IPE - European pension consultants responding to a survey by IPE have warned that being long-term investors cannot exempt pension funds from thinking realistically about their short-term risks.
At the same time, they suggest that regulatory pressures have made investors’ time horizons too short, and that failure to address this issue could force radical measures such as the abandonment of guaranteed pensions altogether.
The theme of balancing long-term aims with short-term risks and obligations is pursued further in the European Pension Consultants special report in the March 2012 issue of IPE. In addition, we canvassed views on two specific questions:
• Are there any factors encouraging pension funds to look to the long term anymore?
• How are consultants adapting their advice and business models to help clients meet that challenge of managing their short-term risk, accounting and regulatory obligations without losing sight of their long-term fiduciary objectives?
Greg Wright, director in investment advisory for pensions at KPMG, outlined the dilemma.
“Pension funds are clearly long-term investors given the liabilities they must pay, yet they are increasingly being caught by shorter-term funding tests,” he said. “Moreover, these tests carry genuine cash implications for sponsors - they are not simply accounting exercises.”
Sean Glasgow, a senior investment consultant at Buck Consultants, agreed that UK pension funds’ moves “to a shorter horizon with a more risk-focused approach” was more than simply a response to perverse regulation.
“It is correct that intergenerational risk and pension liabilities were dwarfing the economic capacity of many sponsoring firms,” he insisted. “Transparency around the true economic cost of liabilities through regulatory and accounting standards has been a very positive development in requiring investors to face reality.”
Buck Consultants consequently sets a lot of store in near-term risk measures such as de-composed, one-year Value at Risk: such risk models have limitations but are “invaluable in getting a shared realistic understanding among trustees and sponsoring companies”.
But he also emphasised that near-term risk measurement was only a starting point. “Perhaps the pendulum of regulatory and short-term risk focus has now gone too far,” he suggested. “Higher amounts of investment and interest rate risk […] should be rewarded over the next investment cycle, and it’s appropriate to look out over a longer horizon than currently encouraged by the system.”
That is the challenge identified by many respondents. Getting the balance right between long-term goals and short-term risks is not so difficult in itself. As Richard Dowell, head of clients at Cardano UK, pointed out: “Short term and long term are intricately linked - the only way of meeting your long objectives is by not failing in the short term. The most sensible place to start is having a goal of achieving a stable growth in the funding ratio. This is best achieved by building a portfolio that is robust to different economic outcomes and not taking a few big risks.”
But pension funds are attempting to do this in a regulatory context that often pushes them into big risks. For example, Gerard Roelofs, head of investment consulting for continental Europe at Towers Watson, observed that recent months have seen Dutch pension funds changing their country and credit exposures in euro-related portfolios.
Diego Valera, chief executive at Spanish consultant Novaster, revealed the damage these short-term risks are doing to Spain’s pensions market. “The volatility of [government bonds] seriously damages the accrual rights of participants,” he said. “There is not a developed and modern annuities market (or, more widely defined decumulation process), and lump sum is the preferred way to receive benefits: that means savers are severely impacted by the valuation criteria.”
But Haitse Hoos, a partner at Asset Advisors, said that, under current Dutch rules, increasing non-euro exposure would technically raise the risk in a fund even as the action is, fundamentally speaking, reducing it. Similarly, he pointed to regulatory pressure to match the volatility of liabilities with asset portfolios - which currently involves entering into 40-year swaps that deliver negative real returns and present the risk of liquidity-squeezing margin calls in the event of rising rates.
There was broad agreement that one key step towards clarifying the issues was to develop a holistic journeyplan. This tended to translate into solvency management in the Dutch context, for example, and bringing trustees and sponsor together in the UK context.
“Trustees and sponsors should be sitting down together to work out where they are now, where they want to get to and what is a realistic timescale for this,” argued Wright at KPMG. “It may well be 10 or 15 years before a combination of contributions and investment returns get a scheme to a position of self-sufficiency or full risk transfer - so we would argue that pension funds are still long-term investors at this stage.”
He pointed to the use of dynamic de-risking and the journeyplan to buy-in. These only work once the funding position has improved, he observed, and the only way to bring that about on a realistic time horizon is to bring sponsor and trustee together - “emphasising the alignment of interest of both parties to better manage down risk over time” - to consider pensions and investment advice holistically.
“By simply concentrating on one or the other, you can miss out on the combined benefits,” he wrote. “For example, in isolation, it may not be possible to afford a pensioner buy-in. But implementing asset-backed funding may unlock the ability to sell equities for bonds, which itself unlocks the assets to fund a buy-in. There will be widespread take up of asset-backed funding to lift pension schemes to a point where they can de-risk substantially. This should be encouraged, as it is good news for trustees and sponsors.”
Business and advisory models have to evolve to deliver this kind of solution. Wright detailed how KPMG had formalised a ‘Risk Knowledge Champions’ group, drawing together pensions and investment specialists - including client consulting individuals “who understand the pressures clients are facing” - to debate and develop ideas.
Others emphasise outsourcing and delegated consulting services, which “leave trustees free to concentrate on the more critical strategic aspects of the management of their scheme”, wrote Roelofs. “In addition to our advisory investment services, Towers Watson offers a spectrum of delegated investment services designed to be flexible and enabling our clients to [delegate] a level of authority which suits their requirements.”
Dowell described how solvency management arrangements put Cardano in the position of executive alongside the trustees acting as “non-executive directors”. To achieve this, the firm has had to build a range of skills, from risk management and investment management through operations specialists to ex-investment consultants with a keen understanding of the needs of trustees.
But it is a fine line between reaching a realistic understanding of the true financial position of a pension scheme and frightening sponsors into abandoning their obligations altogether.
As Wright at KPMG noted, sponsors have already “clearly acted to shorten the duration of a pension schemes” by closing to new members and even future accrual - to facilitate “better long-term planning” for the shorter time horizons they have created.
Similarly, Hoos at Asset Advisors wrote that, unless regulation in the Netherlands is changed, the focus will stay on the short term, and long-term returns will be lower as a result - unless sponsors move to collective defined contribution schemes that enable them to dispense with nominal guarantees, remove liabilities from their balance sheets and allow the scheme to take longer-term risk. “In this case, everyone will benefit,” he said.
Which is true, as long as the risk pays off. While collective DC is perhaps more likely to achieve this than individual DC savings plans, Novaster’s Valera reminded us that “the fiduciary responsibility for the long-term” ought to be stronger in defined benefit arrangements than in DC.
Notably, while many of the ideas that consultants are pursuing in the current environment involve securing the benefits of retired and near-retired members, often by removing guaranteed benefits from the current generation of employees, none chose to highlight the improvement of advice to the DC schemes that are replacing DB as being central to their efforts to help clients balance their short-term risks with their long-term obligations.