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Ireland: Reduce, derisk

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Pension funds now hold a third of their assets in fixed income, and corporate bonds are set for a boost, writes Rachel Fixsen

The process of derisking has altered the balance of asset allocation at Irish pension funds, with a lightening in equities weightings allowing for heavier bond holdings.

Industry participants say the wave of new regulation currently hitting Ireland’s investment institutions will only continue this trend away from equities.

The regulatory landscape shifted last year, with the introduction of sovereign annuities, the reintroduction of the statutory funding standard and the extension of the deadline for defined benefit (DB) pension schemes to submit their funding proposals.

On top of this, the Pensions Board is currently weighing whether to extend the assets funds can hold as matching assets, so that they include corporate bonds.

The new regulations are inevitably going to mean a reduction in the risk assets held by pension funds – equity and property asset classes particularly – and an increase in bonds and cash, according to Graham Brooks, director at F&C Ireland.

Along with others, he says F&C Ireland is keen to increase pension funds’ ability to hold other asset classes that would make up the risk reserve. “Corporate bonds will only be part of the solution,” he says.

Most funds are already well advanced in changing their asset allocation. Although sovereign annuities have had very little take up so far, he says they will be seen as part of the overall package.

“The minister for social protection here is currently considering changing the priority order for those funds in wind up – and there is of a lot of interest to the industry,” says Brooks.
Brian Delaney, senior investment consultant at Aon Hewitt, says there has been a steady shift towards fixed income among Irish pension funds.

“This change, moving to a lower risk profile, has been pretty consistent across all European pension funds, but for Ireland it has probably been more marked.”

Risk appetite has changed significantly following the property and financial crises in Ireland in recent years, he says.

According to the 2011 survey from the Irish Association of Pension Funds, total pension fund assets have fallen to just over €72.3bn from a peak of €86.6bn in 2007.

Over the last two years, the average equity allocation has fallen to 52% from 54%, with the bond allocation moving up to 33% from 25%. Weights have changed as a knock-on effect of the economic crisis in 2008 and subsequent years, says Delaney. “It’s the decline in German government bond yields which has led trustees to make significant changes to asset allocation,” he says.

The drop in yields increased the present value of scheme liabilities, which in turn focused trustees more keenly on matching the duration of liabilities with that of assets, Delaney says.

Along with the reintroduction of the minimum funding standard, Irish pension funds will also be required to hold risk reserves from 2016. But with the majority of Irish pension schemes currently in deficit, the initial target is to build assets up to cover 100% of liabilities, says Delaney. Once they have achieved that, the next target will be to increase scheme assets to cover 115% of liabilities.

Funds will have to hold a risk reserve for risk assets, which will be defined as anything other than cash on deposit and euro sovereign bonds.

But following lobbying from the pensions industry, it is now widely anticipated that the Pensions Board will allow investment-grade credit and global sovereign bonds to be used as the reserve, as long as they are hedged to euros.

Joseph O’Dea, senior investment consultant at Watson Wyatt in Dublin, says this change is particularly necessary while there is instability regarding euro sovereign debt.

“At the moment you could hold Italian or Greek bonds and hold no risk reserve, but if you held US and Japanese government bonds, hedged to euro, you would have to hold a risk reserve,” he says. Ultimately, Irish pension funds would like to hold Irish government bonds, but in the meantime, he says, they prefer to diversify.

The introduction of sovereign annuities will also potentially affect the asset mix of some Irish pension funds.

In order to facilitate lower reserve requirements, trustees have to say they will buy sovereign annuities, and they must hold the relevant bonds for those annuities.

Theoretically, sovereign annuities are annuities backed by any sovereign bond, but O’Dea points out that for practical purposes, they would have to be backed by Irish bonds.

According to Alan Broxson, director of Irish Pensions Trust, the introduction of the risk reserve buffer means that in cases where schemes cannot cope with rising costs, benefit reductions under Section 50 will be more than they would otherwise.

Many trustees are trying to solve this problem by investing in assets equivalent to the pensioner liability in either the new Irish sovereign annuities or in the underlying Irish sovereign amortising bonds, Broxson says.

But there is still considerable debate about the use of these bonds. “Does the fact that the yield on these bonds is reducing mean that the risk of default is diminishing?” he asks.

There is also a question over whether the government minister responsible for pension policy will reduce the priority rights of pensioners, which – he says – may in itself make the bonds less attractive.

“So decisions to invest in these bonds are not lightly made and in the remaining six months to the deadline for submitting funding plans it will be interesting to see how things develop,” he says.

Pension funds are unlikely to hold Irish government bonds unless they want to avail themselves of the sovereign annuities, O’Dea says. Funds that do tend to be in a worse funding situation, or have covenant issues, he says.

And sovereign annuities are only suitable for certain pension funds. “One can imagine that the failure of the Irish state would have more impact on some funds than others,” he says.

Another effect of the new regulations is that certain investments, such as hedge funds and higher-yield funds, are more reserve-heavy because of the actuarial assumptions contained within them. “It’s reduced the attractiveness of some hedge funds and absolute return funds,” says O’Dea. “The tendency to diversify may be reduced.”

But for those funds that went into LDI, that trend will continue, albeit restricted to a certain extent by apparently unattractive low-risk matching assets, he says.

However, while these assets may be less attractive for defined benefit (DB) pension funds, defined contribution (DC) funds should be encouraged to use them, says Jennifer Richards, head of Ireland and joint head of Europe at Standard Life Investments.

While pension funds are working to derisk portfolios, they should be looking at options beyond equities and bonds. “Is moving further into bonds really de-risking?” she asks.

“There’s a much wider opportunity in bond markets now,” she says. “Country risk is greater than before, and you can make more money by being a good manager in these markets than five years ago when it was more homogenous.”

But regardless of the asset allocation changes the new regulatory environment may prompt, there is a bigger picture for DC schemes.

“Most defined benefit schemes in Ireland are too expensive for companies to have,” Delaney says. “Tightening the regulations at probably the most difficult time for DB schemes is probably going to accelerate the move into DC.”

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