Laurus shows the way to LDI
Laurus pension fund has pioneered the use of liability-driven investment in its investment strategy. Dick Kamp, chief executive of the fund, tells David White how LDI has performed.
The combined pressures of international accounting standards and national pension regulations have made liability-driven investment (LDI) strategies, in theory, an attractive proposition for pension funds.
Yet the take-up of LDI strategies by Dutch pension funds has been slower than expected, possibly because of the last-minute easing of the Dutch national bank's regulatory requirements.
Pension funds that have moved to LDI strategies have tended to do so for reasons of their own. One such is Stichting Laurus Pensioenfonds, the fund of the Dutch food retailer Laurus. With about 4,500 active members, 15,000 deferred members and 1,600 pensioners, the fund manages some €430m in assets.
Laurus adopted an LDI strategy in March 2005. Dick Kamp, manager of pension affairs at Laurus Pension Fund, says there were two reasons for the move. "One was from a corporate perspective. With the coming of IAS 19, it was clear that volatility on the balance sheet of the corporate would increase on the pensions liabilities side, and one would want to reduce that as much as possible.
"The other perspective was that of the pension fund itself. We knew the new FTK was coming and that, in a market value environment, the volatility would affect coverage ratios.
"So we had no choice. We were compelled to act by the corporate because we were not a particularly rich pension fund and we did not have the means to ride out the volatility, and by the Dutch central bank because our coverage ratio was too low at that time.
"We had to find a strategy where we could limit the risk as much as possible while retaining the objective of achieving good returns. The LDI solution gives us the possibility to manage our risk budget well."
The move to an LDI strategy meant a switch away from two balanced mandates managed by ING and Robeco to a matching portfolio of fixed income managed by Pimco, accounting for 60% of the assets, and an active portfolio of global equities managed by Alliance Bernstein, accounting for 30% of the assets. The remaining 10% was allocated to alternatives.
"The matching portfolio has a tracking error of 3%, but it is actually nearer 1% so we're not really pursuing any alpha," says Kamp. "But we have given the equity manager a 7% tracking error so this gives them quite a bit of freedom to manage actively."
Today, Kamp says he is satisfied with the change of strategy. "We have just completed an ALM study to see if any further improvements could be made. We looked at all the possibilities of increasing or decreasing duration gaps or having more or less risky assets, but the outcome was that the current split between matching and risky assets is still very satisfactory."
Any changes are likely to be evolutionary rather than revolutionary, says Kamp. He is considering extending the active component of LDI with a portable alpha strategy. "We've got swaps for 70% of our liabilities. So we'll extend this from 70% to 100% and free up a bit of the risk budget," he says.
Under this arrangement, the 60% fixed income allocation would be reduced to 50%. The global equities allocation would remain at 30% and the allocation to alternatives would be increased from 10% to 20%. This increase would be financed by the reduced allocation to fixed income.
"The matching portfolio has had some quite difficult times so there is no real belief at this stage that you can really add a lot of value within this portfolio," Kamp explains. "So if we need some extra drivers for outperformance, we are probably not going to find them in the fixed income part. That's why we would look to extend the alternatives part of our investments.
"It would not really be a major step, more a tweaking of the risk budget. It seems to us to be a more efficient strategy and would deliver us an additional 6.5% excess
coverage ratio, which is quite a lot
A portable alpha strategy would free up an extra 10% allocation to alternatives. "The question then is how we will invest the extra 10%, and that's quite a challenge, certainly at this moment," says Kamp.
Currently, Laurus investment in alternatives is limited to indirect investments in international real estate and convertible bonds. The fund has an equity-linked 10-year bond issued by Rabobank.
Other, more exotic, alternatives have been ruled out for the moment. "We are very hesitant about diversifying into hedge funds, private equity, currency or commodities," he says.
"It would mean speculative thinking, and we're not really into speculative thinking."
There are also issues of governance, he says. "What you have to bear in mind is that we are a mid-sized Dutch pension fund with only limited means for governance. That means that if we make a choice in alternatives, we are there for the long run."
Finally, the current state of the market is unhelpful. "Probably a final decision on what the alternative assets should be will not be taken until the markets have calmed down a bit and we can see a clear direction ahead," he says. "So it could go either way. Either we move ahead and have the 10% in deposits, just to have the cash available, or we just wait."
At the same time as it switched to an LDI strategy, Laurus pension fund also changed structure, adding a top-up DC scheme to its average pay DB scheme. In line with the new pensions law, which removed the option to retire early, it raised the retirement age from 62 to 65.
This enabled a painless transition to the new hybrid structure, says Kamp. "It's very hard to put extra money into your pension scheme without being penalised as a member. But because we had to increase the average pension age from 62 to 65, we were able to use the premium that was freed up to make up, from a taxation point of view, a full pension scheme."
The DC component of the pension scheme uses the life-cycle approach. "Our philosophy is that DC is not something basically different from DB, except for the guarantee," says Kamp. "One way of looking at a DB scheme is a plan with liabilities where every member is 43 years old, while the DC part of the scheme we effectively see as six age groups with different risk profiles."
This is reflected in the asset allocation. In the oldest age group, employees aged between 60 and 64, there is a 80% allocation to fixed income investment. "The duration of that fixed income investment is around eight years, the same duration of the purchase price of a pension," Kamp explains. "The remaining 20% will be divided between equities and alternatives to provide just enough risk to provide inflation coverage."
Laurus, unusually, applies the same investment strategy to both the DB and DC elements of the pension scheme, says Kamp. "All members participate in the DC part of the plan and they invest in exactly the same assets as for the DB part. We use the same consolidated strategic asset mix for the DB as for the DC because we know how many members we have, how much money they have and how much premium will be put in. The result is a consolidated strategic asset mix which forms the basis of the mandates."
Kamp feels the hybrid DB/DC approach has clear advantages over the collective DC (CDC) approach that a number of Dutch pension funds are following. "We believe that the way we set up our pension scheme provides a more cost effective way of having pensions arranged from a corporate point of view than a CDC.
"In the CDC schemes we have seen so far, there is a lot of risk shifting to the participant, with sponsors paying extra premiums. With a hybrid scheme such as ours, there is a real balance of risk going to the participants but also of the rewards coming with it. And no extra premium is actually needed."
The results of the move into an LDI strategy have been reflected in member benefits, says Kamp. "We have been able to see a full profit share for the DB scheme. For three years in a row, we had to pass profit sharing, or indexation, as it was called at that time. Now, for the last three years, we have been able to fully index or profit share."