How We Run Our Money - Prudent and dynamic
Miguel Branco, deputy director of Banco de Portugal pension fund, tells Carlo Svaluto Moreolo about his fund’s investment and risk strategy
With volatile markets and falling interest rates, the DB business across Europe has become increasingly fraught with difficulties. The search for liability-matching assets is as arduous as ever – particularly in Portugal, a country where DB assets was just shy of 90% of total pension assets in 2012, according to the OECD’s 2013 Pension Markets in Focus. Worries about Portugal’s financial stability, which led to an EU-IMF €78bn bailout in 2011 that shook the country’s bond market, made things even trickier for institutional investors.
Against this bleak picture, the pension fund for employees of Banco de Portugal the country’s central bank, has emerged as a winner. Banco de Portugal runs a DB pool for employees hired up to March 2009 and a smaller DC fund for those who were hired after that. As of the end of 2013, the funding level of the DB fund was 102.9%, a sign that its investment and risk management strategies have been successful.
Sociedade Gestora dos Fundos de Pensões do Banco de Portugal (SGFP Banco de Portugal) is the separate company set up to manage the central bank’s €1.35bn pension fund. This is a common arrangement in Portugal, where most companies, save a few large domestic or foreign multinational corporations, use an entirely separate entity to manage their retirement scheme.
Miguel Branco, deputy director of SGFP Banco de Portugal, highlights the “explicit asset-liability orientation” of the fund’s management. Concurrently, among Branco’s concerns are limiting solvency level losses by constraining market and credit risks, and maintaining an adequate liquidity level to meet post-employment benefit payments.
The asset-liability approach, Branco explains, has been implemented in two ways. The first is by using an actuarial valuation based on mark-to-market principles. SGFP Banco de Portugal has adopted a “truly indexed procedure” to determine the discount rate that is used to calculate the present value of liabilities. As such, the discount rate is derived directly from zero-coupon euro area high-credit-quality government bond rates, according to the term structure of liabilities.
“This procedure was extended to the inflation assumption, which has been derived directly from zero-coupon break-even inflation rates extracted from euro area inflation-linked government bonds, again according to the term structure of the liabilities,” says Branco. Regarding the actuarial assumption, he says they correspond to a “prudent interpretation of IAS19, in the sense that the resulting value of the DB liabilities corresponds to the value that has to be invested on the reporting date to ensure the future pension payments, assuming a minimum risk investment policy. Also, this approach allows a direct link between the fund’s investments and its liabilities, contributing to consolidate the asset-liability management of the fund.”
Furthermore, implementing an ALM approach has meant adopting “risk figures that are appropriate to the LDI investment context”.
Because the investment target of the DB fund is maximising the assets return relative to liabilities, “the investment policy is conditioned by the plan’s liability structure”.
As a result, Branco explains, the portfolio structure has been built around three main building blocks. First, the fund has secured a high proportion of fixed-income investment that match the term structure of its liabilities, since the plan’s population is significantly mature and therefore the pensions-in-payment component of the liabilities is large.
Second, the fund has attained significant exposure to inflation-linked bonds, as a way to mitigate balance-sheet inflation risk arising from the long-term price-level dependency of pensions.
Finally, in order to mitigate interest rate risk, the fund’s portfolio managers have looked for bonds with a typically higher duration compared with the duration of the liabilities.
As well as following such investment principles religiously, Branco says that in the past few years the DB fund has made important dynamic adjustments to the composition of the portfolio. Its exposure to derivatives has increased – bond futures are now being used to enhance the LDI framework – and the need to hedge a portion of portfolio’s currency risk has been satisfied through equity derivatives. Meanwhile, equity managers have expanded the geographical diversification of the portfolio and the real estate portfolio has been restructured as the fund has reduced exposure to this asset class.
Branco adds: “We admit the possibility of widening the investment spectrum in the near future but we must be totally convinced that the risk-management framework is prepared to such a change.” Today, he explains, the priority for the DB fund is keeping the liability valuation assumptions as up to date as possible since, from a financial perspective, there is little room for de-risking because “the investment policy is already very prudent”.
As the country’s banks were hit by the financial crisis, and concerns grew about the sustainability of employees’ pension funds, new employees in Portugal’s banking sector have been automatically enrolled in a national public scheme since 2009, rather than in industry-wide, private pension plans like their predecessors. At that time, Portuguese banks created DC plans to supplement their employees’ public benefits; since March 2009, new Banco de Portugal employees have been enrolled in the DC fund, which has an explicit goal to “maximise the real return on the assets under management and to limit the risk of a reduction in the participants’ purchasing power at the expected retirement date”. Branco says the original plan was to implement a lifecycle approach. However, this has been temporarily postponed because of the market turmoil and the low-interest-rate environment. “For young participants, who are the vast majority, there is a trade-off between market risk and credit risk, since the way to mitigate market and re-investment risk – which is to invest in long-term bonds – today implies exposure to credit risk and also to potentially high short-term losses,” explains Branco.
Therefore, DC fund participants can currently choose between two portfolios with different asset mixes, according to their risk profile – a default DC portfolio, with a maximum equity exposure of 30%, and an interest-rate-only DC portfolio.
But the plan to implement a lifecycle fund, consisting of three portfolios, is still alive. “The three portfolios will differ in terms of two main characteristics – the asset mix and the duration of the bond portfolio,” says Branco. He explains that the three DC portfolios will be combined to generate multiple age-appropriate investment profiles for participants. “The likelihood of early pension redemptions occurring according to the applicable rules – mainly in the case of death or disability – will be taken into account while establishing the relevant horizon for risk mitigation purposes.”
The design of the DC lifecycle fund includes a default procedure to annually adjust the investment profile of each participant to reflect the gradual approach of retirement. “As the changes in each individual investment portfolio will be frequent and small, the risk of financial loss arising from the timing of the trades will be very limited,” Branco believes.
How Banco de Portugal’s pensions work
Banco de Portugal’s €1.35bn DB pension fund is a closed fund for the employees of the Banco de Portugal admitted up to 2 March 2009. The fund finances the payments of retirement, disability, survivor and post-retirement health benefits assumed by the Banco de Portugal, as well as the post-retirement charges of contributions to the Social Health Assistance Service for Banking Sector Employees (SAMS). The payment of old age pensions is shared between the pension fund and the state’s social security system.
As of the end of last year, the DB fund had around 1,300 members who were still active employees and 2,400 retirees. The defined contribution pension fund is for employees hired after 2 March 2009, topping up the employees’ first-pillar pension. It was established through Banco de Portugal company-level agreements. Both Banco of Portugal and the employees must pay in 1.5% of the effective monthly wage. The DC fund has 400 active employees and currently manages €5.2m.
Still, since SGFP Banco de Portugal wishes to offer flexibility and enhance client service, the participants will be able to choose an investment profile different from the one recommended for their age.
To complement the emphasis on asset-liability matching and flexibility, SGFP Banco de Portugal has designed a sophisticated risk-management strategy.
Regarding financial risks, Branco says that the relevant measures and methodologies used for the calculation of risk and the applicable limits to asset allocation are part of each of the two funds’ investment policies. These are set out and approved by both the board of SGFP Banco de Portugal and of the sponsor – Banco de Portugal. Such rules are also subject to regular evaluation by internal auditing.
However, SGFP Banco de Portugal has adopted a separate, internal enterprise risk management (ERM) system that pursues “transparency in the internal disclosure of risk”. As is the case for performance evaluation, the risk evaluation, control and reporting functions are ensured by a dedicated business unit reporting directly to the board of the organisation, as a guarantee of independence.
“Under the ERM framework in place, the risk-control function works together with actuarial and compliance functions as a second line of defence against risk, developing risk-management methodologies and supervising the activity of the first line of defence, which is composed of the business units that deal directly with the different risks as a result of their activity,” Branco says. “The third line of defence is the internal auditing function, which tests the adequacy of the risk management policy in place.”
He adds that the function of the three lines of defence is to produce a comprehensive and accurate documentation of risks, based on the COSO Risk and Control Self-Assessment methodology for risk management and internal control. “In order to achieve this goal, it is essential to ensure a high degree of disclosure from the first line to the second. The adoption of a transparent culture regarding the subject of risk is a main concern of the company and was the subject of an enterprise-wide series of training sessions in the recent past.”
These efforts are reflected in the high degree of detail that the risk identification, quantification and mitigation procedures achieve.
To top this risk management structure off, the fund has created a risk-control committee, which oversees and co-ordinates the activity of the three risk-control functions. These teams, along with an IT-risk committee dedicated to IT-related and data protection risks, “have functioned as privileged forums for discussion of major operational risk topics”, concludes Branco.