Shaking off the peer group
One of the main distinguishing factors of Irish pension funds is that they have been and to a lesser extent today continue to be heavily invested in the domestic equity market. This is not so unusual in itself, of course, except that investing up to 30% of one’s portfolio in a market that represents less than 1% of the Eurozone index may be considered just a little risky, even when the market is generally outperforming its counterparts elsewhere in Europe.
When the downturn came many funds got their fingers burned and went into deficit. This forced an industrywide strategy rethink.
The first move came from the Pensions Board. Until July last year there was a requirement for each fund to provide an actuarial funding certificate every three and a half years to indicate its funding level. Last year, in reaction to the funding crisis, the Pensions Board introduced an annual funding certificate requirement.
The requirement states that if a fund is in deficit it must return to full funding within three and a half years. The test was that if the scheme were to be wound up would it have enough money to buy annuities for all its pensioners and pay transfer values for all its active and deferred members. The annuity rates and transfer values are related to bond yields.
Following protests by many schemes which claimed that they would not be able to afford the additional contributions, the Pensions Board amended the funding standard requirement to give funds 10 years to become fully funded; they would have to reach 85% within three and a half years.
This extension would only be granted if the funding deficit could be attributed exclusively to the market and not, say, to a contribution holiday. Following further protests the Pensions Board has agreed to consider extensions beyond 10 years.
Tom Geraghty, partner at consultants Mercer in Dublin notes that “with equities falling and interest rates at historic lows and annuity prices being very expensive it was the most aggressive funding requirement. However, by extending to 10 years they played the balancing act appropriately; they are probably playing it as prudently as they can”.
Nora Finn, chief executive of the Irish Association of Pension Funds (IAPF) argues that “if the profile of your scheme has a liability profile of 15 to 20 years but you have to work within a timeframe of three and a half or 10 years you are possibly creating problems for the people you are supposed to be looking after”.
Companies that haven’t got much to spend on pensions can satisfy the funding standard simply by having a higher allocation to equities which will allow them to assume a higher level of return and thus a contribution rate that they can afford. As Shane Wall at consultants Coyle Hamilton notes, “the funding standard is having a secondary effect on the strategy”.
One might think that a funding crisis would set in motion a mass exodus from defined benefit (DB) to defined contribution (DC). But this has not happened to the degree that it has in the UK. “We have a different kind of pay bargaining system over here that is more national based,” says Nora Finn at the IAPF. “If one was to start changing the benefits within the company it would probably cause quite a lot of union opposition.”
Geraghty at Mercer adds that “a lot of the good DB plans in an Irish context are sponsored by Irish indigenous domestic organisations who have long histories in the Irish economy, are financially very sound who will continue to be legitimate going concerns in the future. In addition there is a strong sense of cultural employee loyalty amongst many of these organisations.”
However, it is very rare to find new DB schemes coming on to the market. DC schemes now represent 50% of total occupational schemes, although 90% of assets are still with DB schemes.
As far as the funds’ trustees were concerned, the major rethink meant a greater focus on the manner in which pension moneys were invested. “There was a belief in the past among trustees that the investment managers would look after the assets,” says Finn at the IAPF. But the last few years have taught trustees that they need to keep an eye on the risk profile.”
Deborah Reidy of consultants Hewitt in Dublin notes that “there are a lot of ALM studies going on and a lot of extraordinary meetings being held to run certain exercises to make sure that the strategy is appropriate. This development has taken place over the last two to three years.”
Finn points out that schemes are nearing the end of the actuarial valuations that followed the problems of the past.
The problem was the peer-group mentality. “It is clear that some of the larger funds should have paid more attention to liabilities than to what everybody else was doing,” says Reidy. “There was a general acceptance of a very high equity weighting over and above what the liabilities pointed you towards; there was that comfort of safety in numbers. Strategies are now more based on fact.”
She adds: “Many segregated funds have their own liability-based benchmarks as a result of stock-specific risk and don’t have a peer group any more. The larger schemes have taken ownership.”
There is an increasing trend towards passive management. The fact that the market is doing well may be one reason, but there is another more important factor, as Wall of Coyle Hamilton explains: “active managers have not really performed,” he says. “We have two or three real active managers in the Irish market and they have done quite well, but people looking at the active management league table are wondering whether it is worth taking this kind of risk.”
The problem that Irish pension funds have is that many of them are small and cannot afford an ALM. Their size also means that many are still reluctant to bite the bullet and change managers unless there is a big issue with underperformance because of the cost.
Size also matters in a broader global context. Mercer’s Geraghty notes that “pension funds in Ireland have not gained the same level of critical assessment as some of their UK and US counterparts. Irish companies are typically small or mid cap in a global context meaning that they are not in the analyst’s eye as much as their larger counterparts elsewhere”.
The small size of the Irish stock market makes it a very risky place to be. Allocation stayed as high as 30% until the late 1990s and then fell off quite quickly with the introduction of the euro. Returns in Irish market over the last 10 to 15 years have far surpassed the returns in any other market.
The proportion of Irish equities now is still around 15% which is quite a large weighting when one considers that the Irish market represents less than 1% of the Euro-zone index. It is the peer group approach referred to earlier that is responsible for this. “When the Euro came in most consultants predicted that Irish equities would account for around 5% now,” says Reidy.
She adds: “The fact that one stock, Elan, can have such a severe impact opens eyes as to how much risk is associated with having 15% of the portfolio in Irish equities. There is a big movement to disinvest from the Irish economy. We are caught in the middle of an evolutionary process, but most managers feel it would be quite a brave decision to be the lone man to sell their Irish equities.”
A lot of the big funds were very conscious of the stock-specific risk and have moved to the Euro equity class which is now considered as domestic because of the currency. The asset allocation is broadly 50% Euro-zone and 50% global ex Europe in the larger fund-specific schemes.
Some of the public sector pension funds might be more conservative in terms of their asset allocations because of the public sector nature of their liabilities and the visibility associated with it.
On average funds experienced a negative return of 20% in 2001. But, as Finn at the IAPF explains, “they decided that they were not going to crystallise the losses that they made at that time and move out of equities into bonds felt that equities would go back up.”
In terms of bonds, no distinction is made between Irish and other Eurozone issuers on account of the common currency. We are also beginning to see managers put corporate bonds in their portfolios in response to client requests.
Domestic property has produced excellent returns over the past few years and allocations are forecast to grow in spite of the fact that some believe the market to have peaked.
There has been very little interest in alternative investments. “For hedge funds, currency overlay or tactical asset allocation there really is a scarcity of institutional friendly vehicles,” notes Geraghty.
He adds that the negative returns of the past few years makes schemes wary of these new instruments. “Unless trustees are completely comfortable as they are with equities and bonds there will be an innate reluctance to allocate to these alternatives. However, we do have clients who are critically looking at this asset class with the intention of making an allocation.”
The problems of the smaller schemes in this regard is compounded by the lack of resources at their disposal to devote to getting to grips with the benefits that alternatives can offer.
From a risk perspective it is perhaps curious that Irish schemes do not show more enthusiasm for alternatives. Wall notes that “many funds in Ireland have 4 or 5% invested in one company such as the Bank of Ireland, so putting 5% in hedge funds is not going to be a big deal.”
In terms of management there is much more competition in the market now, mainly as a result of more unitised vehicles run by non-Irish managers. “This has produced more choice, especially for smaller funds,” notes Reidy.
Fund of funds have been available in Ireland only over the last year. These mainly balanced funds; there are not many fund of funds for property or specialist sectoral investments such as alternatives.
The recent historical allocation mirrors Ireland’s demographics to a certain degree. The profile is very young compared with other European countries on account of the recent immigration and the number of new schemes set up by recently arrived multinationals. Wall of Coyle Hamilton notes that “Ireland is 10 to 15 years behind the rest of Europe in this respect.”
Traditionally small schemes bought annuities for their pensioners. Now, because there are more pensioners and the perception that annuity costs are very high, they prefer to pay the pension out of the fund rather than buying an annuity.
But, as Wall notes, “they’re not altering their investment position accordingly. It takes a bit of a push to get them to put more money into bonds to match that pensioner exposure. The complexity of not just having a managed fund but having a bond fund on the side for small schemes raises the kind of investment consulting issues that normally hit the large schemes, and the associated cost.”
Irish pension funds are now paying the price for a policy of “do as the next man does.” Deficits are forcing them to take more risk than experience would advise. It will be interesting to see how many db schemes will still be in existence in ten years time. Fingers crossed that the market performs.