‘Smart’ diversification aids quest for stable high returns
Danish pension fund ATP has carried off the award for best liability-driven investment because of the innovative way it has transformed its business, creating a consistent framework not only for LDI, but also for investment-driven liabilities.
The cornerstone of this approach is ATP’s belief that excellence in pension fund management requires a strong focus on the mutual dependency between three key pillars.
These are the scheme’s objectives and risk tolerance, its investments, and its pension policy.
ATP believes that the way in which it deals with one of those pillars - for instance, investments - should be consistent with the way in which the other two pillars are constructed.
This philosophy, which ATP has followed for several years, has led to moves such as the hedging of pension liabilities, started in 2001, and the introduction (in 2003) of a dynamic asset allocation rule. This rule defines maximum investment risk as a function of reserves and risk tolerance.
Furthermore, in autumn 2004, ATP brought together its asset managers, ALM analysts and actuaries under the same organisational leadership. And efforts are currently being made to optimise the pension fund’s liability structure, creating so-called investment-driven liabilities.
As a natural development of its previous work, ATP has carried out several major innovations over the past year to get to grips with the recent changes both in pensions and investment markets.
In terms of LDI, mark-to-market valuation and the increased focus on solvency imply that balance sheet risks have become clearly visible. Risk capacity has become a scarce commodity. However, required returns are rising - partly because of increasing longevity - and this would normally force pension funds to take more risk, not less. The challenge is therefore to generate high returns with a limited risk budget.
ATP has taken a three-pronged approach to this problem. First, it has split its investment activities into two parts: a hedge portfolio to minimise risk, and a return-seeking investment portfolio.
The purpose of the hedge portfolio is to secure the best possible hedge of ATP’s nominal liabilities with an interest-rate swap overlay. The hedge portfolio will not normally generate a surplus. Instead, the job of generating profits is delegated to the investment portfolio, which consists of a beta portfolio and a multi-strategy alpha portfolio, managed by separate teams with individual risk budgets.
Furthermore, traditional benchmarks have been scrapped. Instead, the results are measured against an absolute return target calculated in accordance with ATP’s objective of increasing pension liabilities with inflation.
The second step revolves around diversification. ATP says that, contrary to popular belief, most pension funds are not diversified. This is because equities are the only significant source of market risk, whereas other asset classes and active management (alpha) contribute very little.
To generate stable high returns, ATP believes that ‘smart’ diversification is necessary. This is done by designing a template for ATP’s beta portfolio, based on five risk classes, so that it does well in a variety of economic scenarios and tail risk events. As part of this, ATP has considerably strengthened the alternative asset segment of its portfolio. For instance, it has established an IT venture fund, set up infrastructure investment as a business unit and expanded its private equity business, including opening an office in New York.
ATP has also taken measures to increase the alpha portfolio’s contribution to investment returns, for example, adding a new London-based global macro team.
The third step in risk management has been to develop a version of economic capital to measure risk. This enables the fund to translate its risk tolerance into a risk budget measured in Danish kroner. The total risk taken by various units should not exceed the risk budget, which in turn should be smaller than the bonus reserves.
This approach is invaluable in controlling risk, and in allocating the risk budget to different uses.
In 2005 and the first half of 2006, ATP’s reserves grew significantly because of high beta returns and consistent alpha performance. This growth was still substantial, even considering that longevity added 3% to liabilities. The funding ratio is now 121.
It follows from ATP’s philosophy that strategies affecting its liabilities should be consistent with the fund’s investment strategy and risk tolerance. This is why it brought in its new bonus distribution rule last year.
The concept of investment-driven liabilities also embraces the pension product. There is now a global trend from collective DB schemes to individual DC schemes. This could lead to lower pensions in future because of higher costs. Furthermore, investment and mortality risks will be shifted from the scheme sponsor to the individual.
ATP is developing a new pension product that bucks this trend. This product will retain pension guarantees - based on market rates - and various insurance elements. For scheme members, this should mean secure and predictable pensions, as well as lower costs and higher returns, compared with DC schemes.
The new portfolio structure is reflected in ATP’s financial reporting system, by distinguishing between the investment and hedging results. This is more transparent than showing gross investment returns (which include hedge portfolio returns) as these often say little about how the fund has fared. This means that whatever success has been achieved in accomplishing the separate objectives is now clearly shown.
Highlights and achievements
Over the past 18 months, ATP has seen its reserves grow substantially, in spite of increasing longevity.
This is largely thanks to the methodical programme it has created for generating high returns with a limited risk budget. The three-stage programme involved splitting its investment activities into a risk-minimising hedge portfolio and a return-seeking investment portfolio. It established a policy of ‘smart’ diversification, and expanded its investment in alternative assets. The third innovation has been to create a risk budget based on a version of economic capital. All this is now highlighted in a reporting system which is more transparent than previously.
And ATP is also developing a pension product to incorporate some DB-type protection for members.