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Let the investments do the driving...

Europe's pension schemes and the way they operate are evolving fast, especially as governments across Europe are introducing legislation to ensure sponsors and their schemes take a closer look at how well they match pensions assets to pensions liabilities.

Some take a much more fundamental approach than others. Certainly, Denmark's huge €49.9bn public sector fund, ATP, took the bull by the horns some years back and implemented far-reaching changes to its constitution that have given it an award-winning structure.

"Mark-to-market accounting and solvency-based supervision prompted us to rethink our business model in 2001," ATP explains. "The new business model we adopted reflects the inextricable links between ATP's objectives and its risk tolerance, its investment strategy, and its actual pension liabilities. Today, this interdependence permeates our investments which are liability-driven investments, our liabilities which, in the same vein, are ‘investment-driven liabilities' and our organisational structure where asset managers and actuaries work side by side."

OVERCOMING HURDLES

ATP says, to this end, it has recently implemented several important innovative changes in the areas of liability-driven investment (LDI) and investment-driven liabilities.

The foundation of ATP's approach consists of what it claims is a dynamic risk budget and the separation of investments in a liability hedge portfolio and a return-seeking investment portfolio. "In our view, LDI is basically about minimising uncompensated risks. Contrary to common belief, LDI enables you to take more compensated risk without increasing total risk," ATP argues.

In coming years, ATP says its main challenge will be generating high returns on a limited risk budget. Its recent efforts have therefore focused on the investment portfolio which consists of independently optimised alpha and beta portfolios. These are based on a set of key principles:

Absolute return targets instead of benchmarks.
"We would have little chance of achieving our return target consistently if we focused on tracking errors against benchmarks which bear little resemblance to our liabilities. Instead we set an absolute return target that is fully aligned with ATP's goal of maximising future real pensions," ATP says. Thus, ATP believes that when returns after funding exceed the cost of inflation and longevity, which is said to be in the region of DKK9bn in 2007, pensions can be increased. "DKK9bn is therefore our minimum return target."

Diversification that works when it's needed.

"We have drafted a new long-term allocation strategy that is based on five broad risk classes: equities; credit; government bonds; commodities; and inflation-protected assets," ATP begins. "To ensure true diversification, we have opted for a substantial contribution to the overall risk budget from each of these five classes." ATP believes this strategy means it can expect to run a portfolio that is robust in a broad range of environments, including those where equities may not be the best class to invest in.

This, it says, constitutes a major break with the traditional 60% equities/40% fixed income portfolio. Furthermore, it believes it has enhanced the level of diversification within the asset classes. "For example, we have increased our investments in unlisted assets significantly within equities and credit, and we have invested in oil." Within inflation-protected assets, ATP has confidence in substantial exposures to global index-linked bonds, real estate, and infrastructure, as well as now looking to add timber.

Poor implementation can ruin good allocations.
"Being unrestricted by benchmarks, we look for investment vehicles that provide the best risk/return characteristics in absolute terms," says ATP. This means that before implementing an investment idea, ATP must seek the best investment vehicle - a mandate, a total return swap, for example - that will best provide the best absolute return prospects for that idea. "This absolute return focus has had a profound change in our approach to external mandates."

Beta is not static.
"In our view, the immense variation in asset class risk premiums and volatility requires that you attempt to manage beta exposures dynamically in order to capture attractive risk premiums," ATP argues. The scheme says it therefore focuses particularly on contrarian and ‘first-mover' strategies that allow it to exploit fully the fact that it is not constrained by benchmarks.

Asymmetric returns keep you in the game.
"Large losses may reduce your risk budget and curtail your ability to generate high returns in the future," warns ATP. An example of this is when volatility has been low in recent times, ATP's strategy has allowed it to protect a more than substantial part of its equity portfolios against large losses. This proved very effective amid the market turbulence in the third quarter this year.

"Reducing downside risk with options is often dismissed by benchmark-driven investors as being too costly. We see it as a way of increasing your risk budget by making it available to more rewarding investments."  

ATP points out how its innovative approach has also been successful financially. Its funded ratio has increased significantly, from 107.7% at the beginning of 2003 to 128.6% in mid-2007.

NEW PENSION PRODUCT

ATP boasts that its ‘new' pension product is a prime example of investment-driven liabilities, a new concept reversing the concept of liability-driven investments, though complementing it perfectly.

"The product is simple," ATP says. "It retains minimum pensions guarantees while strengthening the security and assumptions for individuals. Incoming contributions are split 80/20 between a guaranteed contribution and a reserve contribution to provide for future indexation. Pension rights accrue at long market rates. Although no change is anticipated in ATP's investment strategy, our asset liability modelling indicates that future pensions could increase by 20%."

HIGHLIGHTS AND ACHIEVEMENTS

Why let the liabilities drive the investments when the investments can drive the liabilities? By asking itself this question, ATP has come up with an innovative structure that allows it to place the liabilities as the scheme's benchmark - as LDI and liability matching requires - without making any fundamental changes to its investment strategy or return objectives. Simply turning the LDI notion around, it has successfully implemented a liability matching solution that has seen it increase it funding ratio to a very healthy and envious position.

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