The Irish Stability Fund, amounting currently to €5.4bn, is held in a temporary holding fund benchmarked to cash, awaiting another contribution this year of €800m equivalent to 1% of GNP, an Irish Association of Pension Funds conference in Dublin was told last month.
John Corrigan of the National Treasury Management Agency (NTMA) said a total of €6bn would be transferred to a new fund expected to be run by the agency. “This is a sizeable sum by any stretch of imagination,” he said.
The purpose of the fund, which he described as a “reserving arrangement rather than a conventional pension fund”, would be to pre-fund two blocks of state liabilities, social welfare pensions and public service pensions in a two-to-one ratio.
Draft legislation was expected imminently to finalise the arrangements, he said. The aim is to have an independent board with investment commissioners who would in essence control the investment process, with the agency acting as the investment ringmaster. “We would expect to use asset liability modelling, but the scope for this would be limited, as to some extent we would just be looking at one side of the balance sheet.”
On the asset allocation, Corrigan had no doubts that a “prudent expert approach be adopted”. “From the state’s point of view it makes little sense setting up this fund for long-term investment of resources if it were not heavily invested in real assets. If there were a lot of monetary assets, it would make more sense to pay down government debt.”
On the management of this “a substantial element if not all should be outsourced”, he said, with the investment commissioners deciding on this, as there would have to be an international competition: “So it will not be the NMTA calling the shots and being judge and jury in its own court.” He foresaw the agency working as a manager of managers under the control and superintendence of the commissioners, responsible for the overall management of the fund.
“The agency has competency in the capital markets area and has been successful in forecasting the economic cycles in how we have managed the Irish debt portfolio and have set up advanced systems in the area of risk management and control.” The key decision areas, he said, were asset mix, the question of sub-portfolio construction, the active versus passive question, and the active portfolio management by the manager of managers. He referred briefly to global custody saying “it made a lot of sense to have one single global custodian”.
The performance requirement of the fund would be driven by a benchmarking process rather than absolute returns. “We believe there should be heavy emphasis on ‘pain threshold or tracking tolerance or risk budgeting’ on the part of those with responsibility for the fund.”
Under the heading of sub-portfolio construction, Corrigan said the emphasis was likely to be on sectoral rather than geographical issues. “In relation to the start-up phase it would make sense to concentrate on the mainstream markets, invest in those initially and have a dynamic benchmark that would eventually expand into the full global remit, covering such mandates as smaller companies and emerging markets.”
On the question of active versus passive, he referred to a US study which showed that 54% of US public sector pension funds’ domestic equity exposures were managed on a passive basis. “But the S&P 500 is not as passive index, so this is not an easy decision.”
However, the number of external managers required would depend on the active passive split and the risk tolerance, he pointed out. “The lower the pain threshold, the lower the number of managers.” But the selection process would be a competitive one, likely to involve consultancy assistance. “We believe the manager of managers should be looking for track record and information ratios. Because of the high weighting on risk budgeting, we believe the attitude of managers towards accepting a risk-constrained mandate would be extremely important. The question of performance-related fees is a factor that will have to be considered.”
Turning to the currency aspects, Corrigan commented that “were it not for the euro, it is questionable whether this project would be viable at all. The question arises whether the currency should be treated as a separate asset class or whether all assets should be hedged back into the euro.”
Summing up, he said “the fund would have clear objectives based on benchmarking, it would have heavy real asset weighting and aim to generate alpha within clearly defined risk parameters”. The next milestone would the publication of the draft legislation, which was imminent, he said.
Looking at the international experience in setting up “buffer and similar funds”, Tim Gardener of investment consultants William M Mercer in London, said these “were an extraordinarily difficult thing to do”. “The theoretical mathematical solutions to setting up one of these funds is usually relatively straightforward, the practical issues can be a nightmare. This was particularly where there were issues of fairness between the competing parties involved, such as the older and younger generations, politicians, civil servants and voters.
He warned against losing sight of the primary investment focus and going for the argument that “it’s in the interests of society rather than on a commercial basis”. This could be an excuse for incompetence and abuse of money, he said. The new funds being set up tended to be market-orientated, have diversified asset allocations, be independently run and have a fiduciary character and structure. “Good funds being set up have strong primary objectives and any secondary objectives must support the primary.”
On governance, Gardener said in earlier models, government and ministries have assumed direct responsibility. “More recently, independent boards of trustees have assumed responsibility.” On the investment management side, Gardener said he personally in favour of the manager of managers approach. “Internal management is not a skill that can be manufactured by government or quasi-government bodies.”
The international experience is that funds should be structured to have independence, should have a defined purpose and a clear chain of accountability. “That’s the way it’s going.” There has also got to be strong independent governance. “Funds without this are not achieving what they should do.”
The government should legislate for “the wholehearted delegation of investment management to a largely independent body,” Jimmy Joyce, president of the Society of Actuaries in Ireland told the conference. “I would quite understand if there were reservations about unfettered delegation.” A plausible case could be made for constraints, he added. “For example, should some requirements be imposed favouring so-called ethical investments? What about speculative or geared investments. We have all heard of spectacular losses incurred by over- ambitious investment managers.”
Joyce went on to say: “One would envisage, the investment mandate specifying general parameters, such as having due regard to the nature and purpose of the fund, prudence, risk and return, diversification, concentration and so on. There may be a case for making provisions in relation for concentration of investment more prescriptive, such as by specifying limits for investment in individual stocks.” He expected significant investment in overseas assets.