Getting fit for the future
In the last 10 years there has been a major revolution in the Netherlands, as to how pension funds approach investment issues, firstly in relation to asset allocation, and then diversification in light of the European developments, moving to public indirect real estate, use of overlays, says Arun Ratra, chief investment officer looking after the E8bn the pensions assets of KLM, the Dutch airline operator. “There has been an enormous sea change not only in the portfolios, but also in those who run pension funds on a daily basis, no longer is it someone with a book-keeping course, it is likely to be an MBA for starters.”
“We have a total investment staff of 17 people here in Amstelveen, of whom nine are investment professionals backed by support staff.” But the role is wider than just running the investment, it entails advising both sides in the collective wage bargaining process about how the pension benefits are going to be structured. “We have to advise the employers, trustees and employees on these aspects. This is what we call pensions advisory at KLM.”
On the investment side, it means advising the trustee board about the yearly plans and the long term strategic asset allocation, as well as the execution of the plans. “A crucial element is the communication and education side, because it is essential that trustees understand what we are trying to do for them. This is now key in the pensions business.” Another role undertaken is the daily servicing of the trustee board.
“We are a full service provider to the three KLM pension funds, the first which looks after pilots, the second cabin crew and the third the ground staff,” he says explaining the role of his company KLM Pensionfondsen Kantoor BV (PK), which handles all the day-to-day running of the pension funds.
Originally, the pension funds were more closely integrated with KLM, but in the 1990s it undertook an extensive review as to whether looking after the pensions area was a core business for KLM. Then in 1997, a report ‘Fit for the future?’ was produced with the help of a Dutch consultant, which presented the options of virtual total outsourcing, expanding to cover all KLM group companies such as Transavia, or to look after not just the group but third parties as well. The report scotched the third approach, as it found the organisation, as it then was, was not fit for the future. But neither were down-sizing and outsourcing chosen as an option, because “if you want to retain people in the company, employee benefits are an important part of this and a centre of competence was needed to ensure this,” says Ratra. Until 1999, the pension department was an integral part of the KLM group, but since then it operates as a separate entity, though the PK subsidiary. “KLM will remain PK’s shareholder until 2002, when the shares will be transferred as per the agreement to the three pension funds.”
A most important aspect was that KLM, the three funds and PK entered into an agreement as to what was to be improved over the three years to 2002, specifying the level of service required and the costs involved. “We have just completed a mid-term evaluation of the agreement and we have completed around 85% of the agenda in half this time.”
Prior to the agreement, all the assets had been managed internally, but under the new approach only what could be done competitively should be handled in-house and not otherwise. “We should concentrate on those aspects that added most value for our internal clients. This meant looking at our core activities and deciding which was the most important for the client and which we could do most effectively.”
On the investment side, the key decision was to concentrate on strategic and tactical asset allocation. “We know from the academic work done in the US on pension fund returns, these aspects add most.” The first ALM study had been completed in 1997, quite late in the day by Dutch standards, and very little TAA had been done, says Ratra. “Since then, we have been very pro-active with ALM, looking at the large economic scenarios over 30-years, factoring in inflation, economic growth and total returns, so by using simulation techniques we arrive at an ‘ideal scenario’, given a certain risk profile.” The supervisory body insists that at all times funding should be at least 100%, he adds. “So we want to see where we can add value from the asset allocation given our risk profile.”
Ratra gives the example of the approach to currency management and international investments: “Do you hedge at all, or do you have a 50% or a 100% hedge policy? And do you do exactly the same over all the three assets? These decisions can make a big difference and are maybe more important than which US mid-cap manager you hire!”
Once the strategic decisions are completed and the fund has its three year plan with assets allocated down to a regional basis, the question then is how are the tactical decisions going to be made, he says. “Around this we have a tactical overlay, to keep working around markets all the time and trying to optimise the risk return profiles. If we outperform by say 50 basis points, it can mean a lot.”
As part of this strategy, all of the asset management has been outsourced, except for just 2% still handled internally, though these aspects too will be outsourced. “About 90% of our assets are on an indexed basis for both bonds and stocks.” Also, the allocation patterns have changed dramatically. In 1998 83% of fixed income investment was domestic or in Germany, now bonds are pan-European. “We have also gone into high grade corporate debt in the US and emerging market debt – so quite a shift!” On the equity side, 40% was domestic and now equities are on an MSCI Europe ex UK weighting. Currently, the weighting for US, Japan and other markets is being reviewed, with a view to moving to MSCI World.
On the real estate side, “the bricks and mortar” were previously managed in-house, but in a novel move with the Hoogovens Pension Fund, a company called Altera was set up. “It is the first time in 10 years that pension funds have succeeded in doing such a venture in co-operation in the Netherlands. This is set up as a fund in which units can be purchased in the residential, office or industrial funds, but only for Dutch real estate. This is now publicly available to other pension funds.”
An investment advisory committee for the trustee board has been set up to which PK makes their annual investment proposals, which includes strategic plans and information on benchmarks and so on. “The committee consists of five outside investment professionals, including two academics and they advise the board.”
PK looks after the internal performance measurement, but also has the performance externally vetted by consultants Wilshire Associates in Santa Monica. The relationship with the custodian had to be completely reworked with the move to external management and custodianship is handled by Northern Trust.
Because of the three-pension-funds structure, an investment pooling structure is being set up at the portfolio level, so that each fund can buy the units they want. “We are quite advanced with this.”
The fund has a senior fund manager for equities, for fixed income, currencies and real estate, with a head of strategy and research. “We then have three strategists, for equities, fixed income and real estate, with two other fund managers, one for fixed income and equities. At the moment, we are looking for a strategist for equities and a fund manager for fixed income and currencies.”
The investment philosophy underlying KLM’s approach is that it is research-driven, says Ratra. “This is where we differentiate ourselves by providing unbundled products. We want to be in the position that if another part of KLM approaches us to see if we can handle part of their investments, we are able to do so with our pooled approach.” But he also wants to be able to respond positively to enquires for ALM, strategies, currency management, as well as other advisory services. “We want to be a service centre, but on a commercial basis.”
The strategic allocation process is based on the ALM and is the responsibility of the strategy and research functions with PK. “TAA is return-risk driven and on a medium to short-term basis, and falls more into the rea of the senior fund managers. On investment styles, what we are trying to create is a pool of one or more asset managers, in such a way that you end up with a style alpha, that is by creating style portfolios.”
The selection of asset managers is seen as a core competency for PK. “But we will only choose external managers within the asset classes, only if alpha is larger than zero on a risk adjusted basis.”
The selection of eternal managers starts with the four ‘Ps’ – people, process, philosophy and performance, says Ratra. “We have within our control department, an analysis section, where three people do all the risk and performance measurement to support the investment department.”
But the team is under constant scrutiny as to its success in delivering ‘client satisfaction’, measured by the extent to which they meet their financial targets and the quality of the advice given. “We are also judged against our peer group in the Netherlands.”
“What is our product at PK?” he asks. There are two: The first is financial outperformance against the benchmark over the three years of the agreement and two further years. “What is expected of us is in the first year is index return, but net of costs, which were heavy because of the significant reallocation; the second year would be at least index return, and in the third to fifth, year we should index plus 75bps per annum.” In fact in 1999, the fund outperformed by an average 80bps and last year the returns was around 45bps, he says. “So we are ahead of target.”
The asset allocation and return figures for the three schemes are: For cabin crew the return was in 1999 20.7%, for ground staff 19.3%, and for pilots 12.7%, due to the scheme’s lower allocation to equities, just 30%. The ground staff scheme has 45% in bonds, 45% equities and 10% real estate. For pilots, the breakdown is 30% equities, 55% bonds and real esate 15%; for cabin crew it is 50% equities, 40% bonds, 10% real estate. “There are sharp differences in allocations, due to the fact of different risk return profiles as the liability streams vary significantly.”
The outperformance came from taking small tactical bets about the index. “We were generally slightly overweight equities vis a vis all other asset classes in the fourth quarter of 1999, for example. We don’t believe in the big home runs, but go for the smaller bets to add value that way,” he says.
The schemes are starting the process of finding more active managers. “We don’t want it to rest on some strategic decision about the proportion, such as 60% passive and 40% active. But if we can find good managers in the right markets and you come up to 30% active, then that will be your limit. I think deciding on active versus passive should be a much more bottom up than top down approach!
He believes that the arrival of specialist pooling vehicles could provide an alternative to balanced management for even the smallest of funds. “Why couldn’t a scheme with just E2m in assets buy units in these specialist funds and build up all the mandates they want.” He thinks it is possible that his team might someday be offering their services outside the group. “But this is something we have to earn and show that we can deliver. It will come about as part of the natural evolution of what we are doing.”
The group uses BGI for both European passive bond mandates and the indexed portion of Japanese equities, while State Street does the remainder of the equities, as well as some bond indexing in emerging markets.
“We see our approach is to get the correct market and sector exposure and obtain the market return as the first step. The second step is to move towards core-satellite and hire the active managers. That is our next step in the process. What we have been doing was getting these structures in place and catching up on the backlog that had inevitably been built up.”
The PK has been researching the question of alternative investments and hopes to present a full report to the board later this year. “Perhaps, we will be able to start off with a programme in 2002.”
The KLM board has expressed its satisfaction at what has been achieved, which Ratra is very satisfied about. “At the end of the day, it is about the happiness of your client and they have said they are pleased with what we have been able to put in place – it is much more than they expected.”
In the next 10 years, Ratra sees consolidation in the asset management and administration of Dutch pension schemes, particularly through the activities of the service companies, such as PK, being set up. “It is not too clear as to how this will unfold as yet and with the pension funds setting up insurance companies in the form of joint ventures, we are seeing the arrival of ‘pension-assurance’model – this is the way things are evolving.”
While DC is hot in the Anglo-Saxon countries, it is not part of the Dutch tradition, he claims. “I think there will be a role for DC here, but it will be limited. Perhaps it will take the form of third pillar individual provision, as add-ons to their pension schemes.”