Ireland: On the road to diversity
The pummelling suffered by Irish pension funds in the recent financial crisis is encouraging them to review their investment risk strategies, writes Nina Röhrbein
The financial crisis hit pension funds in Ireland harder than those in any other country, with real returns after inflation amounting to a loss of -37.5%, according to the OECD's Pensions at a Glance 2009 figures. But with equity markets recovering from March 2009, what does the road now look like for asset allocation in Ireland?
Taking into account managed funds as well as segregated assets, overall average asset allocation in Ireland was 56.5% equities, 24.0% bonds, 6.7% property, 9.9% cash and 2.5% alternatives at the end of September 2009, according to Michael Butler, investment consultant employee benefits and investments at Willis Risk Services Ireland.
This compares with an overall asset allocation of 52.3% equities, 26.1% bonds, 10.9% cash, 8.4% property and 2.4% alternatives at the end of 2008 and an asset allocation of 66.3% equities, 18.5% bonds, 9.1% property, 3.8% cash and 2.3% alternatives at the end of 2007, according to the Irish Association of Pension Funds (IAPF).
The change in equity exposure over the past two years has been driven by fluctuating markets rather than through active strategic changes in asset allocation, believes Butler. But the general underlying trend has been a move away from equities, particularly in defined benefit (DB) schemes.
"Pension funds need to have a greater level of certainty about what their investment performance is going to be like, especially when working with a funding proposal, which is the case for many underfunded DB schemes," says Jerry Moriarty, director of policy at the IAPF. "On the defined contribution (DC) side the equity content has remained in the region of 60-70%. But even in those schemes, people have started to discuss the high equity content, particularly the one in default investment strategies."
With the financial markets collapse still fresh on their minds, Irish pension funds have begun to adopt de-risking strategies. "The Pensions Board in Ireland at present puts a lot of emphasis on making sure that pension schemes manage their assets relative to their liabilities and continually emphasises the need for this greater risk management, as does the IAPF," says Butler. "Matching assets with liabilities means reducing the equity content over time and increasing exposure to better matching asset classes such as bonds. Some pension schemes are considering the implementation of trigger levels. At each of these trigger points - for example, when their funding level increases to 80%, 90% or 100%, they reduce equities by a certain amount and increase the bond allocation. This still enables them to capture the recovery in equity markets."
Moriarty adds: "The dilemma with DB schemes is that when they are underfunded they almost need to have equities in order to return to a positive funding level - although many would argue that the high level of equities got them there in the first place. Obviously the desire of the sponsor is to go back to full funding with as little impact on their business as possible. The only other way to reach a positive funding level again is through a rise in contributions or a reduction in liabilities."
Back in 1998, Irish pension funds typically had about 25% of their portfolios invested in Irish equities, says Butler, but with the introduction of the euro in 1999 the main rationale for that fell away and funds could buy euro-zone equities without taking any foreign exchange risk. By the end of 2008, Irish equities made up only 5.1% of the total equities allocation, according to IAPF figures.
"The Irish market is a very small and concentrated market, with the top three stocks making up 50% of the Irish index," says Butler. "Pension funds wanted to reduce that exposure for risk reduction and diversification reasons."
But Irish schemes still do not have a large amount invested in emerging markets. "The typical equity mandate for an Irish pension scheme with a scheme-specific benchmark is based on the FTSE World index, the MSCI World index or a combination of the FTSE euro zone and FTSE World ex-euro zone index, none of which have a large exposure to emerging markets," explains Butler.
In that respect, the €989m Construction Workers Pension Scheme (CWPS) is an exception. "While the majority of its equities, around 70% of the portfolio, is in a passive or indexed fund, about 20% is invested in global active management and the remainder in emerging markets," says Patrick Ferguson, CEO at CWPS. "And because we do not want to get out of property, our biggest play is between equities and alternatives."
Irish pension fund trustees are indeed becoming a lot more aware of the benefits of investing in alternative asset classes, such as hedge funds, commodities, private equity, forestry, currency and absolute return funds. "Companies have seen a lot of volatility in their accounts and pension fund trustees in the funding level," explains Butler. "To address this without unduly reducing the expected return of the portfolio, more and more pension funds are looking at alternatives, which have a low correlation with traditional asset classes."
The foray into alternatives is again being led by the larger funds, although there has also been growth in ready-made diversified funds that are offered to DC members. "Rather than invest in only one alternative asset, what has become popular in Ireland over the last two years is to invest in a diversified alternative fund, which has exposure to all of those," says Butler.
Hedge funds might become the most important asset class in Ireland, subject to a fairer deal, according to Joseph O'Dea, senior investment consultant at Towers Watson. "Irish real estate has been a problem during the crisis but global real estate could be part of the diversity solution," he says. "Global real estate investment trusts (REITs), for example, have greater liquidity and diversification than the property that Irish funds typically have had in the past, but again there is a caveat there on governance. The same applies to commodities and private equity."
The CWPS increased its alternatives allocation - consisting of hedge funds, currency and commodities - steadily over the past few years. At present, it is near the maximum of its band allocation to alternatives but Ferguson does not exclude further small investments. "We made a tactical decision to go into corporate bonds in 2009 when the spread between government and corporate bonds was quite wide," he says. "However, when that yield gap started to close we stopped any additional investment, as it was no longer profitable. Of course, this tactical play is helped by the fact that the scheme is one of a few with a positive, 107%, funding level."
Tactical or dynamic asset allocation will become more important with the move towards a much greater management of benefit security, believes O'Dea. "The whole investment structure should allow trustees to make a decision to de-risk dynamically if things go in their favour," he says.
But tactical asset allocation is more talked about than implemented. "Ireland only has a small number of large schemes that would have the ability to become more tactical or dynamic," says Moriarty. "The vast number of small schemes would neither have the Budget, nor the time or expertise to do that."
The asset allocation of the CWPS has remained largely unchanged over the last two years. The main components of its entirely segregated portfolio are fixed income (40%), equities (33%), property (6%) and alternatives (20%), which have only fluctuated with market movements.
"We set our strategy about three years ago with a minimum and maximum allocation for various asset types," says Ferguson. "Because of the rally in 2009, equities moved above their maximum so we had to reduce our equity holding on a number of occasions and build up our alternatives instead. Therefore, at the moment we would not be changing our strategy - we would be changing the tactics within our strategy."
Pension schemes should continue to manage assets relative to scheme liabilities in 2010, says Brian Delaney, investment consultant at Hewitt. "Although many Irish pension schemes are in deficit today, opportunities will arise to reduce portfolio risk - for example, when assets recover or the present value of liabilities declines in response to rising interest rates," he says.
Apart from the move to LDI, other changes are taking place as well, such as a trend towards passive management. "There will be a split among pension funds, with many smaller and medium funds simply going passive with some use of packaged diversity solutions, while others, particularly larger schemes with enough governance, are likely to increase their allocation to alternatives," says O'Dea.
In 2004, about a quarter of Irish pension funds invested their assets passively. This figure increased to around 30% at the end of 2008, according to Butler, who blames disappointing performance by active investment management companies.
"A lot of investment managers have been expanding the amount of passive funds they offer to pension funds, by for example teaming up with other managers, such as Bank of Ireland Asset Management and State Street Global Advisors," he says.