Pension in Ireland: Route change
The latest investment survey compiled by the Irish Association of Pension Funds (IAPF), published last June, shows that the value of Irish pension assets reached €91.5bn by the end of 2013, growing almost 14% year-on-year.
The figure is well above the previous high of €87.7bn recorded in 2006. Since the end of 2008, when assets had plummeted to €63.5bn, Irish pension funds have grown by 44%.
The growth during 2013, notes the IAPF, was due to bullish equity markets. According to the survey, there was little change in the overall asset allocation of Irish pension funds throughout the year.
However, the Pensions Authority, wants to see significant changes in the level of allocation to equities in DB funds. The IAPF survey shows that DB funds had 47.5% of their portfolios invested in equities and 36.7% allocated to bonds at the end of 2013 (see figure 1).
Another leading survey by Mercer, the 2014 European Asset Allocation survey, shows a high level of investment in equities on the part of Irish funds. Mercer reports that at the beginning of last year 44% of Irish pension funds assets were invested in domestic and non-domestic equities. Funds allocated 45% to bonds, 6% to alternatives, 4% was held in cash and 1% was invested in real estate.
There is mounting pressure to adopt a more systematic liability matching approach, which has prompted trustees to gradually move away from risky assets.
The Pensions Authority sees the current aggregate level of equity allocation as too high. In March 2014, Brendan Kennedy, CEO of the Pensions Authority, says the regulator is concerned about the “great deal of equity risk” on funds’ balance sheets, which appears to be “out of sync” with liability structures. Kennedy thinks trustees do not see matching as appropriate.
At a Glance
• Overall asset allocation has not changed significantly in the past few years.
• However, DB funds seem to be embracing more systematic liability matching.
• The switch from active to passive may slow down as funds look for diversifying assets.
• DC funds have moved assets into cash as they re-think default investment strategies.
Kennedy reiterates that the regulator believes the level of liability matching of Irish DB schemes is too low, adding that the progress seen in recent years has been “disappointing”, and expresses concern about the investment risk caused by the mismatch.
However, evidence shows that Irish DB funds are accelerating their de-risking plans, albeit slowly. At the same time, both DB and DC funds appear to be committing to diversification.
Drilling down into the IAPF survey shows that in 2009 the balance between equity and bond assets for Irish DB funds was 64.3% versus 24.9%. Although the aggregate equity allocation is high compared to other countries, that balance has shifted recently towards bonds.
A slow but sure shift Paul Kenny, DB investment consultant at Mercer in Dublin, believes the fixed income allocation of Irish DB schemes will remain unchanged throughout 2015, but the allocation to equities may come down by a few percentage points, as DB funds move towards alternative asset classes. “The trend out of equities is going to persist, but allocations will trend down closer to 30% over the very long-term,” he says.
During 2013 in particular, Irish DB funds increased the overall duration of their bond portfolios. They allocated 68% of their bond assets to issuance with a maturity of over 10 years, up from 58% in 2012.
Yet the poor outlook for the bond markets, with high valuations and low yields, means Irish DB funds are finding it difficult to engage in liability matching.
Joseph O’Dea, head of investment at Towers Watson in Ireland, argues that until yields on core euro-zone sovereign bonds rise, Irish DB funds will prefer other assets.
He says funds de-risking from equities are shunning low-risk bonds, and instead gravitating towards euro-hedged global credit strategies and absolute return bond strategies.
“DB funds with recovery plans that stretch five years and beyond might anticipate holding high quality matching bonds by the end of the period, but would only switch to them if yields rose to higher levels,” O’Dea comments. “In the interim, they would choose other diversifying assets or bonds that are not pure LDI.”
O’Dea says these dynamics may lead to further de-risking within equities and bespoke allocations to diversifying strategies, including greater use of diversified growth funds.
During the most recent two years observed by the IAPF survey, DB funds have started abandoning peer-group benchmarks and adopted scheme-specific benchmarks. At the end of 2013, 85.3% of DB funds used a bespoke benchmark compared to less than 60% in 2009.
This, coupled with a preference for passive strategies, supports the hypothesis that Irish DB funds are becoming sensitive to the need for diversification and liability matching.
Since the aftermath of the global financial crisis, Irish DB funds have continued to shift assets from active to passive management. At the end of 2010, the proportion of passively managed assets was 40.2% and that figure has increased to 58.2% now (see figure 2).
The trend, says O’Dea, was firmly in place before the financial crisis but has accelerated in subsequent years as trustees have reviewed their portfolios more closely and regularly.
Passive and smart
Kenny believes a significant portion of the assets that have shifted to fixed income are managed through passive strategies. Given that the portion of fixed income in portfolios is unlikely to increase, he argues, the trend from active to passive could slow.
“You might have schemes that have active equity managers moving away from equities to passive bond strategies,” Kenny says. “If funds increase their allocations to alternative assets, which is more naturally an active space, there may even be a reversal of the trend, with more assets being managed through active strategies.”
But O’Dea observes that, where DB funds have shifted to passive fixed income strategies, they have made use of smart beta-type strategies to manage the risk of exposure to the most vulnerable countries, especially in the euro-zone.
“While the trend towards passive management is certainly one that our clients have followed with our encouragement”, says O’Dea, “it’s not universal and one needs to be careful in applying it to any part of the portfolio.”
For 2015, Kenny sees three alternative strategies substituting the equity allocations of DB funds. These are multi-asset strategies, such as diversified growth funds, long-term illiquid real assets, such as infrastructure and real estate, and multi-asset credit strategies.
O’Dea predicts interest for “diversifying betas” such as listed infrastructure and real estate, particularly if funds that benefited from the rally in peripheral euro-zone bonds seek to take the gains. He predicts more use of smart beta, “both in mainstream asset classes, but also in non-mainstream ones that are not correlated to equities, such as hedge fund-type strategies”.
He believes the complexity that these investment choices bring will lead to “development and progress in the trend to use fiduciary management” by Irish DB funds.
Grappling with DC
In DC funds’ portfolios, the only asset class that has gained ground is cash. According to the IAPF survey, the aggregate allocation to cash was 12.5% at the end of 2009 and has now risen to 17.3% (see figure 3).
The equity allocations of DC funds have been stable at around 53% for the past three years while bond allocations have reduced from 25.2% in 2011 to 21.1.% now.
Jerry Moriarty, CEO of the IAPF, notes that the increasing portion of cash may be due to many schemes having lifestyle strategies in place.
“But, the main reason would be that investors, who were spooked by the market falls in 2009 switched most of the new money into cash and do not appear to have moved back. This shows limited understanding of the market by some individual investors”, adds Moriarty.
The switch from active to passive has been less marked in the DC sector. At the end of 2009 Irish DC assets were 27.9% passive and that has only increased to 32.6% by 2013.
Grainne Newman, DC investment consultant at Mercer, says that while DC schemes still favour active management, that could be offset by other market trends. “If funds increase diversification you might see more passive management for single asset classes,” she says. “And in the Irish market we have more products that are pseudo-passive.”
At the same time, she argues, the gradual re-thinking of default investment strategies by trustees may generate more appetite for diversification and thus keep active strategies popular.
Trustees of DC funds are currently grappling with the best way to construct a default investment strategy, Newman says, in response to the intense debate on DC regulation.
“Decisions are becoming more complex,” concludes Newman. “I think the idea is that you would have as much investment sophistication as you’d like, but you have to have a very simple interface with members, because that’s in their best interest.”