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Impact Investing

IPE special report May 2018


Pensions that follow the members

They haven’t stopped running at the Novartis pension fund in Basle since the merger of the two chemical companies Sandoz and Ciba Geigy in 1995. Not only was there the merger of the two funds into one, but a string of divestitures of non-core businesses has continued, as part of the restructuring of Novartis into a major life sciences force.
The process of divestment started with the spin-off of Ciba Speciality Chemicals in 1996 and is ongoing. Head of the pension fund Gino Pfister has overseen the changes, which have always impacted the fund significantly, as the group’s approach is that the pension arrangements follow the active members.
“Our philosophy is that the pension fund is always exclusively the pension fund of the company it serves. This means that it is not an open fund covering a number of funds for the group,” he says. “We believe the pension fund has to support the personnel strategy.”
The effect of this is that, where there are spin-offs, the people move with the company or division being disposed of and are no longer covered by their former plan.
This way of thinking permeates the group’s approach to pension provision in that it fits in with the needs of the company and its personnel, as well as being a key instrument in personnel policy. The aim is to provide benefits which are very comparable with the benefits of similar-sized companies, be they other chemical groups, the banks and insurance sectors. “While our benefits levels are definitely up to the average, we have very good early retirement conditions, allied with low contribution levels,” says Pfister.
At the formation of Novartis, Ciba had a “state-of- the-art” defined benefit (DB) plan that was adopted. “It was absolutely up-to-date, meeting all the legal requirements fully, and since then it has not basically been changed significantly.” One key development was to add a defined contribution (DC) plan to cover the variable proportion in remuneration packages, while the DB element looked after the fixed portion in pay packets, he says. This is in line with the company’s thinking that the larger portion of pay should perhaps come from the variable part dependant on the company’s results or the contribution of the individual. “This aspect is hard to cover through a DB plan and is better handled by a DC approach.”
While there are two plans, there is just one pool of assets backing both, Pfister points out. “In this way we like to be sure we can meet the needs of staff, who are attracted and stay because of the good benefits.”
The various restructurings and divestments has had a dramatic impact on the workforce. “Despite all the mergers and spin-offs, the pensioners remained with the fund and have not moved.” As a consequence, following the latest raft of divestitures, the fund will end up with some 9,250 active people, as against 19,300 retired people, he notes. “For Switzerland this is an unusually high proportion of pensioners.”
Under Swiss law, the pension fund is legally a separate entity from the employer and has to be fully funded. “The board of trustees has to have equal representation from the employee as from the employer side, but only from the active membership as the pensioners are not represented.” Generally, the representatives serve for three-year periods. Usually the people who look after salary negotiations on behalf of the employees are the representatives to the fund. “So the employee point of view is really represented at all the discussions when there are spin-offs,” he says. “Nowadays, those representing the workforce can be of a very high calibre. So they are very qualified to look after the pension fund and those of us running the fund on a day-to-day basis make determined efforts to keep them abreast of the issues.”
In addition to the rules for the administration and control, there are rules for the investment side, he points out. “The pension fund has a contract with the company, which manages the assets for the fund. This is an agreement on an arm’s-length basis and the same as an external third-party arrangement, except that it is cheaper – as they do not charge the fund for what they do!”
While there is an overall strategy set for asset allocation, this is reviewed annually with a budget being agreed, which sets out the limits for the year ahead. “This defines the deviations we want to have, whether we want to have a higher or lower share of equity, or say increase or decrease real estate.” So the fund has much narrower bands to operate within, compared with the overall strategic breakdown. “Once the trustees have approved the budget, it delegates the operation to people running the fund. It is the task of the fund management to watch that these limits are observed. An internal monthly report monitors this, with a quarterly report provided to the trustees. The board, for example, asked that the investments be reviewed from a sustainability viewpoint,” says Pfister. “The outcome is not a narrow-minded set of guidelines, but gives general guidance as to what types of investments are excluded, such as armaments manufacturers. We do not consider this to be a restriction, because we expect to invest in companies which are successful in the long-run and by definition these are companies that are well run.”

The actual investment committee is limited to the group’s CFO, the group treasurer, head of portfolio management Andre Ludin, as well as Pfister and the manager in charge of the fund’s back office. The group treasury runs not just the pension fund money, but also that of the corporation, which does provide synergies, says Pfister.
As at the end of 2000, before the agreed spin-offs, total assets came to Sfr19.5bn (e12.7bn), which will fall as a result of the transactions to around Sfr18bn.
The fund does not have a strategic asset allocation approach in the conventional way, explains Ludin. “We look at what we need.” So to meet the needs of pensioners in the fund, around 75% of the assets designated for their needs is invested in fixed income including money market funds and 25% in equities, while the active members have a mirror image of 75% equities and 25% fixed income, which includes real estate and mortgages.
For the reserve portion of the fund that is 50% equities, with balance in a mix of fixed income, property and mortgages. In fact, the overall total asset allocation works out at 50% in shares and 30% in fixed income, with 12% in real estate around 8% in mortgages and other areas. “But depending on the timing, we could have up to 10% liquidity, with, for example, equities reduced to 40%,” says Pfister. “But our preferred stance is to be invested.”
The fund has up to 60% in equities overall and foreign currency exposures limits have been increased from 30% to 50%. “We found assets of this magnitude could not be invested securely in Switzerland. Also, we have adopted a new rule recognising the euro as being equivalent to the Swiss francs for pension funds,” says Ludin.
Under the latest Swiss pension fund investment rules the old set limits can be ignored if the fund adopts a prudential approach to risk and to protection of the assets. But even before, the investment restrictions could be waived if, in an ‘expert’s view’, it was in order to do so, Pfister points out.
“Our view is that the fixed income provides a cash flow for the pension fund, but where it aims to have growth in assets this will be in equities.
“Our equity stock picking is very focused,” says Ludin. “We have four sectors we invest in. The selection criteria have been ‘value-adding against invested capital’. We have four families where the ratio has been excellent, in finance, information, health maintenance, including pharmaceutical stocks, and consumer goods.”
He continues: “In the first place, what we are looking for, is to have high return on invested capital, against weighted average cost of capital. We have the EVA value approach , that for us is the important tool.”
But at this stage, it could lead to including a range of other sectors, Ludin points out. “So these have to be judged against the costs.” Here the tool is the price/earnings ratio, in the context of the earning growth rates of the past five years, so we separate the earnings growth from the p/e ratio, to arrive at ‘PEG’, which has to be under 1.2 before we start to buy. But if it goes higher than 2.5, we sell.” Instead of selling, the fund may buy a put option or sell a call option.
At anyone time, the fund holds just 28 stocks, with only seven from each of the four sectors. “We started with this approach in 1990 and it has been very successful.”
“In addition, we have a small trading portfolio just to keep us in touch with the market and it gives us a feeling as to what is going on there.”
For reasons of liquidity and efficiency, the portfolio only operates in stocks trading in the US and European markets, but it compares its performance with the MSCI World Index. “So over the 10-year period to the end of the year, a return of 1,129, from a base of 100, this compares with an index rise to 308, from 100.”
For the period to end June 2000, compared with the Swiss professional asset managers running the pension investment foundations Anlage Stifftung, for world equities the figures over five years show significant out-performance by the Novartis fund. “We had 23% of performance in the last year on equities and long term our average has been 38% per annum.”
From a risk perspective, Ludin says simply “what’s the risk? For us the risk is only downside and we manage our risks on this basis.” As a former chemist, he explains it in terms of a container being used for chemical reactions: “What we want is a certain temperature within the container, so when it is low (that is, the market is cheap) we raise the temperature (we buy stocks), but when the heat is too high, we have to cool, that means we sell, either directly or via options.” This provides an insurance system, which has worked without problems, he claims. It is similar to production processes involving measurement and risk management techniques used in the production. “It really is much the same as an industrial processing.”
Ludin has worked extensively with Franz Winkler, who ran the PKE fund for the electricity sector on a similar basis until he recently set up his own firm Accuro in Zurich, where Ludin sits on the board.
This approach, which they have no intention of changing, will not work for all conditions, Ludin points out. While they missed the IT bubble, both upswing and downswing, the portfolio did well last year with pharmaceuticals and consumer sectors. “We have to take a rolling performance view over a three year period.”
One main big advantage is that with just a concentrated portfolio it is much easier to control the portfolio. “We do it all in-house, so our total equity portfolio for the fund and the company of Sfr12bn, we just have two of us looking after this.”
Novartis shares can be included once they measure up to the screening process. “It is just a normal stock as far as we are concerned.” There can be some currency hedging on the share portfolio from time to time, but this is in particular circumstances, such as when the dollar was very high to the Swiss franc.
“We are likely to do more on the currency side. As in the company, with much the same fixed income and bond exposure as the fund, we found that the currency now plays a more important role than the yield in the returns on the portfolio.” And as investors increasingly go outside their domestic markets for fixed income investing, currency is going to play a bigger part, he believes. On the corporate bond side, the problem is finding good quality rated bonds, say AA or above.
The euro had an impact on the equity portfolio as it reduced cost of Euroland-based companies, so the more the currency fell, the more the fund bought, while it sold dollar stock on the same basis. “But we are limited to these currencies as our stocks are limited to those currencies. We do nothing in sterling or other currencies.”
On the fixed income side it had been largely government bonds, but now it is a mixture of these and company issues. “We do not regard this portfolio as a trading one as the final goal is to have the cash flow for the pension fund – we’re not looking for capital gains.” But the shortage of government debt issues is posing Novartis a problem, as it is for others. “This portfolio more or less is an insurance and it depends on quality. The difficulty is to invest in Japanese bonds, for example, as it is purely a currency play.”

The fund has looked from time to time at asset backed structures, such as oil bonds. “We started with an oil bond at a $14 per barrel price, with the yield of the bond fixed to the oil price. At $12 a barrel we did another one! We sold both and not at the highest price, but it opened our eyes as to how to do things in the future.” The fund is now looking at the hedge fund field. “We are interested where we have no risk, other than the yield. So we are looking at these strategies, but we want to concentrate on one model, and gain experience. But we will only invest in areas we are familiar with.”
The whole team comprises just six people to handle the Sfr40bn assets, including a currency management specialist. They do the research on the individual shares themselves, as otherwise you cannot judge how expensive or not the company is, says Ludin. “We look at the reports of the banks and are amazed that there could be one portfolio manager dedicated to a Sfr150m portfolio. At that rate we would need 300 here!”
Mortgage business is restricted to people covered by the pension plan and only for their primary residence, says Pfister, who looks after this area. “This is a low risk area, with mortgages deducted from the pay cheque or pension and limit loans to 80% of the value of the property being mortgaged. We do not lose money here and see it as an alternative to bonds. Originally, people could get better terms than from the banks, but now we are strictly on bank terms.” It is a service to members, without being any more favourable and the fund makes the same return as a bank would on similar business. In the past six years, we have only lost Sfr80,000 on one house, on our portfolio of Sfr800m.”
The real estate portfolio is managed by a small team, with all services outsourced, says Pfister. “There is no pension fund money in property used by the company, though there is a considerable amount owned in the Basle area by the fund.” About 15 years ago diversification has been elsewhere. “Our aim is to securitise the portfolio, but this is a matter of finding the right partners.” But the advantages of having the portfolio in a more liquid form would be very helpful for spin-offs and it is simpler to handle securities and real estate, he maintains. Trustees are often wedded to the comfort of bricks and mortar and find it hard to accept the idea of securitisation in the area of property, which they accept when buying shares in a company.
He also points to the difficulties of running a portfolio where tenants can interfere or management gets involved with issues. “You need to make a barrier between those who invest and those who run the business, it is best for the business. As a shareholder, you don’t tell Cisco how to manage their business. If you don’t like it you sell the shares.” His ideal is to have a Sfr4bn–5bn portfolio securitised, as this would give sufficient liquidity. “You don’t want to be in the same position of having a portfolio you can’t sell replaced by shareholdings you can’s sell. So we are working to this objective and are optimistic this will happen eventually. What we have will be of interest to the marketplace.”
As to the future, Ludin says: “We don’t intend to make any changes on the portfolio management side. Why change a winning approach and team?”

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