Innovative solution provides independence and efficiency
You may well be forgiven for thinking that schemes with sponsors operating in the same sector offer a level of protection and understanding that others may not enjoy. This could be said of Pensioenfonds KBC, whose sponsor is the Belgian banking and financial services group, KBC. Sure, KBC's finance director may be well suited to help understand the scheme's investments and financial positions and potential difficulties it may face in this respect. And again , as a small scheme, you might presume the sponsor can easily absorb the problems the scheme might create in its own finances.
But at the end of the day, both scheme and sponsor have to co-exist within and abide by the same pensions legislation and that often means a nannying approach is not possible. And the sponsor may not be interested. So the solution Pensioenfonds KBC has come up with as a small scheme is not only inventive but allows the scheme as a small player to stand alone independently and operate efficiently.
A DETERMINED APPROACH
The first thing that proves Pensioenfonds KBC is determined to succeed despite being a small scheme having to match its pensions liabilities against bond values, as the law now demands, is its reluctance in complying with the law to give up its 6% return objective from the scheme's investments.
Indeed, it had only recently reviewed its investment strategy on the back of an asset/liability modelling study that revealed it could continue to justify a high level of exposure to equities. Coupled with a 40% fixed income weighting and a 10% real estate portfolio, Pensioenfonds KBC believed it had found the perfect solution with the remaining 50% allocated to equities to cover its obligations with the returns on investments alone.
But the new liability matching laws in Belgium - as elsewhere in Europe - and accounting standard IAS19 do not fit well with an equity dominant portfolio, as they require the value of the pensions liabilities each year to match bond values. In addition, the Belgian pension regulator will no longer allow schemes to rely on investment returns alone. "A typical bond-heavy LDI strategy would increase the costs of the DB scheme," says the fund. "As of 2007, the Belgian pensions regulator requires pension funds to calculate their technical provisions with a discount rate linked to the expected return of the assets of the fund, not a fixed discount rate of 6% as in the past," it adds.
However, the fund was not about to throw in the towel. All laws are open to interpretation and, having studied the implications of the new pensions arena in Belgium, Pensioenfonds KBC, decided there were ways schemes could be innovative in both their thinking and practical solutions. Rather than go back to the drawing board and redraft its investment strategy to comply with the new legislation, it decided the LDI strategy would simply have to fit in with its existing investment strategy.
There were two problems Pensioenfonds KBC basically needed to overcome. Firstly, its portfolios have an equity bias, but under IAS19, this creates a mismatch, as it needs to match the liabilities against the value of bonds, not equities. Secondly, the scheme's average pensions liabilities spanned 12 years, but the average duration of the bonds portfolio was only seven years. So how could it match 12 years ‘worth of liabilities against bond values that only covered seven years? Pensioenfonds KBC realised it could not simply go out and buy more bonds and lengthen their duration. "A more substantial intervention was required," it said.
Pensioenfonds KBC did not want to give up its return-seeking investment strategy. Yet it needed to match its liabilities in line with new regulations. And it had to find a way within the exiting portfolio to accommodate both principles. The answer was staring it in the face. With more than a little innovation, it split the portfolio into three to comprise a matching portfolio, a return-seeking portfolio and a matching and return portfolio.
The matching portfolio basically saw the fixed income element restructured into structured LDI maturity baskets. Here was an example where having a sponsor in the same industry came in handy. KBC Asset Management helped the scheme achieve its aims for the matching portfolio by creating a Luxembourg-based UCITS III investment vehicle. This was split into sub-funds that invested in fixed income instruments with durations spanning 0-5 years, 5-10 years, 10-15 years, and so on. This way, Pensioenfonds KBC solved the dilemma of having average pensions liabilities over 12 years but with a fixed income portfolio that didn't last beyond seven.
The return portfolio, with the fixed income element removed, contained just the large 50 per cent equity weighting and as this no longer had a direct role in the liability matching solution, Pensioenfonds KBC saw no reason to play around with the equity mandates it had already established. These are split equally among the Euro-zone and rest of the world, save for a small 5% allocation to private equity.
But the return portfolio will undoubtedly affect the value of the liabilities, so Pensioenfonds KBC needed to be inventive in the ways it could minimise the risk this would pose. Thus was created the matching and return portfolio. This basically contains the 10% allocation the scheme had set aside for real estate, albeit with a fresh allocation approach. To diversify the real estate portfolio so it correlated minimally with the equity portfolio but offered a similar rate of return, it replaced part of the quoted real estate securities with non-quoted real estate funds, infrastructure funds, timber funds and long term government leases. This, the scheme argues, offers a better match for the pension liabilities.