How We Run Our Money: KZVK-VKPB
It seems fitting that the KZVK and VKPB pension schemes, which provide pensions to employees of a number of German Protestant churches, have a propensity for rewarding entrepreneurship.
The two schemes are separate legal entities but are managed through a single fund and investment team, led by CIO Wolfram Gerdes. He says that what sets the KZVK and VKPB joint fund apart from its German peer group is a large and stable allocation to equity.
Gerdes oversees a total portfolio of around €10bn of assets and has a firm belief that equities will outperform in the long term.
Equity risk lies at the core of his investment belief structure, and that is why 25% of the fund is currently invested in the global equity markets. Gerdes stresses that this is going to be the case for the next decade at least.
He notes that such a high portion of equity risk is not often seen in a German pension fund’s portfolio. In fact, according to Mercer’s 2014 European Asset Allocation survey, German funds invest, on aggregate, 14% of their assets in domestic and non-domestic equity. The survey suggests instead that, last year, German funds increased their fixed-income exposure.
What are KZVK and VKPB?
From an asset management point of view, Kirchliche Zusatzversorgungskasse Rheinland-Westfalen (KZVK) and Gemeinsame Versorgungskasse für Pfarrer und Kirchenbeamte (VKPB) are managed as a single fund, despite being two separate schemes.
KZVK is the second-pillar pension fund for employees of the many undertakings owned by German churches, which manage organisations such as hospitals, care homes and kindergartens. KZVK insures around 500,000 people.
VKPB provides first-pillar pensions of church ministers of the Evangelical Church of Rhineland, the Evangelical Church of Westphalia and the Lutheran Church of Lippe. At the end of 2013, the book value of KZVK assets was €5.8bn, and the scheme had additional unfunded liabilities of €1.2bn. VKPB’s book-value assets totalled €2.1bn and the unfunded liabilities were €2.1bn.
Gerdes explains that the first step in building the strategic asset allocation is finding an appropriate structure to cover the liabilities. In order to cover the future pension payments, the board has set a target return of 4.25-4.5%.
But ultimately, what distinguishes the fund’s investment strategy is strong conviction, not only on equities.
Gerdes says: “Our strategic allocation is determined by our long-term view of the market. We estimate what our risk-return profile will be over a five-year period or longer.”
KZVK-VKPB at a glance
• Total AUM: €10bn
• Location: Dortmund, Germany
• Members: KZVK – circa 500,000; VKPB – circa 9,000 (as of end 2013)
• Average annual return, 5-year period 2009-2013: KZVK – 7.3%; VKPB – 7.4%
He believes that the fund’s ‘unique sales proposition’ is that it is able to retain a stable strategic asset allocation for a longer-than-average period. “The fact that the institution has been able to keep its strategic asset allocation stable even during the turmoil on the market has proved to be very beneficial.”
There are also objective reasons why the fund is allowed to stick to a given allocation and withstand the added risk that comes with it.
Gerdes acknowledges that the two schemes find themselves in a special situation, as they carry a relatively stable structure of liabilities with no risk of early redemptions, and are expected to be in a positive net-cash-flow position for the next 10 years at least.
This will make the job relatively easier. But it appears that the reasons for the tilt towards equities are the result of a more nuanced investment philosophy.
Before holding several senior positions in asset management, Gerdes earned a PhD in pure mathematics at the Massachusetts Institute of Technology (MIT) and spent a number of years as a professor in the US.
He considers whether being a pure mathematician helped him in his finance career and argues that, unlike mathematics, finance and economics are ‘heuristic disciplines’ rather than a science. “Trying to predict the markets is equivalent to trying to predict people’s behaviour,” he says.
And the question is whether science would ever be able to produce viable mathematical models of people’s behaviour. However, Gerdes concludes his argument with one undeniable fact – that if there were no equity risk premium, the economic world as we know it would cease to exist.
This implies that if you are willing to tolerate a higher-than-average degree of risk – defined as volatility – you will almost certainly be rewarded for holding equities.
KZVK and VKBP have endorsed the guidelines on ethical investment published by the EKD (Evangelische Kirche in Deutschland), the umbrella organisation of 20 Lutheran, Reformed and United Protestant regional and denominational churches in Germany.
CIO Wolfram Gerdes, responsible for both schemes’ assets, explains that the document does not constitute a “strict rule book” for investment. “It is rather a working document that describes the key values that should provide guidance to investors and define a common denominator of what ethical investment should mean.” Gerdes admits that in practice 100%-compliance with strict guidelines is difficult or impossible to realise, as judgments on ethics can be “highly subjective and controversial”. However, the document represents a proactive stance towards ethical investment, says Gerdes. This means the schemes engage in activist ownership to a certain extent, as well as selecting or barring investments on the basis of ethical principles. Gerdes adds that the scheme reports and limits violations of the principles and reconciles pure investment objectives with the effort to constantly improve portfolio compliance with respect to those principles.
Gerdes argues that, either because of regulatory pressure or a narrow definition of risk as volatility, equity investments are penalised, and that seems to be the case, especially in Germany.
“Typically the industry acts in a pro-cyclical way, often because of regulation. When you lose money, the risk budget gets smaller and, as a result, you sell risky assets at low prices. I think the key to a successful investment strategy is to maintain a strategic position that is derived from an understanding of the liabilities,” he says.
And in terms of pure cash flow-generating power, equities today seem much stronger than fixed income. Gerdes notes that today investors can earn higher yields from dividends than from fixed-income securities, which he says is a rare occurrence.
As a result, a diversified equity portfolio could generate a cumulative dividend yield that is higher than the yield generated by a fixed-income portfolio, even accounting for risk.
He adds: “If you are willing to hold on to equities for the long term, your cumulative dividend yield is almost certainly higher than the yield on the fixed-income market. Over a time period of 15 years, I think it is very unlikely to suffer from capital losses that eat up the benefit of the positive yield differential.” He believes that this principle applies even in the case of continuously slow economic growth.
But which equity markets look more attractive? Gerdes sees value in Europe, where a slower economic recovery is leaving many assets undervalued, and particularly emerging markets.
However, because the plan is to keep the asset allocation stable, he rules out shifting large chunks of assets towards those markets. At this stage, only “fresh money” coming from new pension premiums paid in may be allocated to those areas.
Nevertheless, the CIO believes in the long-term potential of the US market in particular. The record highs reached by the S&P500 recently and the outperformance of the index compared with Europe make US stocks look expensive, but Gerdes argues that there is a reason why the US equity markets should trade at a premium at any one time.
“I think investors around the world systematically underestimate the capability of the US to adapt to significant economic changes. There is a kind of ‘better quality’ there, in areas such as governance, which means the US adjusts faster than other economies to external shocks, and returns to growth earlier,” he says.
Aside from the 25% in equities, the rest of the portfolio is split between private equity, fixed income and real estate. A large portion of the assets, about 45%, is allocated to “relatively riskless” developed sovereign debt. The credit assets with a higher risk profile – which include corporate bonds, high-yield and emerging-market bonds – take up 20% of the allocation.
Almost 10% of the portfolio is invested directly in real estate. The fund has made a strategic decision to invest directly in domestic real estate assets, particularly in and around its home base in Dortmund, and that allows the fund to retain the management of the assets in-house.
This means, Gerdes says, that the organisation retains a large part of the value chain, making real estate a more profitable investment.
He admits that, as much as many investors would hope, it is difficult to find new opportunities in the German real estate market. Today the ‘prime’ markets are already saturated and prices are at historical highs.
However, there are many areas in the country to which the real estate ‘boom’ has not spread, and Dortmund is one of them, according to him.
That is a reason to believe that there is no German real estate ‘bubble’, says Gerdes. He says: “Actually, we see this as an opportunity to buy residential real estate in this area and manage it directly.” He adds that this strategy has provided a track record of 4% to 5% unleveraged return per annum on German real estate assets.
Therefore, while investing directly in real estate takes considerable time and effort, the fund should be expected to grow its real estate exposure gradually over the next few years.
Managing assets internally is another strategic principle that the CIO strongly believes in. He recounts of his effort to convince the board that in-sourcing, rather than outsourcing, is the way to go.
The KZVK-VKPB investment team is much larger than average, being made up of around 60 professionals, although that includes those who manage the real estate portfolio. A number of professionals also work on the fund’s mortgage business.
The research and trading in ‘core’ assets, including equity and fixed-income, is done internally. Gerdes says this is justified by the critical mass of the portfolio and argues that, unless there is a need to outsource parts of the asset management to specialised managers, there is a strong case for developing an internal team.
“I have convinced my board on numerous occasions that in-sourcing is the way to save and boost return, if you do it properly”, says Gerdes.
He sees a trend in professionals moving from the world of asset management to pension funds once they have reached a peak in their career around the age of 50. This trend simultaneously matches the pension funds’ need for talent and cost-cutting.
Running an almost entirely in-house investment operation means having to work intensely on risk. Gerdes says the fund runs its own model-based analyses and has developed internal rating models for fixed-income securities which, he adds, are more conservative than those of the main rating agencies.
Although volatility is used as the main definition of risk, he believes volatility does not represent the most important parameter.
Because the fund has set a relatively ambitious return target, it has to bear higher shortfall risk in the short term. Gerdes explains: “All the models show that if we are on track to meet our return expectations, we have to bear a significant shortfall risk in the short run.”
The key is not failing to meet your pension promise: “If we limited our short-term downside by taking a lot of the risk premium out, we would get a more benign path in the first years, but inevitably the gap between your expectations and your actual returns widens.”
This means sponsors must accept short-term volatility, which goes in hand with a large allocation to equity risk.
Underlying the words of the CIO is an essentially optimistic undertone, and his investment decisions support that. This is a reminder that optimism, as well as prudence, should be the foundation of any investment undertaking, even in the pension world.
“People think the world is in turmoil. But I do not think that today the world is a more dangerous place than before.” There have been substantially more worrying times over the past hundred years, Gerdes says, but the markets today respond to events much quicker and more sharply, most likely due to the dramatically increased amount of information available.
“People tend to look too much at the most recent incident to make decisions, whereas investors should firmly keep their long-term objectives in sight,” the CIO concludes.