The fund with an iron grip
The Hoechst Pensionskasse in Frankfurt is not only one of the oldest pension schemes in Germany, but it is also the most influential in shaping both the private and public sectors’ approach to pensions. “Ideas such as a widow’s pension at 60% of the member’s pension, having a qualifying period of five-years for benefits and co-contribution by employer and employee were all part of our rule books before they spread elsewhere,” says Joachim Schwind, managing director of the fund.
With some E5bn in assets, it ranks among the largest of the funded pension schemes in the country. In its 117 years of history it has passed through many turbulent periods. “But through this, a trust has built up between the Hoechst workforce and the PK that it will deliver the benefits in old age.” The number actively involved in the scheme comes to 55,000, with 42,000 retired members.
“Through the PK, we offer just one plan to provide a life-long promise to our beneficiaries - on a uni-sex basis,” Schwind says. “We aim to make it as easy as we can to understand and that too helps to keep the element of trust.”
A high proportion – some 60% – of the assets are managed on a self-invested basis, including doestic real estate and the mortgage loan portfolio. “We do as much as we can in-house because it is more cost effective,” says Andreas Hilka, board member of the PK and head of asset management. Fixed income assets that do not require very active management such as the Schuldscheine and Namensdarlehen, which make up 20% of the portfolio, are managed in-house.
While real estate, accounting for 10% of assets, can be very labour intensive to manage, but only the domestic portion is looked after in-house. “For the overseas part, we use an investment fund.” The cost gap between doing real estate in-house and externally is very significant in his view.
The mortgage loan side, making up some 8% of investments, is one in which Hoechst has a long tradition, so much so that now it uses its expertise to offer mortgages in the marketplace and not just for the workforce, through its web-site. “We treat it as a highly interesting investment providing returns that are higher than for straightforward bonds,” says Schwind. “If you manage this business properly, you have low capital risk. We deal at market rates, adjusting them on a weekly basis if necessary.” He is so positive about the class, that he would like to handle more of the business if he could.
There is no intention of bringing the 16% invested in equities in-house.
The asset allocation including that for the equity portion is a liability-driven process, explains Hilka. “So whatever our liabilities give us as the required return, this is broken down into different asset classes at a micro level and then into different regions, and we try to allocate on a risk return basis. Through risk return optimisation, we reach a required return where we have the highest probability on one hand and where the shortfall risk is at a minimum.”
The equity portfolio is broken down by regions and then by countries, with aim of diversifying the portfolio. “The aim is to generate alpha from multiple sources. But where we think markets are efficient we adopt a passive approach. So we look for differentiation by country, concentrating mainly on the EU. And on the fixed income side we divide between government and credit-based investments.”
The equity and fixed income assets are run through two Spezialfonds, the pure equity fund is divided into 10 different segments, one for each of the mandates, with a similar structure on fixed income side. “We aim to put the different pieces together with hopefully optimal results,” says Hilka.
Currently the equity portfolio is 80% in EU countries, 15% North America, predominantly the US, and the balance in Asia, mainly Japan, he says. “For the EU portfolio, we more or less GDP-weight our country distribution, so France, Germany and the UK, rank highest.” On the equity side, the fund is usually non-hedged from a currency viewpoint.
When it comes to fixed income, the hedge style can be different, with investments outside of the EMU. “About 10% of FI exposure is US-dollar based. And we look for more diversification in international credits and asset backed.” The portfolio will move to increase the international component, but he points out that there are overall regulatory limits applying to Pensionskassen ability to invest outside European Economic Area. “We have some room to expand this, but not a lot,” says Hilka.
“We are looking for the extra yield pick-up and the diversification, as in the US corporate bond market particularly, which is more diversified and liquid than others. The European market is catching up, though it still has some way to go.”
On the equity side, 65 to 70% of the portfolio is managed either passively or on an enhanced indexed basis. The fund likes the enhanced approach, with its controlled risk return characteristics, providing stable outperformance. “We find the managers have a consistent information ratio of 0.5 to 1%, that’s very attractive – much more attractive than most active managers.” The fund has been using the enhanced approach from as far back as 1998 and is pleased with the consistency of the results.
The remaining 30% is on an active basis, mainly within a tracking error of 2 to 4%. “However, we have a couple of mandates where we allow a 5% tracking error, but only with very strong controls.” Hilka adds the good results from the enhanced side gives pause for thought as to whether the fund should use active managers at all.
“When you track the record of active managers, you find they have not proved themselves in our experience. What we have seen with enhanced indexing is that the approach has been very reliable with the managers’ strict controls and this has become more an more important,” says Schwind.
“Our belief is that you cannot scale up performance really by adding more risk. The more risk you add, the more likely it is that you are underperperforming,” says Hilka. “Maybe, in the end, there is an ideal – a sweet spot – say a 2% tracking error which will offer you the best risk return characteristics. Any risk manager who has tried to add more performance by adding more risk has failed. We still believe in outperformance, but think there are different ways of achieving this. Currently, of the 70% of the equity portion of the portfolio that is indexed, just 20% is on a full replication basis. The indexed proportion, including the enhanced, is managed by three managers.”
While the bond portfolio invested in government debt is not purely passively managed, it is very risk controlled, says Hilka. “Usually our managers are within plus or minus one year bets around the benchmark duration, which is very risk controlled, so while it is not passive, it’s not really active either. Otherwise you should aim for higher duration bets there!”
On the credit side, the approach is quite different, as the PK hires explicitly active managers. “We want to avoid the major disasters, so we need active management there. But all mandates are very risk controlled, so we have limits on certain rating categories and industries. However, we need to avoid the big mistakes, which active management can do, as one catastrophe can damage your absolute returns.”
Schwind says: “The accounts show our very risk controlled approach, as we were not in those very risky markets that have been hit severely.”
On the risk control side, all the external managers and all the investments on a total composite level, are put through risk measures in terms of standard deviation and the other measures available each month, both on an individual and on a total account basis. Says Hilka: “We know from this whether we are within our risk limits. A certain ‘band-width’ has been defined, so that on an operational level we can see if we are still on track in terms of risk control and in terms of deviation from a given total return. As we do have a benchmark return for our total investments, we try to manage that and to measure against deviation, watching for our ‘traffic lights’ that warn us if we break the limits, on one or the other side.”
The fund has to produce an absolute return of the guaranteed 4% interest rate, Schwind points out. “We also have an absolute return target, obviously not for single managers or mandates, as we try to break down the required return into different strategies, mandates, regions and asset classes. Hopefully, the composition of all the elements will give us the required return with the maximum security.” He adds: “What we require from asset managers is the same as we require from ourselves.”
So each asset class has its expected return which is tracked on a monthly basis, points out Schwind, with liabilities assessed on a quarterly basis. The PK does this in-house regularly so they are not waiting on actuaries to do their work. “While the liabilities do not change much from quarter to quarter, they however tell what you need to know.” In the markets of the last three years, Hilka says that the models and simulations run by actuaries would not have encompassed these conditions. So how can a fund wait that long to know its actual position, he wonders.
“Ours is a very technically driven process. But this type of control and disciplined approach to investment management strategy is the only way to survive in these capital markets,” says Schwind. The fund has achieved its return each year, because it has to, he explains. The fund has also managed to maintain reserves through this difficult period. “What you have to remember, is that as a PK we are in effect an insurance company and have to meet our margins each year. So it is essential to know the liabilities clearly as well as the assets.”
He adds that previously people would point to their lack of equity in the portfolio, but now attitudes have changed to investment and long-term returns. “Absolute returns are what you need.” People became unrealistic about equities looking for ongoing returns from just one asset class. “Currently, you are better off with more risk control.”
The asset allocation is set yearly, but there can be tactical adjustments on a monthly basis.
Private equity would be a possible investment despite its lack of liquidity, but with the poor returns experienced in recent years, the PK was happy it had not become involved, says Hilka, though it examined the area. “But it does look more attractive today with reduced valuations and in technical terms it is not volatile. However, the premium you need for bearing the illiquidity is high and, in addition, it does not offer cash-flow returns that are predictable.” But a very small allocation for reasons of diversification might be on the cards, he acknowledges.
Hedge funds are also being examined, but there are doubts about the returns and the high costs under German law render them unattractive. Hilka adds: “There is the transparency issue and the illiquidity is even higher than in private equity. Then you are completely in the hands of a fund of funds manager or gate-keeper, so you have to rely on individuals, which is something we try to avoid when hiring external managers. We aim to hire teams – or themes – and not individuals. As long as hedge managers do not want to disclose their process, as long managers do as a matter of course, then we do not want to invest.” There is a limit on the amount of time that can be spent on these alternatives.
The Hoechst PK has a strong record of being innovative, having been the first of the pension funds to use a global custodian, when it broke the mould and hired Chase, in the mid 1990s, much to the consternation of the German banking industry. “We also realised the advantages of the master KAG system and were the first to go 100% into the concept, using just one equity and one fixed income Spezialfond, and moved all the assets to a single KAG, with the segmented sections for the different managers,” Schwind points out. The PK is always on the watch out for ways of improving and doing things better. “You cannot stay still.”