Jump the hurdle

Nina Röhrbein spoke with Dirk Lepelmeier (pictured), managing director of Nordrheinische Ärzteversorgung (NAEV), the pension fund for North Rhine Westphalia’s medical profession about the challenge of successfully obtaining an annual internal rate of return in a highly volatile market

The Nordrheinische Ärzteversorgung (NAEV) is the professional, defined contribution (DC) pension scheme for all employees in the medical profession in the federal state of North Rhine Westphalia.

Self-employed medical staff have no choice but to join NAEV, while employees can choose between joining the statutory state pension insurance and NAEV. But well over 90% of employees do opt for NAEV, according to Dirk Lepelmeier, managing director. The pension fund is an open cover plan, in other words a mixed system comprising capital cover and a pure adjustable contribution procedure, which ultimately produces a capital cover ratio of approximately 50%.

Most of the nearly 90 Versorgungswerke in Germany - the pension funds responsible for professions regulated by a chamber such as doctors - follow an internal rate of return (IRR), also known as a hurdle rate (Rechnungszins), of 3.5% or 4%.

NAEV’s overall strategy is based on the optimisation of investment risk and return in order to at least meet the hurdle rate of 4% per annum on a risk adjusted basis. Everything from expected future contributions to future pension benefit payments is calculated based on the hurdle rate. If asset growth exceeds 4% in one year, the additional returns can be either distributed or be put aside as reserves. If returns fall below 4%, the pension fund can either dip into previously accumulated reserves or must define them as undisclosed negative reserves (stille Last) for exponential smoothing purposes, according to the commercial legal code (HGB).

Since inception, NAEV has always kept the same hurdle rate. While it is relatively easy to generate during periods of high interest rates, low interest rate environments, such as the current one, make it difficult, particularly if the pension fund did not manage to put aside enough reserves beforehand.

“If the markets fail to produce adequate yields you cannot simply conjure up a 4% return,” says Lepelmeier. “That is why we try to optimise our risk-return relationship. But if we fail to generate the 4% target through the markets we have to use reserves built up in previous periods as a buffer. In its entire history of half a century, NAEV has never had to define them as undisclosed negative reserves [stille Lasten] and we have always been able to achieve the 4% hurdle rate.”

To absorb returns below 4% the pension fund usually has reserves built up to last for three years. That was still the case at the end of the financial crisis year 2008. However, a third of the reserves were spent in 2009.

In 2007, the pension fund strayed off its 4%-orientated path with a 7.27% return after excess positions. That was an extraordinary effect and part of the re-financing undertaken in the wake of the introduction of new mortality tables. NAEV was then able to meet its additional financial needs with €350m of internal reserves.

At NAEV, manager selection is undertaken with an independent third-party adviser, followed by long lists, short lists and on-site visits. The final decision is documented by the third party adviser.

The fund’s investments are based on an annual asset liability structure analysis, followed by an asset class plan and, finally, micro-control within the framework of a risk adjusted asset allocation model, implemented and exclusively used by NAEV working together with the University of Applied Sciences Osnabrück where Lepelemeier holds a professorship.

In other words, NAEV’s asset allocation is based on a threefold process: long-term optimisation, 10-year asset liability management (ALM) study with Monte Carlo simulations undertaken with Feri Institutional Advisors as a starting point, an internally calculated three-year forecast focused on the 4% hurdle rate as the second stage and, thirdly, an asset allocation strategy for each individual calendar or respective business year based on the previous two stages.

The NAEV’s official bodies need to agree to the first two stages of strategic asset allocation (SAA), while the tactical asset allocation (TAA) of the third phase is based on bandwidths of 4% and agreed by management. If these are crossed, however, permission needs to be sought from one of the official bodies, such as NAEV’s administrative board (Verwaltungsausschuss).

The asset allocation strategy for 2010 consists of 34-38% Schuldscheine (promissory notes), 24-28% bonds, 15-19% mortgages, 10-14% real estate, 2-6% equities, 2-6% alternatives and 0-2% liquidities.

Schuldschein investments and liquidity are managed internally and mortgages in collaboration with commercial banks, whereas bonds, equities and alternatives are managed by different advisers via German Spezialfonds.

NAEV’s real estate investments are divided between direct property investments in Germany - which are managed internally - and indirect, global investments via Luxembourg FCP investment vehicles or real estate Spezialfonds, which are managed with the help of qualified advisers.

The asset allocation of 2009 was almost identical to that of 2010 (see figure), with a mere 1% increase in the bandwidths of Schuldscheine and alternatives, and a 1% reduction in the bandwidths of both mortgages and bonds on the previous year.
The big shift occurred between 2008 and 2009. In 2008, equity exposure stood at 16-20%. Its decline to 2009 was not only driven by market forces but also by the efficient use of available risk capital, as equities were competing with other asset classes, such as hedge funds. NAEV did not return to the equity market in 2009 because it felt the risk-return ratio of hedge funds offered more in comparison with equities.

Real estate and alternatives exposure was cut from 12-16% to 11-15% and from 6-10% to 1-5% respectively between 2008 and 2009. The asset classes that benefited from the reduction were Schuldscheine and bonds.

Mortgages remained stable at 16-20%. “For us, mortgages are a long-term business because the refinancing contingents we offer to our partner have to be stable to serve them as a planning base,” says Lepelmeier. “Around half of our total assets are invested in Schuldscheine and mortgages, which we can always balance at 100, according to the nominal principle. In other words more than half of our asset allocation does not consume any of the risk budget. It is in fact being depleted by the other half of the asset allocation.”

The ratio of direct versus indirect real estate has not changed much over the last three years. Prior to that though, between 2000 and 2006, NAEV invested intensively in international indirect property.

Exposure to commodities is included in hedge funds and derivative structures via long-short commodities trading advisors (CTAs). “We used to be invested in long-only commodities but because of the contango-backwardation shift the market was very volatile,” says Lepelmeier. “In the end we came to the conclusion that while commodity markets still tend to be non homogeneous and show little transparency, they still represent a significant growth market and a source of alpha. Therefore, in terms of commodities, we do not bet on a pure long-only beta-driven structure but on a neutral long-short market with a hint of beta, which is the common strategy if you invest in them using hedge fund structures.”

“If it was legally possible we would probably expand our alternatives quota because alternatives absorbed at least part of the big losses experienced in other asset classes in the tough year of 2008,” says Lepelmeier. “However, hedge funds and other alternative investments only function well in the necessary accordance with a sophisticated risk management system. We do not think the supervisor’s maximum hedge fund limit of 5% is a problem because some of our own internal risk parameters are even tighter than the ones set by the supervisory authorities. However, German pension funds typically have less than 1% invested in hedge funds, while NAEV’s current 4% allocation to hedge funds and derivative structures comes close to the limit of 5%.”

NAEV’s equity allocation is split roughly between 50% Europe, 25% North America and 25% Asia including Japan. The split has remained stable over the last few years but Lepelmeier to admits being overweight Asia and underweight North America at present.

“A careful rebuilding of equities in our portfolio depends on the available risk capital and their direct competition with alternative asset classes,” he says. “All our Schuldscheine are issued by public issuers in Germany given that only around 15% of our bonds are sovereign bonds. The rest is made up of emerging market bonds (35%) and investment grade corporate bonds (50%). However, we are in the process of reducing our corporate bond exposure, which brought us very good returns, in order to realign it with the objectives of the ALM study in favour of a higher allocation to emerging markets, derivative structures or maybe even equities. Another objective for us is to further diversify our bond portfolio, for example through Danish mortgage bonds or inflation-linked bonds.

“At the moment we are dealing with inflation through our commodities investments,” continues Lepelmeier. “A challenge for us - particularly in view of the 4% hurdle rate - would be a prolonged low interest rate environment. If we, for example, only managed to generate 3.2% returns on 10-year sovereign bonds it would be incompatible with our system. You can cope with that type of return only for a certain time period. However, we expect more re-inflation over the coming two to three years.”

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