A defining characteristic of leading pension funds globally is the cost savings garnered from in-house investment management. An organisational design study by CEM Benchmarking has revealed that “leading” funds have an average of 49 per cent of assets managed in-house, and yet the internal staff and non-manager third-party costs make up only 15 per cent of total investment costs.

The study examined the organisational design of 19 of the world’s largest funds with average assets of $90 billion and found that these funds spend an average of 46.2 basis points on external management, compared to 8.1 basis points on internal investment capabilities.

Partner at CEM Benchmarking, Mike Heale, said the funds with internal management platforms are better performers after cost, and this is largely driven by lower costs of internal management.

The biggest cost savings were from internal private equity, with the median cost of internal management for private equity 25 basis points, while for external private-equity management the median cost was 165 basis points.

For fixed income the difference was 3 versus 18 basis points, for equities 10 versus 40 and for real estate 21 versus 75 basis points.

Heale says in the past 10 years there hasn’t been a great deal of internal private-equity management, but he believes the industry is on the cusp of change.

According to CEM Benchmarking vice president, Jody McIntosh, the extent of in-house investment management was a driver of many organisational aspects, including the number of staff and the compensation.

“The number of staff at these 19 funds ranged between 20 and 647 full-time investment staff. This is a big variation, and it was interesting to see what was driving that was internal assets under management.”

CEM conducted a regression analysis that revealed 70 per cent of the variation in the number of staff was due to internal management.

McInstosh says most funds plan on increasing the number of staff over the next three to five years, some by as much as 10–20 per cent as they increase internal management.

There was also a clear relationship between the number of front and back-office staff, with 1.7 people required in the back office for every member of front-office investment staff.

“The number of front-office staff is the best predictor of governance, operations and support staff,” he says.

Resource allocation matters

But it is not just the number of staff that distinguishes these funds, it is where the resources are allocated.

Large funds have a substantial number of full-time staff dedicated to asset allocation and risk, with an average of 13 of 135 staff allocated to this area.

A survey of these funds strategic objectives revealed that risk management was the number one priority, followed by organisational leadership, culture, talent and asset allocation.

McIntsosh says the number of internal staff was also a clear indicator of the compensation paid to the senior staff.

“The best predictor of compensation for the highest paid five staff was the number of full-time staff in the organisation. The higher the number of people, the higher the compensation,” she says.

Of the funds surveyed, the highest compensation was in Canada, followed by Europe, US and Australia/New Zealand.

Average salaries at investment departments in Canada was $536,000, in Europe it was $246,000, for the US $148,000, and in Australia and New Zealand $139,000

The average salary of the top five investment staff in Canada was $1.5 million, in Europe $720,000, in the US it was $372,000 and in Australia $297,000.

Heale says the study is part of global leaders program introduced by CEM last year, which looks at understanding the common characteristics of the funds, including big internal operations, sophisticated asset mixes, high need for performance-management information and high allocation to private markets.

The organisation design study is the initial piece of research into which CEM plans to drill deeper.

US public pension funds, under fire for the sustainability of their defined-benefit plans, are increasingly opening a new social-media front line in the battle to influence public opinion.

The Maryland State Retirement and Pension System is the latest to step up its social media presence, posting its first You Tube video, which outlines the positive effects of its $37.7-billion defined-benefit (DB) scheme on the local economy.

The video, which sees senior staff, including chief investment officer Dr Melissa Moye, discussing the system’s investment strategy, is part of a social-media strategy at the fund that included launching a Facebook page 18 months ago.

The 265 likes on Maryland’s Facebook page are dwarfed by CalPERS, which has garnered 2596 likes on its page and exhorts fans to encourage another five of their friends to like America’s biggest public-pension plan.

The Teachers Retirement System of Texas (TRS) is another large fund that says it has “gone social” and now has a presence on Facebook, Twitter, LinkedIn and You Tube.

While pension funds can be media shy, TRS has shown a liking for You Tube, posting one video each month for the last six. Its Twitter feed includes information on upcoming town hall meetings and reminds members when agendas to board meetings are available.

 

Social media reframes public debate

Unlike other social media users, TRS does seem to have ambitions to create a broader online community. On its website, it states that “TRS’ social media presence is not intended, nor created, to be a general public forum”. The message is that social media is viewed as another avenue of member engagement.

However, Maryland’s head of external communications Michael Golden says the system’s push into social media is an attempt to provide balance in a public debate, where it feels opponents of DB public pension schemes have had much more airtime.

“Defined-benefit plans, Maryland’s being but one, have a great story to tell. Unfortunately, that story has not received the same attention and balance that the criticism and challenges levelled at public DB plans have,” Golden says.

“This is our attempt to reframe the discussion about Maryland’s plan, and in a way all such plans that are effectively providing retirement security. It is presenting the facts directly to our members and everyone else who is concerned with the future of these plans and the broader concerns about retirement security.”

In keeping with this active strategy, the fund responds to comments on its Facebook page, clarifying criticism and posting links and responses to articles in the mainstream media.

It also posts research from DB advocate organisations such as the National Association of State Retirement Administrators and the National Institute of Retirement Security in an attempt to more broadly circulate their findings.

 

The Face(book) of pension reform across the US

The push into social media for Maryland came amid efforts by the state governor and legislature to address the funding shortfall in its system.

Maryland managed to cling onto its DB scheme when Governor Martin O’Malley designed a reform program that aimed to address the 65-per-cent funded ratio of the state’s pension system.

It was a win for DB advocates against the recent growing push to shift to defined contribution, or a hybrid mix, in state reforms designed to reign in pension costs.

The drive to tackle funding issues in public pension funds has seen unprecedented legislative reform of state and local pension systems in the last three years.

A recent US National Conference of State Legislature report found that 43 states have enacted major legislative reform of their pension systems from 2009 to 2011.

The report reveals that the number of states instigating reform has more than tripled from 2009 levels, with 32 states in 2011 undertaking major changes to their public-pension systems.

The most common reforms include moves to increase employee contributions, slashing cost-of-living increases, raising retirement ages and changing the years of service required to calculate benefits.

The Facebook pages of public pension plans put a face to these changes, with members of a number of plans commenting directly on the effects of these reforms on their benefits.

Golden sees social media as a way of communicating Maryland’s drive for a sustainable DB plan as part of this broader national debate around pension reform.

“Maryland’s governor and state legislature made it clear during last year’s reform of the pension system that Maryland continues to support a DB plan for its employees,” he says.

“Actions taken, in Maryland and elsewhere, make the case in this debate that DB plans are sustainable. It’s important for everyone to understand how import the pension system is to its members and the community at large.”

Other pension plans, such as CalPERS, have geared up to defend benefit payments to members, investment performance and the sustainability of the fund in the face of a push by state legislatures to reign in pension costs.

Last year the fund launched a blog-style site, CalPERS Responds, that details the fund’s views on a variety of topics, including reform of California’s pension funds.

Reforms include closing the current defined benefit schemes to new public employees and enrolling them in a hybrid scheme.

Other smaller funds, such as the $73-billion Ohio Public Pension Employees’ Retirement System, also have their own blog in an attempt to proactively influence public debate.

Going social, as TRS puts it, is a big step for funds, particularly smaller resource-stretched ones, whose previous public engagement may have been limited to comments from the floor of a trustee board meeting.

While there is always a reputational risk for any organisation entering the social media sphere, Golden says that the reward of getting views into the public domain outweigh the potential risks.

“We have a great story to tell; there is little risk in telling the truth,” he says.

MSCI looks at why investors may have a limited small cap representation in their equity portfolios and how this may potentially impact on both risk and returns.

The researchers find that investors may be making an unintentional decision to minimise their exposure to small caps that could have cost 60 basis points of annual performance over the last decade.

The flight to quality was not limited to certain developed-country debt during the volatility in the second half of 2011. Indeed, Pimco’s global co-head of emerging-markets portfolio management Ramin Toloui says that some emerging-market government bonds are potential safe havens during times of market stress.

He says that the bond giant’s Global Advantage Government Bond Index now has an approximately 35 per cent exposure to emerging-markets.

A standard government-bond index typically has an exposure of around 5 per cent to emerging-market government debt, Toloui says.

Pimco’s Global Advantage Bond Indexes (GLADI) are a series of GDP-weighted, investment-grade fixed income benchmarks. Pimco uses the indexes as benchmarks from which it takes active positions around for its GLADI group of funds. These GLADI funds have more than $9.4 billion in combined assets under management in both government and corporate bond strategies.

An increased exposure to emerging markets also fits into Pimco’s overarching view of the long-term global rebalancing underway, with slow-growing developed markets deleveraging and capital shifting to assets in fast-growing emerging markets.

“If you look at a world where many investors are looking to diversify their global bond holdings, such as sovereign wealth funds in the Middle East and Asia and central banks, a key asset class they are going into is government debt in emerging-market countries,” Toloui says.

“So we think because of this re-allocation, part of that is going to result in yield compression and rising currencies.”

 

Divergence in emerging markets

This year, capital flow research firm EPFR Global notes that movement into local currency emerging-market bond funds enjoyed nine weeks of positive flows up until the first week of April.

Toloui warns that traditional market-weighted bond indexes may, in fact, have a greater allocation to the biggest issuers of debt, namely developed-market economies, diminishing the defensive characteristics typically associated with government bonds.

The strong balance sheets of some emerging countries have meant they have more policy flexibility to deal with market uncertainty than many indebted industrialised countries, Toloui says.

“The key factors are the levels of external indebtedness and the debt-service payments relative to foreign reserves is absolutely essential,” he says.

According to Toloui, passive government-bond strategies that use traditional market-weighted bond indexes have a high allocation to the largest debt issuers, potentially diminishing the defensive characteristics typically associated with government bonds. Pimco prefers GDP-weighted indexes, which its research reveals results in an average gross government debt-to-GDP of 82 per cent across the countries in its government bond index. This compares to an average debt-to-GDP of 138 per cent for an equally weighted selection of three common market cap-weighted indexes.

He points to a necessary shift in the way bond investors should think about how industrialised and emerging-market countries perform in times of global economic stress.

“Traditionally in risky market conditions, you have industrialised-country bonds rally as central banks cut rates and emerging-market bonds face pressure because emerging markets had to raise rates to prevent capital flight and defend the currency,” Toloui says.

“Recently, however, there has been a big divergence in emerging markets with some countries, like Hungary and Turkey, falling into the old model of having to raise interest rates when there is capital flight, but other countries, like Brazil, being able to cut rates aggressively to shield their economies in periods of external stress.”

Brazilian two-year bond yields fell by more than 200 basis points in the second half of 2011, more than those in Germany and the US.

Italy, Turkey and Hungary saw bond yields rise by more than 200 basis points over the same time period.

 

Reconsider bond investments and asset allocation

Toloui makes the point in a new research article that investors who purchased Italian bonds a decade ago would have anticipated that yields compensated for interest rate risk – primarily the volatility of interest rates in the eurozone.

In contrast, purchasers of Brazilian bonds would have wanted a yield that compensated for the potential credit risk of Brazil not paying its debts. This is completely reversed in 2012, with investors perceiving credit risk in Italian bonds, while purchasers of Brazilian local currency debt would have been focused on central-bank policy and its impact on interest rates.

Pimco now makes the distinction between hard interest-rate durations, when yields on these bonds typically fall during times of market stress, and soft-credit duration, when yields rise during market stress.

“The old mental apparatus in investing in bonds seems to be reconsidered, and therefore the asset allocation needs to be re-considered,” Toloui says.

“Investment in emerging market bonds can provide income but can also provide some of the attractive qualities that bonds have in periods of volatility.”

Investors who structure a bond portfolio around the traditional dichotomy of developed markets representing hard-duration interest-rate risk and emerging-market soft-duration risk may, in fact, find they are holding assets that are acting like a credit risk, Toloui notes in his research.

He does, however, acknowledge that the financial markets of emerging markets are currently not deep or liquid enough to deal with large-scale capital in-flows that would result from global investors looking to allocate up to a third of their government-bond portfolios to emerging markets.

Pimco sees considerable first-mover advantage for investors who position themselves early to take advantage of the push into emerging-market debt, but Toloui warns that valuations may be bumpy.

“Positioning yourself there early is a way of taking advantage of the fact that we anticipate that there is going to be large capital flows going in as more investors allocate to these markets,” he says.

“In that journey, we are going to have periods where valuations are stretched where a lot of money moves in in a short period of time and we, as active managers, are trying to be mindful of that. Emerging markets are smaller. Navigating those markets is more difficult than it is in deep, liquid markets in industrial countries, but it does mean that getting there before others is especially important and also being sensitive to valuations as you are making your investments.”

The recent sharp growth in US corporate defined-benefit-plan liabilities, coupled with concerns that interest rates will start to rise from current historical lows, is slowing the push to de-risk plans, Wilshire Consulting’s head of investment research, Steven Foresti says.

The latest Wilshire Consulting research into defined-benefit (DB) plans at S&P 500 companies reveals that aggregate funding ratios for all plans combined had decreased from 84.9 per cent to 79.7 per cent.

The funding shortfall at the beginning of the year has grown by $286.9 billion to a total of $1,415.5 billion. This represents an 11.2-per-cent increase in liabilities in 2011, driven by a discount rate that has fallen 5.01 per cent.

“The tendency with this dynamic de-risking is to move more heavily into fixed income but plans are waiting for the opportunities to present themselves based on both where the yield environment is and where funding ratios are,” Foresti says.

Exacerbating the push to de-risk by allocating more to fixed income is the return assumptions of many funds. These assumptions are another vital component to calculating a fund’s long-term liabilities.

 

Warnings from Wilshire

Wilshire warns in its 2012 Wilshire Consulting Report on Corporate Pension Funding Levels that it expects the long-term forecast for return on corporate-pension assets to be approximately 5.6 per cent, well above plans’ median-return assumptions of 7.95 per cent.

The report cautions that the difference between market-based earnings and these so-called accounting earnings used to calculate liabilities cannot continue unabated. Once this gap exceeds 10 per cent of assets, it must be amortised over time, further worsening the liability picture for underfunded plans.

“Funds are looking at if an investment program can be put together that begins to mimic some of the volatility in liabilities, so assets tend to move up when liabilities move up and down when liabilities move down. Then you have a much predictable funding ratio and a much more predictable set of contributions going forward,” he says.

“The problem with doing that is you have to invest in a heavy fixed-income portfolio, which means that expected returns come down, and a big detriment to plans is that – if you look at the interest rate environment we are in now, low-rate environments where plans are concerned – one of the scenarios that could happen, whether triggered by inflation or other sources, is a rise in rates.”

Wilshire finds that corporate DB funds still have a strong exposure to equities, with a median allocation to public-market equity of 51 per cent, compared to 36.3 per cent for public-market fixed income.

Interestingly, Foresti says that the research does not reveal a strong link between funding levels and equity exposure, with the data not showing funds with low funding levels chasing returns through high allocations to equities.

A fixed-income push is more apparent when looking at the biggest 100 DB-corporate plans in the US.

 

Fixed income allocations up over equity

Actuarial and consultancy firm, Milliman, has also released its own study of funding levels among these 100 largest DB plans. It finds that for the first time fixed-income allocations are larger than equity allocations.

Overall, the 100 companies Milliman studied allocated 38 per cent of their pension-fund assets to equities. This was down from 44 per cent in 2010 and 55 per cent in 2007.

This compares to 41 per cent for fixed-income instruments, up from 36 per cent in 2010 and 33 per cent at the end of 2007.

“The decline in equity allocations reflects one form of pension-risk management: de-risking,” the report notes. “Plans pursuing liability-driven investment strategies are typically reducing their exposure to equities, increasing their allocation to fixed income and lengthening the duration of fixed-income assets to more closely match their liabilities.”

Foresti says many of its clients are looking at dynamic de-risking plans, which look to target particular allocations that lower risk as funding levels improve.

 

Maudlin at Mercer and Milliman

This view is borne out by a Mercer survey of chief financial officers (CFOs) in December last year that found that 40 per cent of them were either already or very likely to increase allocations to fixed income in the next two years. Almost a third reported that they were already or were going to start a dynamic de-risking strategy.

Chief financial officers were also pessimistic about the prospects for their DB plans, with almost 60 per cent saying these pension plans posed at least moderate risk to their respective company’s near-term performance.

In attempting to address this funding situation, Milliman says it is expecting 2012 to be a record year for company contributions to pension plans.

It notes that contribution for the Milliman 100 companies in 2011 fell from $60.3 billion to $55.1 billion.

Milliman predicts that 2012 contributions should rise to a new record level of more than $80 billion.

According to Foresti, another advantage of putting a de-risking strategy in place is that it limits some of the behavioural risks that plans may have suffered from in the past, when they were lulled into a false sense of security in bull markets.

“It is very natural if you have only experienced positive market returns and a tranquil environment to feel much more confident about the future and potentially discount the risks that are embedded in investments a bit more than you may have if you have gone through a difficult environment,” he says.

It could also be potentially more difficult at that time to say, hey, let’s move to a lower risk portfolio in that environment.”

General Electric had the largest funding shortfall of the 316 S&P 500 plans in the Wilshire survey at $18.4 billion.

Three other companies showed a pension-funding shortfall exceeding $10 billion for the fiscal year 2011: Boeing Company at $16.6 billion, Lockheed Martin with $13.3 billion and AT&T at $10.6 billion.

Boeing and Lockheed Martin have both announced that they expect pension contributions in 2012 to be at least $1 billion.

Milliman notes that while the funding deficits grew in 2011, the deficits represented less than 10 per cent of market capitalisation for 65 of the 100 companies that researchers looked at.

 

 

Moving from reactive engagement to proactively working with companies and regulators to avoid major environmental, social or corporate governance (ESG) events has become a key focus of the Swedish Ethical Council, its new head says.

Newly appointed chairwoman Ulrika Danielson says that the council, which is a collaborative engagement effort for the AP 1 to 4 buffer funds, has moved into the next stage of its development after it was launched in 2007.

Assisting this preventative push, the Ethical Council is also working more closely with other investors, including asset managers, to push companies to improve their sustainability performance.

“From the beginning, the Ethical Council focused mainly on reactive work and engaged with companies where convention breaches had been proven,” Danielson says.

“Today we have a much greater focus on preventive initiatives and dialogues. Moreover, we collaborate with other investors on a regular basis. Collaboration with investors and demand for transparency, both for companies and investors, will continue to increase in the future.”

The council prioritises face-to-face meetings with executives and boards of companies. Its proactive engagement is done on a confidential basis and aims to persuade the particular company to improve its internal processes around environmental and ethical issues, as well as the transparency of its reporting.

 

Best-practice guidelines

Such proactive engagement has been seen in encouraging a North American mining company to improve its dialogue with the local communities affected by its operations, entering into dialogue with a European timber company on issues of sustainable forestry initiatives and working with two European oil companies on deep-sea-drilling safety concerns.

In its recently released annual report, the Ethical Council details a range of engagements with companies, including an innovative mining project that aims to apply the industry’s own best-practice guidelines to the companies the funds invest in.

The project resulted from a 2008 report into the mining industry, which Danielson says came out of a number of engagements the council had conducted with mining companies.

“On the basis of this report and our experience that mining companies also face challenges regarding corruption, social issues such as respecting indigenous rights and communicating with local communities, as well as often having operations in countries with weak laws, we started this initiative,” she says.

The mining project enlisted the cooperation of Dutch fund PGGM and the seventh AP fund.

As part of the project, 30 mining companies operating in different parts of world were evaluated for the compliance with the 10 principles of sustainable development issued by the International Council of Mining and Metals.

The research found the lowest level of compliance with principles that dealt with engaging constructively and respecting the rights of indigenous and local communities. The companies ranked highest on implementing risk management based on valid data and sound science.

 

Making a difference

Other issues the council has focused on include tackling corruption, the working conditions of employees in the electronics industry, climate change and carbon disclosure, and the sustainability of the oil industry.

Over the course of 2011, the Ethical Council conducted engagements with 126 companies – 52 from North America, 40 European and 26 Asian.