Asset managers rise to challenges
One of the greatest challenges facing the Irish pensions market at present is the average funding level of Irish pension funds, which stands at around 70%. This came about largely due to high equity exposures at the time of the stock market turmoil and today restricts the room for manoeuvre which pension funds have in terms of their investment options.
The reason that the funding level is such a challenge is the funding standard. The funding standard was extended in 2003 following the recent stock market turmoil with the intention of protecting member benefits by ensuring that funds in deficit return to full funding and be in a position to pay out all accumulated benefits in full if the sponsoring company were to be wound up – probably the most costly standard that could be imposed.
Some argue that the funding standard is too severe. “The funding standard is a ridiculous, because it is a one year hurdle,” says Jennifer Richards, investment director at the Dublin office of Standard Life Investments. “It is putting a lot of pressure on pension funds because it is moving them towards a short term outlook rather than their own long term view.”
She adds: “The concern is that because the pension funds have not all got piles of cash they will be tempted to move to from defined benefit to defined contribution (DC).”
William Slattery, managing director at State Street in Dublin agrees about the problem for DB. “The transformation of DB schemes into hard promises and their highly regulated investment strategies is contributing to a flood out of defined benefit,” he notes. “This has very severe public policy consequences but there are also enormous consequences for the asset management industry. Ultimately DC will mean more employee choice; this will change the asset management approach which will then become more like retail management.”
Tom Geraghty, head of investment consulting at Mercer in Dublin stresses the importance of getting the balance right between meeting the funding standard requirements of protecting member benefits in the short term and meeting their obligations to provide for the long term benefits. “It’s like trying to train an athlete to be a world class sprinter and marathon runner at the same time,” he says. “The trustee role is becoming increasingly complex. In a world of potentially conflicting objectives trustees need to step back and decide whether their focus is short or long term. While trustees understand the solvency requirements based on the wind-up principle they are still typically viewing the pension plan as a long-term promise and still see the business as a going concern. So they are not necessarily materially adjusting their asset allocation to reflect these shorter term pressures - this is evidenced by a continued high equity allocation amongst the average Irish pension plan.”
Rory McIntyre, managing director at PI Investment Management shares the concern about investment strategy and performance: “Funds must adopt a prudent approach: if they take a very strict view and match with bonds they will be doing themselves out of returns from equities.”
Scepticism abounds. “Accountants have too much influence over the way the money is invested,” says Sean Hawkshaw, CEO of the Dublin office of KBC Asset Management. “It pushes a lot of funds to a less than appropriate investment strategy – for example by forcing them to buy bonds when yields are exceptionally low.”
So it seems to be incumbent on asset managers to look at the DC market. “It is currently very new and immature, but people need to give more thought to it,” says Gerry Keenan, CEO of Irish Life Investment Managers. “The long-term winners will have to offer open architecture. This is the only way a manager can assure a client that it can chose from the best available at all times so the client does not feel that he is always being sold to.”
But the shift to DC may be good news for Ireland’s active balanced managers. “For DC schemes product simplicity is important,” notes Keenan. “DC accounts for 15% of assets at present; in 10 years’ time this will be 50%. This will give long-term support for active balanced along with the current high use of consensus/passive funds.”
Overall the single active balanced manager still has a sizeable book of business. There are many smaller and mid sized pension funds in Ireland; assets of e100m or more would be considered large; indeed there is only a handful of schemes with assets of more than e1bn. Typically the smaller funds would not have the resources, time or governance structures to handle a portfolio of specialised managers. Furthermore, as Geraghty points out, “clients have done well from active balanced over the last number of years due to the favourable market conditions for equities which make up 70+% of the average Irish pension fund”.
But the move to specialised management continues. Hawkshaw notes: “Five years ago 75% of assets were in traditional active balanced structures – my guess is that it’s around 30% now.”
Peter Wood, director of institutional business for Ireland at Bank of Ireland Asset Management notes: “It is fair to say that international managers have made some headway this year, particularly in response to the demand for specialist mandates.”
But some Irish managers are responding to the move to specialisation, as Richards explains: “they are changing their business model to adapt to this changing environment and focusing on their specific areas of expertise or indeed developing new skills and products.”
So how much of an impact have foreign managers had on the market as they exploit the specialised management opportunity? Keenan believes the impact has been somewhat disappointing. “Over the last five years a number of foreign managers – notably Capital International and MFS – entered the market to offer global equities,” he notes. “But these managers have not matched clients’ expectations over the past couple of years. Capital International in particular have had underperformance problems recently. That is a big issue. If they had been successful, the flow of capital to foreign managers would have increased, but their lacklustre performance has shaken confidence in foreign managers.”
Ireland’s largest home-grown manager, Bank of Ireland Asset Management (BIAM), has had a tough year or so, after Perpetual Investment Management (PI) poached six of their most senior executives towards the end of 2004.
One senior local consultant believes that BIAM has lost its prominent position in the Irish market to such a point that it is unable to recover it, and that the strategy to replace the lost expertise has failed. Trustees are losing patience.
“The whole market seems to be moving away from balanced funds which historically have been a large part of BIAM’s Irish business,” says David Kingston, chairman of Dublin-based investment consultancy Acuvest. “So we would like to see them change and move towards more specialised management.”
BIAM has placed great emphasis on the value strategy. “BIAM have had a challenging year or two,” says Robert Richardson, chairman of the Irish Association of Investment Managers and CEO of Pioneer Investments’ Dublin operation. “Part of the problem has been their investment strategy. They stuck to their knitting and have just been through a period when the environment did not reward this strategy.”
“We stick to value – we are conservative and focus on the larger cap stocks,” says Wood. “Over the last two to three years small and mid cap have outperformed. But there is evidence that large cap is slowly returning to favour.”
Regarding BIAM’s personnel issues Richardson notes: “Perpetual offered considerably above the market. Finding the right skills is not easy and is much harder in a small market like Dublin than in a world market like London. My understanding is that BIAM is looking overseas as well as in Ireland but in our experience it takes three times as long to recruit from abroad to Ireland than it does to recruit locally.”
Wood notes that so far BIAM has succeeded in replacing five of the six senior staff that were poached by PI last year, and currently BIAM is seeking three further team members. It also appointed an agency last summer to search for a replacement for Chris Riley, BIAM’s CEO, who is due to retire in March 2007.
BIAM’s situation does not appear desperate. It is still the dominant manager in Ireland with a market share of just over 30%. “There have been North American client losses in the EAFE area but in Ireland there has been a net inflow of business in the past year,” Wood notes.
Some suggest that the consultants have favoured foreign managers. Indeed there is a feeling in the market that Mercer’s domination has generated a bias against local asset managers. But Mercer’s Geraghty has a simple response: “The proof of the pudding is in the eating,” he says. “We don’t take anything for granted and know that we face stiff competition as well.”
He explains that as more clients move away from active balanced mandates they have to consider Irish managers as part of a broader pool. “We are being accused of leading Irish pension assets abroad, but that is unfair. We wouldn’t be doing our job if we gave our clients an incomplete universe to chose from. At the end of the day our clients are intelligent people and base their choice on merit.
“If we are managing a selection process for an Irish active balanced mandate we would invite only Irish managers every time - we may include a foreign multimanager but only if it had a suitable product” Geraghty continues. “If we are managing a tender for a specialised mandate we will invite the local incumbent in the vast majority of cases. But often the local incumbent is not successful.”
Having said that, local managers have won or retained a fair share of business in 2005. “Between 75% and 80% of assets stayed with local managers over the last three years,” says Geraghty. “This figure has been slightly lower - 70-75% - in the last 12 months.”
Local managers have been forming alliances with foreign managers to enable them to specialise where their competitive strengths are greatest while continuing to offer the whole range of products. They started to specialise when it became clear that their pursuit of the practice previously common among Irish managers of trying to be all things to all people was not working.
Due to the popularity of passive management BIAM has an alliance with State Street Global Advisors for provision of passive product. “BIAM does not specialise in passive but our clients expect us to offer it so we teamed up with SSGA,” says Wood. “BIAM also plans to purchase 71.5% of Guggenheim to enable us to offer alternatives.”
Meanwhile Standard Life has been working with Wilshire to provide both passive management and multi-management. “In the new DC environment we have to offer the full range of products,” says Richards.
But Irish firms still face considerable challenges. Richardson notes: “They have a much smaller home market and now need to expand their reach efficiently; they need to have both an engine locally producing return efficiently as well as distribution and client service. Irish asset management firms will have to work harder and smarter because their home market is smaller.”
There is still significant exposure to equities among Irish pension funds. Keenan points out that the typical portfolio consists of 78% equities, 12% bonds, 7% property and 3% in cash. “Irish pension funds feel that they should invest more in bonds but don’t because they are waiting for bond yields to rise,” he says. “This is why equity weightings are high but will tend to drift down with time.”
He adds: “We would see them decline more quickly if interest rates were to rise. Most predict that 10-year bond yields will rise by 0.75% in the near future which will bring about a shift to bonds to 15-30 % of the portfolio. This will create a platform on which to match with fixed income and we shall see the first of that within 12-18 months.”
Part of the reason for the high allocation to equities among Irish pension funds is that the outlook for alternatives is not very promising for the time being. “Pension funds are not ready for alternatives because they are so preoccupied with solvency issues,” says Richards of Standard Life Investments; “pension fund size and resources are a problem here.”
There is also a strong feeling that Irish pension funds are over exposed to local equities. The average exposure amounts to some 18% which compares with the Irish stock market’s own share of less than 1% of world market capitalisation. The worry is one which pertains to many small markets, namely that of concentration; in Dublin’s the top five stocks represent 60% of the total market capitalisation. The popularity of Irish equities is because they have performed so well for so long.
Standard Life has 18% of its institutional assets invested in Irish equities. “Last year Ireland returned less than continental Europe but over the long term it has way out performed Europe,” Richards notes. “We analyse Irish equities in a broad European context. We believe that the outlook for European equities is very strong but we find a lot of very good value and well managed companies in Ireland.”
She adds: “in the European context Irish equities count as small to mid cap which provides the portfolio with added diversification.”
But Geraghty counters the claim: “The European small cap market is much more diversified than the Irish stock market and has performed every bit as well. People need to get their facts and arguments right.”
Another reason that is given for the popularity of local equities is that people understand Irish companies because they are local. Geraghty pours cold water on this argument. “An increasing proportion of the revenues earned by top Irish companies derives from abroad.”
The suggestion has been made that the desire to have a significant proportion of funds in Irish equities has protected Irish managers from foreign competition. “If you are going to have a reasonably large Irish equity content, there is a strong case for using an Irish manager,” says Kingston.
But Richards is sceptical: “Some 40% of Irish equities are held by non-Irish managers so this has not protected local managers at all.”
The average exposure to Irish equities of 18% is about half the peak level. “Many of local equities are well positioned at the moment so I wouldn’t be selling Irish to buy something overseas at the moment,” says Keenan. “But I don’t think the market will outperform Europe in the long term. We will see a gradual shift downwards in allocations to Irish equities to settle at around 10% by 2010.”
Disappointing performance by active managers has led to a growth in both passive and multi-management. Mercer Global Investors will be entering the market next year with a fund of funds product under Tom Murphy. “This is a very interesting development,” says Richards. “They will have to manage their conflicts very carefully. They will have to have Chinese walls.” Hawkshaw is sceptical: “Consultants have vested interests in that they are both an investment consultancy and offer investment products.”
Keenan does not share the scepticism. “We are not worried about a conflict of interest,” he says. “Some manager complaints about Mercer entering the investment manager market are unjustified. Everyone has conflicts of interest; the question is how you manage them. I think they will grow the multi-mamagement business which should have a larger shelf space than it does in Ireland at present.”
Geraghty stresses that Mercer Global Investors is a separate legal entity from Mercer Investment Consulting (MGI). “All the relevant Chinese walls are in place,” he says. “Furthermore, the multi-manager product is targeted at a different client segment than our traditional consulting services. The protocols between both organisations are pretty clear: if we are providing consultancy for a manager selection process we cannot put MGI forward to the client. If the client decides that they want the MGI multimanager product we have to remove ourselves from that exercise.”
Multi-manager products may have a wider appeal than some have led us to believe. “Some consultants have views that multi-management is only good for the smaller pension fund,” says Hawkshaw. “I don’t see the logic in this and can only conclude that they want the fees from higher value funds for themselves. Trustees who want to delegate the monitoring, hiring and firing of managers to a full time team of specialists can best achieve this through a mult-manager approach regardless of whether the fund is e2m or e250m.”
In 2003 European legislation introduced a new collective investment scheme structure in Ireland called a common contractual fund (CCF). However, a recent change in UK/US tax law exempts pension funds from withholding tax on dividends paid by US investments. It has been suggested that this removes the competitive advantage of the CCF for UK funds.
Slattery says that CCFs are still needed to provide cross-border tax transparency. “So when it comes to pooling assets there is still substantial interest in the CCF,” he says. “There could still be tens of billions of euro for the Irish CCF industry. At the moment it is still fairly small, somewhere between e1bn and e2bn. Next year we expect to have another e2bn from investment managers and multinationals.”
There are still hurdles to overcome. “A number of multinationals are looking at CCFs and the government is doing all it can to promote the idea, especially in the context of pan-European pensions” says Geraghty. “But there are still a lot of question marks. We’re there in the asset pooling side but not liabilities. We need a harmonised tax regime and legislative and accounting frameworks before we think seriously about moving forward with true pan-European pensions, and your guess is as good as mine as to when those will be in place. In short, we can’t put the cart before the horse.”
Ireland has been looking at the opportunity presented by the EU directive and the pan-European pension fund. Slattery notes: “the directive makes it quite unattractive to set up a pan-European pension fund, especially to redomicile one, because of the requirement that it be fully-funded. In fact this puts a sledgehammer on it. So it’s more suitable for new schemes starting from scratch. On the other hand we have a well developed pension industry here with the accountants, actuaries, lawyers, good proactive regulators, and strong asset-servicing industry so we are well placed to compete efficiently.”Richardson is upbeat about the opportunity for Ireland presented by the pan-European pension fund. “Along with the UK and Luxembourg, Ireland has both the necessary scale and expertise. The challenge is now to build an internationally recognised capability.”