTK.”
Since the electronic giant Philips decided to hand over the management of its pension fund to Merrill Lynch, outsourcing has become a hot topic for debate in the Netherlands.
But asset managers are split over whether the Philips move heralds the start of a trend.
Roeloffs says: “At present, only a few funds are outsourcing but in future, I suspect more pension funds will do so. It may be that a pension fund feels it does not have the expertise in-house. It may also be the case that there are so many decisions to make that a fund would rather be taken care of by the investment manager. However, it is not a panacea for all, as the board members have to realise that they are responsible for the funding ratio and they cannot outsource their financial responsibility.” Roeloffs says that she expects pension funds will need to outsource before FTK decisions have to be taken.
“Outsourcing is very much the start of a trend, although not everyone of the size of the Philips fund will consider this,” says Heenk. “Philips realised they were better off outsourcing, as they have limited resources and plenty of corporate projects to put money into. But for other company pension funds, the outsourcing decision may not be as pressing as for Philips.”
Heenk says that outsourcing will be a result of the recent changes in the regulatory and accounting framework, a much more complex product environment, and lower funding ratios arising from poor investment returns in the early 2000s.
“These factors have increased the need for good corporate governance and risk management,” he says. “This means that every pension fund has to increase the professionalism of its internal organisation. However, medium and smaller-sized pension funds are fishing in the same pool as everyone else for talent. Every fund under about e2bn in size will have problems hiring and retaining talent, and will be looking at outsourcing.”
Heenk says that outsourcing need not be done using a single manager, but alternatively via life or insurance companies, an industry-wide fund, or pooling with other pension funds.
The alternative is a buyout of the fund - to buy pension funds from employers such as Philips.
Roebroek says: “I suspect we will see more of the Philips type of deal in the coming period. Companies with this size of pension fund consider that the key issue which pension funds should take is making the right decisions when it comes to ALM. Handing this decision to, say, a fiduciary manager means that all kinds of service can be bundled together as a one-stop solution.”
But others are less certain about the future of outsourcing.
“I do think outsourcing is a trend,” says van den Broek.
“But some pension funds are contemplating using fiduciary asset managers instead. One of the options is to outsource the complete pension fund, as in the Philips deal, where the asset manager buys ten years’ worth of service from the pension fund. I see that as a trend, but not a large one. You can sell a lot of things before you sell the operation.”
And van Beijma says: “We don’t see the Philips outsourcing deal as a trend.”
Given all the circumstances, it is imperative for asset managers to aim at - ideally - providing increased returns together with lower risk.
There is a fairly strong consensus as to how to tackle this. “Increased returns and lower risk can be achieved by using absolute return products, and diversification within return portfolios,” says Roeloffs. “This means you get a higher return with the same risk, or the same return with lower risk.”
Van den Broek has a similar point of view.
“Pension funds should be searching for sources of alpha and designing portfolios which combine alpha - rather than look for beta-like returns - but on a stable basis,” he says. “They have to do that within their risk profile, which means diversification.”
Van den Broek says that popular sources of alpha in the Netherlands are asset classes such as private equity and hedge funds.
“Discretionary and long-short portfolios will also gain momentum,” he says. “But they are very expensive ways for pension funds to generate alpha, so you still see beta-like exposure.”
Roebroek suggests that pension funds might realistically set slightly more modest targets.
“They might go for a higher return for the same risk, or the same return at lower risk,” he says. “It also depends on the LDI solution which the pension fund is willing to choose. As soon as the interest rate is hedged, it creates an opportunity for the pension fund to rethink the way they should restructure their return portfolio into an alpha solution, and a more diversified solution in the portfolio.”
Fortis’s approach to this conundrum is to use a well-diversified smart benchmark portfolio consisting of a variety of different diversification tools, including non-listed real estate, commodities, European small caps, high yielding fixed income and emerging market stocks.
Roebroek says that all these elements can be brought together in a diversified portfolio, depending on the risk appetite of the client.
Fidelity and BGI also have specific solutions to the question of return.
BGI offers products which combine liability solution funds with some of the long-short funds. “On long-short fixed income strategies, we try to get an alpha of 2%,” says van Beijma. “Using these in combination with swap-based funds means you can boost the total return by 40 - 50 basis points, and obtain a portfolio tailored to the liabilities of the pension scheme.”
Van der Meer says that the best way to cope with the demand for higher returns for lower risk is multi-management.
“It’s a very simple rationale - if you mix different styles, the combination of these styles gives added value,” he says. “We are looking into expanding our existing multi-manager offering in the Netherlands, and giving that part of our business a high profile.”
The Dutch asset management market has long been considered an area with a level playing field between domestic and international companies.
Nevertheless, there are those who believe there are barriers to entry.
“A mature market is always a difficult market to break into, as it sometimes requires the managers to be able to administer pension funds and also to have a local presence,” says Kruger.
But does one side rather than the other have an advantage in terms of pension fund mandates?
Van Beijma certainly thinks so.
“Some international players are having above-average success, mainly driven by better performance and are making an increased contribution,” he says. “Foreign companies have grown substantially in importance, because of the demise of local competitors. This has happened mainly because Dutch pension funds they think that large companies have more expertise. It is not enough any more just to be a niche player, which is what some local managers are. Also the large pension funds no longer want 20 managers.”
“The Dutch system has been very closed, very Dutch, but we are being urged by the European Commission and others to open up,” says Van Heel. “There is direct access now in the Dutch market to foreign competitors, and of course we are one of the beneficiaries. At present, about 50% of the assets are managed by foreign, rather than Dutch, managers.”
“Anglo-Saxon competition has clearly increased in the past couple of years, and there is no reason why it should not continue,” says Roebroek. “In the past five years, a lot of domestic managers have stuck to balanced mandates, whereas indexed management is traditionally provided by non-Dutch managers. Right now, fiduciary managers are still bigger there than indexed managers, but Anglo-Saxon investment houses are making inroads.”
Van der Meer is even more bullish about the current situation of the big international groups.
“Over the past five years, international managers such as ourselves, BGI and Merrill Lynch have been successful in the Netherlands,” he says. “Some foreign players have economies of scale that local players are unable to offer. We have grown our customer base very rapidly because we are able to offer specialised products with very large resources behind them.”
However, he sees a fight back on the part of the local players.
He says: “Companies such as ING, ABN AMRO and Blue Sky are trying to get back part of their market share. They can offer a security blanket by offering top-down management which gives the confidence of specialised strategic benchmarks. They may also be very well tuned in to local legislation and offer asset management and specialisation on the back of that. So I think the market share of local players will start to grow again.”
Van den Broek agrees. “In the Netherlands, we’ve had a lot of legislation in the pensions market, and that will dictate the future,” he says.
“It will be those managers who deliver sources of alpha in the long run who will be in demand, but the winners will also be those managers who can cater to Dutch legislative needs. You need local knowledge, and not all asset managers have that.”
He says that other factors are also important, such as the search for alpha.
“And pension funds are now looking for managers who are more than just asset managers,” he says. “For instance, Goldman Sachs have been very successful as fiduciary managers.”