Every pension fund is, or should be, aware of its liabilities – the benefits it owes each one of its members, now or in the future. But although taking steps to tailor the investment mix to cover these liabilities may seem to make sense, in practice pension funds take different approaches.
Vienna-based multi-employer fund APK Pensionskasse is currently discounting its liabilities at the fixed actuarial rate, as with Austrian pension funds, there is no mark-to-market valuation for liabilities, says Günther Schiendl, head of investment.
“The assets are valued mark-to-market, but the liabilities are not,” he says. So conventional liability matching does not work in Austria in the typical way that it is being presented by consultants elsewhere in Europe, he says.
“Therefore the situation is more complicated because we have different valuation schemes for the assets and liabilities,” he says. It is up to the pension funds themselves to develop a suitable investment approach, Schiendl says. Consultants have to recognise that the traditional liability matching approach does not apply in the Austrian case, he says.
If a typical discount rate is between 3.5 and 4.5% – for some older plans it is even more – then this implies a de facto absolute return target of 3.5 to 4.5%, which is double or three times the current risk-free rate. Add in the fact that reserves are close to zero, and it becomes clear how difficult the situation is, says Schiendl.
He expects this situation to change over time. Also, the practical experience will increase in other countries as they move towards mark-to-market pricing of liabilities, he says.
The European Pensions Directive is being implemented and there will be moves made towards convergence. But in the meantime, just how Austrian pension funds cope with the situation differs from fund to fund.
“In Austria, the investment approach taken varies among the pension funds,” says Schiendl. Most funds are rising to this challenge by complementing traditional asset allocation methods with active market risk management. In addition, there is more diversification into other asset classes, he says.
“In any case, given today’s low bond yields, this system somehow forces the pension funds to take (additional) risks. We have to take a different route,” he says. “We have to follow more active investment strategies that have more of an absolute return character, because we need to achieve absolute returns of typically far more than 4.5%.”
There is an assumption in the European pensions consultancy industry that certain solutions will work in every different country. But this is wrong, Schiendl says. “This is not widely recognised in European pensions, that there is still a lot of variation at the national level, that often needs a country-specific approach.”
Ernest van der Velden, pension fund manager at Reed Elsevier Nederland, says his pension fund is fundamentally looking to get the best returns on its investments. But of course, he says, it conducts asset-liability studies every three years. “But my opinion as an actuary is that it only costs money. When you see the results, what sort of division between shares and bonds, it is not always about actuarial results but stability in the market.”
At the moment, the fund is invested 80% in bonds, but the bond/equity split is gradually changing towards a 50/50 division.
From June 2006, says van der Velden, the fund will have to calculate all its obligations based on their market value. “Because your horizon as a pension fund is about 30 years, I think there will be a tendency to have a longer duration of bonds,” he says. In this way they will match the liability profile. But this strategy will not mean the best returns on capital, he says.
While pension funds have to look as far ahead as the end of this century, he says, they also have to look to see what the situation will be at the end of the year. There are many organisations within the pensions environment asking pension funds what their rate of coverage is.
“When the rate of coverage is very low, in my opinion, you have to do it (match assets to liabilities),” he says. “The reason that there are such rules is so that measures will be taken when coverage is low.”
All parties in the pensions industry are worried it will not be possible to fund pension benefits in the future. Pension funds have to be clear about their profiles, and acknowledge that they will be paying out benefits for the next 40 years. This is particularly the case for schemes with significant volumes of younger members.
So it is important for funds to aim their investments more in the direction of absolute returns. “You have to focus on that,” says van der Velden.
Already there is a lot of debate in the Netherlands about which direction investment strategies at pension funds should take in order to put themselves in the best position to fund their liabilities. Whether absolute returns or a liability-oriented approach is best is under consideration at the OPF pensions association and among the country’s largest funds, he says.
“There is a lot happening among pension funds in Holland this year and next,” says van der Velden. “They are discussing everything and in the end, there will be a good solution.”
How best a pension fund acts to cover its liabilities depends on the profile of the schemes involved. At the UBS Pension and Life Assurance Scheme in the UK, there is a closed scheme for the defined benefit side, and a defined contribution (DC) scheme. This DB scheme has been closed for five years and is now rapidly maturing. Eighty percent of active members are in the DC scheme.
Taking into account the maturing membership profile of the pension funds, the trustees decided this year to move from a 60/40 equity/bond split towards a 50/50 split, says Matthew Webb, head of UK benefits at the scheme. So the asset allocation shift is being made in response to the changing liability profile of the scheme, but it is not necessary to match pension assets with great precision to liabilities, he says.
“I don’t think you need to be exact, because it is an inexact science,” says Webb. “The only thing you can be sure about with an actuarial valuation is that it will be wrong… you are never going to be able to match liabilities exactly; you can take long-dated bonds, but they are not an exact match.”
The liability profile of any pension fund is always changing, he says.
This year, the scheme has moved into property investment for the first time. The fund now has 5% of its assets in property. The trustees were concerned with the potential impact of inflation on the scheme, and property was seen as offering some protection against this exposure, says Webb.
The trustees of the scheme did consider hedge funds as a new asset class, he says, but they decided not to use them. “Because they are more of an absolute return product,” he says. However, the alterations to the asset mix do not stop here. “Over time we will change it as the profile changes,” says Webb. “We have got a lot of deferred members.”