The Spanish Social Security Reserve Fund is set to be depleted by another €7 billion ($9.05 billion) before the end of 2012, according to IESE Business School pension expert, Javier Diaz Gimenez.

The $90-billion fund has already been asked by the government for $3.8 billion, which is likely to go towards a raise in state pensions this month.

Diaz Gimenez says “there is no question” that Spanish social security system will run into a multi-billion deficit in December at the latest, when pensioners draw an extra Christmas payment.

“That has to come out of the fund,” he adds.

Diaz Gimenez also says that ballooning unemployment in Spain and sharply worsening demographics make the outlook bleak for the Social Security Reserve Fund. Without deep reform of the social security system, it could be forced to make a number of asset sales in the years ahead, he reckons.

Patriotic fund

The fund has almost doubled its holdings of Spanish government bonds since 2008 in what many believe to be an effort to compensate for weakened demand for government debt issues.

Spanish sovereign paper totaled a shade under 90 per cent of the fund’s asset holdings in 2011.

The remaining 10 per cent is a combination of French ($3.9 billion), German ($2.6 billion) and Dutch (€1.6 billion, $2.1 billion) sovereign bonds.

“This was a neat way for the government at the time to cover its financing needs but it has created an accounting fiction at the reserve fund,” explains Diaz Gimenez. “If you buy your own debt, you effectively have nothing, so the government has filled a giant piggy bank with IOUs it has signed itself. There was obviously a hope that a financing bridge could be built, but it hasn’t turned out as planned.”

Diaz Gimenez continued to criticise the strategy of the fund, which was established in 2000 to support Spanish social security commitments by investing budgetary surpluses.

“In reality,” he says, “it has just continued the total domestic exposure you have in an unfunded pay-as-you-go system anyway.”

Diversifying abroad or investing in domestic corporate debt or equity would have placed the fund on firmer foundations, according to Diaz Gimenez.

Sopping up bonds

The fund is managed by a committee of senior civil servants and politicians, headed by the Secretary of State for Social Security.

On a pure investment basis, the fund’s mainly long-term government bond focus has been a success.

The fund has earned average annual returns of 4.14 per cent following its inception in 2000.

Critics warn, however, that this strategy is now set to backfire for the fund’s sponsor government.

A sale of bonds to dissolve a section of the fund could flood secondary markets, dampen demand for newly auctioned debt and raise yields at a critical time for the Spanish government.

The fund also stands to lose out from sales in the secondary market due to low prices for government debt, Diaz Gimenez believes.

The fund purchased $14.6 billion of Spanish government bonds in 2011 on both primary and secondary markets with a full spread of maturities.

Any need for the fund to deplete its holdings would also likely reduce its future potential to soak up government debt issues.

Looking for the best deal

Carmela Armesto Gonzalez-Roson, who sits on the Social Security Reserve Fund’s management committee, refutes suggestions that the fund has invested poorly.

She says that the management committee’s decisions are taken with an advisory committee and “always takes decisions in the best market conditions”.

The fund is obliged to ensure all assets are of “maximum credit quality”, Gonzalez-Roson explains.

Octavio Granado, who was Secretary of State for Social Security until the end of 2011, has defended the recent strategy of filling the fund with debt from Madrid by arguing it is looking to profit from the higher yields on offer.

The $3.8 billion that the Spanish government has requested from the fund will be financed from coupon returns and asset appreciation. The fund has amassed over $18 billion in coupon returns since its inception.

Moving with business cycles, procyclical stocks have been found to yield higher average returns than countercyclical stocks. William Goetzmann and Akiko and Masahiro Watanabe use 50 years of real GDP growth expectations from economists’ surveys to determine forecasted economic states in order to avoid the effects of econometric forecasting model error. The scholars created a priced risk measure by loading the expected real GDP growth rate and from this have discovered the procyclicality premium. Welcome to a snappy new term. Read on to find out how it works.

121109_Procyclical stocks earn higher returns

Despite the constant pull on Railpen chief executive Chris Hitchen’s expertise in other directions, most recently helping to run NEST, the UK government’s new low-cost pension scheme, he is resolute that his primary task is ensuring Railpen, inhouse manager of the £19-billion ($30.4 billion) pension scheme for Britain’s rail industry, successfully delivers on its monthly pension obligations. In a policy shaped by innovative investment ideas and a willingness to diversify, it’s a challenge he relishes.

The Railway Pension Scheme is an umbrella fund for the entire rail sector. Some 170 different rail-related companies – from large train operators to small engineering specialists – as well as pensioners of the former state-run British Rail that was privatised 17 years ago give their pension pots to Railpen to manage. Although the liabilities from the diverse contributors are separate, the assets are pooled into different funds, each with particular risk profiles, like a unit trust. The employers decide how and where to allocate their funds in the different pools Railpen operates with a clear delineation between liability-matching and return-seeking assets.

The scheme, one of the UK’s biggest, is a defined-benefit fund open to new members. Although many defined-benefit funds are closing as employers collapse under the weight of these more generous schemes, Railpen is still attracting enough members to make it work. New, young employees paying into the scheme give Hitchen’s team a long-term horizon and more punch and flexibility in its investment strategy. “Many funds are closing down their risk and investing in government bonds and LDIs. We are not taking unnecessary risk but we still want returns,” says Hitchen, who joined Railpen in 1998 as investment director.

Bold strokes in the growth pool

Of all Railpen’s pooled funds, its bold strategy is best encapsulated in the flagship $9.6-billion Growth Pooled Fund, introduced in 2010 and targeting 5 per cent above the Retail Price Index (RPI) in liquid, return-seeking assets.

Strategies for today’s straitened times include paring down the equity exposure in the growth pool over the last year. “We had 70 per cent in equities, now this is about 30 per cent. We’ve done this not because we know equities are going to do badly but more because we are worried that they might,” he says. The cut in stock-market exposure hit managers BlackRock, which saw its mandate drop from $4.8 billion to $3.8 billion, Pimco, Martin Currie and London hedge fund manager TT International. Railpen oversees asset allocation but has used external managers since 1987 and now has 80-odd, managed by an inhouse team of eight. The switch out of equities has pushed investment towards the other asset classes in the growth pool, including short-dated bonds and non-government bonds, property, commodities, private equity and emerging market debt. “The growth pool is invested for the long term, not to pay next week’s pension,” he says.

Hitchen is pragmatic about the enduring euro crisis. Where needed, the different pooled funds hedge their currency exposure and all are light on peripheral euro countries. The scheme has never had a particularly high allocation to European government risk anyway. “It’s difficult to say what will happen if and when the euro breaks-up – perhaps we should be overweight in German manufacturing,” he says laughingly, although it’s clear he’s not really joking. Last year the largest equity holdings within the growth pool and global equities pool included heavyweight manufacturing groups Samsung Electronics, British American Tobacco, Microsoft and GlaxoSmithKline.

Equities abroad

Another strategy is to push into emerging markets, where the scheme is modestly overweight, focused on greater China particularly, although he wants exposure to the “fantastic economic potential” of some African countries like Nigeria, too. Here, investment is limited to equities rather than resource or infrastructure plays. In China private equity investment via the Private Equity Pooled Fund, which returned 13.9 per cent last year, is Hitchen’s preferred route to market rather than direct equity investment. Access to the benchmark Shanghai Composite Index for shares listed in China, known as A shares, is restricted to foreign investors due to Beijing’s tight control over both its currency and the flow of money across its boarders. China’s stock market is also dominated by retail investors adding to market volatility and risk, he says. “With private equity there is more of a feeling that you are getting to the real economy,” he says. It’s a theme he raises again when explaining Railpen’s shift out of UK equities to a globalised equity portfolio. “UK equities account for 20 per cent of our stock portfolio; 10 years ago that would have been two thirds. Many large UK companies no longer exist. The FTSE isn’t a bellwether for UK PLC.”

PIP, CPI, RPI and the members

That’s not to say Railpen doesn’t see opportunity in the UK. It is one of six founding investors in the government’s Pension Infrastructure Platform (PIP), which will launch as a fund in January 2013, targeting $3.2 billion worth of projects. The Property Pooled Fund has around $3.2 billion invested in UK property, managed by Orchard Street. Here the emphasis isn’t on London, where he thinks returns are still “doubtful” because of oversupply, pointing out that “commercial rents are still lower than what they were 25 years ago”. Instead his focus is in regional property, in places like Cambridge’s Silicon Fen, where a technology cluster spun out of the university has kept the city insulated from the ravages of the recession.

Hitchen is wary of deficit-tackling government policy like the recent pegging of public sector-pension increases to the Consumer Price Index (CPI) rather than RPI. On average CPI inflation is roughly 0.5 per cent to 0.75 per cent below RPI inflation. He admits the reduction in the rate of increase makes his job easier but he is “acutely aware” of the impact on those pensioners who worked on the national railway and who “must now expect less than what they’ve had in the past.” He’s similarly circumspect of the raft of new regulation flowing out of the European Union that he believes will affect the way pension schemes and employers think about investment. A new caution will “tilt the playing field” towards low-risk strategies and “the appalling value” of government bonds.

It’s hardly surprising he’s using all his expertise and influence within the industry to campaign against any changes that would hurt his members. They are his first priority.

Endowments and foundations in the United States are more concerned with the US political and fiscal gridlock than the uncertainty caused by the European debt crisis, according to a survey of non-profit organisations by Mercer Hammond.

Partner at Mercer Hammond, Russ LaMore, says the US situation dominated the global macroeconomic concerns of these investors, followed by the European debt crisis and slowing growth in China.

The survey found that the investors had an “ambivalent” attitude to investment in Europe. On the one hand they thought equity valuations in Europe were too attractive to ignore, but they also wanted their global equity managers to tactically reduce their exposure to the euro, either through asset allocation or the use of currency hedging.

LaMore says the biggest investment risk cited by the fiduciaries was an over-reaction to short-termism.

“Short-termism as a fear was readily identified by respondents,” he says. “The good news is if they are conscious of it then they can address it. Good governing bodies and good governing documents will ensure events are viewed in terms of the statement of investment policy, and not what happened this morning.”

With regard to investment risk, the organisations responded that the biggest concern was fear of losing money, with market volatility ranked second.

These investors typically have large allocations to growth assets, LaMore says, and achieving the targets of their spending rates plus inflation was a big challenge given interest-rate levels.

This paper suggests a new specification for leverage aversion, which may better capture the unique risks of leverage. The authors also introduce mean-variance-leverage efficient frontiers, comparing them with conventional mean-variance efficient frontiers. They conclude that leverage aversion can have a large impact on portfolio choice.

Leverage aversion, efficient frontiers and the efficient region

The agenda at the United Kingdom’s National Association of Pension Funds (NAPF) annual shindig in Liverpool’s Echo Arena on the banks of the Mersey couldn’t have been broader. From early analysis of auto-enrolment, the biggest shake-up of the industry in a generation and just days old, to life expectancy, Britain’s role in the European Union, and even man’s place in the universe, there was something for every one of the record-1400 delegates. But for all its breadth and interest, the gathered trustees came in search of leadership and clarity from their representative organisation on just a handful of investment issues.

Reporting transparency

European regulation is one of the biggest dangers hurtling towards UK schemes. In what one trustee said was “the last straw” and another labelled “incomprehensible”, the European Commission’s planned new occupational-pensions directive could have profound implications for defined-benefit provision. In a plan modelled on the Solvency II insurance directive, the Commission wants to inject greater transparency into the way pension funds report their assets and liabilities. It would demand huge capital buffers and force companies to divert investment into their pension schemes. It would also push schemes towards low-risk investment strategies because of greater sponsor cash commitments for growth seeking portfolios. NAPF estimates the new rules could cost UK pension funds an extra £300 billion ($484 billion) and argues that companies faced with extra funding demands from their pensions would be forced to shut their final salary schemes.

At he heart of the proposals lie a new valuation method, a so-called holistic balance sheet or HBS. Worryingly, when the $54-billion Universities Superannuation Scheme, one of the UK’s biggest, applied HBS criteria to its scheme, it pushed liabilities from $56.5 billion to $105 billion. “These are not good numbers for a regulator to look at – it is not a good place to be. We want to avoid it all together,” said Tom Merchant, chief executive of the fund. “This looms large on the risk register and would have a serious impact on every scheme.”

Gabriel Bernardino, chief executive of the European Insurance and Occupational Pensions Authority, the body advising the European Commission on the proposals, tried to mollify critics: “We are not a bunch of lunatic, crazy guys in Frankfurt and we are not out to kill defined-benefit pension plans,” he said. Despite infusing his language with compliments about the UK industry and assurances that new rules would only be supervisory, trustees were left unconvinced. The worry is that supervisory measures will come with a 10-year deadline for full compulsion. “There is a great deal of fear and confusion in the different messages,” said Charles Pender, at the $589-million Lloyds Superannuation Fund. Even funds supportive of European federalism had their doubts. “There is a lot of concern among the audience about regulation coming out of the EU, but there is also a lot of mythology here – like the EU decrees cucumbers or sausages have to be straight,” said John Pantall, a councillor representative on the $18-billion Greater Manchester Pension Fund. “What I would say is that we must have the opportunity for overweight positions, to take risks and outperform.”

Quantitative easing is not pleasing

The impact of quantitative easing, so-called QE, pushing UK gilt yields to historic lows was the other top grumble among trustees already juggling deficits. The Bank of England Asset Purchase program stands at $605 billion, with a further $80 billion expected next month; because the government spend has been almost exclusively targeted at buying gilts, rather than any other asset class, it has pushed yields down below historic lows, where they were already languishing. Today the yield on a 10-year linker is minus 3 per cent and on a 10-year conventional, 1.74 per cent. “Our assets are healthy but our funding levels have dropped because of the low gilt yields,” said one trustee. Another remarked how negative yields leave buyers of UK gilts “in effect paying a premium to the government in return for inflation protection.” NAPF estimates QE has added $145 billion to the UK’s pension deficit, which, according to the Pension Project Fund’s June figures, stands at $430 billion.

It’s a call to arms NAPF chairman Mark Hyde Harrison heard. “This is an issue that requires urgent government and regulatory action,” he said. “We cannot afford to wait. Pension schemes need help and they need it now. In the US, Sweden and the Netherlands, governments have acted.” It is lobbying the government to apply an explicit uplift, or margin, to gilt yields. “Even a 0.5-per-cent rise in gilt yields would cut the pension deficit of the FTSE 350 by about 40 per cent,” said Hyde Harrison. Trustees welcomed the news, with one commentator saying she wanted more evidence that QE was actually working. “NAPF lobbying will spark debate as to its benefits,” she said.

Critical mass at the core of PIP

The why and wherefore of infrastructure investment was also much discussed with six funds pledging $161 million each to the government’s Pension Infrastructure Platform (PIP). The Railways Pension Scheme, Strathclyde Pension Fund, the Pension Protection Fund, the West Midlands Pension Fund, BAE Systems Pension Funds and BT Pension Scheme have provided what NAPF called “a critical mass” of investors for the scheme that will channel money into “core” projects such as energy and transport free of construction risk. It will feature low leverage – no more than 50 per cent per project and fees will be low, at around 50 basis points. Investments will be inflation linked and the fund is seeking long-term cash returns for Retail Price Index plus 2 to 5 per cent. “We believe the PIP is an important development that will help schemes like ours gain access to infrastructure on terms that are aligned to the long-term interests of pension funds,” said David Adam, chief investment officer of BAE Systems Pension Funds.

Founding investors only account for a third of the $3.23 billion the PIP hopes to raise in its first year. Although the scheme has confirmed “strong interest” among other pension funds, many remain lukewarm on the idea. They cite their own, existing infrastructure allocations and a preference for debt investment in infrastructure, rather than equity, as reasons. A reluctance to invest in schools or hospitals, where greater expertise would be needed, was also a reason to hang back.

The city of Liverpool’s regenerated Albert Dock was a fitting backdrop to the industry gathering, rejuvenated and buoyed by the early success of auto-enrolment. European legislation clouds the horizon and gilt yields weigh on portfolios, but with NAPF lobbying on their behalf, trustees are confident they will get their message across.