Three-pronged approach brings flexibility and focus
Danish pension fund ATP has won this year’s country award for its excellence in four main areas: investments, pension policy and liability side issues, overall objectives and risk tolerance, and dealing with the interdependence between these three areas.
The fund believes that what distinguishes it from other pension funds is its focus on the relationship between investments, pension policy and overall objectives. It says that although the industry rightly puts much effort into achieving excellence in these three separate areas, particularly investments, far too often the issue of interdependence is neglected. For example, there are many cases where investment policies have been set with little regard for a fund’s liability structure.
Since the beginning of the new millennium, ATP and other pension funds have seen a rapid rise in their liabilities because of falling interest rates (assets as well as liabilities are marked to market in Denmark) and increasing life expectancy. In addition, investment returns have been volatile.
In the light of this, ATP has over recent years put into place far-reaching measures guided by the above principles.
This has been possible because of the fund’s strong focus on ALM, especially in setting up an in-house model a few years ago. The most important decision, taken in 2001, was to hedge the interest rate risk on ATP’s liabilities. Another important decision, in 2003, was to implement a dynamic asset allocation rule. This rule links investment risk directly to the reserves and the risk tolerance set by the fund’s board.
Over the past year, however, ATP has started other important new projects arising out of its new paradigm for pension fund management.
In the sphere of liability-driven investments, it has set up a process to pursue alpha, beta and liability hedging independently.
The traditional investment approach focuses on generating high returns compared with specific market benchmarks. However, to cope better with the issues facing all pension funds, ATP has opted instead to put more emphasis on liabilities and absolute risk/return, and place less emphasis on market benchmarks and relative risk/return.
The starting point is for ATP to underpin its commitments to its clients by a risk-minimising portfolio which hedges liabilities as far as possible. But to generate a higher return it is necessary to accept some investment risk. Additional returns come from ‘beta’ (the excess return of asset classes over the risk-free return), and ‘alpha’ (the value from investment skill). The risk budget allocated to alpha and beta will depend on the level of the fund’s reserves, and its objectives and risk tolerance.
The three types of portfolio – alpha, beta and risk minimising – are independent, and will be managed independently by separate teams. Traditionally, the asset class decision (beta) is made first. Next comes the decision as to whether or not to attempt alpha generation from the asset class. This ‘beta trumps alpha’ approach is not a part of ATP’s new approach.
In contrast, the new approach is more flexible. The fund has also found it to be more focused, and to foster better risk management and accountability, than the process which it previously used.
ATP’s other main project is to set up a new profit distribution strategy in relation to investment-driven liabilities.
The fund’s approach now is to go beyond the concept of liability-driven investments. Instead, it takes the view that causality goes both ways. This means that liability issues are approached with a view to ensuring that they are consistent with the fund’s investment strategy, the board’s risk tolerance and other factors.
ATP’s new profit distribution strategy, set up in 2005, is an example of this approach. The profit distribution strategy sets a new standard by making the principles which determine the payout of bonuses to customers fully consistent with the long-term investment strategy and the dynamic asset allocation rule, among other things.
ATP’s new paradigm has given rise to an organisational redesign. In late 2004, the fund put its asset managers, ALM and actuaries under common supervision. It says that experience suggests the close integration of asset managers, asset liability analysts and actuaries is necessary for its overall approach to be successful.
The separation of alpha and beta has also been reflected in the organisational design. The fund has put into place a multi-team structure which mirrors the separation of alpha, beta and liability hedging. This has been done with a view to optimising the focus and accountability of portfolio managers.
ATP’s investment returns for 2004 and the first half of 2005 have been very satisfactory and, despite a steep increase in life expectancy, have led to a further improvement in the funding ratio.
In 2004, ATP’s investments returned almost 18.9% or €6.6bn (Dkr49bn), and in the first half of 2005, the return was 14.5% or €5.9bn (Dkr44bn). Over half the return stemmed from interest rate swap contracts, which were made to hedge liabilities.
Highlights and achievements
ATP’s distinctive approach to investing means that it not only aims for excellence in three areas – investment, pension policy and liability side issues, and overall objectives and risk tolerance – but also in terms of the interdependence between them.
As a result, it has started to pursue alpha, beta and liability hedging independently, with the three types of portfolio run by independent teams. The fund says this is more flexible and more focussed than the process used before, and that it fosters better risk management and accountability.
ATP has also set up a new profit distribution strategy in relation to investment-driven liabilities. This sets a new standard by making the principles which determine the payout of bonuses to customers fully consistent with the fund’s long-term investment strategy and the dynamic asset allocation rule.
To carry out these changes more effectively, the fund has put its asset managers, ALM and actuaries under common supervision.
In terms of performance, ATP’s portfolio has done outstandingly well over the past 18 months – that is, since the start of its new approach to investment. This has led to an improved funding ratio at a time when life expectancy has increased sharply.