As almost every market in the world looks to move from defined benefit to some sort of defined contribution model, academics at the Pensions Institute of the Cass Business School, City University London have developed a set of 15 principles for designing a defined contribution model. The principles, consistent with the recently published OECD guidelines, are based on more than a decade of research.

First launched in London at an event jointly hosted by the OECD, World Bank and the International Centre for Pension Management (ICPM) earlier this month, the principles cover model specification and calibration, modelling quantifiable uncertainty, member choices and characteristics, plan charges, longevity risk, the post-retirement period.

The principles also leapfrog some of the more developed defined contribution markets, such as Australia, and advocate integrating the pre- and post-retirement periods. It also models additional sources of income, such as state pensions and equity releases, and looks at modelling extraneous factors, as well as scenario analysis and stress testing, periodic updating of the model and changing assumptions.

Head of the Pensions Institute at Cass, David Blake, says a defined contribution model should project both at-retirement pension outcomes and post-retirement outcomes, and consider pre- and post-retirement periods in an integrated way. It should also consider other sources of retirement income outside the members’ pension plan in an integrated way.

He says that most defined contribution pension plans are “very badly” designed.

“A well designed plan will be designed from back to front, that is, from desired outputs to required inputs,” he says.

Speaking at the event, director of ICPM, Keith Ambachtsheer, says building an ideal retirement income system should cover three phases: pre-work, work and post-work, and in doing that answers seven questions.

  1. Length of the three phases
  2. Individual versus collective decisions
  3. Pay as you go versus pre-funding
  4. Embedded risks
  5. Risk-pooling mechanisms
  6. Demographic, economic and capital market prospects
  7. Institutional structures.

According to the Towers Watson Global Pension Assets Study, defined contribution assets represent about 43 per cent of total pension assets, but are growing at a rate of about 8 per cent, compared to 4.6-per-cent growth in defined benefit.

The UK, which is the third largest market in the world and has about 40 per cent in defined contribution assets, is looking closely at its pension modelling. It is estimated that about 11 million people are at risk of an inadequate pension in the UK. Last October the government introduced automatic enrolment and backed NEST, a defined contribution fund for low-income earners.

Also speaking at the event, chairman of NEST, Lawrence Churchill, says the European Commission has identified four problems with pensions: participation, adequacy, security and sustainability.

“We can transform this in a generation if we address those four boldly, transparently and simultaneously.”

The conference also discussed the importance of communicating to members, a function more prominent in a defined contribution environment, and in particular that any communication with members should have the aim of actually influencing behaviour.

The OCED and the Chilean pension regulator have collaborated to develop a retirement-income tool for members, with which the Chilean regulator actually standardised the assumptions used by providers in communicating benefits to members – also supported by the recommendations of Cass.

Head of private pensions at the OECD, Juan Yemo, says projections have a critical role to play in communicating with members at any age.

“They help with the emotional aspect of losses, not just about volatility or risk, but behaviour when people see those losses,” he says. “This information can change behaviour.”

The Cass Business School is looking for feedback on its prinicples. To access the discussion paper, Good Practice Principles in Modelling Defined Contribution Pension Plans, click here.

The Cass Business School’s principles of designing a defined contribution model

Principle 1: The underlying assumptions in the model should be plausible, transparent and internally consistent.

Principle 2: The model’s calibrations should be appropriately audited or challenged, and the model’s projections should be subject to back testing.

Principle 3: The model must be stochastic and be capable of dealing with quantifiable uncertainty.

Principle 4: A suitable risk metric should be specified for each output variable of interest, especially one dealing with downside risk. Examples would be the 5 per cent value-at-risk and the 90-per-cent prediction interval. These risk metrics should be illustrated graphically using appropriate charts.

Principle 5: The quantitative consequences of different sets of member choices and actions should be clearly spelled out to help the member make an informed set of decisions.

Principle 6: The model should take account of key member characteristics, such as occupation, gender, and existing assets and liabilities.

Principle 7: The model should illustrate the consequences of the member’s attitude to risk for the plan’s asset allocation decision. It should also show the consequences of changing the asset allocation, contribution rate and planned retirement date, thereby enabling the member to iterate towards the preferred combination of these key decision variables.

Principle 8: The model should take into account the full set of plan charges.

Principle 9: The model should take account of longevity risk and projected increases in life expectancy over the member’s lifetime.

Principle 10: The model should project both at-retirement pension outcomes and post-retirement outcomes. The risks associated with the following strategies should be clearly illustrated: the risk of taking a level rather than an index-linked annuity in terms of a reduced standard of living at high ages, and the risks associated with drawdown strategies in terms of taking out more from the fund initially than is justified by subsequent investment performance.

Principle 11: The model should consider the pre- and post-retirement periods in an integrated way. This is necessary to avoid undesirable outcomes at a later date – such as a big fall in the standard of living in retirement. It will also help to determine what adjustment in member choices – in terms of higher contribution rate, an increased equity weighting and later retirement – are needed to avoid this.

Principle 12: The model should consider other sources of retirement income outside the member’s own pension plan. These include the state pension and home equity release. A well-designed DC model will also help with lifetime financial planning.

Principle 13: The model should reflect reality as much as possible and allow for such extraneous factors as unemployment risk, activity rates, taxes and welfare entitlements.

Principle 14: Scenario analysis and stress testing are important. For any given scenario, one should also: make key assumptions explicit; evaluate key assumptions for plausibility; and stress-test assumptions to determine which really matter. This allows the modeller to determine the important assumptions and focus on getting them (as much as possible) ‘right’.

Principle 15: The model will need to be updated periodically and the assumptions changed. Such modifications should be carefully documented and explained in order to make sure the model retains its credibility with users.

 

Despite upturns in equity and bond prices sending 2012 returns into double digits at many large Danish funds, it appears that successfully implementing infrastructure initiatives remains the holy grail of Danish institutional investing.

Instead of merely basking in 12.9-per-cent annual returns, Industriens Pension, for instance, used its 2012 results announcement to make a commitment to double its infrastructure and real estate investments to DKK10 billion ($1.73 billion).

That marks yet another move in Danish funds’ determined hunt for yield – many of the largest funds have set similar targets with PensionDanmark earmarking 20 per cent of its $23.9 billion portfolio for “stable alternatives”.

Bertel Rasmussen, partner at Copenhagen pension consultancy Kirstein, says “funds started off with infrastructure and private equity funds but have been going more directly lately. They are looking for Danish projects and co-investment in a very long-term commitment.”

Due to the limited investment choices defined by strict Danish solvency laws, funds are seeking to make the most of infrastructure, clubbing together to invest and push for public works opportunities.

PKA, for instance, now owns 20-per-cent stakes in two large offshore wind farms under construction, with PensionDanmark holding a similar-sized stake in one and Industriens Pension in the other.

Finn Rasmussen, chief executive of Mercer in Denmark, cautions that a detailed debate between funds and the government on the spread of risk in public-private partnerships needs to be resolved before domestic infrastructure investing can truly take off. And Bertel Rasmussen thinks that Danish investors’ drive in alternatives still has an experimental air to it.

That could be a reason why there has been some notable divergence in performance – even though funds can’t know from a single year’s returns if they have found what they are looking for. Industriens Pension lost over 7 per cent on its absolute return allocation in 2012; Frank Jensen, an analyst on PKA’s asset strategy team, stated that the fund has “not been satisfied” with year’s returns on its timber allocation; yet Danish giant ATP’s hedging portfolio outgrew the fund’s overall increase in liabilities with a return of $7.78 billion; and Finn Rasmussen believes it is simply too early for the hunt for yield to show in investment results.

Counting the gains

While Danish funds bucked the global trend with positive returns last year, Finn Rasmussen says that on the whole they are close to clawing back from the blows dealt in 2008 and 2009.

Michael Nellemann Pedersen, investment director at PKA, says 2012 was an “extraordinary” investing year as decent returns were generated by the fund across all asset classes.

Results at PKA were boosted by a call made to hold on to government bonds in southern Europe during the worst moments of the sovereign debt crisis in 2012. An 18.1-per-cent return from these peripheral holdings pushed the output from nominal bonds above 10 per cent. PKA, which currently counts $35 billion in assets, gained 13.7-per-cent returns over 2012. The result comes on top of the 9.4 per cent it generated in the troubled year of 2011 when the average for investors in the OECD was a 1.7-per-cent loss.

Lønmodtagernes Dyrtidsfonds (LD) also reported decent returns from its fixed income portfolio, helping it to an overall result on its $9.1 billion portfolio of 9.9 per cent in 2012.

For Bertel Rasmussen, booming bond prices are a key reason that Denmark’s labour-market pension funds are shown in a Kirstein study to have performed better in the recent past than the country’s commercial funds.

Rasmussen explains that the generally more conservative (and fixed income-heavy) approach of labour-market funds has made them find their feet better in the low-returns environment after the financial crisis.

The same dynamics might explain another intriguing finding of Kirstein, that there has been limited correlation lately between high investment costs and high returns.

Hello risk

Danish funds saw equity holdings rocket in value in 2012. The asset class generated average returns of 13 to 14 per cent in Bertel Rasmussen’s assessment, with the $57-billion-investor Danica stating that its equity returns were above 15 per cent.

Domestic equities proved particularly spectacular as Copenhagen’s small-cap heavy stock index significantly outgrew the global average.

Industriens Pension generated 26 per cent from domestic equities, while a strong emphasis on domestic stocks also helped LD gain 19.3 per cent in 2013 from its combined listed and private equity bucket – figures that lifted the overall returns.

As with every booming market, those that moved early to tap last year’s upturn in equities were rewarded most. Benny Buchardt, investment director of PenSam, explained the fund’s 12.6-per-cent 2012 return for its traditional plans by saying “thanks to our strong focus on risk capacity, we have been able to invest in shares and corporate bonds from the start”.

Several funds have been increasing equity exposure since the autumn as their outlook gets more bullish, according to Bertel Rasmussen, with the confidence from the 2012 results further boosting risk appetites.

Finn Rasmussen argues, however, that equity investments “will not change too dramatically” due to the strict solvency rules that Danish pension funds operate within. “If it was up to the funds, they would already have moved much more towards equities”, he concedes.

The introduction of new unguaranteed life-cycle-pension products that allow members to define their own risk profile is, however, opening up the scope for greater equity investment in the long term, says Finn Rasmussen.

Don’t give up the hunt

Dorrit Vanglo, chief executive of LD, says that while assets across the board pushed returns close to double-digit territory at the fund, she is not counting on replicating the results in the future, noting that interest rates and bond yields seemingly can’t go much lower.

Finn Rasmussen agrees with Vanglo’s point on the bottoming out of rates, but notes with a chuckle that he was also telling people at the start of 2012 that interest rates had almost no room to fall.

Looking to 2013, “I would be very happy to get just half of last year’s result – 5 per cent, that is,” Vanglo says, adding that a future shock to bond prices due to a rise in interest rates is something to be wary of.

Danish funds’ sustained attempts to diversify and find yield thus looks the most predictable feature of the next few years. It might prove an informative exercise for funds in other countries also moving away from classic asset classes.

Certainly, it will add to the vast experience Danes have in low-risk investing. That could be a useful guide in a world where risk is seemingly being squeezed out of pensions – whether by force with the EU’s planned Danish-style solvency provisions or by the natural maturing of closed defined benefit schemes.

If everything continues on schedule, the $60-billion AustralianSuper will begin testing its new internal investment-management systems this month, with a view to managing its first money in house in the third quarter of 2013.

Within four years the fund expects to manage as much as $40 billion in house, funded primarily from cash flow, and to have built an investment management capability the equal of any in the world.

AustralianSuper’s head of investment operations, Peter Curtis, says the fund has the benefit of starting with a blank piece of paper and designing something from the ground up. He says it can focus on doing the things it believes add value for members, such as implementing asset allocation decisions more efficiently and profitably, and outsource the things that are not its core business.

“We’re really starting from scratch and that’s allowed us to work out what we want to do internally,” Curtis says. “Our philosophy has been that we want to do things that are going to add value to the whole investment process, and the returns back to our members. We do not want to get into large-scale processing and we don’t want to get into areas where it doesn’t fit with our core capabilities.”

Curtis says the fund has “outsourced the whole middle office, and that means we’re not putting in a massive system which in itself would probably run to millions of dollars”.

“We’re not going to have a team of 20 people matching contract notes and doing a whole lot of other things,” he says. “We’re going to use an organisation that has that capability and has those systems and the scale to do all that.

Rolling out the plan

The first phase of the project will cost the fund about $5 million, but this expense is dwarfed by the expected cost savings. Curtis says the fund is close to finalising contracts for middle-office services and an execution platform, and is continuing to recruit new members to the investment management team.

“We’re hoping to have the model in, connected, and to have done our testing around the end of May,” Curtis says.

“Our plan is we’ll be doing testing in April and May. We will test the individual components, and then we’ll test the whole end-to-end process to make sure everything works in the manner that we’re expecting.

“That will then allow the internal team to go through the normal process of what’s their style, how are they going to manage the money – a bit like an external manager does a presentation – get the approvals, and then we work out how we allocate capital to them.

“AustralianSuper has very strong cash flow coming in every year, so we expect that we will allocate to these managers from our cash flows as they come into the fund.”

Once the Australian equities team is bedded down and managing money, the next asset class to be brought in house will be Asian equities. “We’re sitting at the bottom of that time zone, and as you’d know from various other things we’ve done – establishing the research office up in Beijing and the Asia advisory committee – Asia is a very critical part of where we believe the fund will be allocating capital in the future,” Curtis says. “We think that the next logical area for us to start to roll out is Asian equities, as the second cab off the rank.

“After Asian equities we then look at fixed interest and cash; and then after that, developed markets.”

Nailing down the costs

As money is allocated to its internal team, a growing proportion of the fund’s assets will be managed at what is affectively a fixed cost. The savings arise from the difference between the expected fixed cost and the cost of having the same funds managed externally. The fund currently spends about $200 million a year on external managers; if those costs continue to grow in line with funds under management, by the time the fund reaches $100 billion, its annual external management costs will hit about $500 million.

“With the internal team, once we get the scale, it’s almost a fixed amount that will be spread over an increasing AUM,” Curtis says. “At the moment we’re in the low 60s [basis points] with our investment costs; we would hope in the next three to four years to see the next step-change in our costs, down to the 40s.

“We want to put in place best-in-class investment management capability. If you look at where the numbers go on our projections, this platform will be running $30 to $40 billion in the next four to five years. We need to be as good as the large fund managers in Australia and large fund managers globally – because it’s going to be a global operation.”

Spin-off benefits

Curtis says the initiation of an internal investment management capability will not directly affect the asset allocation decisions the fund makes, but it will have effect how decisions are implemented – including a focus on after-tax returns.

“We think it’s going to give us a number of spin-off benefits,” Curtis says.

“Because we’re going to have an execution capability in the fund, we’re going to be able to think about how we execute our asset allocation changes. So we’ll be able to buy futures directly, if that’s what we want to do, to sell Australian equities and buy international – the ability to implement those asset allocation changes a bit faster and on a timely basis.

“We also think it’s going to give us much better insights into the asset allocation discussions. We’re going to have those direct touch points with the markets; we’re going to have people in different asset classes who are dealing in those markets on a daily basis that the asset allocation research group can talk about what they are seeing in the markets, and what you are hearing from companies when you’re out talking to them.

“The whole one-fund philosophy will continue to gain benefits. We think that the brokers and the counterparties are going to see AustralianSuper as a far more substantial organisation because we’ll be doing more things with them directly, across different asset classes.

“We think that’s going to mean the fund will see more things that are happening in the market. We will become hopefully a preferred client for most of those counterparties in the marketplace.

“We think that flows back into our existing engagement program that we’re running on governance and how we vote at meetings, et cetera. We just see there are multiple spin-offs and intangible-type benefits that will flow into our investment process and discussions we have with companies as shareholders and potential investments. It’s pretty much the virtuous circle.

More information, better decision-making

“The critical thing that the investment committee keeps talking about is, right, we’ve got to make sure that we capture these,” says Curtis, “and we’ve got to monitor that we are getting the benefits back to members and on better investment returns.”

Curtis says that the fund will also take a new look at after-tax investment returns. “One of the pieces we’ve put into the process is a capability from GBST,” he says in reference to the global financial services software provider. “What that’s going to allow us to do, almost as a pre-trade compliance check, the portfolio manager will be able to send the proposed trade file out to this GBST database that will come back to them pretty much instantaneously to say, if you go ahead and do those trades here are those tax implications. So it gives the portfolio manager some insights to effectively consider the tax implications before the trade goes on.”

A less than optimal after-tax result won’t necessarily prevent a trade from occurring, according to Curtis, but it gives portfolio managers “some more information to think about… and factor into your decision-making process”.

“The GBST database we will probably in the 2014 financial year rollout to our external managers, so they will able to ping the database through a website and basically see the same information,” he says.

“It’s one of those areas we’re looking for where we can tweak the investment management model to get some more benefits back for the members and just get a better outcome. We’ve been very pleased to be able to partner up with GBST to partner-up in that process.”

After-tax management is just as important for AustralianSuper’s members in the accumulation phase as it is for members in the pension phase. “Franking credits are of value in the pension as well, because effectively they get the cash value for them,” says Curtis.

Managing complexity

However, with a project the size of this one, unforeseen complexities inevitably arise. “How we fitted into the overall cash management and liquidity management processes [is something] we’ve spent a fair bit of time looking at and engineering in the most efficient manner we can,” he says.

“Once we started looking at how we allocated capital into these portfolios and how that impacts across the broader capital-allocation process, we spent a bit of time working that through so the portfolio managers would have access to how much cash they’ve got each day.”

On the flipside, however, connecting to external counterparts proved to be relatively easier than expected.

“The FIX [Financial Information eXchange] connectivity through NYSE Market has been simpler. We hook up to them and then they hook up to X-hundred brokers globally, and we can just turn them on as we wish. So that’s been relatively straightforward.”

Curtis says the project remains on schedule, but “the whole thrust from day one has been we want to have the right people, processes and systems in place. If we hit the date, that’s good but we’re not going to cut corners purely to hit a date”.

AustralianSuper is in the throes of building its Australian equity management team, before turning its attention to other asset classes. “We’ve made the appointment of Shaun Manuell as the senior portfolio manager for Australian equities,” Curtis says. “On the people front, he’s now looking to build out his portfolio management team. We’re currently looking for a portfolio manager and about four analysts to support that group. Separately, we’ve also appointed Trent Hayes to look after the execution desk and he’s also looking for an offsider for the execution team to focus specifically on Australian equities.”

Some pension funds have hit on a lucrative strategy to extract more value from their private equity portfolios. The £34-billion ($51.6-billion) Universities Superannuation Scheme, the United Kingdom’s second biggest pension fund for university and higher education staff, is expanding a private equity co-investment strategy begun in 2008. It’s a model whereby schemes portion some investment to private equity funds run by managers, but the rest goes directly into the same projects in which the funds are investing. The strategy incurs a fraction of the fees and enables schemes to better tailor their exposure. It’s a strategy increasingly available as private equity funds struggle to close in today’s climate, offering co-investment rights to secure commitments and access larger deals.

Private equity plus

“Our aim is to make co-investment account for one third of our $6-billion private equity program up from current levels of around 13 per cent. We now have a strong origination network of private equity managers that we regularly co-invest alongside,” enthuses Mike Powell, head of alternative assets at USS Investment Management Limited, inhouse fund managers for the scheme. “Co-investment reduces the fee drag for the overall program and allows us to better tailor our risk exposure within the portfolio. We don’t necessarily believe we are better at selecting transactions than our managers, but we do have superior information around our own portfolio exposures and risk tolerances.”

The USS says it now commits to private equity funds on the basis of strict co-investment deal flows and although returns from co-investment don’t exceed broader private equity returns, co-investment allows a lower level of risk within transactions. “We’ve found that with co-investment, we can reduce the risk but maintain the return because we are not paying normal private equity fees,” says Powell. USS benchmarks its private equity portfolio against public equity plus an illiquidity risk premium, which it has historically “materially outperformed.”

The scheme’s push into private equity co-investment comes at a time Canada’s biggest pension schemes, Ontario Teachers’ Pension Plan and Canada Pension Plan Investment Board are abandoning such handholding in the asset class altogether. They are taking the principle of co-investment one step further by cutting out the middleman, both reportedly considering direct bids for Ista, a German meter operating company being sold by its private equity owner. “Our co-investment strategy will always need managers to generate the deal flow,” says Powell. “There is no reason you can’t go direct but it will involve recruiting talent and appropriate compensation levels – you are creating an internal GP.”

As it is, USS has a 26-strong alternatives team with seven years’ experience. Within private equity it uses 34 managers and invests in 63 funds with commitments ranging from $100 million to $500 million.

The cost of diversification

But not all schemes have had such a profitable relationship with the asset class. The $6.8-billion London Pension Fund Authority, LPFA, began its foray into private equity a decade ago in response to the Myners Report, a review urging pension funds to diversify. “We decided to take our private equity strategy seriously and by 2004 we had $530 million invested with three fund of funds managers,” says Mike Taylor, chief investment officer of the LPFA, talking recently at the NAPF investment conference in Edinburgh. Taylor recalls that his only prior experience of private equity back then was a stake the pension fund he ran before LPFA had in Sanctuary Records, the management company for heavy rock group Iron Maiden. He enjoyed trawling their back catalogue, but it was no preparation for the bumps the LPFA has endured with its 14-per-cent allocation to the asset class, he notes with a rueful smile.

“It’s too early to tell how it’s performed. We’ve got several years to go until we get our money back,” Taylor says. “The entire program is running two to three years behind schedule.” The portfolio won’t be cash-flow positive until 2014 after losing ground for being too diverse, changes in European government regulation on feed-in tariffs that hit investments in green tech and the biggest bugbear, high fees. The fund of funds approach, invested with HarbourVest, Pantheon and LGT, meant the scheme paid nearly double the fees, he says. “We were never happy with the fee levels and should have negotiated harder. We didn’t stress-test the cash flows and had administration overheads too,” he says. “The correlation with global equities also returned in times of stress.”

Fees, liquidity and style drift

Trustees raise other worries with the asset class too. The downturn has led to managers selling fewer portfolio companies because of a lack in investor appetite for private equity-backed IPOs. It’s left less money available for some investors, although the USS has received $2.28 billion in distributions back from managers over the course of its program. Timing of cash back is also unpredictable, with some trustees saying they are forced to pull money out of other assets to cover liabilities. And despite declining distributions, fund managers have stuck to the 2-per-cent annual management fee and the 20-per-cent performance fee structure. High fees are particularly contentious given unknowns around fund drawdown. Management fees are payable on commitments, not investment but sometimes private equity managers, waiting for the right opportunity, have money languishing uninvested. “This is an issue although we had no problems getting our money away,” says Taylor.

Liquidity is another concern. Investors got their fingers burnt during the financial crisis when calls on their capital resulted in them having to sell private equity assets at distressed prices. US endowments Harvard and Yale University were hit this way. “The liquidity risk associated with private equity is arguably exaggerated, particularly since the secondary market has become much more liquid,” reassures Powell. “Investors who historically were locked in for 12 years or more now have the ability to sell. It’s just an issue of price and valuation. A private equity program can also be highly cash-generative once it’s through its investment phase”.

Schemes also bemoan a “style drift” in private equity whereby managers tout the asset class for investments that don’t necessarily qualify as private equity. “We’re seeing private equity being launched for anything,” said Steven Daniels, chief investment officer of Tesco Pension Fund, the $10.6-billion UK defined benefit scheme, also speaking in Edinburgh. Some managers are creating investment models that allow them to take private equity-style fees when in fact the underlying investment is not truly a private equity investment, he explains.

Many schemes want to raise their exposure to alternative investments, and greater private equity allocations are one option. But it’s a complex, expensive business and only the biggest schemes may have the resources to make it pay.

Sustainability is constructing a portfolio today on the earnings of the future, according to global head of investment content for Towers Watson, Roger Urwin. Not all performance is born equal, he says, and sustainability is performance with purpose. A cap-weighted portfolio is made up of an earnings stream based on today’s conditions, Urwin explains, with any externality unpaid for. He believes ESG is one of those unpaid-for externalities.

“If you played through a decade, then new operating conditions apply, such as carbon pricing, and those externalities will be internalised. Environmental, social and corporate governance is not priced in yet, but it will be,” he says. “This creates the potential to do sustainability alongside fiduciary duty, as you are doing it for finance reasons: buying on tomorrow’s earnings today. People are suspicious of the argument.”

Urwin believes in “sustainability beta” because he believes sustainability is a return driver.

“Take a portfolio long good ESG and short bad ESG over the long term, it will inherit more fair conditions but also a better pricing structure for those investors a decade way.”

The abnormal pricing argument supports smart beta, and anything outside cap-weighted has the potential to perform better than the market. That includes examples such as emerging wealth and sustainability.

Missing the change of generations

Urwin says institutional investors have lost sight of one of their purposes, which is the intergenerational transformation of wealth and risk, and are focused too much on capital formation.

“I’d like to have an industry that is stronger on scores of those dimensions,” he says. “Asset owners are there to pursue their true purpose. The last decade has been all about the financial capitalists, the next decade is about the fiduciary capitalists.”

Urwin doesn’t have a title on his business card. In function he is the global head of investment content at Towers Watson and sits on the Thinking Ahead Group. He’s also an advisory director at MSCI and a board member of the CFA Institute.

He is a mathematician and actuary, graduating from Oxford in 1977 with two degrees: a Master of Science majoring in Applied Statistics and a Master of Arts in Mathematics.

The softer side

But these days he’s more concerned with the “softer” side of institutional investment, looking at behaviour and decision-making, governance and transformational change, rather than a quantitative orientation.

“Finance in many respects came out of a physics-envy model, but behaviour plays a big part,” he says. “These days I’m more interested in the soft stuff, behaviour and decision making, and the effectiveness of asset owners.”

Urwin thinks that asset owners have fallen behind other parts of the financial sector, due in part to the fact they are not driven by the “creative destruction” of competition.

Urwin leads Towers Watson’s research and thought leadership on sustainability, and last year the consultant released its seminal work, Telos, which came to some conclusions on how to invest sustainably.

“Resource scarcity, demography, economic growth and climate change all add up to think about investments in a decade, not a year, but the industry is built on the short term,” he says.

“The sustainability theme has a performance edge so long as you have the resilience to deal with the challenges that can exist of putting you out of line with others.”

There are certain behavioural challenges this presents, and Urwin says that most trustees exercise predictable behaviour when it comes to their fiduciary duty: if they don’t have proof of something then they won’t do it.

“The record of innovation is held back by that,” he says. “Fiduciary is a scary term to many. But it is a powerful term for representing the greater good and we see it as more expansive than the financial return of your direct beneficiaries. There are externalities in any portfolio and you can claim responsibility for that.”

Decency in ownership

To some extent Urwin says personal values are at the heart of this shift, and the “decency that we are owners and have to think about the responsibilities that come with that”.

“The world is so complex, and costs will be shifted on to others, for example carbon/climate risk is not paid for. We need a situation where managers and owners start to have responsibility.”

One of the practical ways to do that is to set long-term mandates, something Towers Watson championed with actual client mandates almost 10 years ago.

“Unconstrained long-term, long-only are the preferred vehicles for Towers Watson,” he says, adding the bulk of its mandates are moving that way. “Mandates that stretch out in time, and have long-term optimisation.”

Towers Watson “believes” in active management, and the move to smart beta is complimentary with that, he says. “Cap-weighted is beatable. Price takes you to a misallocation of capital, you put a lot of money to work on the most expensive stuff.”

In January, presenting at a CFA India conference, Urwin said alpha and beta can be thought of as a continuum differentiated by capacity and skills: there will be reduced expectations for “bulk beta” and pressure on other return sources.

To this end smart beta makes sense, and there is a duality between something that has risk in it and can be turned around as a return driver.

Edwin Meysmans, chief executive of the KBC Pension Fund, sounds extremely relaxed for a man who rises early to avoid Brussels’ clogged roads on the way to the office. Then again, that Meysmans shies away from the madness of commuting crowds should perhaps be no real surprise given that his fund focuses on avoiding being swept along with short-term market moods.

The Belgian recounts enthusiastically – in distinct American tones picked up as a University of Michigan student – how the fund launched a radical liability-driven investment (LDI) strategy in 2007 and has not looked back since.

“We wanted to hedge our liabilities against our interest rate and inflation risk. We explored the options, but we found government bonds weren’t a very good option – only Greece and France were issuing long inflation-linked bonds at the time,” he says.

KBC decided to switch almost its entire bond holdings into interest rate swaps, a strategy that has performed handsomely. The swaps portfolio returned 19 per cent in 2012, surprisingly only its median performance in the past five years – less than the near-25-per-cent returns in the crisis year of 2008 and stellar 33-per-cent returns in 2011, another year when equity markets dropped.

Getting the magic formula right

You would expect Meysmans to be fully satisfied with those results, not least as the funding ratio of the €1.2-billion ($1.6-billion) fund leapt from 100 per cent coverage in 2008 to a 14-per-cent surplus in 2011.

There are loose ends that Meysmans can point to, however. He says that “we use the swap rate as a proxy for the liabilities, but they are actually discounted to the corporate-bond yield curve. While they move in the same direction, the correlation is not perfect.”

Naturally the dramatic shift to LDI in 2007 changed the risk profile of the fund. In place of sovereigns backing up the 40-per-cent bond portfolio, in came large investment banks as counterparties to swaps.  “We tried to control this risk by diversifying it across 12 investment banks and collateral management. We will only accept high class collateral such as cash or highly rated government bonds”, Meysmans explains.

This risk reduction technique saw the fund through the financial crisis in fine shape. “We did replace one counterparty with another as there was an issue, but that only took a couple of days,” he states.

Meysmans thinks the fund was “lucky” to launch its dramatic hedging moves in 2007 when yields were substantially higher than they were today. “An important question is what are we hedging today?” says Meysmans. “How much lower can interest rate yields go from 1.6 per cent?”

A major market risk at the moment to KBC’s hedging strategy is the prospect of rising interest rates in the future. “We are keeping track of that and we have reduced our LDI allocation and duration,” Meysmans says.

An interest rate-rise threat does not compromise the thinking behind KBC’s LDI approach, however. “If it happens, then our liabilities will fall so our funding ratio will more or less stay the same, and that is the whole idea,” he adds. 

The right match

The KBC fund describes itself as a medium-sized investor and Meysmans concedes that significantly larger institutional investors would struggle to find counterparties to back up interest rate swaps.

There is an added advantage for the fund in that the fund’s sponsor KBC Bank, part of one of Europe’s largest banking groups, acts as a middleman in the interest-rate swap deals.

Meysmans explains that as the fund’s sponsor is the official counterparty for the swaps, the fund itself is relieved from a large administrative burden and is freed from any obligation to post collateral should the swaps unwind.

Meysmans also has a personal advantage from the fund’s sponsors. He honed his financial knowledge in 15 years spent working in various departments at KBC Bank before taking the reigns of the pension fund in 1997.

Over the hedge

The interest rate swaps in the fund are leveraged by 200 per cent, effectively meaning that 80 per cent of the KBC fund’s liabilities are hedged. Real estate and equity holdings form the remaining return-seeking part of the portfolio.

Around 11 per cent of the assets are in real estate and infrastructure, holdings that the fund has sought to use to fill the gap between the hedging swaps and pure equity holdings. Meysmans explains that a reduction in listed real estate fund investments in 2007 in exchange for direct real estate, non-listed funds and infrastructure has offered added interest rate hedging and made a major contribution to covering inflation risk.

“We saw before the crisis that the correlation between listed real estate and listed equities is pretty high,” says Meysmans. “The volatility is much smaller in unlisted real estate.”

KBC’s real estate and infrastructure holdings are focused on Europe, with the exception of the UK, which Meysmans feels is too volatile and carries excessive currency risk. He is enthusiastic about social infrastructure such as schools and hospitals due to their capacity to deliver low-volatility returns.

Reducing exposure

While the KBC fund has been striving to reduce its exposure to market volatility, a degree of pragmatism is evident in its treatment of equity holdings in the recent past. The fund began to sell equities as it targeted reducing the equity pool from 40 per cent of holdings to 30 per cent. “After some big discussions with the risk department, we decided to keep the holdings at around 35 per cent, but invest 20 per cent of equity holdings in a low-volatility strategy”, Meysmans explains.

Around 15 per cent of equities were allocated to emerging markets in 2009 to further diversify the portfolio. These new investments have averaged an annual return of 8 per cent from 2010 to 2012, around halfway between sluggish European and strong US equity performance.

KBC’s asset management house manages around 90 per cent of the portfolio, with external managers appointed on non-listed real estate, private equity and infrastructure.