For Theo Jeurissen, investment manager of the e22bn Pensioenfonds Metaal en Techniek (the Dutch metalworking and mechanical engineering sector pension fund), the two newest issues are: how to deal with the rule changes requiring pension fund valuations to use market rates when valuing a portfolio rather than a fixed 4% return assumption; and how to deal with the gap between the length of time an asset will last and the longer period for the scheme’s liabilities to its members.
Jeurissen believes that going to fair value valuations, which is scheduled to start on 1 January 2006, would add a new level of volatility to the pension scheme. Although the fund’s average funding level to liabilities is 137%, under the fixed 4% rate the funding rate is 113%. But under the floating, or fair, rate the funding rate would improve to 120%, as the present interest rate levels are slightly more favourable than 4%.
But any change in interest rates would affect the funding rate under the fair valuation model. For the PMT scheme a 1% change in interest rates affects the fair value funding rate by 10%. Jeurissen says there was 42% probability that the scheme would fall below the 127% funding rate and 14% chance of falling below 105%, which is the minimum funding requirement that has to be restored within one year. These rates would be restored with 15 years with 100% probability but only 48% likelihood within one year, he adds. In his view the minimum funding requirements were too strict.
And for the PMT scheme if the funding rate went below 115% then the scheme is not obliged to pay full indexation benefits to its members and could potentially lead to higher premiums. The PMT premium levy of 15% is split between employers and workers.
Jeurissen says: “The key is to smooth the volatility of premiums. People cannot handle large changes. The regulator has finally accepted that, so smoothing premiums is possible, but it is not yet clear how to do this. This is a challenge for the actuaries.”
The second major change is the current focus on the duration gap between liabilities and assets. The fall in interest rates, reflecting the fall in inflation, during the 1990s meant increasing bond values, but had no impact on liabilities. This will change under fair value. Jeurissen says this area was a focus of concern at the PMT scheme.
He adds: “How do you cope? Investment banks say the use of derivatives is the perfect answer. But it is not perfect in all circumstances. Derivatives help to reduce the duration gap and volatility. But by reducing volatility you reduce flexibility and if the interest rates increase nominal derivatives take no account of indexation promises. We are trying to strike a balance.”
But before such modern challenges, Jerissen says as long as four or five years ago the main investment task was how to diversify broadly. “We were one of the earliest Dutch pension funds investing into emerging market debt, commodities and private equity.”
The PMT scheme has more than 100 people in its investment department managing the money internally or monitoring the external fund managers. Of the e22bn in the scheme 60% is managed internally, mainly in fixed income, and the rest by external fund managers, usually in specialist areas.
“The classical dilemma is to decide what is managed internally and what is outsourced. We use an external consultant to help decide our competitive advantage but the general viewpoint is that as Europe is our home market we should have the skill to deliver there unless it can be proved external managers are better, but vice versa in the overseas markets.
“We decide our strategic asset mix using asset liability studies. We carry out the studies internally so that we can consider all the details needed for the model and to better understand what the model tells us but do use additional external consultants.”
The PMT scheme’s asset mix is broadly 40% in fixed income; 33% in equities; 12% in direct and indirect real estate; and 10% in alternatives, such as hedge funds, private equity and commodities. Over the past five to 10 years the alternative weighting has been increased by about a percentage point a year.
In hedge funds the PMT scheme initially used a fund of funds structure to get access to those types that offer the most diversification to its existing assets. Now it allocates to individual managers in four styles that achieve the required asset diversification: macro, long/short, fixed income arbitrage and commodity trading advisory.
But as to recent concerns that hedge fund returns could fall, Jeurissen says that “more managers means some opportunities will shrink – so we target a modest performance return of 7% – and it takes more time and effort to find the good managers”.
But even with the bear equity market since 2001 there has not been much of a shift from equities to fixed income, he adds. The main reason, he says, was due to the scheme’s relative youth. Even though it has been going for about 50 years there are still a large number of firms joining the sector, particularly in mechanical engineering. Jeurissen says: “As a younger fund we can be more confident of our capacity to restore our funding ratio in not too long a period if there have been negative results for a few years, as there was in 2001 and 2002.”
The scheme’s nominal target return – that is before inflation is compensated for – is 7% to 7.5% a year, and this “relatively modest” target has not changed even through the 1990s bull market. Jeurissen says that over 10 years this target has been hit, with negative years, such as the 4.1% and 4.5% falls in 2001 and 2002, compensated for by the 3.6% and 12.3% rises in 2000 and 2003.
The relative stability had come from being widely diversified and more recently from becoming fully hedged on its dollar exposure and moving down the credit curve. He emphasises that strategic allocation rather than tactical bets were the driver of returns. “We do not aim to achieve our performance in a major way by placing bets on global tactical asset allocation or in active equities. We are pragmatic; are we able to perform better than the markets in efficient allocation of capital? Our tracking error is 1% to 2% and we monitor these decisions carefully as 1% is still a lot of money!”
And as the job of managing investment risk gets more complicated the difficulty on focusing on where the scheme will get its returns becomes harder.
This article is based on an address to a recent conference on liability-driven investment