The key question for pension investors today is whether risk premiums are the same as they were a few years ago when interest rates were much lower – or in the past when economic growth was much faster.
So says Timo Löyttyniemi, CEO at VER, the €21.6 State Pension Fund of Finland, established in 1990. In a recent research note, he writes how many investors expect returns to fall slightly in the coming years, but warns the economic backdrop can quickly change.
Interest rates were so low a couple of years ago that low return expectations had a real basis. Now that interest rates have risen by 2-3 percentage points, the key question is whether this rise in rates will be directly reflected in improved overall returns or whether risk premiums will be lower than before.
“The assumptions concerning these developments will be key questions to be pondered by many pension investors this autumn,” he writes.
“Risk premiums may vary depending on interest rates, the overall market sentiment and market prices. Even if the calculations were completely revised in response to these developments, the new assumptions could also prove wrong.”
Underlying return assumption are based on the yields of each asset class above the risk-free rate, he continues.
“The risk-free rate is the short-term interest rate, which in the euro area is currently around 4 percentage points.”
When investors make their return calculations they must determine how much equity investments, corporate bonds, high yield loans, private equity, real estate investments and other similar asset classes will yield above this said bond rate, he explains.
“When these are then weighted by asset class, we obtain the expected return for the entire portfolio. For pension investors today, it could be from 4 per cent to 6 per cent, or 2 per cent to 4 per cent in real terms over the long term (more than 10 years), depending on the pension fund, the composition of the portfolio and the assumptions used.”
The long-term return assumption (expectation or target) is probably the most important assumption made by a pension investor. It is determined, explains Löyttyniemi, by investors making a wide range of assumptions concerning returns, volatilities and correlations in respect of the various asset classes.
“While the return assumption seldom hits the bull’s-eye in the short term, it often proves more or less accurate over periods exceeding ten years. This means that while it is advisable to disregard it in the short term, it may well be used as a basis for the pension system in the long term. Reliability is not perfect but could be sufficient if other adjustment measures are available.”
As for pension liability calculations, he says they are complex and involve a huge number of assumptions relating to age, retirement and mortality rates. Perhaps one of the most important assumptions concerns the discount rate. “It may be a fixed rate or can be derived from market rates, in which case it varies in response to market rate fluctuations,” he says.
“In this respect, individual countries have made different choices. In Finland, the rate is fixed whereas in the Netherlands the discount rate is currently based on market rates.”
One challenge arises if interest rate assumptions prove wrong.
“If interest rates are sufficiently low, the risks of incorrect assumptions are probably lower as pension liabilities are higher in terms of current value and no false notions have arisen. Choosing a highly volatile market interest rate, on the other hand, forces you to invest at least partly in line with the corresponding interest rate behaviour.”
Löyttyniemi explains that long-term investors base their decision on key assumptions and investment beliefs are a key part of the decision-making process. “Investment beliefs are important because they usually serve as a guideline for long-term policies and investment allocations,” he says.
Investment beliefs are used to draw up assumptions. Which in turn serve as a basis for various calculations, usually to optimise portfolio structures and the relative weightings of asset classes. “For example, one assumption could be the belief that a more sustainable company produces better returns or risks are lower,” he says.
“It can also be assumed that the carbon neutrality goals and schedules of governments and companies will be fulfilled. If these assumptions are not fulfilled, the investor can easily make wrong decisions and in that case investment returns may suffer. Of course, if there has been more talk than action in terms of responsibility, no damage has been caused by following the indices.”
Pension investors do not modify their portfolios overnight, concludes Löyttyniemi.
When changes to portfolio structures are made incrementally, the assumptions made or beliefs used in any given year do not result in undue risks or deviations. However, small changes accumulate to transform into big ones.
Many assumptions are confirmed over the long term rather than in the short term. But any correction to assumptions is also costly.