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Impact Investing

IPE special report May 2018

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When the balance sheet rules

IPE asked three pension funds – in Portugal, the UK and Denmark – the same question: ‘What do you see as the implications of the implementation of IAS 19?’ Here are their answers:

Colin Hartridge-Price, scheme secretary and chief pensions officer at the BT Pensions Scheme & BT Retirement Plan, which have assets under management of £36bn (e52bn) and £90m respectively
“The implemen-tation of IAS 19 requires considerably more disclosure than was necessary in the past, and it enables international compara-bility, although there is still the potential for differences in demographic assump-tions and assumptions in discount rates and salary increases. Obviously the end figure is very sensitive to the underlying assumptions.
“But I think that this comparability is a positive factor. It is certainly seen to be such by analysts as it enables them to make better comparisons than they could in the past.
“The pension commitment is now something that is recognised on BT’s balance sheet. There has always been a good dialogue between the pension trustees and BT on scheme funding issues and investment strategy but the fact that IAS19 appears on BT’s balance sheet encourages that dialogue even more.
“And indeed in general IAS 19 has focused the minds of senior people in the business on just how significant pension costs are. We see immediately what the effect is in terms of any scheme changes and even changes in investment allocation. “But I would not say that it has resulted in BT taking an increased interest in the pension fund, it has always taken a keen interest in the scheme’s affairs.
“BT closed its defined benefit scheme on 1 April 2001 and set up a defined contribution scheme for new hires in response to the fact that a DB scheme has so many factors that are totally outside the influence of the sponsor. And there are other developments where IAS19 will be a factor although not linked directly. For example by highlighting that a pension scheme is a significant cost and must be taken into account in acquisitions.
And while there is no actual requirement for matching investments to liabilities it is an issue that has been aired quite extensively, especially by consultants, and it is obvious that there has been a significant move into bonds by pension scheme trustees in consultation with their plan sponsor.
“And that has driven bond prices to exceptionally high levels to the point where they are a very unattractive buy at present.
“We have a current target of around 65% in equities, and that is likely to continue, compared with 25% for bonds in total. We have tended to feel that recent issues of long-dated bonds have not been attractively priced.
“Although IAS 19 may not require changes to be made, it has acted as a catalyst so that pension funds and sponsors have taken a long hard look at both the pension cost and the asset allocation. And in the current regulatory environment on funding there is a tendency for trustees in general to look more at the IAS 19 accounting deficit because that is an important figure as far as the plan sponsor is concerned.”

Peter Melchior, executive director of PKA, which has assets under management of DKK105bn (e14bn)
“I don’t think that IAS 19 has much of an impact in Denmark and I don’t expect it to have much influence on pension fund management For example, in the Danish occupational pension system the underlying companies, the sponsors of the funds, do not have to carry the liabilities on their books. Once they have paid their contributions, Danish employers have no pension liabilities at all and no obligations.
“So we don’t need a dialogue with the companies about matching liabilities and assets.
“At PKA we had already moved into bonds and a variety of derivatives for asset/liabilities matching some years ago we knew we were going to have to introduce market valuation, or fair valuation, on both assets and liabilities because of local regulations. So IAS 19 has not changed anything.
“However, when you introduce market valuation it is an eye-opener. You know how your liabilities and assets will react if interest rates go down. And that was a risk we felt we ran back in 2000 and 2001 and consequently we hedged it. So we had already more or less pre-empted the liability-matching question.
“And it was a good time to have done it, at least until mid-January of this year when interest rates began to rise. Nevertheless, this is not a problem. We do have a negative yield and people with a traditional outlook say ‘it’s terrible that you are losing money’. But because our liabilities also decrease by at least the same amount there is not a problem.
“Nevertheless, we still measure pension fund performance in a very old-fashioned and only measure the performance of the assets. But any issue here is more of a psychological problem. What we should do is measure the performance of the assets compared with the performance of the liabilities.
“In addition, in 2002, prior to the implementation of IAS 19, Danish pension funds had experienced the introduction of a traffic light system by the regulator. This required us to explain the system to pension fund trustees to ensure that they had a better understanding of what we do, the impact on our business of different scenarios and were enabled to take more responsibility in dealing with the problem.
“I think that this was useful but other people in the industry disagreed, arguing that the traffic light limited investment options and that it meant they could not invest in the way they wanted. And indeed it really forces you to be prudent. For example, it forces you to sell equities if you really cannot afford them from a risk point of view, and I find that a very sound system.
“So you could say that in this way it pulls in the same direction as the IAS 19. But being prudent also means finding other ways of dealing with the problem as we have in PKA, and we have kept a high amount of stocks during the last years – even increasing our allocation to this asset class.”

Luís Veloso, director of the Energias de Portugal (EDP) pension fund which has assets under management of e1.1bn
“There are various implications. At the end of 2002 EDP began to implement the methodologies required when the IFRS was implemented. Similarly, it anticipated the impact of having to take the pension fund liabilities’ higher volatility onto its balance sheet and at the end of 2004 started a DC plan for new participants.
“On the asset management front, the IFRS brings higher volatility to the balance sheet because the IAS 19 states that you should use market rates with good credit quality (AA or better) to compute the discount rate. So every year you have a new rate by which to discount your liabilities instead of a fixed rate as used in the past.
“As a result it becomes clear that the objective function of a DB pension fund should be to minimise the volatility of the funding ratio to the company.
“To achieve this one can apply two complementary sets of strategies. One is to pursue a cash-flow matching strategy, which implies managing your assets against a duration target indexed to a subset of your liabilities. The time horizon of pension fund liabilities goes well beyond the 30-year mark, but we don’t have enough securities in the market to cover all the time structure of pension fund liabilities.
“So, we need to consider another strategy to deal with the ultra-long liabilities. It is perceived as a growth strategy as it allows alpha generation. With the right risk tools in place and proper tactical asset allocation models to dynamically manage the correlations you are able to fulfil your objective
function.
“If you are short duration with a gap to your liabilities of several years you end up with an expected annual return of 3-4% from your bond portion and with an undesirable volatility built on excess and inefficient equity exposure. In market downturns it tends to be a heavy burden to the company’s contribution policy because your liabilities imply a return of 6% or more a year, independent of the macroeconomic conditions at a particular time.
“So, we look for alternative investments, for alpha, for specialist managers within different asset classes, and for this we need to broaden the investment universe. This strategy helps deal with the mortality risk. We also need to look for the right hedging strategies to deal with interest rate and inflation risk.
“Falling yields increase liabilities, but when rates increase you end up losing on the asset class. Even if the liabilities lose value the assets tend to lose even more. So, without proper macro hedging strategies at the balance sheet level you are behind the curve.
“Consequently, we need to look for swap overlays to handle the interest rate risk and inflation risk. Even currency risk should be handled as an independent overlay.
“With all the pressures from the accounting standards to move to a mark-to-market approach the industry welcomed the Portuguese government’s issuance of a long-dated bond in March, the first time it has issued 30-year bonds.”

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