The Fiduciary Investors Symposium (FIS) at Harvard University has identified several of the key barriers to pension funds, endowments and sovereign wealth funds adopting more effective long-term and sustainable investment strategies, and is preparing a communiqué to the upcoming meeting of the G20 to convey its concerns and its policy requirements.

FIS, organised and hosted by Conexus Financial, the publisher of top1000funds.com, acknowledged that asset owners have a critical part to play in influencing policy to ensure long term strategies can be implemented and that they are fostered and supported by appropriate policy frameworks.

Sharan Burrow, general secretary of the International trade Union Confederation (ITUC), told FIS that “any recommendations you make, I will take to the current chair of the B20, Richard Goyder”.

“We have just prepared a joint letter from labour and business – I think we’re struggling over a couple of sentences – and we will make sure that in my presentations to the G20 leaders and in his that we have some understanding of this.”

The G20 Leaders’ Summit 2014 is being held on November 15 and 16 in Brisbane, Australia.

“There’s nothing stopping this conference writing a letter to the Australian Prime Minister saying we met…and we believe that these recommendations are critical for the future of sustainable investing and long-term investment principles,” Burrow said.

“And we can do the same to bosses around this table: you’ve got the World Bank, the IMF and indeed the OECD, that have significant influence on this question – particularly the OECD.”

Panel session

Six organisations participated in a FIS panel session chaired by David Wood, adjunct lecturer in public policy and director of the Initiative for Responsible Investment (IRI) at Harvard University’s Hauser Center for Nonprofit Organizations.

The managing director of Principles for Responsible Investment (PRI), Fiona Reynolds, said discussions about encouraging the right policy settings to foster sustainable long-term investment have to take place “everywhere where there are asset owners”.

“They have to take place on a global scale,” Reynolds said.

“PRI is a global organisation and we try to do that, but we need to work with other organisations at the local level around the world.

“I want to try and make sure we use our report on progress…as a way of having those discussions. Some countries are doing this better than others.”

Get together

Conor Kehoe, a director of McKinsey & Company, said that at a more micro level it has been suggested “for several big asset owners to get together and represent their views through a joint organisation to a corporate, because if you add it up, they own 15 or 20 per cent of it”.

“That’s also been encouraged by the Stewardship Code in the United Kingdom, where asset owners do get worried about concert party regulations. But they’re being encouraged nonetheless to associate more – this is very micro – to bring a well-thought-out viewpoint to a corporation they might be worried about.”

If asset owners do not make their voices heard, then change won’t happen, said Ethiopis Tafara, vice president of corporate risk and sustainability and general counsel at the International Finance Corporation (IFC).

“I used to be at the SEC [Securities and Exchange Commission] for a number of years and I was amazed the number of times we engaged in conversations internally; for example, around materiality and whether or not ESG should be part of the materiality standard, whether we should issue an interpretive note asking companies to do that,” Tafara said.

“Frequently the debate in the building was: investors are not asking. We haven’t heard, with enough force and enough insistence, that this matters to them. And as a consequence, the SEC was not prepared to take the risk of making that part of the materiality standards. So engagement – micro and macro – is critical.”

Under-utilised

Jane Ambachtsheer, partner and head of global responsible investment at Mercer, said “long-horizon investing [is] an under-utilised asset that a lot of long-horizon investors have”.

“It doesn’t mean you move everything into long-horzion strategies; it just means that often you’ve under utilising your ability to be able to do that.”

However, the forces ranged against long-horizon investing are considerable, Ambachtsheer said.

“I can name 20 people who lobby on behalf of global pension funds, and there’s many more than that in the global investor coalitions that I see,” she said.

“But if you think about the number of people who are lobbying for long-term capital markets on issues like climate, versus folks lobbying on behalf of shorter-term financial outcomes, the scales are not in balance. what will it take for long-horizon investors to invest more in having those types of individuals on staff?

“What does that job description look like? And how do you measure their success? How do you [ay them their bonus? These are really new challenges.”

Jameela Pedicini, vice president of sustainable investing at Harvard Management Company, said the ability to genuinely think and act over the long term held very significant benefits for asset owners. The $36 billion Harvard endowment was the first university endowment in the world to sign up to the PRI.

Centuries, not quarters

“We have the great fortune, should I say, to have the one client, and also to have that client that’s now been around almost 400 years – a client that thinks in decades and even in centuries sometimes, as opposed to quarters,” Pedicini said.

“That is extremely helpful as we look at our performance, as well as when we look at our investment strategies.

“One of the challenges we face is: how do you actually implement a long-term investment strategy? What does it actually mean for each individual investment decision?

“What we need is a more comprehensive evaluation criteria.

“What we’re starting to do is look at a broader set of risks – environmental and social and governance risks across our portfolio.

This is a huge project. This is a long-term project. We’re a year into this project.”

Note: This article was edited on October 27, 2014, to remove a quote incorrectly attributed to Jane Ambachtsheer and to insert a  correctly attributed quote.

Liabilities in UK pension schemes are grossly under-estimated with the current valuation system not recognising  the perilous funding position in both corporate and public systems. The implications for not addressing this include huge financial costs borne unfairly by younger members of the schemes. Stefan Lundbergh, head of innovation, and Andrew Stewart, client manager at Cardano, believe reform is needed.

 

If you are sick and the thermometer shows that you have a temperature of 40 degrees Celsius (104 degrees Fahrenheit), you should accept that you are sick, take your medicine and stay in bed.

Few would be tempted to fiddle with the scale of the thermometer, declare themselves healthy, go to work and hope that they will get better.

In the world of  defined benefit pension schemes, however, this is precisely what many are doing.

Unrealistic or overly optimistic liability valuations mean the economic reality of the funding positions is being brushed under the carpet.

However economic reality is bound to catch up with us at some point and although the general move towards defined contribution in the private sector means the problem is contained it is far from solved. Therefore ignoring the risks leaves us not only exposed to deteriorating health but also unable to identify appropriate remedies.

As an example, in the UK corporate sector most defined benefit pension schemes have closed to new employees but the liabilities (and assets) remain on the balance sheet. This is a good thing in that it provides some recognition of the huge pension gap that UK corporates face.

However the problem is that the current system uses a liability measure (based on corporate bond yields) that understates the economic value and hence suggests smaller deficits than is really the case.

If the liabilities are measured on an economic (i.e. risk free) basis then the deficits are seen to be of such magnitude that the required top up contributions fall somewhere between immensely burdensome and critically debilitating.

Based on reasonable estimates of future asset returns, we estimate that around £20 billion per annum is required for the next 10-15 years, equivalent to 20-25 per cent of total UK corporate dividends.

Hence it is wishful thinking, facilitated by unrealistic valuations of liabilities and overly optimistic recovery plans, to assume that UK corporates will be able to carry this cost and stay competitive on the international market.

The somber reality is that at some future point the DB pension liabilities will need to be restructured and the key question is how to do so equitably.

A fair outcome can only be achieved by sharing the pain between generations but at present there is no legal framework for restructuring the schemes in an ordered way without putting the corporates in bankruptcy.

This means all the pain will be felt by the ‘younger’ members in the closed DB scheme when the restructurings inevitably take place.

More worrying are the UK public DB schemes. The funded Local Government schemes face the same issues as the UK corporate sector, while the unfunded schemes, such as the NHS or Civil Service schemes, present a whole other problem.

These mostly operate a pay-as-you-go system without any funding buffers.

This means no assets are set aside to cover the accrued pensions – they are effectively paid out of the state budget – and neither are the hard liabilities included in the national debt. The issue is that as the baby boomers retire the balance of money going into the schemes will gradually reduce relative to the money going out.

The system will therefore face huge future shortfalls unless there is sustained economic growth which outstrips these demographic trends.

If this does not occur, the unfunded pensions will ultimately become a wider societal problem as the scarce national budget has to be allocated away from law enforcement, health care, schools and other public services to pay generous public employee pensions.

Any ‘younger’ public employees should therefore be seriously concerned about the quality of their DB pension in the future.

However, the current valuation system means there is no recognition of the perilous funding position and hence there is no drive to address the impending issues. Alternatively, if an economic valuation was applied to the public DB schemes, there would be an immediate recognition of the problem and the significant increase in the national debt would force public pensions to the top of the agenda.

Clearly some kind of reform is necessary. The longer the problem is neglected, the larger the intergenerational redistribution will be and the greater the pain for individuals. The DB schemes pose a huge problem in the private sector and an enormous one in the public sector.

Reforming pensions is not an easy thing to do, since the problems will play out over the long term and no one wants to take the pain up front.

As in most cases, it is much more convenient to kick the can down the road and hope for the best. However the least we should do is measure the size of the problem in the correct way, instead of fiddling with the scale of thermometer and pretending there is no problem at all.

How to implement long-term ideology is one of the enduring questions for investors. Unilever UK Pension Fund, The Pensions Trust and the Environment Agency Pension Fund have collectively allocated $750 million to the start-up, Ownership Capital, for its long-horizon engagement-focused strategy. For The Pensions Trust chief investment officer, the decision to allocate to a specialist engagement strategy was simply an assessment of a competitive strategy that was consistent with its investment beliefs.

Ownership Capital, which was launched in 2013 by the in-house team that founded and managed one of the world’s largest engaged ownership mandates for Dutch pension fund PFZW, aims to generate returns through active ownership of the companies it invests in.

Led by chief investment officer, Alex van der Welden, it seeks to create value by working in partnership with management to encourage a long-term focus, strong corporate governance and sustainability leadership.

Uniquely, for global equities, investments are made with a 10-year time horizon and the portfolio, which holds only 20-30 stocks, seeks to align the long-term success of well-managed companies with the long-term obligations of pension funds. The fund takes substantial stakes in the companies in which it invests and has a proprietary investment model that fully integrates qualitative factors, such as management, governance and sustainability within its financial analysis.

The Pensions Trust allocated £130 million to Ownership Capital, as part of its global equity portfolio that has £1.8 billion in total.

David Adkins, chief investment officer of the £6 billion multi-employer occupational pension fund in the UK, says the fund has 10 investment beliefs and Adkin says two were relevant to the allocation of this mandate. The first is that it seeks to find active managers that can outperform a benchmark but recognise it is difficult.

Within the equity portfolio, approximately two thirds of the assets are passively managed, and one third is active split between four managers. Two of those are global equities mandates, of which Ownership Capital is one, and the other two are regional specific mandates, one in the Asia Pacific and one in emerging markets. Ownership Capital is the first concentrated portfolio.

The second investment belief which aligns the fund with the decision is that it believes that responsible investing can add value over the long term.

“Above everything we spent a fair bit of time with Ownership Capital looking at their investment process,” Adkins says. “We thought they had a competitive process that gave them an advantage over their peers, and the appointment stood on its own two feet for that alone. The sustainability and the long-term aspects were supporting factors in our decision.”

Adkins says the mandate, which has a performance horizon over 10 years when most global equity managers look over two or three years, is being viewed as a long-term partnership. However the mandate will be monitored like any other equity mandate.

“We are looking at them using normal manager assessment criteria. For me they’re a global equities manager with the philosophy of sustainable investment, which fits with our beliefs,” he says.

The Pensions Trust does ask all of its managers to consider ESG, and rates its managers on those factors.

“We look at the extent to which ESG is integrated into the investment process and we give them a stronger rating if it is,” he says.

The Pensions Trusts is a UK occupational pension scheme with one trust deed and multiple underlying defined benefit funds.

It is an umbrella for employers in the not for profit sector and there are 36 underlying defined benefit arrangements, with single employers such as Oxfam, and multiple-employers such as the Social Housing Pension Scheme with 500 employers.

Each one has its own actuarial valuation and set of accounts, while there is different asset allocation there is a common pool of assets.

In total the assets are broadly split 70 per cent growth of which half is in global equities and half is in alternatives.

Alternatives is split into two buckets – liquid and illiquid – with the dividing line a consideration of whether the investments can be turned into cash within six months. Investments include property, infrastructure and distressed debt. There is no private equity as Adkins says there is plenty of exposure to equity beta.

The other 30 per cent is liability focused in liability-driven investments, gilts, and sterling corporate bonds. These investments make up the foundation of the 36 scheme investments.

The Pensions Trust is advised by Mercer but now has a team of eight so the reliance on external advisers has reduced in the past two or three years.

Australia’s sovereign wealth fund, the A$101 billion Future Fund, has just upped the stakes in not only attracting the best co-investment deals from fund managers, but in its bid to attract the world’s best investment professionals.

Two months ago the fund’s long serving chief investment officer, David Neal, become chief executive in name (following the resignation of the previous CEO Mark Burgess, who held the role for nearly three years), but he might more accurately be described as the fund’s chief big picture strategist.

Frustrated at the lack of time he had to think strategically as chief investment officer, in his new role he now largely focuses on this alone, while former head of infrastructure and timberland Raphael Arndt has been promoted to chief investment officer where he designs, implements and oversees the investments and Steve Gilmore, as head of investment strategy, focuses on the overall risk exposure of the portfolio. The latter two tasks were both formerly led by Neal when he was chief investment officer.

“As the portfolio has got bigger there is too much for a single person,” he says.

He describes his new role as ensuring that the Future Fund keeps evolving so that it can remain at the forefront of the investment industry.

“We need to think continually of better ways of doing things,” he says.

One of the ways the fund is upping the stakes is in the increasing number of co-investment deals it brokers with global fund managers, on which it offers partnership but rarely pays investment fees. There have been 30 such deals this year, with 12 in the last quarter, across debt, private equity and infrastructure.

The increasing numbers of deals means the need for more staff to negotiate and manage them. Finding the right people is not easy and the fund likes to search the globe for the best people.

Prominent new members of the Future Fund team in 2014, include Craig Dandurand, who joined in February as director of debt and alternatives from CalPERS, where he had been in charge of the $288 billion Californian public employee fund’s hedge fund program.

While in August, Joel Posters joined as the new head of environmental, social and governance risk management, from Rabobank Group in the Netherlands.

Neal says they want those who have directly managed such assets, but also those who can work within the competition for ideas framework at the Future Fund, where all new investment ideas must compete with other current ideas across the asset spectrum before a purchase decision is made.

“We need the rare beast of someone who can do transactions but who also understands how it fits into a broader portfolio, and that is challenging for us to find,” he says.

The investment team is currently at 46 and Neal sees it rising to a maximum figure in the mid-50s, any more and there are dis-economies of scale he says.

“I do not want too many people in an individual team”, he says fearing team splits or having too many senior people so that the whole team finds it hard to work together.

“There is a point at which the whole team becomes too big. we are not far off that,” he says.

The fund has a target return, but adopts benchmark unaware approach with no strategic allocations to individual asset classes.

Neal gives an example of how this works. “When we go to buy a property, we do not think of it in terms of the real estate universe, but if it is a better investment than just sticking it in listed equities,” he says.

There is also the big matter of attracting people from overseas to Melbourne, one of the world’s most remote major cities as well as the high cost of living in Australia.

However, Neal believes the fund is riding a trend of investment professionals falling out of love with the idea of working for a large financial services institution in one of the world’s big financial centres.

“In the past if you were a very ambitious, very skilled investment professional, you had a choice of asset management or investment banking,” he says. “What has changed a little is that the big sovereign wealth funds and pension funds around the world are professionalising and paying for this so they are able to compete for good staff.”

The lack of job security since 2008 has been a factor in this job trend and so has the desire to move away from some of the excesses of the financial services sector.

“People are more thoughtful about a long term career and are looking for an intellectual challenge and a sense of purpose.”

He judges that the allure is greater around the large asset owners who are doing “interesting things”.

“We get to compete pretty well for that pocket of people.” However, he concedes: “Those that want to make as much money as possible are still going to go to New York.”

 

 

A study of 300 US pension funds by CEM Benchmarking reinforces the importance of asset allocation, highlighting the performance of asset classes, as well as new evidence on correlations between asset classes. Alex Beath, author of the study, discusses the implications for asset allocation with Amanda White.

A CEM Benchmarking study “Asset Allocation and Fund Performance of Defined Benefit Pension Funds in the United States Between 1998-2011,” has revealed the power of asset allocation as a driver of performance, and how asset class correlations add vulnerability to diversification.

Alex Beath, author of the study that looked at the asset allocation, fees and returns of 300 US pension funds with combined assets of $2.8 trillion from 1998-2011, says during that period the defined benefit pension plans included in the study increased their investments in alternative assets – private equity and hedge funds, real estate and other real assets such as commodities and infrastructure – by nearly 400 percent on average.

CEM used its extensive databases to examine how this reallocation to alternatives paid off in terms of gross returns and realized returns net of fees charged by investment managers.

And basically it didn’t.

Large corporate plans were the best performers among the funds analysed and this was due to their higher allocations to long duration as part of a liability matching strategy.

The report concludes that many pension funds could have improved their performance by choosing different asset allocation strategies and optimizing management fees.

CEM found that listed REITs were the best performing asset class over the period, and that hedge funds were the worst performer.

“Hedge funds didn’t just perform poorly but it also revealed that on average hedge funds look like US large cap stocks,” Beath says. “Hedge funds have a lower volatility than US large cap so that is a benefit, but they perform like US large cap stocks, but have much higher fees.”

In addition to the correlation between hedge funds and US large caps being very high, the study revealed a very high correlation between private real estate and REITs, and between private equity and US small cap stocks.

“If you look at raw data it looks different but once you correct the data to account for lag then you see there is a very strong correlation,” he says. “You might think by investing in these asset classes you are increasing diversification but you are not at all. Thinking you are de-risking by adding in uncorrelated asset classes like private real estate is totally an illusion.”

The performance differences in the cohorts of funds analysed in the study are due primarily to their asset allocation differences, the study found.

Large corporate plans were the best performers, and this was due to those investors allocating more to long duration fixed income, which is a direct result of those funds more consciously investing according to liability matching strategies.

“These large corporate funds had a much higher net return compared to public funds due to a shift in asset allocation prior to the financial crisis and a timely increase in long duration fixed income and a decrease in US large cap stocks. Corporate funds are more interested in liability matching than public funds and embrace LDI, which means they are more likely to alter allocations.”

The study found that corporate sector plans reduced their average allocations to US large cap equities and US broad fixed income securities by 19.6 percentage points and 10.3 percentage points, respectively, with the largest declines among the largest plans, those with total assets of more than $10 billion. Over the same period, allocations to long duration US bonds and hedge funds increased 16.9 percentage points and 5.0 percentage points, respectively, and again most dramatically among the largest plans.

Public sector plans also reduced on average their allocations to US large cap equities (by 18.7 percentage points) and to US broad fixed income (by 11.0 percentage points), although the reductions in both cases were somewhat larger for mid‐sized plans.

Unlike corporate sector plans, however, the allocation to long duration US bonds among public plans was notably unchanged over the period as public sector plans did not embrace LDI to the degree of their corporate sector counterparts. Public plans on average increased their allocations primarily to non‐US equities (by 11.0 percentage points), TAA/hedge funds (by 4.6 percentage points) and private equity (by 6.0 percentage points).

Large corporate sector plans were the best performing among all major pension fund cohorts classified by fund type and fund size, achieving an average annualized compound net return of 7.54 percent over the period 1998‐2011, significantly outperforming the 6.61 percent of all funds combined.

Linking the asset allocation decisions to performance and to determine the potential impact of a shift in asset allocations on portfolio net total returns over the period 1998‐2011, the study looked at estimates for each year of the marginal benefit or loss of a one percentage point increase in the portfolio weight for each of the main asset classes, with the average annual impact shown in the bottom row.

The estimates reveal that US long duration fixed income, listed equity REITs, and other real assets (infrastructure, commodities, etc.) would have provided the largest marginal increases to total portfolio annualised average net returns of 4.4 basis points, 3.9 basis points, and 3.8 basis points per year, respectively, for each percentage point increase in allocation over a period that includes the financial crisis.

Other portfolio allocation shifts that would have appreciably increased portfolio net total returns over the period include reduced exposure to US large cap equities (2.9 basis points per year for a one percentage point lower allocation), increased exposure to private equity (2.8 basis points per year for a one percentage point higher allocation), and reduced exposure to TAA/hedge funds (2.1 basis points per year for a one percentage point lower allocation).

In terms of costs, not surprisingly, US fixed income was the lowest at around 17 basis points, with costs increasing up to 10 times that in private equity.

The CEM study also touched on implementation styles with the performance of small public funds highlighting the cost of using fund of funds.

“You can explain why different cohorts of funds do better mostly by looking at asset allocation, which explains about 90 per cent. But with small public funds you can’t do that, their asset allocation is fine and so they should have got average asset performance, but their private equity lagged so much because they use fund of funds – the fund of funds performance lagged even before fees were considered.”

Numerous surveys suggest that Australians are not completely satisfied with superannuation as it exists today.

First, fund members tend to think that they will not have enough to retire and second, that investment plan providers are not necessarily acting in their best interest.

In this context, we asked in a recent study supported by AXA Investment Managers whether the recent rapid development of self-managed superannuation funds (SMSFs) may be related to the level of dissatisfaction with the more mainstream types of pension funds (retail, industry and non-profit) especially amongst the relatively more financially literate and wealthier segment of the population.

The original attractiveness of SMSFs springs from tax incentives available to wealthy individuals and small business owners.

But today it can be argued that if Superannuation funds, especially default option embodied by the MySuper legislation, gave individuals a clearer and more explicit vision of what their pension savings are invested to achieve at the relevant horizon, a number of well-off middle class households would not feel compelled to switch to a “do-it-yourself” version of pension wealth management.

This trend may be seen as symptomatic of the difficulty for an industry to demonstrate the benefits of delegation, leading a group of the more active and engaged members to take matters into their own hands.

 

Developing a reporting standard

 

While more financial education of individual members is necessary, the objective cannot be one of making each individual member a specialist of long-term pension investment.

Moreover, behavioural biases are likely to prevent even the best informed from optimally managing their pension savings. If education can only play a limited role and delegation is necessary, the quality of reporting (i.e. what performance information pension investment solutions providers return to their members) is an essential dimension of the credibility of the pension system as a whole.

Existing reporting requirements leave individuals faced with the problem of computing the contribution of a particular investment option to their pension investment objectives by themselves.

The current debate between industry and regulator about the most useful type of reporting will continue so that innovation and learning can take place, while minimising the burden of compliance costs. Part of this effort can come from superannuation funds themselves and the leadership of major providers is important in this regard.

Regulatory effectiveness and regulatory costs could be optimised by developing a reporting standard of only the most relevant information for fund members. This standard, we argue, can only be developed as part of an iterative dialogue between industry and regulator and pension solutions providers should lead it.

 

Certifying solutions

As well as transparency and the role of reporting, the ability of a pension system to apply sound governance principles is an important criterion against which it may be judged. Australia has long been in line with most OECD guidelines for fund governance. With the exception of self-managed pension funds, super funds are structured around trustee arrangements by which there is complete separation between members and trustees, who have fiduciary obligations and take ultimate responsibility for the fund.

A further industry-led step in the direction of good governance and transparency is the establishment of a governance body to oversee standards for the industry. To support innovation in the pension investment sector in Australia could be the creation of a certification scheme for retirement solutions compliance with generally accepted / best retirement investment and risk management and governance practices.

Such a scheme could be created by the industry to inform the default option selection work of the Fair Work Commission, but also signal service quality to individual investors and employers.

 

Better information and possibility of choice

 

Over the past decade, the super sector has been characterised by both increasing fund sizes, which should lead to scale economies that, in turn, should translate in lower costs for members. At the same time, the presence of a significant number of smaller funds also preserves the possibility of competition.

The premise of recent reforms of superannuation is that with better information and the possibility of choice, competition can play its role to improve the quality of service and the adequacy of pension investment products. However, increasing competition through member choice has not been associated with a dramatic decrease of costs, and the impact of economies of scale has also been muted.

Studies of the relationship between fees and investment performance suggests strongly that super funds with higher costs do not generate a consistently higher investment return.

The literature also finds an inverse relationship between costs and active performance and concludes that higher expenses cannot be justified with claims of more active management aiming, successfully of not, to achieve superior performance, especially in the case of retail funds.

When institutions allowing market participants to compete without restriction on prices or volumes are in place and the expected benefits of competition do not materialise, market mechanisms can be considered to be failing.

The Australian super sector is large and not dominated by any particular provider. Nevertheless, neither choice nor scale appears to have had a marked effect on prices (costs) or the relationship between prices and service quality and adequacy.

 

Adequate default option

The current problem faced by the average super fund member, as well as the regulator, is one of identification of the most desirable investment solution. The possibility of choice and the potential for competition have not yet been sufficient conditions to reveal what the advanced service providers could offer.

With perfect information about what investment solutions can be created to achieve a set of long-term objectives, competition between fund members would work as expected: individual members exercise choice and decide which solutions are best suited to their needs e.g. a real consumption/wealth target (liability) to be achieved at different points in their lifecycle while respecting a certain risk budget.

The difficulty arises from the absence of information (i.e. reporting) and point of reference (i.e. certification) for fund members, who cannot discriminate between providers. In this setting, efficient plan providers have an incentive to mimic inefficient providers (moral hazard), make no costly effort to design advanced investment solutions and provide the same products as inefficient providers. What drives up costs in this case is not the absence of competition, but the tendency for all providers to “pool” and behave like the inefficient type of service provider.

To avoid this pooling equilibrium, market participants can create “sorting devices” or “revelation mechanisms”. In this context, we note that consultants may play an important role in reducing asymmetrical information and that progress in this respect progress should be encouraged.

In their role as gatekeepers, consultants can for example challenge providers to improve reporting along lines that would be consistent with state-of-the-art principles for retirement management, and to redesign products to add value.

In the end, either individual pension fund members, through the regulator, can request bids for a limited number of pre-defined investment solutions (i.e. the regulated default option) in an auction, or pension plan providers can choose to highlight the different solutions that are available through the kind of reporting standard and certification scheme that we discussed above.

 

Designing high-quality default options

Whether auctions or certification is used to determine the most adequate default option in a defined contribution system, the question of what the optimal default fund should be is extensively discussed in the literature and its conclusions tend to be in contrast with the content of existing investment products.

The question with default options is to determine whether or not they should be standardised and, if necessary, regulated, which amounts to asking if on average the combination of a given set of asset allocation strategies and risk management techniques tends to deliver superior outcomes.

Improving the performance of default options in superannuation plans could begin with maximising the benefits of diversification both within and between asset classes, to design better performance portfolios to allow more ambitious targets at different levels of risk tolerance.

Likewise, better liability-hedging portfolios would reduce the risk of dispersion around the objective at the horizon and allow for a higher allocation to the performance portfolio at a given level of risk tolerance.

Going beyond a static liability-driven approach, dynamic allocation between the performance-seeking portfolio and the liability-hedging portfolio can recognise the time-varying nature of asset and liability risks and advantage of the mean-reversion of asset prices over the investors’ long-term horizon.

Without short-term downside protection included in their investment products, fund members are exposed to drastic losses when risky assets plummet simultaneously, as has been the case in the recent financial crisis.

Such insurance can be complex and costly to manage, yet a pension system aiming to rely on individual DC funds should aim to integrate the third pillar of risk management into its default option.

Indeed, the separate management of long-term liability risks (via hedging) and short-term loss aversion (via insurance) allows the investor to optimise risk taking in a dynamic manner over the investment period.

The latest advances in risk and investment management can be used to design a new generation of retirement products that would not only offer better performance and risk control features, but also more risk customisation.

In this context, the definition of advanced lifecycle benchmarks (representing reasonable partitions of the population of members according to investment horizons, short- and long-term risk aversion, etc.) would support the design of adequate default options would support convergence towards better default options within MySuper.

Lifecycle investment benchmarks would promote performance and innovation in this market. Providing information about reference asset allocation, they would be combined with generally accepted investment benchmarks to generate performance figures that could be presented using the standardised reporting framework discussed above, to serve as references for the industry.

 

Obsolete distinction between “pre” and “post” retirement

Australian retirees are likely to spend several decades of their lives in the “post-retirement” stage and the generation of adequate income to fund their desired level of real consumption over such periods should be integrated in the broader question of individuals’ asset and liability management over their entire life.

In effect, the period of retirement has its own stages, characterised by different consumption needs and risks, which would benefit from a lifecycle approach.

Crucially, the retirement of one’s human capital, the end of labour income, is the largest but also the most predictable asset allocation shock in one’s lifetime. We argue that an integrated, whole-lifecycle approach can thus improve wealth outcomes if this predictable shock is taken into account.

The choice of horizon at which labour income ceases could conceivably be managed as a variable in a dynamic lifecycle environment.

The standardisation of reporting and the provision of planning tools to members could allow the impact of financial, career and lifestyle decisions on retirement preparedness to be simulated, and even accommodate the de-regulation of the pensionable age and members’ increasing freedoms to transition out of the labour force.

Given the high expected inflation of the costs of healthcare and long-term care, savings accumulated until retirement risk being insufficient to cover these predictable expenses for a significant share of members.

Neither would a typical life annuity be indexed on healthcare price inflation. It thus follows that a proportion of individuals’ savings should stay optimally exposed to rewarded risk for a much longer period than the official retirement date currently suggests.

Since Australian pensioners are still exposed to investment, inflation or interest rate risk when they retire, and as they face a multi-decade liability/consumption objective with a likely upward slopping profile (a significant proportion of medical costs are incurred in the last years of life), they can still benefit considerably from applying efficient and targeted asset and risk management techniques to their pension savings after they have retired.

The most adequate investment horizon in the super system could thus be a function of individual member’s life expectancy, not the age from which they cease to receive labour income.

Hence, default options under MySuper could be designed to encompass the entire lifecycle of fund members and use several significant investment horizons including the official retirement date (the end of labour income) but also the stochastic horizon implied by life expectancy and longevity risk.

The investment and risk management technology described above remain the proper way to address this problem: optimise diversification benefits through the design of efficient building blocks, dynamically manage a combination of performance seeking and liability hedging portfolios to target long-term liabilities/wealth objectives taking into account not only age and risk preferences, but also changing market conditions, and control risk budgets through insurance mechanisms.

 

Frederic Blanc-Brude, research director, EDHEC Risk Institute—Asia, and Frederic Ducoulombier, director, EDHEC Risk Institute—Asia