The latest Willis Towers Watson (WTW) Pension Risk Management Study gives a snapshot of the 2020 investment strategies of German pension funds, based on a survey of 38 participants with more than €163 billion of assets. We undertake the survey annually (our first study was in 2010) to provide insight into how the industry is evolving, drawing participants from a broad range of corporate and first pillar pension investors.
Around 60 per cent of these are unregulated, German corporates with a contractual trust arrangement. The remaining 40 per cent are quasi-insurance regulated, utilising differing funding vehicles (Pensionskasse, Pensionsfonds, First Pillar industry-wide funds) and therefore subject to more stringent regulations akin to those applied to insurers prior to the introduction of Solvency II.
On average, we found regulated investors allocate 65 per cent in bonds, 10 per cent to equities, 9 per cent to alternatives, 14 per cent to real estate with the remainder in cash. Unregulated investors have, instead, a somewhat reduced bond allocation, with some 44 per cent in bonds, 21 per cent in equities, 22 per cent in alternatives, 14 per cent in real estate and the residual in cash.
We found that on the whole returns have been acceptable, albeit dampened by low levels of equity investments. Some 71 per cent of the investors surveyed met their investment goals in the previous 12 months, although this was considerably lower than the corresponding result in 2018 of 96 per cent.
We note changes in the asset allocation of both regulated and unregulated investors over the last 10 years – indeed several stand-out investors having radically transformed their portfolios. For example, we’ve seen asset liability modelling approaches become standard practice in determining portfolios. Elsewhere, real estate portfolios, always a mainstay of German investors, have been substantially built out and emerging market allocations have also moved from marginal to core. We note the adoption of far more diversification in bonds, a reduction in the equity home bias and a doubling or even tripling of alternative allocations for regulated/unregulated investors. Also noteworthy is the increasing adoption of outsourcing (fiduciary management) arrangements to improve the governance and effectiveness of portfolios.
However, we would argue that despite that level of change, it has not kept pace with needs. Expected 10-year median returns for regulated investors are now 1.3 per cent versus unregulated investors forecast median returns of 2.2 per cent. Whereas unregulated (corporate) investors may be disappointed by this prognosis, they come in the context of their liabilities measured on a mark to market basis and with the potential for some relief should discount rates rise from their current low levels. Furthermore, corporates may well decide this level of return is acceptable within their broader corporate goals.
For regulated investors the situation is, however, more critical. They face a different asset/liability framework as they use fixed discount rates, typically set in the distant past with reference to long-term return expectations that range typically from 3-4 per cent. Only a few funds, sometimes at the insistence of the regulator, have adjusted their discount rates downwards (taking a one-off balance sheet hit as liabilities correspondingly rose) to accurately reflect less rosy returns.
Regulations stipulate that investors are always required to maintain funding levels above 100 per cent. This has led them to look to beat the discount rate year-on-year to build up reserves – or to eat into these reserves when returns are lower than discount rates. The expected future returns will, for many investors, lie below their required rates and thus reduce their reserves. The reserves for several regulated investors are already looking lean.
Change is required, but many German investors are set in their ways. More investors need to reassess, and increase, their risk budgets. Risk budgets continue to be considerably lower than those of international peers, in reflection of an unnecessary degree of conservatism.
Among peers, German funds show the highest allocation to fixed income instruments and lowest allocations to risky assets, with equity levels particularly suppressed. Allocations to diversifying assets have increased in the last 10 years, but primarily in a one-to-one trade off with equity allocations. While this has improved the diversity of risk assets, it has done little for increasing overall return expectations.
Secondly, we believe portfolio construction could be significantly improved. By embracing a broader range of return drivers, the expected returns for regulated investors could be improved by nearly 50 per cent from 1.3 per cent to 2.1 per cent. For unregulated investors (able to spend more on risk and facing less regulatory constraints) the corresponding change is again approximately 50 per cent from 2.2 per cent to 3.4 per cent.
In particular, the BaFin regulations applied to regulated investors prescribe both the types of assets they can invest in, and the maximum amounts they can invest in the respective asset types. Furthermore, additional solvency requirements – broadly speaking a requirement to be 100 per cent funded at all times, based on the chosen long term fixed discount rate, with additional stress testing – lead to restrictions on risk. This has also “forced” regulated investors into a pro-cyclical reduction in risk, and an inability to “sit out” short-term market noise to profit from the long run.
Barriers to change
The complexity of Germany’s regulatory and tax environment is one barrier to change. The other barrier is one of governance. With increased portfolio diversity comes increased governance requirements. Whereas a small number of the larger corporate investors have addressed this by creating in-house teams, this is not a viable option for the bulk of corporate investors. Similarly, whereas larger regulated investors have built up dedicated resources, smaller and medium sized entities are challenged.
The low yield environment also highlights a key governance problem facing the regulated investors. A component of regulated investors investment strategy has always been to purchase long-dated, unlisted fixed income investments (“Schuldscheine”) and hold them to maturity. The regulatory framework has encouraged this approach by treating them as hold-to-maturity instruments with no balance sheet volatility. It’s just that yields are now substantially below what is required. Moreover, funds’ lean governance and portfolio construction and risk budget processes have not been able to keep pace with the need to continuously redesign and realign portfolios.
Our study suggests that in the last 10 years investors have increasingly looked to address governance challenges by outsourcing of selected asset classes. Study participants identified reasons for outsourcing as improved cost effectiveness and transparency, improved portfolio returns, a relief on the burden on internal resources, improved portfolio diversity, and improved risk management.
Short-term comfort vs long-term cost
Portfolios in Germany have evolved in the last 10 years and are gradually adapting to the challenging economic environment. Nevertheless, opportunities still exist to improve portfolio efficiency and the level of expected returns. This creates additional governance requirements, but solutions exist to address these, and increasingly we see evidence of these being adopted. The conservatism of the portfolios is seemingly more difficult to move. It reflects the higher degree of comfort required by German investors, but it is important to note that the short-term comfort this may provide may well come at a long-term cost.
Nigel Cresswell is head of investments, Germany, Willis Towers Watson.