The €140-billion ($191-billion) Dutch pension fund PFZW is in the midst of completely rethinking its investment philosophy, Jaap van Dam, managing director of PGGM, told the Fiduciary Investors Symposium in Amsterdam.

PGGM manages the investments of PFZW and has traditionally guided them.

Van Dam explains that ownership of the investment strategy is to shift decidedly into the hands of PFZW’s board as an integral part of the fund’s new constitution.

“Essentially, engineers of PGGM used to run the fund, going to PFZW once a year, presenting the investment plan and asking them to sign it. Now the board will be in charge.

The new investment framework is a consequence  of a decision of the PFZW board in 2011 to seek new guidelines in order to adapt to a changed world since the financial crisis. Van Dam outlines a number of key transformations in the fund’s environment that spurred the soul-searching.

Firstly, despite its continued good reputation on international comparisons, funding problems within the Dutch pension industry make the “societal license to operate the pension system no longer self-evident”.

Also van Dam says “with 1.8 times the Dutch GDP in pensions, a higher amount than total bank lending in the Netherlands, there is now a societal responsibility to deploy capital that transforms savings into wealth.”

A changing role for governments and regulators, the scarcity of both long-term risk-bearing capital and good returns, reduced confidence in the efficiency of markets and financial chain agency issues are additional spurs to PFZW resetting its beliefs.

Van Dam reckons that the fund’s past maximum diversification strategy meant “we weren’t really shielded from very extreme events through textbook diversification exercises”.

He adds that “efficient markets tend to make you act as a price taker, which means the price maker can manipulate you in many ways. We should really reconsider this role and think a lot about the prices of companies, sectors, everything.”

As well as reacting to what PFZW saw as fundamental changes to the outside world, van Dam explains that efforts to overcome additional troubles became part of redefining its investment beliefs. The complexity of the fund, with 21 sub-asset classes was a real concern for board members, says van Dam, which is addressed in its new beliefs. He stresses that “they do not want to avoid complexity but they really want to see the value added and ask ‘are we really in control?’”

Assumptions of the past, such as the benefits of innovation and increasingly complex investment solutions, have also came under scrutiny, as have cost effectiveness.

Building from scratch

PFZW’s soul-searching process has been enormously detailed and methodical, with a “tremendous amount of education” needed. “We wanted to place the PFZW board in the lead, look outside-in and answer central questions on the pension fund’s function,” van Dam says.

A 27-question pyramid was created to help define the fund’s fundamental views on a strategy suitable for its benefit ambitions, sustainability concerns and desire to make the changes intelligible and controllable.

A working group of six board members helped by PGGM staff was established to formulate the new beliefs. In order to look far and wide, the group conducted literary reviews as well as consulting 30 external experts, including Towers Watson’s Roger Urwin and pension academic, Keith Ambachtsheer. It added contrarian thinkers into the mix when the working group was able to elucidate its plans, in order to add another layer of consideration and contemplation.

A comprehensive 600-page thematic document led to the drawing up of a 16-principle investment framework. “All kinds of collaborative thinking and collective decision-making made it a very strong document,” van Dam reckons.

Rediscovering the fund’s fundamentals has naturally set off a chain of additional work to be done as they are put into practice. PFZW is aiming for full implementation of its beliefs by 2020. Van Dam says that focus will be on investments that “materially contribute to matching pension ambition”, ensuring flexibility to adapt to changing market environments and reducing complexity by concentrating on the essentials.

Taking a snapshot of the current investment portfolio through the new framework is the next step in order to show what kind of shifts might be needed in investment strategy, costs and complexity. A strategic investment plan based on the fund’s new constitution is due to be finalised in 2014. Plenty of questions will still need to be raised along the way though, says van Dam, such as how PFZW could possibly look beyond efficient-market thinking.

 

The enviable surplus of the $47.4 billion Healthcare of Ontario Pension Plan, HOOPP, is down to a key focus on what David Long, senior vice president and co-chief investment officer at the fund, attributes to a “single strategic objective:” namely to pay benefits at a reasonable cost to the fund’s 247,000 workers in Ontario’s hospital and community-based healthcare sector.

It’s a mission informed by maintaining returns (17 per cent last year) but also keeping to within what he calls “maximum limits” of the impact of any potential losses on the funding status of the plan.

Speaking at the Conexus Financial annual Fiduciary Investors Symposium in Amsterdam, Long explains that the funded ratio of the pension fund is dictated by the expected return on assets.

“The higher the expected return, the higher the funded ratio,” he says.

The fund also puts together a worst case funded ratio where it simulates in stress tests how things going wrong in the financial world – from inflation to nominal interest rates or equity volatility – would impact the funding ratio negatively. “Apply extreme market movements to assets and liability to find out how they would be affected,” he says.

For HOOPP, the worst case funded ratio would be for the plan to be underfunded between 80 and 100 per cent, with any dip towards 80 per cent entering what he calls a red zone.

“We don’t want to go below 80 per cent,” he says, explaining that in this scenario a “vicious” spiral effect means pressure on risk and better returns increases, while all the time the ability of the fund to withstand loss shrinks. “You want to stay out of this zone.”

In contrast, a green zone – “a great place to be” – shows a balance between controlling risk and maintaining return. Here the funded status hovers between 110 per cent funded and, in a worst case scenario, 80 per cent underfunded. But a fund in surplus can also promise challenges for “intergenerational equity”, in which the scheme is obliged to distribute money back to beneficiaries. The “ideal” is a blue zone, “a happy medium” between being in no real danger of being either underfunded or overfunded.

 

Olga Pomerantz, economist at Chicago-based William Blair & Company, offered delegates at  the Fiduciary Investors Symposium reasons to be positive. Pomerantz says the factors inhibiting growth from 2009 until last year have altered and that global economic growth is starting to evolve. She notes stronger growth in developed markets, where growth in the US has been “tested” and withstood political challenges, and “stable” growth in Japan.

In the US she predicts increasingly strong private sector growth, averaging 2.5 per cent consistently and believes that as the negative impact of the government deleveraging lessens, so growth will become stronger. In Europe she says that beneath the barrage of negative news, broad-based structural change is beginning to bear fruit. Europe’s peripheral economies ran current account deficits while Germany ran an equally large current account surplus, in a level of imbalance which was “quite staggering”. Now Germany’s current account surplus is just under 2 per cent, something she calls “quite an impressive achievement.” Moreover Portugal and Spain are now running current account surpluses. “Exports are up 20 per cent in Spain compared to 2009; in Portugal exports are higher than this. Europe’s problems are not over but the impact of fundamental structural adjustments has been overlooked.”

Pomerantz attributes her positive outlook on Japan to stronger Japanese corporate profits, a growing consensus within Japanese monetary policy, plus the “deregulation side” offering much to get excited about. She predicts incentives structures will trigger changes in the way Japanese corporates operate, expecting “different behaviour” from both corporates and households.

Growth in emerging markets, now coming off cyclical highs, will be geared to growth in developed markets highlighting Turkish exports to the EU and Mexican exports to the US as examples. Emerging markets that benefit from commodity exports to China, particularly linked to China’s real estate boom, will find this “unlikely to be repeated”. Other sources of growth in emerging markets will come from local companies producing manufactured goods and industrial services. “Local companies geared towards this will benefit,” she says using India’s outsourcing market as one example.

Pomerantz advises active management to best tap these opportunities, saying indices “are inefficient”. Global indices particularly are overweight developed economies, so don’t tap growth in emerging economies. “As sources of growth change around world, active management in equity markets still makes sense,” she says.

 

Hybrid pension schemes, combining both defined contribution and defined benefit characteristics, are best for governance because they align interest of both employees and sponsors argue David Villa, chief investment officer of the $91-billion State of Wisconsin Investment Board (SWIB) and Sorina Zahan, partner and chief investment officer of Chicago-based Core Capital Management, speaking at Conexus Financial’s Fiduciary Investors Symposium in Amsterdam.

Their study, drawn from two years of research, into benefit design has developed a mathematical framework to compare the different vulnerabilities and returns within defined benefit, defined contribution and hybrid pension schemes. The model is based on option modelling.

SWIB itself is a hybrid plan, with both a defined benefit component and a defined contribution component. It’s this “sensitivity” between DB and DC in a “compromise solution” that allows for real success, they argue.

“We put everyone on an equal footing and compared the cost systems, and asked what do you see?” Zahan says, explaining their research process. “In the US the debate doesn’t ever look at the entire robustness of pension structures. We’ve tried to create a framework that compares these different structures.”

Not surprisingly the study found that DB employees with guaranteed benefits were not as subject to market risk as DC participants.

“If you want to switch from a DB plan to DC plan, make sure DC has robustness from market risk because it is the most vulnerable to market risk,” she told delegates. Their research also shows that DB plans cost less for an employer than DC schemes.

Surplus squandered

It begs the question, behind the “rush” to change a DB structure that is efficient from a cost perspective into a more costly DC structure.

“The reason is we have not observed the surpluses of DB plans,” says Zahan. “We think the answer is that a lot of surplus is squandered. DB plans are an efficient structure. The one drawback is that they require good governance.” She believes that although DB does carry market risk, with good governance and good regulation these plans are more cost-effective and generators of wealth.

Under its hybrid model, SWIB is strict on sharing any surplus.

“In Wisconsin we give our entire surplus to the employees,” says Villa, whose list of governance sins includes contribution holidays, unfunded benefit increases, unrealistic investment targets and uneconomic investment decisions.

Challenges with wholly DB or DC schemes are also revealed when it comes to shouldering risk. Employees take the risk in DC schemes, yet in a DB scheme employers suffer any loss in value because they will have to pay more in benefits – although they also benefit in value creation.

In what Villa describes as “looking like magic” hybrid plans allocate both upside and downside risk between employees and the sponsor to achieve better alignment of interest and healthy governance. “One of the features of hybrid plans is that value creation and destruction is shared by employees and the sponsor. It produces a much better alignment of interests,” concludes Zahan.

The monthly income pouring into the $1.3-billion North Dakota Legacy Fund arrives as thick and fast as fracking technology and new pipeline networks can draw the state’s oil and gas reserves to the surface. But investment strategy at the fund, set up in 2008 when it was portioned 30 per cent of the tax dollars from the state’s rejuvenated energy sector, hasn’t been anything like as aggressive. An ultra-conservative approach with the entire fund invested in short-term fixed income earning low single-digit returns didn’t match the aspiration of America’s other legacy funds in mineral-rich states, such as Alaska’s $45-billion Permanent Fund, Texas’s $14-billion Permanent University Fund and others in New Mexico, Wyoming and now West Virginia and Utah.

New recipe for returns

A rethink in North Dakota has shaped a new allocation focused on equity in what acting chief investment officer, Darren Schulz, describes as a new dawn. “The goal was to protect and grow the corpus, but the decision to keep it in cash and cash-like equivalents was incommensurate with the fund’s investment horizon and the ability to tolerate risk,” he says. After much “educational effort”, Schulz convinced colleagues of the need for a different approach. “We are in the process of transitioning to the new policy allocation. This really is a unique opportunity to build an investment program for a newly created special-purpose fund. We’re entering a new era.”

Under the new allocation, 50 per cent of the Legacy Fund will be invested in global equity, 35 per cent in global fixed income, 10 per cent in diversified real assets, namely timber and infrastructure, and 5 per cent in US-only private real estate. “The most important thing is that we have introduced a layer of equity exposure,” says Schulz, adding that the equity portfolio comprises a 30 per cent allocation to domestic equity divided between passive and active management. United States large cap is a blend of passive and enhanced mandates tracking the S&P 500 and there is an actively managed allocation to US small caps. The remaining 20 per cent is a blend of active and passive international equity. A private equity allocation will likely follow in coming years, he says. The fund’s 35 per cent fixed income allocation is broad-based, split between core US, where the focus is on five-and-a-half-year durations benchmarked against the Barclays US Aggregate Bond Index, and a more flexible allocation to agency securities, bank loans and emerging market debt with longer durations.

Norway and the accidental chief

It’s an asset allocation that is comparable to the Government Pension Fund of Norway. Although Schulz says “he never set out to structure the fund in the same way”, executives from North Dakota have visited Norway and Schulz trawls the Norwegian oil fund’s website, which he values for a level of transparency that sees the $743-billion fund’s value updated every second. The legacy fund will continue building revenue until June 2017, by which time lawmakers are allowed to begin tapping the account, although there is no spending plan in place yet.

As the legacy fund takes off, so Schulz hopes his own internal team of 18, mostly dedicated to benefits administration, will begin to grow. “All investment is externally managed, but the growth in other non-pension assets will see us build out staff,” says Schulz. Just six months after he joined the fund from Indianapolis health insurance group Wellpoint, Schulz was promoted to acting chief investment officer at the Bismarck-based North Dakota State Investment Board when John Geissinger resigned. He hasn’t formerly applied for the chief investment officer role and says that once the role is filled, he is looking forward to sharpening his focus on investment strategy, the role he was originally hired for.

A rising-rate environment

North Dakota’s $4.3 billion in pension assets, which includes eight different pension funds, returned 13 per cent in the fiscal year ending June 2013. The biggest funds in the portfolio are the North Dakota Public Employees Retirement System and Teachers’ Fund for Retirement. Both have target global equity allocations of 57 per cent divided between domestic equity (31 per cent), international equity (21 per cent), developed markets (16 per cent) emerging markets (5 per cent) and private equity (5 per cent). Allocations to US and international equities and high yield fared best in the year ending June 2013, says Schulz. “We’ve had decent returns from US private real estate and infrastructure too, although timber hasn’t been so good,” he says attributing the poor performance in the 5 per cent timber allocation, much of it in softwoods used in construction, to a slowdown in demand from the US housing market. The target 20 per cent allocation to global real assets comprises 10 per cent to global real estate and a 10 per cent allocation to infrastructure, timber, commodities and other inflation-linked assets.

Rather than change the asset allocation, Schulz is planning to change implementation in the fixed income portfolio with fewer benchmark-sensitive mandates. He wants to redesign the allocation, where 17 per cent is in domestic fixed income and 5 per cent in international fixed income, to integrate some short-term durations and unconstrained mandates as a complement to traditional core/core-plus mandates. “We want more wriggle room in a rising-rate environment,” he says describing a strategy which would cave out two distinct portfolios: one in core fixed income and another in actively managed, shorter core-plus mandates.

Derivative use in the pension assets includes treasury futures to manage interest rate exposure and also synthetic exposure to the S&P500. “Passive management is our default option in efficient markets,” he adds. The pension fund is in deficit at only 62 per cent funded. Something Schulz attributes both to “the challenges of meeting actuarially required contributions” and the ravages of the financial crisis. However, he is confident he has the right strategy to get back on track. “We are back on our glide path to shrinking the deficit and turning a corner,” he says. “The state is in good fiscal health, which does put the plan in a better position to address the funding status.”

Oleg Ruban at MSCI finds that the stories behind yield rises in Japanese government bonds matter greatly. They influence the correlation between Japanese equities and government bonds, which is crucial in determining the size and direction of the impact of these scenarios on representative portfolios in different geographical segments and asset classes.

Why does this matter? It’s that old gem interconnectedness again: as the tsunami illustrated begins in Japan and roils around the Pacific, turmoil in the Japanese government bond market effects, at first, bond and equity markets in the Asia-Pacific region. As these markets are so inextricably connected to markets around the world, the impact is then felt globally.

You need to know about that. Read the whole story here.