The UK’s £3.3-billion ($5.6-billion) Merchant Navy Officers’ Pension Fund (MNOPF) is poised to offload the final portion of its defined-benefit liabilities in the old section of the scheme. The fund, which has provided pensions to the shipping industry since 1937, comprises a $3.2-billion new section and a $2-billion old section, closed since 1978 and with around 22,000 retired members. Galvanised into action when funding levels plummeted to 81 per cent in 2008, the MNOPF insured a total $960 million of its old section in two separate deals with insurance group Lucida. Now, to counter all investment and longevity risks within the old scheme, the balance is likely to be insured by a third party too. “Subject to market conditions, we are close to making a decision regarding the buy-in of our remaining liabilities in the old section,” said MNOPF chief executive, Andrew Waring, who took over the helm in 2008, joining from Benfield Group.

The next step in Waring’s risk-averse, insurance solution will be keenly watched by the many other UK schemes weighing up the best way to handle the headache of ballooning pension liabilities. He’s convinced it’s the only strategy to meet the MNOPF’s $160-million monthly pension obligations and safeguard against the old section’s deficit landing on the balance sheets of the thousand-odd diverse employers that stand behind the scheme. The old section is currently 96 per cent funded on an all-gilts basis.

The multi-employer MNOPF scheme is a last-man-standing fund whereby the liabilities from any employer withdrawing from the scheme are reapportioned among those that remain, increasing their share of the deficit. Although Waring jokes how employers “visibly pale” when they understand the principle behind such a scheme, he is adamant the MNOPF’s structure, shared by other UK schemes including the $48-billion Universities Superannuation Scheme, ensure a particularly robust constitution. Waring’s particular challenge is that although the old section has around 3500 employers comprising all types of seafarers from oil companies to ferry operators, the fund can only track 250 of them. It’s a problem that has bled into the new section too. It has 350 employers but the last valuation showed that around 25 per cent of all liabilities in the scheme are now so-called orphan liabilities, ultimately forcing the MNOPF to call on its employers again.

In a process Waring calls “taking chunks of risk off the table”, Lucida first took on $797 million worth of liabilities in 2009, then a further $160 million in May 2010. “Half our liabilities in the old section are now extinguished. If we don’t approach risk like this, we are putting at risk the accrued benefits of our members,” he says. He’s just as determined not to call on the support of the UK’s lifeboat fund, the Pension Projection Fund, as he is to not impose “unreasonable funding obligations” on the schemes’ remaining employers. “The idea that if we get into trouble the PPF is always there isn’t a view I share,” he says. “We don’t want to use it because we need to work though our last-man-standing principle.”

New fiduciary management

In another strategy, again born from conservatism and caution but which has also grabbed the headlines and differentiated the MNOPF from peers, Waring has overseen the introduction of a new fiduciary management at the fund. The fund outsourced investment management to Towers Watson in 2010 and appointed Hymans Robertson as independent investment advisor to oversee Towers in 2011. Although the MNOPF investment committee, which meets five times a year, still decides on basic strategy including asset class and allocation, plus the size of the risk budget, Towers Watson oversees the rest. This includes hiring and firing managers – the number of managers has grown to 30 from 15 since Towers Watson took on the role – and negotiating fees on the scheme’s behalf. “We don’t have any resources for an inhouse investment team and the investment world gets ever more complicated,” he says. “Because of the way the fund is structured, members and employers sit on our board.” The old section is invested in a passive, low-risk strategy that targets 105 per cent funding over 10 years on a gilts basis. Growth assets include equity, investment and non-investment grade credit and property.

Strategy for the new section, which is between 60-70 per cent funded, also veers on the side of caution. Assets are portioned in global equity (20 per cent), private equity (4 per cent), hedge funds, including a distressed-debt allocation (10 per cent), property (3 per cent), commodities (2 per cent), reinsurance (3 per cent), non-investment-grade credit (8 per cent) and investment-grade credit (12 per cent). There is a 35 per cent matching asset allocation and 3 per cent in emerging market currency. The fund recently cut its equity exposure and increased its private equity and re-insurance allocations. “Our time horizons are a bit short for pure infrastructure,” says Waring. “Early stage infrastructure fits other funds better than the MNOPF – even our new section isn’t as new as it once was.” He says the fund is now robust across all possible scenarios rather than taking a bet on one particular asset class. Since the new management structure was introduced, returns have increased and risks reduced. The new section outperformed its 7.8-per-cent benchmark by 0.9 per cent over the year.

How to wind up

Waring says that other funds mulling a similar wind-up should focus on how best to present the fund to the insurance market. “Watch out for skeletons in the cupboard,” he advises. “There could be things lurking in dark corners that newer trustees wouldn’t be aware of.” For all his enthusiasm he warns that wind up is an emotional, “gut-wrenching” journey. He says the MNOPF is a club that members like belonging to; they won’t have the same affiliation or sense of trust with an insurer.

But he’s still resolute that with a mature scheme like the MNOPF, the downside risk is always greater than the upside potential. The MNOPF has less freedom than other funds; shifting more of the portfolio into return-seeking assets wouldn’t solve the problem. He talks about compromise and the balance that he’s had to strike between the fund’s diverse members. Some are big corporates, strong enough to withstand short-term volatility seeking long-term equity investment, but others are small ship owners with a low threshold for risk. “We traded in upside potential for security. It was a tough decision but we decided security was more important,” he says.

When the Netherlands pension reforms were announced in 2011, many experts argued they were likely to substantially increase the risk appetites at the funds guarding the country’s $1-trillion pension assets.

Recent developments to the reform proposals make the overall impact far from clear, however, suggesting there will be no bonanza for Dutch investment managers. The pension funds themselves are not indicating any major changes to their investment mix, although the possibility of future changes resulting from the reform measures remain. Any impact on investment is intended as a by-product by the Dutch ministry of social affairs, which regulates pensions.

Helping pension funds cut benefits without the burden falling too greatly on any age group and keeping contributions at current levels were the driving motives.

The reforms are nonetheless set to relax some key restrictions on pension funds that have helped cement a conservative investment approach in the Netherlands.

Centrally set guarantees on members’ pension entitlements are to go, even though these are only nominal. In their place will come the freedom for funds to set their own pension promises. Granting more freedom for funds to chase returns and acknowledging the inherent risk in pensions via longer recovery plans both give the green light for funds to acquire more risk. At least that is what many argued.

Risky ambition

The state secretary for social affairs, Jellejetta Klijnsma, acknowledged the complexity of the reform project when she announced the new rules would be delayed until 2015.

“The development of the new legislation is taking more time than was anticipated. The issue is highly complex and is an important topic which I wish to approach cautiously,” she said, adding there will be a pilot introduction starting in January.

The reforms are set to allow nominally defined-benefit (DB) funds to share investment risk with members, by becoming hybrid defined-ambition (DA) schemes. That also promises to take Dutch funds away from their cautious investing stances – a choice that rests very much with the fund, explains Aegon’s David van Bragt.

He confirms that “if a fund chooses the ‘soft DA contract’, there will be more room for long-term investing”, adding though that there is plenty of uncertainty as to whether existing rights can legally be transferred from a DB to a DA contract.

Van Bragt says that “jurisprudence and practical experience will probably first have to develop further before many funds will switch to DA and redefine their investment policy”.

Another potential snag is that while many pension funds might welcome the long-term benefits of moving more into equity markets and alternatives via a DA arrangement, they might need to impose short-term benefit cuts to do so.

This is a result of the poor funding status at many Dutch funds, van Bragt explains.

The average Dutch pension fund was 3 per cent underfunded at the end of September 2012.

“This will be hard to explain to existing members as they are used to the hard benefit promises,” Van Bragt says, “so I expect there to be plenty of debate if funds are to press on with this.”

Bart Oldenkamp, managing director of fiduciary managers Cardano, says that pension funds should also tread carefully in gauging the risk appetite of members before passing the risk of an altered investment mix onto them.

If you add to that the probability of DA pensions having inflation-linked return targets, then a sea change in investment strategy looks unlikely.

To further muddy the water, those pension funds deciding to remain DB (with the Dutch provision of being able to cut benefits to match liabilities with assets) look set to face stricter capital requirements that may temper any demand from them for high risk assets.

Van Bragt has done a detailed analysis of the capital requirements for funds that chose to remain defined benefit. He reckons there may even be “some degree of de-risking” with bond allocations actually rising further.

In everybody’s interest

Some of the initial expectation that the new legislation would push funds into riskier assets was based on proposals for a new discount rate for the Netherlands.

Intense debate since the reforms were first outlined in 2011 resulted in a compromise discount rate being temporarily adopted in September 2012.

The initial proposals for use of the ‘ultimate forward rate’ common for Dutch insurers raised fears of a drive-out of long-term bonds.

These fears arose because the formula, as was first proposed, discounts any cash-flow maturities with a duration of more than 20 years.

A modified ultimate forward rate was adopted, which van Bragt says has largely eliminated these concerns.

Trimming the hedge?

Van Bragt thinks that the use of the modified ultimate forward rate could lead to a reduction in interest-rate hedges by pension funds.

“We have not seen very large movements so far – although some long-maturity swaps were rolled back to shorter maturities,” he says.

According to a 2011 Dutch central bank analysis, the level of interest-rate risk hedged at the largest funds ranges by 35 to 40 per cent. The analysis found that short-term interest-rate changes (for the next five years) were fully hedged.

While an accounting basis now shows many Dutch pension funds to be over-hedged, there is plenty of sentiment in the industry that most funds will appreciate that the fundamentals that led funds to hedge at the current levels has not changed.

A side effect of the modified discount rate has been an overnight increase in the funding status of Dutch pension funds, from around two to as much as 10 percentage points.

That has led to some new worries that investors will be lulled into a false sense of security and fail to moderate risk.

Waiting game

Investors emphasise that they will not judge the impact of the reforms until all the crucial details are hammered out. The €124.9-billion ($159-billion) PFZW fund said it is close to gaining clarity on the reforms’ consequences.

Another giant fund, the $340-billion ABP, is also waiting to see what the reform package will bring exactly. A spokesperson said that the fund expects any significant change to come in its interest-rate hedging rather than investment strategy.

ABP had around $935 million invested in interest-rate and currency-hedge overlays in 2011.

The spokesperson admitted that ABP was under-hedged in comparison to other funds as it was seeking to avoid locking in low market interest rates and not being able to absorb unexpected future inflation.

ABP regularly reviews its interest-rate hedging, and any movements in the wake of the pension reform will be sure to draw the attention of analysts.

The $16.6-billion Phillips Pension Fund has said it won’t change its investment strategy in the wake of the reforms.

The reforms still need to be approved by the Dutch parliament in The Hague, but are now set to be introduced in 2015 after a pilot program beginning in January 2013.

Some funds are already exploring the chance to move to the new DA status by opening up a dialogue with members, says Oldenkamp.

 

If it ain’t broke, don’t fix it

Dutch funds currently invest an average of 67 per cent in bonds as opposed to just 24 per cent in equities, according to Mercer.

Only pension funds in Portugal, Denmark and Norway have lower equity exposure, according to the consultants’ 2012 European Asset Allocation Survey.

A conservative discount rate based on long-term interest rates has led Dutch funds into strong positions on government bonds in particular, which make up 54 per cent of the average Dutch fund.

Alternatives are another relatively small asset class in the Netherlands, occupying 7 per cent of Dutch funds on average. In both the UK and Germany, the asset class accounts for 12 per cent of pension assets, according to the Mercer survey.

The reforms might do little to change this relative disinterest in the riskier asset classes.

Given that the Dutch pension system continues to be rated in various studies as the most dependable in the world and that Dutch funds returned 8.2 per cent in 2011 compared to an OECD average of -1.7 per cent, that might prove to be no bad thing.

 

Until a few years ago, every aspect of the investment strategy at the UK’s £20-billion ($32-billion) coal industry pension scheme was outsourced. The main inhouse task at the pension fund was benefit payment but now, in a fresh approach spearheaded by straight-talking 38-year old New Zealander, Stefan Dunatov, the new chief investment officer of the Coal Pension Trustees Investment (CPTI), the scheme is coming home.

The decision to rebuild the investment arm of the UK’s closed coal-industry pensions – the Mineworkers’ Pension Scheme and the British Coal Staff Superannuation Scheme – actually began in 2007. The CPTI registered with British regulator the Financial Services Authority in 2011 and Dunatov, who used to work for Deutsche Asset Management and as a portfolio strategist at Equitas, was promoted to the helm from head of strategy earlier this year. He’s just hired two more inhouse strategic experts, both with asset management backgrounds, bringing his City-based team to eight. Apart from the passive equity allocation, none of the assets are pooled; the two funds are run as separate pension schemes with a separate board of trustees. They do, however, share a guiding mantra – to constantly question what we own and why we own it – and both currently target overall returns above a real discounted rate of around 3.5 per cent. Combined monthly pension obligations stand at about $160 million.

How the coals burn

The CPTI has a 65-per-cent global equity allocation, which includes 10 per cent in private equity, a 10-per-cent mostly UK property allocation, and a 5-per-cent uncorrelated bucket. The remaining 20 per cent is in global fixed income, made up of sovereign, corporate and emerging market debt. Both schemes divested from UK gilts “a few years ago,” escaping the effects of the government’s successive monetary-easing measures on yields. Apart from property, there is no home bias in either fund’s asset allocation; only a “tiny” amount is invested in infrastructure alongside the property allocation, which is managed by LaSalle. “We’ve never really done infrastructure,” Dunatov says. “It doesn’t yet achieve our objectives.”

All management is outsourced to 20-odd fund managers, not including the private equity relationships. Wellington and Western manage most of the fixed income allocation, while Legal and General Investment Management and BlackRock handle the passive equity allocation depending on the scheme. However, since strategy is now thrashed out inhouse, decisions regarding which manager to use don’t take long. “You need to get the cake right; managers are just the icing on the cake. In my opinion far too much time can be spent choosing and then monitoring managers,” says Dunatov. The funds’ requirement for proactive managers is also diluted by large passive portfolios – half the total equity allocation. The default is for passive management; active management is only used where it clearly adds value, he says.

Investment decisions have a three-to-five-year horizon and are made according to key themes the team identifies as important. Today these include well-told stories like emerging markets, but also US re-emergence and, precisely because of all the turmoil, Europe. “Europe is not going to go away and the euro will survive despite the naysayers,” Dunatov says. “Europe is very cheap at the moment.” Investment there, not excluding peripheral countries, is focused on fixed income and equities. Going forward, the team is starting to consider the best way to access African growth via private equity.

Short-termism, liabilities and the really exciting stuff

Despite CPTI’s determination to innovate, Dunatov flags an inhibiting caution among many UK fund trustees. Apart from the likes of the $23-billion Wellcome Trust, the UK’s biggest charitable investor, and the clutch of other big UK schemes such as Railpen and the $48-billion University Superannuation Scheme, he believes most British schemes have grown short-term in their approach to investment. One reason for caution is the fact that many funds still measure their liabilities off gilt yields. They have fallen, forcing a rise in liabilities. “We value our liability according to our expected return,” he says.

Another part of the problem lies with FRS17 accounting rules. Used by all private-sector companies, these rules highlight huge gaps between liabilities and assets in many schemes. “It drags pension liabilities onto companies’ balance sheets and takes away the ability of many funds to focus on the future. A time horizon becomes replaced by a risk horizon,” he says. In stark contrast, the coal industry’s pension funds prove a rich seam for their corporate sponsor, the UK government. Surpluses generated from the funds are split between members and the government; over the last 20 years the government has pocketed around $7 billion.

Clawing back control of investment strategy has injected a new energy, freedom and ambition into one of the UK’s biggest pension funds. If Dunatov has his way, it’ll transform the old coal industry schemes into the nearest thing the UK institutional market has to Denmark’s ATP or even the big US endownement funds. “Now they are doing the really exciting stuff,” he says.

 

Sulzer is a Swiss manufacturer with a proud past. From pioneering the diesel engine to making the specialist pumps that drive power production around the world, it has been around for 178 years.

Perhaps leveraging off such a rich history, the company’s pension scheme is very much looking into the future thanks to solid returns so far in 2012.

The 3.6-billion Swiss franc ($3.8-billion) Sulzer Vorsorgeeinrichtung has seen returns of 6.1 per cent up until the end of October, almost a full percentage point over the fund’s benchmark.

Dr Urs Schaffner, who heads the fund, says the good showing is the result of intelligent investment picks by the inhouse investors, who manage 90 per cent of bond and equity assets.

Schaffner says he is “positively surprised. Investing in an interest-rate safe haven like Switzerland and assuming normal risk premiums, our expected returns for the next few years amount to between an annual 2 and 3 per cent.

“Given this expectation, combined with the many risk factors currently connected with the US and European debt situation, we hadn’t expected performance to be so good.”

Buoyant equity markets have helped things, with a 14.57-per-cent return in the fund’s overseas equity holdings assisting a 13.28-per-cent return in domestic equities based on “good picks”, according to Schaffner.

Schaffner explains that the Sulzer Vorsorgeeinrichtung has also been able to navigate the European sovereign debt crisis well.

The fund withdrew from peripheral bond holdings before their yields spiked and has acted quickly to shed poorly or even negatively returning safe-haven government bonds in favor of corporate debt.

Keeping it simple

While picking winners within asset classes seems to be paying off, Schaffner says the investment strategy on the whole at Sulzer Vorsorgeeinrichtung has been defined by continuity.

The fund has a conservative investment mix principally because a large proportion of its members are claiming benefits.

Some 70 per cent of the liabilities are linked to pensioners as a consequence of major restructuring at the sponsoring company in the 1990s.

This leads to a “rather rigid investment risk budgeting process” says Schaffner, with the risk appetite staying on the conservative side for a good number of years.

A declining pensioner pool may see some change for this in the years ahead.

For its beta, Schaffner explains that the fund has established target allocations in each asset class, and a bandwidth allocation range designed to avoid over or underexposure.

The bandwidths and target allocations were designed with the help of a consultancy, PPC Metrics, which completes an asset and liability study for the fund every three years.

Choosing where to pitch the asset allocation within that bandwidth is where alpha can be won or lost.

In 2011 the Sulzer fund made the wrong call in underweighting domestic bonds, going for a 29-per-cent holding, with the long-term target being 35 per cent.

This saw the fund miss out a little on a debt boom and miss its benchmark that year.

Schaffner explains that the fund has gone for fairly narrow bandwidths “to limit the alpha risk” but at the same time ensured they are wide enough “to allow the flexibility needed to absorb some natural market fluctuation”.

For instance, the domestic bond holdings are currently permitted to fluctuate between 27 and 40 per cent, while domestic equity is limited to 5 to 7 per cent.

No-nonsense investing

Overall bond holdings at the fund are now at 48 per cent after recent increases, with equities making up 21 per cent.

Those equity holdings are outsized by a 23-per-cent stake in real estate – not an unusual amount in Switzerland and a reinforcement of the fund’s conservative outlook.

Real estate continues to perform well for Sulzer Vorsorgeeinrichtung, with indirect real estate allocations increasing by over 7 per cent in the first nine months of 2012.

Further, Sulzer co-owns a real-estate asset-management firm with about 70 experts, allowing it to retain control over its direct real estate investments that comprise about 90 per cent of its total real estate investments.

The 4-per-cent alternatives holding is divided down the middle between private equity and commodity investments.

Schaffner says the conservative identity of the fund is reinforced by its avoidance of “complicated instruments”, such as structured products.

Hedge funds are no longer in the portfolio, with Schaffner saying that the fund’s investment committee “lacks confidence” in the ability of hedge funds to perform over the next few years. He adds that “hedge funds really are tactical investments rather than the strategic investments we are looking for”.

Emerging market bonds and infrastructure are asset classes that the Sulzer fund has an interest in acquiring, with others also on the ‘watch list’.

Schaffner says that even though these are being evaluated, “it will take a long time to work these through to the investment strategy”.

Discussions between the fund’s investment team, investment committee and management board are usually protracted when concerning a significant new investment venture.

Entering into new asset classes would also change the risk dynamics that the fund prioritises and likely require adjustments in existing asset classes.

No room for complacency

Funding is good at Sulzer Vorsorgeeinrichtung, with a $214-million surplus on the accounts at the end of 2011.

Schaffner says this “does not take any pressure off investment at all”.

“You just need to look at the numbers behind that to see that there is no room for complacency”, he suggests, indicating that the official discount rate in Switzerland inflates funding ratios.

The Swiss discount rate for pensions is 3 per cent, significantly higher than a 10-year government bond yield of 0.4 per cent.

The fund is aiming for a 17-per-cent surplus, which equates to around $636 million at the fund’s current size.

As the benefit level of the Sulzer fund exceeds the legally required minimum contributions considerably, it has a release valve in the form of its hybrid status.

Thus, it aims – but does not guarantee – to credit the legal minimum interest rate to the retirement savings of all active members.

Anything beyond that is usually the subject of intense negotiation.

The pension and funds management industry is self-serving.

There are too many players, there’s too much jargon, too much leakage and too much patting each other on the back.

And that’s not just my opinion: the results of a 12-month research project, across 60 countries and more than 3000 investors concur.

The research by State Street’s Center for Applied Research sought to find the forces that will shape the future of the investment management industry over the next decade, and has concluded that there is too much of everything in this industry.

It says that the delivery model will have to be streamlined at both industry and organisational levels to eliminate complexity and bring strategic priorities in line with what investors want most: personal performance.

It’s the system, stupid

According to this research, the system itself is in the way, and will need to be rationalised.

If you look around for a minute or two, this is self-evident. A simple example is the sheer number of pension plans in the UK – around 10,000!

In Australia there has been rationalisation on the buy side – with the number of APRA-approved superannuation funds falling from 1244 in 2004 to around 300 now.

Many consultants – including Jeremy Cooper, who chaired the MySuper reforms – believe this will, and should, continue.

However, while the pension funds have rationalised, the Australian market remains over serviced. Mercer reports there are more than 130 funds managers offering largely similar strategies in Australian equities and yet Australian equities makes up about 2 per cent of the MSCI.

While choice is a product of the free world, it also comes with costs and unintended consequences. Further, if choice is good, does that make more choice better?

The paradox of choice is at the core of attention economics – first articulated by economist and psychologist, Herbert Simon, in the early 1970s – that a wealth of information creates a poverty of attention.

Two Australian academics, Ron Bird and Jack Gray from the Paul Whoolley Centre for Capital Market Dysfunctionality at the University of Technology, have been proposing the need for rationalisation for years.

Too much of everything

In the Rotman International Journal of Pension Management article, Improving Pension Management and Delivery, the authors say the plethora of agents – trustees, fund staff, managers, consultants, custodians, lawyers, financial advisors, regulators, ratings agencies, government, academics, placement agents, even journalists – create substantial indirect and direct costs.

This plethora is driven by the ready availability of money, massive and intrinsic uncertainty and growing complexity, sometimes intentional.

Estimating the indirect costs of an excess of agents is especially difficult because almost all agents genuinely believe they are adding value net of their costs, just as each of us believes we are in the top quartile in intelligence and driving ability, the authors say,

“This belief justifies agents resisting market forces aimed at reducing their number. We expect total unnecessary agency costs to be substantial. The most evident and dominant direct agency cost is active equity management, a predictable consequence of competing on performance. Because active management is effectively a zero-sum game, aggregate retirement incomes are reduced by at least the cost of 1 per cent per annum of playing the game.”

Bird and Gray question whether more than 80 active Australian equities managers, managing more than 150 broadly similar strategies are needed to achieve efficient pricing in such a small market.

Writing this article five years ago, Bird and Gray concluded that fewer agents and less-destructive competition will force a sharper focus on members’ long-term interests.

Five years later and nothing has changed, State Street’s comprehensive research, interviewing more than 3000 industry participants, concludes the same thing. There are too many players and there needs to be a sharper focus on personal performance.

 Artscience embraces change

So what happens next? A little less conversation, a little more action! But how do you make change happen?

Change happens out of necessity, if there is opportunity and if there is strong leadership.

Clearly change in this industry is necessary if it is going to take seriously the very large and very global problem of funding retirement.

Leaders in the industry are needed to embrace the conclusions of the State Street research, and the pontificating of academics, and actually facilitate change.

Apparently, change doesn’t happen quickly, according to the Nobel-prize winner, Max Planck, who was considered to be the founder of quantum theory, “science advances one funeral at a time”.

His view was that new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it. Fortunately, funds management is not a pure science.

In fact, most participants in the industry like to believe investment management is part art and part science. And while science may advance one funeral at a time, the art world changes quickly – there have been 36 contemporary art periods since the term was defined in the 1960s.

Maybe there is hope for change in this industry.