The concept of investment beliefs is the basis for strategic management and, while widely used in other parts of the world, is “innovative” from a US perspective, Allan Emkin, managing director of Pension Consulting Alliance, says.

In a session at the Risk Summit, convened by World Pension Forum and Conexus Financial, publisher of conexust1f.flywheelstaging.com, Emkin said he favoured the investment beliefs investigations being undertaken by some of his clients.

“In my 30-year career, people have implied investment beliefs but never explicitly had them. It provides a vehicle to provide a discussion in depth.”

Emkin is consultant to CalPERS, which is currently undertaking an investment beliefs process that has included discussions with staff, the board and consultants as well as an offsite workshop.

“The most important thing that has come out of the process, in my opinion, is it has dramatically improved dialogue between staff and the board about what is important for a large institutional portfolio,” he says.

Emkin said he was personally pleased that a number of the investment beliefs the board has adopted are not textbook – such as risk being multi-faceted and not fully captured by tracking error.

“I personally hate tracking error: it is a way to guarantee managers never get fired because they have a band within which to operate.”

 

For the story on the CalPERS investment beliefs workshop and a list of the draft investment beliefs, click here

 

 

The funding levels of US public pension funds, falling from 100 per cent in 2001 to 77 per cent now, is the result of bad governance, according to David Villa, chief investment officer of the $91 billion State of Wisconsin Investment Board (SWIB).

He says irrational governance and imprudent management has resulted in the funding crisis in the US.

He gives examples of bad governance including contribution holidays, unfunded benefit increases, unrealistic investment return targets (with a huge bias to be optimistic), uneconomic investment decisions, higher than normal expense ratios and under-compensated investment professionals.

Villa and Sorina Zahan, partner and chief investment officer of Core Capital Management, have been working together on a paper that looks at governance, market risk and system design. They presented the findings at the World Pension Forum Risk Summit, jointly convened by Conexus Financial, the publisher of conexust1f.flywheelstaging.com.

The study aims to develop a palatable mathematical framework to compare different structures to find their vulnerabilities. The modeling is based on option modeling.

Zahan says the study looked at market risk and the impact on different pension structures – defined contribution, defined benefit and a hybrid model – and how they behave when there is not an equilibrium return.

“We looked at the robustness of the structure and the variability of returns, and the net payoff to the employee and the sponsor.”

Not surprisingly the study found that defined contribution plans are very sensitive to market risk, but defined benefit funds were not.

“Convexity, or sensitivity to market risk, is a critical source of return that is often ignored,” she says.

The study found that the defined benefit structure is the most beneficial to the plan sponsor because it keeps the upside. However, that can only be realised when there is prudent investment and management.

“The impact of poor governance is greater on less robust, or more convex, structures. The trick is not to squander the cushion,” she says. “Nothing is wrong with the defined benefit structure, but with the way it is managed.”

The study argues that hybrid plans, which SWIB offers, can allocate both the upside and downside risks between the employee and the sponsor to achieve better alignment of interest.

Villa argues that the hybrid model means better governance because when the trustees come to the table, they’re more interested in getting it right.

 

Continued use of quantitative easing is sowing the seeds of financial instability, according to Sheila Bair, former chair of the Federal Deposit Insurance Corporation, who says that the 2008 crisis taught us a credit-driven economy is not sustainable.

Bair has been an outspoken critic of quantitative easing and says there has been too much reliance on the Federal Reserve Bank.

“The economic problems are structural, not cyclical, so they need to be solved through fiscal policy,” she says, recommending tax reform and the creation of an infrastructure bank.

She says quantitative easing, or cheap credit, is designed to get people spending again, but it penalises savers and creates pressure for the investment community to find yield.

“It encourages you to take risk,” she told the audience at the Conexus Financial/World Pension Forum Risk Summit.

Bair said she was worried about the assessment of risk in markets, and says that both the bond and stock markets are inflated.

In particular, she says investment in stock markets is driven by low yields in the bond market.

“I want to think that stock market growth is driven by fundamentals, but think it’s driven by low yield on bonds.”

Bair told the pension-fund audience that there was continued volatility to come, and that long-term structural reforms were needed.

“Monetary policy has been the only game in town. We have been in quantitative easing for too long, but the Fed will have to detach very slowly,” she says. “We need to get back to real economic growth, with real wage growth and the production of goods and services that people want to buy.”

The Federal Deposit Insurance Corporation (FDIC) is an independent agency created by the Congress to maintain stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions for safety and soundness and consumer protection, and managing receiverships.

Bair says she believes in a rules-based process to regulation and recommended that, as part of that,banks are required to have more capital on their balance sheets.

“They rely too much on short-term funding,” she says. “A well capitalised banking system is essential if we want to have a stable financial system.”

As investors of bank stocks, she recommends that pension funds look at whether they are getting good shareholder value. In particular, she says there is more value in the large financial conglomerates in pieces, rather than as large institutions.

“2008 could have been avoided,” she says. “There should have been more fundamental restructuring of the banks. The investing community needs to weigh into this.”

 

 

Moody’s recent downgrade of the City of Chicago was because of its pension liabilities, according to the city’s treasurer, Stephanie Neely, who says the current actions to fix the funding deficit problems are just “re-arranging the furniture”.

“The benefits and contributions are the problem: we cannot invest our way out of this,” she says, adding that the new lowered rates of expected return won’t help in a significant way.

On average, the city’s five retirement plans are 40 per cent funded, with the Firemen’s Annuity Benefit Fund the worst off at 20 per cent funded.

The city’s pensions are guaranteed and to change the state constitution would be very difficult, she says, making changes to the situation unlikely.

Neely says the funds are liquidated every 10 to 12 months in order to pay benefits, which means the portfolios are unable to take advantage of private equity and other illiquid, long-term assets.

The city treasurer was speaking as part of a panel discussion at the World Pension Forum Risk Summit, jointly convened by Conexus Financial, the publisher of conexust1f.flywheelstaging.com.

Compared to Australia

Her session saw the comparison of the Chicago funds and their dire predicament to the Australian defined contribution system and specifically MTAA Super, the fund chaired by former Victorian Premier, John Brumby.

Brumby outlined to the largely US public-pension fund audience that the Australian superannuation guarantee system was possible because of agreement between unions, government and business about a long-term vision for Australia’s retirement, and a compulsory superannuation guarantee was legislated in 1992.

Because of the mandated contributions, the $6-billion MTAA Super, like many Australian funds, is able to take a long-term view of investments without having to worry too much about liquidity.

This allows the fund to invest in unlisted investments, and it currently has about 30 per cent in those investments.

Brumby says the big debate in Australia is the privatisation of infrastructure, with the infrastructure deficit estimated to be between $250 and $700 billion.

“If the states privatised rail, electricity and port assets to institutional investors, it would make privatisation process politically more palatable,” he says.

An indication of the demise of the system in Chicago is that the Labourers’ and Retirement Board Employees’ Annuity and Benefit Fund of Chicago was 130 per cent funded in 2000. This year it is 55 per cent funded.

It is estimated that given current contribution levels and market conditions, Chicago will drain pension assets in 12 years.

The Australian system, on the other hand, is estimated to grow from $1.7 trillion now to $7 trillion by 2020, due to the guaranteed nature of the system and mandated contributions, now at 9 per cent.

 

In his first major announcement as governor of the Bank of England, Canadian-born Mark Carney says ultra-low interest rates are here to stay. This couldn’t be worse news for pension funds, according to pension’s expert, Ros Altmann, but private-public collaboration on infrastructure could help ease the pain.

 

The prospect of another three years of ultra-low interest rates in the United Kingdom couldn’t be worse for pension schemes, argues Dr Ros Altmann, a pensions and economics policy expert and former investment banker who has advised governments, corporations, trustees and the pension industry.

Renowned particularly for her championing of savers short-changed by government policy, it’s no surprise she describes the first major announcement from Canadian Mark Carney, the new governor of the Bank of England, as promising three more years of misery.

Central to her argument against low interest rates is the “profound damage” pension funds are suffering from quantitative easing, QE, the government policy begun in 2009 designed to stimulate the economy by creating new money to buy government bonds.

“By buying so many gilts the government has forced long-term interest rates down and this is what pension funds use to value their liabilities. It is becoming more and more expensive to fund pension funds.”

Although the government argues asset price rises caused by QE will offset any increase in pension liabilities, Altmann doesn’t believe asset prices have risen in line. Estimates suggest that a 1 per cent point fall in gilt yields leads to approximately a 20 per cent  rise in pension liabilities, but only a 6-10 per cent rise in typical pension fund asset prices, she says.

Ballooning liabilities have caused many UK funds to try to adjust their investments to reduce risk by investing in bonds.

A strategy Altmann says “might prevent further sharp deteriorations but won’t overcome their deficits.” Adding: “Gilts are not a return generator” and “lock in” any deficit removing the potential of asset growth over time.

 

Infrastructure has the answer

 

One answer is for pension funds to invest more in infrastructure. The illiquidity premium will earn higher returns than gilts with the addition of a natural inflation hedge.

“It is disappointing that there has not been more urgency in putting pension fund money to new infrastructure,” she says.

One way to encourage it would be for the government to underwrite future inflation linked income streams for large scale infrastructure projects.

“This would provide pension trustees with a realistic alternative to long-term inflation linked gilts,” she suggests. “The government should say that if a project doesn’t deliver whatever the benchmark is, we will make up the difference. It would have been far better for the economy than QE.”

Altmann would also like the government to help pension funds better hedge against people living older. It is why she argues for the government to issue a longevity bond.

Although pension funds can enter into longevity swaps Altmann argues that this can be a risky transaction for many funds because of counterparty risk.

“If the government was counterparty it would be a safer and better yardstick against which pension funds could measure longevity risk,” she says.

The coupon on the bond would be linked to rising life expectancy, so if life expectancy at the fund rose, so would income from the bond. Alternatively if life expectancy fell, income would too.

“Longevity bonds would pay an interest rate dependent on rises in life expectancy which would allow pension schemes and annuity providers to better match their liabilities.”

She argues that too many UK funds have assumed that stock market returns will keep pace with their liabilities, calling it “an assumption” among pension funds that equity returns would keep up with longevity and inflation.

“This is now not the case,” she says, and urges funds to diversify and for trustees to look for both long-term themes and opportunities outside the UK.

Investment strategies she admires include the Pension Protection Fund, the UK’s lifeboat fund, which she says has the right balance between hedging its liabilities and diversified growth with its portfolio split between a 70 per cent allocation to bonds and cash, 10 per cent in global equity and 20 per cent to alternatives.

She is gloomy about the ability of local authority schemes to make up their growing deficits, saying “at some point” central government will have to bail out local authority pension schemes because taxpayers can’t fund all the pensioners.

“Funds need to be careful about their liabilities. Asset returns are not the only thing they should worry about.”

 

For more of Altmann’s views visit her blog

 

 

 

 

The Norwegian government should establish a new fund, the Government Pension Fund – Growth, to invest in developing countries, resulting in the dual benefits of jobs creation and investment returns for the fund, recommends a report by Re-define, commissioned by Norwegian Church Aid.

The NCA, which is a member of the humanitarian alliance, Act Alliance, believes that the  $760 billion sovereign wealth fund’s unique long-horizon positions it for investment in developing countries, and could go some way to providing capital for job creation.

It argues that capital from the Norwegian Sovereign Wealth Fund could be channelled into low income and lower middle-income group of countries, benefiting the fund by securing its value for future generations, but also provide much-needed capital to developing countries to create jobs and infrastructure.

Currently the Government Pension Fund – Global, invests 94 per cent in developed markets, with a target of 10 per cent in emerging markets. At the end of March, 2013 the fund invested 62.4 per cent in shares, 36.7 per cent in fixed income and 0.9 per cent in real estate.

 

 

To access the report, authored by Re-define’s managing director, Sony Kapoor, click here