When Jean Frijns, the CIO of Europe’s largest pension scheme, the e146bn Heerlen-based ABP pension fund, speaks publicly it is generally a reported event.
Moreover, with market conditions as they are today, industry peers listen that much more carefully to see how Frijns believes ABP will steer its mammoth assets going forward.
And in his opening address to the seminar sessions ahead of the second annual IPE Awards in Amsterdam in November, Frijns did not disappoint – obliging a room full of pension industry peers not just to listen, but to think. The message was stark. Frijns warned pension funds that extreme market events were becoming more frequent, resulting in greater short-term volatility and a need for pension scheme long-term investment horizons to be stretched.
To begin with, Frijns flagged up some of the difficulties under which pension funds currently have to work – particularly regarding solvency requirements in different countries, which he noted had left schemes in a ‘distressed’ situation.
In the US and UK where pension funds are valued at fair market value, Frijns noted, schemes had suffered from both the sharp fall in equity markets and real interest rates: “They were not prepared for this. They always assumed that falling equity markets would be due to a rise in real interest rates and gilts, which would be a hedge between assets and liabilities.”
He made the comparison to the Dutch situation, where he explained that liabilities were linked to inflation and valued at a fixed 4% interest rate. “Dutch funds have also suffered from the market crash, but they additionally operate in a local environment with high wage inflation, whereas at the European level interest rates are rather low.
“In both cases you have a breakdown of the built in long-term hedges and this is one way to explain the distressed situation that pension funds are in.”
The second major issue the ABP chief broached he termed the ‘spill over’ from the company pension fund deficit into the valuation of the sponsoring company.
Citing the comment of a US analyst that: “any shortfall of pension plan assets contributed dollar for dollar to the market cap of the company”, Frijns suggested that this confirmed the “positive feedback” between pension fund surpluses and company valuations. “You know you have to fear positive feedbacks because they make things more volatile.”
Frijns added that this connection between pension funds and their sponsors was reinforcing the downward trend of equity markets.
These two scenarios together, according to Frijns, explained in part the current situation of financial markets and the frequent occurrence of ‘extreme’ events.
This he said meant that pension funds today were living in a world where short-term return distributions could be badly affected.
“These extreme events occur once every two or three years, instead of once every 20 years, which is the way we used to think. We can expect this trend to continue due to the integrated nature of global markets today.”
Frijns then moved on to consider the medium term investment potential. He argued that the next three years would remain uncertain in terms of economic growth, with Europe and Japan persisting with disappointing growth figures and the risk of further surprises to come.
On a positive note, however, he opined that if US companies consolidated over the next few years then a faster than expected recovery might not be unexpected.
For the long-term, Frijns said his basic assumption was that the global economic system was “long-term stable”, but that individual companies could not rely on stability, despite any economic resilience.
He explained that his assumption implied that long-term returns were either independent or negatively correlated and showed mean reversal. “If that is the case then we can use the old central limit theory that everyone learns early in their career. This says that the geometric return converges in probability with the mean return.
“If you have to have a mean return of 8%, whatever the short term is, the probability that if the long-term horizon is long enough then the shortfall with respect to that mean return decreases over time. In other words you will be able to reach the mean return. This is the good news.”
The bad news, he reminded the audience, was that there was no guarantee for short-term stability. “I think there is still a reason to believe in long-term stability, but with one caveat, that the long term gets longer. The long-term investment horizon for pension funds can no longer be five, but 10 to 15 years.”
Tying together his thoughts on the dilemmas faced by pension funds in an uncertain investment world, the ABP chief posited two possible investment scenarios going forward. The first, he labelled the ‘stress regime’. “This would have negative returns and be an environment where diversification doesn’t work anymore and even diversified portfolios suffer from increased volatility.”
The second, he called the ‘normal/historic’ regime. “This has low correlation, no extreme events, and diversified portfolios have low volatility.”
The response of ABP to such short-term uncertainty, he demonstrated, was to draw up four economic scenarios on a vertical and horizontal axis.
These, he explained, represented: ‘reflated capitalism’ – characterised by re-regulation, more prominent government roles and companies focusing on consolidation and deleveraging; ‘Good deflation’ – meaning the return of global growth, low inflation and an equity bounceback; ‘strangled growth’ – where the threat of war continued alongside a widening diversion between the US and Europe and stagnation in 2003; and ‘bad deflation’ – represented by ineffective monetary and fiscal policies, disinflation and stagnation.
“These four scenarios are used to span up the potential range of uncertainties, because the different assets we invest in behave differently under each scenario.”
Frijns then went on to explain that each scenario in theory prompted a different asset allocation approach. Good deflation suggested investment in equities, credits and commodities. Reflated capitalism was best approached through equities credits and real estate. Bad deflation required government bonds, cash and credits in the portfolio, while strangled growth meant exposure to commodities, government bonds and real estate.
However, his real message was that there was no one strategy that performed best under all four scenarios. “There are second best strategies though, such as a mixed allocation that doesn’t perform best in scenario one nor does it perform worst in scenario two.”
Such an allocation, he argued, would entail pension funds looking ‘between’ equities and bonds for attractive downside hedges. “You could lengthen duration in a deflationary environment, increase your dollar hedge, increase credits relative to equities. You can also buy insurance, but this will cost you a lot of money. We got some quotes for put options and they were roughly twice as expensive as two years ago.”
Pension funds, Frijns added, had to seek to increase the robustness of their long-term investment strategies and strengthen their capacity for risk absorption in stressful times.
This, he said, should involve exploring their capacities to diversify risk further: “We cannot be satisfied with the traditional asset mix. There is a need to expand the investment universe to look at more alternatives – hedge funds and private equity and to look at commodities, cat (catastrophe) bonds or index-linked bonds, for example.”
Frijns further advocated the use of more buy and hold strategies by pension funds and argued that they could also look at tactical opportunities in the buying and selling of volatility.
Another area where he believed pension funds needed to be more active was on corporate governance and sustainability issues for corporations: “If pension funds are active on this side then it will make their investment strategy more robust.”
The ABP investment head also took great pains to stress that the current market environment was not a time for passive investment strategies. “This is the time for active equity and credit selection. It really is worthwhile to be very selective in picking stocks or credits and most of all trying to avoid concentration risk. You have to ask how much exposure you have to individual companies between equities and credits.”
In these difficult times with pension funds fighting fires on all sides, Frijns concluded that it was time to look thoroughly at opening up the risk spectrum. “We have to find a strategy that is both ambitious in terms of expected pension result but also feasible in terms of pension contribution levels.
“My proposition is that this will require a rather aggressive asset mix and by implication we need to grow our risk base on the liability side. There is a need for new risk sharing arrangements between sponsors and participants of the fund.”