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

 

 

 

Spain is a country of high geographic diversity where barren plains meet lush mountains and quiet old villages dot the landscape between vibrant, majestic cities. Fittingly perhaps, the country’s largest occupational pension investor Fonditel shines out as a highly sophisticated investor among an underdeveloped pension landscape.

The €3.9-billion ($5.2-billion) fund – that mostly covers employees at Spanish telecoms giant Telefonica – is getting more sophisticated too, according to chief investment officer, Jaime Martinez Gomez.

An important part of the fund’s “significant evolution”, according to Martinez, has been defining its investment philosophy. This has led to the adoption of a dynamic risk model centered around a tool that informs the fund of its tactical risk position. A series of inputs make long-term assessments that aim to give the fund an asymmetric return profile.

The tool has consistently told Martinez since the start of 2012 that the fund should be in a risk-on mode. He explains that this has come because long-term price momentum is the most dominant of the tool’s inputs. The fund has accordingly taken a hefty overweight on its equity position – some 47 per cent compared to a strategic allocation of 35 per cent.

As the fund does not want to fully incur the risks involved with blindly following its dynamic-risk management tool, it has also begun a “tactical hedging” process to cover its heavy equity exposure. “We believe it’s the right moment to hedge equities as low volatility has reduced the prices of hedges and performance has been good for the past 12 months,” says Martinez.

Despite Fonditel covering the potential downside, its 47-per-cent equity allocation marks a bold position in relation to other Spanish pension funds. They tend to follow the general continental European tradition of being bond-heavy investors. “We are more global in that sense than our peers, with the average equity allocation of Spanish funds being around 20 per cent,” says Martinez.

Fonditel invests to a steady strategic geographic spread, with 50 per cent of equity exposure in Europe, 30 per cent in the US and 20 per cent in emerging markets. It might decide to gain Japanese exposure at an upcoming strategic review, Martinez reveals, as well as possibly reducing an underweight on Spanish equities to reflect a brighter economic outlook for crisis-hit Spain.

Smart side of alternative scene

Fonditel’s 14 per cent strategic alternative allocation is also unusually high for a Spanish fund, says Martinez. With the financial crisis and the country’s real estate crash hitting the alternatives portfolio badly, he concedes, “This hasn’t served us too well over the last five years.”

The alternatives segment has been underweighted, too, in order to cater for a growing number of inactive or retired members who have worked for Telefonica since the fund was established 20 years ago. “Having a lot of members retired or close to retiring means we have to be more conservative with our illiquid investments,” Martinez explains.

The fund now has a 6.5 per cent private equity allocation, 3.5 per cent real estate investment and 1.5 per cent commodity exposure. Commodities were occupying as much 5 per cent of the portfolio as recently as 2011, but Fonditel has made a sharp switch out of cyclical commodities to retain just gold and agriculture investments, and has since reduced two-thirds of its gold exposure. “In our opinion, gold has lost part of its attraction in the past 12 months due to the probable end of quantitative easing in the United States,” he argues.

“In the next five years, we will probably further reduce our investments in very illiquid assets,” Martinez says. Instead of shunning alternatives as a consequence, Fonditel is reinvesting alternative-asset sales in a smart-beta portfolio. This should allow it to keep an exposure to alternative-risk premiums while enjoying greater liquidity.

“We have developed a model smart-beta portfolio that includes a number of strategies benefitting from different risk premiums and this will likely evolve further,” he explains.

The pain and gain in avoiding Spain

Keeping a substantial alternative exposure is a key focus, says Martinez, as Fonditel has a “low expected return” on its fixed-income portfolio, which is given a strategic weighting of 51 per cent of the fund.

Ironically, these expectations, Martinez says, would not be so dampened were it not for its activity during the eurozone crisis. “If you have all your investments in Spanish bonds, you will now have a nice expected return, but we decided not to focus on this risk,” he explains.

Fonditel has been underweighting its bond holdings significantly. “Fixed income is not going to be as good as it has been in the last two years, so we need to trust in the equity market to generate a real return,” says Martinez. It splits its fixed-income portfolio in two equal segments covering duration risk and credit risk. The first category includes core European government bonds and the second category mainly US and European corporate debt, along with emerging market sovereign bonds. Fonditel has added its remaining Spanish government paper, along with Italian and – intriguingly – French government debt in the latter category. Martinez sees “more credit risk than interest rate risk” in these investments.

Managing most of its assets passively in house, Fonditel uses futures and other traded derivatives to match indices.

The fund operates on a defined contribution basis and aims for returns of three percentage points above European inflation rates. Its risk-on position has delivered returns of between 9.9 and 14 per cent (for separate plans) in 2012 and up to 8 per cent to date in 2013. Most significantly for Martinez, he says confidentially that “the innovations we are making in our investment process are adding to our returns for the time being”.

United States equities and real estate were the strongest suits at the $26-billion Hartford-based State of Connecticut Retirement Plans and Trust Funds (CRPTF) out of an entire portfolio that posted 11.6 per cent in the fiscal year ending June 2013.

Now the manager of Connecticut’s six retirement plans and nine trust funds is developing opportunistic strategies across the portfolio, as well as its alternative asset allocation.

It’s an approach focused on seeking investments that generate cash flow and strategies to protect the fund from rising interest rates against a backdrop of underfunding, with the biggest plan in the CRPTF portfolio, the Teachers’ Retirement Fund, only 55 per cent funded.

“Given our funded ratio, we need to make up ground and keep pace with achieving our targeted returns,” says Lee Ann Palladino, chief investment officer at the CRPTF, who joined in February 2005.

Explaining the challenge ahead she says: “It is a question of looking in the rear view mirror in terms of the portfolio value lost as a result of the market declines associated with the recession, and looking ahead to muted returns in the short-to-medium term horizons.”

Reducing equities in favour of alternatives

Following a 2012 review of asset allocation, CRPTF now has a 48 per cent equity allocation, reduced from 52 per cent, and a 20 per cent allocation to fixed income, pared from 25 per cent and comprising core fixed income, inflation-linked bonds, high yield and emerging market debt.

Connecticut’s private equity allocation is unchanged at 11 per cent, but it has increased its real estate allocation to 7 per cent and has 8 per cent of the portfolio in alternatives, with the remainder in a liquidity fund.

“Over the course of the last fiscal year, we have been overweight equities and this has been positive,” says Palladino. “Our plan is to reduce equities in favour of our alternative investment portfolio, going forward.”

As well as reducing its fixed income allocation, Connecticut will reposition the allocation to better “protect the principle and earn cash flow”.

Palladino explains: “Cash flow generation is a key element of our strategy given our plan-participant demographics. We have reduced allocations from US fixed income and treasury bonds to high yield debt. We also seek strategies that have a high component of cash flow within private markets such as secondary private equity, mezzanine debt and credit opportunities.”

She says the fund will use less constrained bond funds and hedging strategies to help protect its US fixed income portfolio against rising rates.

Real and diverse

Real estate is a particular focus for the fund in its search for cash flows. The portfolio, which returned 10.2 per cent in the fiscal year 2012-2013, is benchmarked against the National Council of Real Estate Investment Fiduciaries Property Index (NCREIF Property Index) and is focused on every sector, from retail and industrial to hotels and real estate investment trusts, looking particularly at “beaten down and value add areas”.

Palladino says that although the portfolio only invests in the US, it is diversified with a split between a core portfolio, accounting for 40 to 60 per cent of the total allocation, a value-added portfolio, an opportunistic portfolio and a publicly traded portfolio. Investments encompass externally managed separate accounts to limited liability companies or limited partnerships with a focus on professionally managed commercial properties and land.

The fund’s boosted real asset allocation, sitting within its alternatives, global inflation-linked and real estate portfolios, will offer diversity away from equities and fixed income and hedge against inflation.

Here the emphasis is on energy, global inflation-linked bonds, commodities, agriculture, metals and timber, says Palladino. The alternatives portfolio also includes an allocation for opportunistic investments such as dislocated European credit.

“We are long-term investors and committed to our diversified asset allocation strategy,” says Palladino. “However, we strive to be more nimble in these ever-changing markets and have built in flexibility across all asset classes, and in public and private markets, to allow opportunistic mandates.”

These mandates will employ more flexible investment guidelines versus the benchmarks and allow for short and intermediate opportunistic positioning, she says.

Equities exposure

Connecticut’s domestic equity allocation, invested in its mutual equity fund and benchmarked against Russell 3000 Index, is primarily passive. Developed-market international stocks also hold “a meaningful passive allocation” as does the fund’s core US fixed income allocation.

All other public market allocations are active. “Our philosophy for active or passive management is based on efficiencies of the market, the ease of replicating the benchmark, cost and the ability of active managers to add value,” she says.

Developed-market equity exposure, via its $5.6-billion developed markets international stock fund, benchmarked against MSCI EAE IMI, is 65 per cent active and includes an overlay that hedges 50 per cent of the currency exposure.

“This is a sizeable portfolio and we were concerned about our exposure to short-term currency fluctuations,” says Palladino. “The strategy has added 240 basis points to overall returns given the rise in the US dollar.”

The overlay is currently managed by Insight Pareto Investment Management. In other portfolios, such as emerging markets, foreign securities remain unhedged because of the smaller allocations to these markets. The overlay can be managed passively or actively, depending on opportunities in the marketplace, she says.

Connecticut’s private equity portfolio returned 9.5 per cent between 2012 and 2013.

The largest allocation is to buyouts but investments include early, mid and late venture capital funds, acquisition and restructuring funds, mezzanine debt funds, turnaround and distressed funds. Target returns vary between a 400-to-800 basis-point premium net of fees above the 10-year average annualised return of the Standard & Poor 500.

Palladino says primary funds are the predominant investment vehicle, but Connecticut also invests via secondary funds, funds of funds and separate accounts. Investments are diversified according to their vintage, geography, industry and strategy, she says.

Palladino’s internal team is made up of seven investment professionals and all assets are externally managed. “We are not entertaining any move in house; we are happy with how it is working,” she says. For now the focus is on clawing back lost ground and meeting an 8 per cent state legislature-set rate of return. “It will keep us on our toes,” she says.

CalPERS has adopted 10 preliminary investment principles following a board offsite in July, but a number of topics, including the role of active management, are still under debate ahead of the September board meeting that is the deadline for the principles’ adoption.

The $266-billion Californian fund began the process for establishing investment principles in January and the workshops have been guided by Towers Watson.

While many of the draft investment beliefs could be described as more generic investment-related principles – such as CalPERS articulating its investment goals and performance measures and ensure clear accountability for their execution – the fund has also adopted a unique view of its fiduciary duty.

Anne Simpson, director of corporate governance at CalPERS, says it has wrapped a new framework of economy around the fund, including three forms of capital.

Specifically it states that “long-term value creation requires effective management of three forms of capital: financial, physical and human”.

“We have some old-fashioned economics to ground what we’re doing and why sustainability matters,” she says. “It is ground-breaking stuff this investment beliefs work. We want to be engaged owners. This is a transformation, it’s like the oil tanker turning around.”

Questioning duty

In the past CalPERS chief executive Ann Stausboll has also been vocal in questioning the fiduciary duty of pension funds.

At the Ceres conference in January 2012 she said the fiduciary duty of pension funds should extend to issues outside the parameters typically understood as being directly related to beneficiaries’ financial interests.

Stausboll said it is a fiduciary duty of investors not only to manage risk and look for opportunities associated with climate change, but also to push for business and government action to tackle environmental and sustainability issues.

“We’ve made enormous progress in just the past few years, but we need to keep up our continued engagement with companies and policymakers to help advance the transition to a sustainable global economy,” Stausboll said.

“As fiduciaries, it is our job to make sure investors, businesses and policymakers are responding aggressively and creatively to the risks and opportunities associated with climate change and other sustainability issues.”

This sentiment has now been reflected in one of the draft principles to come out of the July offsite: “CalPERS investment decisions may reflect wider stakeholder views, provided they are consistent with its fiduciary duty to members and beneficiaries”.

Woven right through

Simpson says the fund now has a goal of integration for sustainability, which is a long way from the “scattered initiatives” of a few years ago. “The thinking is woven right through,” she says. “We are thinking about future members and pensioners and encouraging managers to do the same.”

CalPERS will also be pushing its managers further on cost and disclosure issues.

Another principle is that “costs matter” and as part of this all costs should be transparent. But Simpson points out that this is difficult in the private asset classes. “In these asset classes there is no disclosure of carry. We are pushing the thinking on this.”

 

The July draft

The 10 investment beliefs, listed below, required a “super majority” or two thirds of the board votes, to move forward for consideration or adoption at the September investment committee, at which the fund’s investment beliefs will be finalised.

Since the April investment committee workshop, a number of topics have required additional discussion, that will continue until September. The issues for further discussion are: active management, investment performance targets and alignment of interests, the approach to integrating sustainability into investment decision making, and risk management and measurement.

The fund, which returned 12.5 per cent for the year to June 30, 2013, outperforming its benchmark by 1.5 percentage points, is also doing its triennial asset liability study.

Here are CalPERS’ draft investment beliefs asthey were in July 2013.

  1. Liabilities should influence the asset structure.
  2. A long time-investment horizon is a responsibility and an advantage.
  3. CalPERS investment decisions may reflect wider stakeholder views, provided they are consistent with its fiduciary duty to members and beneficiaries.
  4. Long-term value creation requires effective management of three forms of capital: financial, physical and human.
  5. CalPERS shall articulate its investment goals and performance measures and ensure clear accountability for their execution.
  6. Strategic asset allocation is the dominant determinant of portfolio risk and return.
  7. CalPERS will take risk only where we have a strong belief we will be rewarded for it.
  8. Costs matter and need to be effectively managed.
  9. Risk to CalPERS is multi-faceted and not fully captured through measures such as volatility or tracking error.
  10. Strong processes and teamwork and deep resources are needed to achieve CalPERS goals and objectives.

This policy memorandum from the Paulson Institute describes the current state of the Chinese pension system and offers some suggestions to address a range of issues.

The author, veteran academic and policy wonk Robert Pozen, discusses the key challenges facing the Chinese pension system, examines the causes of each of these challenges and puts forward proposals to address them. The paper focuses primarily on one of the four subsystems that constitute the sprawling Chinese pension system, the Urban Enterprise Pension System, which covers urban workers who are mainly employees of large private and state-owned enterprises.

The problems China faces in providing for its elderly are not entirely different from those in the developed world – ageing populations, increased life expectancy and insufficient funding. However, there are some doozies that have uniquely Chinese characteristics, such as the one-child policy, the mobility-hobbling household registration system and the pension system’s administrative and geographical fragmentation.

The refreshing take of this offering is that, unlike the noisy partisan nature of pension fund discourse in the real world, it comes up with sensible, well considered solutions to the extraordinarily complex issue of caring for our families. Take the time to read Tackling the Chinese pension system.