US investment consultancy Callan Associates favours fund of fund hedge fund allocations as the need to do comprehensive operational due diligence adds to the growing complexity of hedge fund investment. (more…)
Pension reform in the state of New York is politically embroiled with the New York Governor Andrew Cuomo and fellow democrat New York State Comptroller Thomas DiNapoli at opposite ends of the defined benefit/defined contribution debate.
DiNapoli is the sole trustee of the state’s $149.9 billion public fund and a strong proponent of its defined benefit (DB) status.
His advocacy of the current system and its generous benefits to public employees stands in contrast to Cuomo, who has galvanized bipartisan support from mayors and counties across the state for his pension-reform package.
Governor Cuomo’s plan aims to cut pension costs that for local governments across the state now top $12.5 billion annually.
DiNapoli, as the sole trustee of the New York State Common Retirement Plan (CRF), has advocated the continuation of the current DB system, denying it is a drag on public finances.
He has previously said that over the past 20 years investment returns from the fund account for 83 cents of every dollar paid to New York public pension recipients, compared to a national average of 68 cents.
He also has hit out at the trend towards using defined contribution (DC) funds to provide for public employee’s retirement benefits, saying 401(k) plans had been “woefully inadequate”.
It is not the first time Cuomo has proposed changes to the state fund. The Governor ran for office on a promise to reform the governance structure of the CRF, replacing the sole trustee with a board.
He is yet to deliver on this election promise but has pushed ahead with his reform package, which focuses on winding back generous retirement packages for new hires.
It appears DiNapoli’s opposition to reform is shared by New York City Comptroller John Liu.
Liu oversees five NYC public pension funds and is conspicuous in his absence from the list of 12 city mayors and 13 county executives who have signed up to support reforms.
Prominent backers of the plan include New York City Mayor Michael Bloomberg, who says pension costs now account for one in every six dollars of the city’s budget.
“Local governments around the state are all in the same boat and we are joining together to support Governor Cuomo’s push for pension reform to ensure the boat does not become a sinking ship,” Bloomberg said.
“Passing responsible pension reform is essential to ensure that we can afford retirement benefits for tomorrow’s workers – and the public services that today’s citizens deserve and demand.”
It is retirement benefits of tomorrow’s public workers that Governor Cuomo has clearly in his sights.
Governor Cuomo is set for a bitter fight with unions to push his reform package through, with claims by organised labour groups that it cuts retirement benefits to new public employees by up to 40 per cent.
The plan aims to cut back generous pension benefits by excluding overtime from the formula used to calculate final average salary for pension payments, as well as providing a new DC option that public employees can choose.
While other states have made DC options compulsory for new hires, New York has stopped short of denying DB schemes to new entrants.
Unions have flagged that that the push to increase the DC component of future public employees’ retirement benefits will be a key a battleground.
Governor Cuomo’s reforms also include raising the retirement age from 62 to 65 and raising employee contribution levels in line with other states.
New York State public employees currently contribute around 3 per cent annually of their salaries to retirement funds. The reform plans will increase this from 4 to 6 per cent, depending on salary.
Public employees currently retire on around 60 per cent of their salary and the Governor’s proposal will see retirement benefits for new hires cut to 50 per cent.
As part of a coordinated campaign by the Governor, city and county executives called NY Leaders for Pension Reforms, new pension costings for NYC were released this week.
They show that pension costs have risen almost five-fold since 2002, with pensions swallowing an increasing share of the public purse.
Pension costs are projected to take up to 16 per cent of the city’s operational expenses by 2013, totaling more than $8 billion and crowding out spending on other programs, city officials claim.
The Kay Review into UK equity markets and long-term decision-making is one of the more sensible of a raft of reviews that have evolved from the crisis. It looks at the interaction, behaviour, incentives and decision-making of all the players in the financial services “value chain”.
More than some nationalities, the Brits have been concerned with long-termism in investments over the years and the latest incarnation of that thinking is this review commissioned by the UK business secretary, Vince Cable, chaired by economist, John Kay.
Kay, who is a visiting professor of economics at the London School of Economics, has handed down the interim report in which he looks at the submissions from industry so far. The full report, with submissions still being received, is due in July.
British investors, including the Local Authorities Pension Fund and Hermes, have told the review through submissions they think that regulation and the structure of markets has increasingly moved to favour liquidity and trading activity over long-term ownership.
The genesis for the review is concerns that short-term incentives and pressures may be damaging to the way companies are owned and managed.
The review’s terms of reference, that relate specifically to institutional investors and the financial services value chain, include:
- Whether Government policies directly relevant to institutional shareholders and fund managers promote long-term time horizons and effective collective engagement.
- Whether the current legal duties and responsibilities of asset owners and fund managers, and the fee and pay structures in the investment chain, are consistent with asset owners’ long-term objectives.
- Whether there is sufficient transparency in the activities of fund managers, clients and their advisors, and companies themselves, and in the relationships between them.
- The quality of engagement between institutional investors, fund managers and UK-quoted companies, and the importance attached to such engagement, building on the success of the Stewardship Code.
Over the years there has been some innovation from British financial service players with regard to investment time horizons.
Towers Watson has been a proponent of 10-year mandates and reports to have about 30 clients which have awarded about 50 mandates at that length.
In its February 2012 Thinking Ahead Group report, The Wrong Type of Snow, Towers Watson discusses the tension that exists between equity and bondholders from long-term funds that are obliged to invest in corporations with short-term incentive arrangements: “This tension tends to be balanced out by funds focusing on shorter term, rather than corporations adopting longer-term incentives.”
But it also points to a “class of investor” that may help to resolve this conundrum in favour of the longer-term perspective. In what is an act of “fiduciary capitalism”, the report states that universal owners are long-term asset owners who are committed to inter-generational equity and recognise the issues of sustainability in that challenge.
Philosophical change
Many funds managers have also been vocal about the need for a change of philosophy.
One of those, Neil Woodford, head of investment for Invesco Perpetual in the UK, described to the Kay Review panel the obstacles he faces in the pursuit of a “stewardship relationship” with investee companies.
His obstacles also go some way to sum up the challenges faced by those with a long-term view, including:
- The measurement of fund management performance over short time scales
- The broader industry’s obsession with quarterly reporting
- Corporate management’s interactions with intermediaries (investment bankers and sell-side analysts) at the expense of interaction with ‘owners’
- The remuneration structures of fund management professionals – an overemphasis on one-year returns rather than longer time periods
- Fund management fashions – for example, the popularity, for obvious reasons, of hedge fund management techniques
- Human nature – the innate preference for conventional failure over unconventional success
- Regulation, in particular of pension funds, has helped to significantly diminish the role equity investment can play in providing attractive long-term returns to savers
- Incentive structures in the broking industry which encourage increased trading activity
- The ability to remain constantly in touch with market movements, for example, via mobile devices
- The proliferation of derivative strategies which drive underlying cash market turnover
- The absence of fiscal incentives that might favour long-term investment strategies
- The tyranny of the benchmark has created an environment in which fund managers are less inclined to back businesses or industries for the long term because they are concerned with the career risk of moving too far away from their benchmark index over shorter time periods.
The first two of these concerns, the measurement of fund management performance over short time scales and the broader industry’s obsession with quarterly reporting, were a consistent theme among respondents to the Kay Review.
The interim report states that a large majority of respondents, whether they represented companies or investors, considered that quarterly reporting and interim management statements fell into the category of useless or misleading information.
Kay has not made any recommendations and will present his final report, including recommendations for action, to the secretary of state for business in July, but the comments and proposals discussed in the report “signal areas of interest for the final report”. Could this signal the end of quarterly reporting?
The complete interim report can be accessed here
Returns are a secondary consideration to the ethical values of members when framing the socially responsible investment policy of Swedish fund AP7.
AP7’s head of communications, Johan Floren, says that the fund is less concerned with socially responsible investment (SRI) as a driver of returns rather than as a reflection of the values and ethics of members and the broader community.
The comments come as AP7 released research reviewing 21 SRI performance studies from 2008 to 2010 that show no link between responsible investment and returns.
“The findings in the report strengthen our belief that there is no ‘easy alpha’ to find here,” Floren says.
“The primary driver behind environment, social and corporate governance (ESG) simply isn’t yield. It’s values – both on behalf of the people in the industry and societies around it.”
The approach of AP7 continues a broader debate in the industry about how far fiduciary duty extends for pension fund trustees.
At a UN-backed investor summit in January, CalPERS chief executive Ann Stausboll called for funds to look beyond just returns to members and push for broader environmental and social action on such issues as climate change.
According to Floren, the AP7-commisioned study has given fresh impetus to the fund’s SRI efforts, with research finding there was no automatic drag on returns from applying SRI investment strategies.
“The findings are important in several perspectives. The report confirms that SRI doesn’t come with an automatic penalty on performance, which is important to establish in itself,” he says.
“But it is also interesting since it turns the whole debate upside down – if it doesn’t cost anything, why isn’t everybody doing it? We now can go on developing our work without second thoughts.”
AP7 bases its asset management and SRI strategy on academic research.
Frustration about the contradictory messages being received by both academics and practitioners around the effectiveness of SRI resulted in the fund commissioning this latest study.
The Performance of Socially Responsible Investments by Dr Emma Sjostrom from Stockholm School of Economics, is also a timely caution to SRI investors not to overestimate the effectiveness of responsible investing.
“Another perspective is that there is no evidence that SRI (ESG) improves performance,” Floren says,
“Our impression is that a lot of people, both among practitioners and academia, would like responsible investing to have better returns, so much so that they abandon demands for evidence. Apart from being more faith than facts, it also might backfire when fantastic figures are missing and disappointment follows. To us, the conclusion is: don’t make promises you are unlikely to keep.”
Sjostrom discussed her findings at a recent UN-backed Principles for Responsible Investment (PRI) webinar looking at the latest developments in SRI research.
The report reviewed the available studies over three years that investigated the link between performance and SRI but excluded studies that focused exclusively on governance.
SRI performance a “mixed bag”
It found that two-thirds of the studies found no obvious connection between responsible investing and performance.
Of the remaining third, five studies suggested a positive correlation and three a negative correlation between SRI and performance.
“SRI as far as we can see does not automatically generate higher or lower or similar returns,” Sjostrom says.
“There is nothing to say that SRI always underperforms or outperforms – it is a mixed bag.”
Sjostrom and Florens highlighted the need for more comprehensive research into performance and SRI, with it not a matter of merely counting the studies to provide evidence either way of the link between SRI and performance.
The studies investigated used widely differing methodologies and looked at funds in various locations, under different market conditions and those employing different investment strategies.
Sjostrom says the findings highlight the need for more in-depth research into what is driving the performance of these SRI funds when compared to funds that do not consider SRI factors.
“What are the underlying factors for these results? What is going on in the market at this time? Does this performance have anything to do with the skillsets of the managers,” she suggests.
“Whatever the case may be, we would hope for studies that take the next step in measuring performance.”
Index construction is pushing the boundaries of active management, with index providers launching products such as high beta to take advantage of market movements.
S&P Indices is the latest to add to its family of high-beta indexes, recently launching two indexes of developed and emerging markets.
Alka Banerjee, S&P Indices’ vice president of strategy and global equity indices, says index construction is pushing into areas of strategy that have previously been the domain of active managers.
S&P, along with other index providers, has been moving aggressively in recent years into what it describes as “strategy indexes”.
“There is definitely a lot of innovation in the indexing world, moving into things that have been in the domain of active managers so far, of trying to extract value other than market value by developing new strategies,” she explains.
“We find, if we have clear, transparent and easy-to-understand rules that can be implemented in a consistent and regular manner, over time those strategies can be indexed and it is a huge cost advantage to the investor.”
In S&P research conducted last year that tracked the performance of alternative beta strategies researchers found that some strategies had outperformed compared to active management.
The report Evaluating Alternative Beta Strategies by Xiaowei Kang, S&P’s index research and design director, finds that over a 10-year period from 2001 to 2011, simple equally weighted and low-volatility strategies significantly outperformed the S&P 500.
Specific objectives
By comparison, the average US large-cap manager has lagged behind the S&P 500 over the same period.
Kang finds that although alternative beta strategies aim to achieve better risk-adjusted performance than cap-weighted portfolios, they are often constructed with more specific objectives in mind.
“These objectives include achieving a systematic value tilt, lowering portfolio volatility or reducing stock-specific risks, and may define the essence and main applications of different strategies,” the report finds.
In an indication that investors are increasingly looking to hedge for a market upswing, S&P Indices’ latest additions to its high beta family of indexes cover stocks in both developed and emerging markets.
The indexes measure the performance of 200 stocks in their respective markets that are most sensitive to changes in market returns.
The most sensitive stocks receive the highest weights. The indexes: The S&P BMI International Developed High Beta Index and the S&P BMI Emerging Market High Beta Index have been licensed to a third party which plans to launch exchange-traded funds based on them.
“Of course, you have your basic market beta investment, but then you have allocation to high beta and an allocation to low volatility and you cover yourself for both bull and bear market scenarios so you are not completely at the mercy of the markets,” Banerjee says.
The developed market index tracks the 200 most market-sensitive stocks within the S&P Ex US-Korea LargeMidCap Index. Countries it covers include Canada in North America, Germany, France, Ireland and Italy in Europe and Australia, Japan and New Zealand in the Pacific, and Israel.
The emerging market index covers stocks in Eastern Europe, Russia and Turkey as well as countries throughout Asia, Latin America, the Middle East and Europe.
It is possible for the best elements of defined benefit (DB) schemes to be applied to defined contribution (DC) schemes, by replicating real deferred annuities to produce superior pension outcomes for members, according to a new paper by APG.
The paper, How to mimic DB-like benefits in a DC product, does what it says.
It demonstrates through simulation that by using derivatives there is a way to combine the best of both worlds into an individual pension product that has clearly defined ownership while delivering a DB-like pension.
In the paper, its author, APG-intern Jens van Egmond, says while there is a clear global trend towards defined contribution, the solution is sub-optimal because of the disconnect between the accumulation and decumulation phases of the schemes.
“Defined benefit is a fully integrated product,” van Egmond says. “Defined contribution is a pension savings scheme, a wealth management strategy. It doesn’t tell you what you can do with that money at retirement.”
Van Egmond says the study rests on the premise that people want income over their whole life.
“A real annuity is the best way to achieve that, and you can only get that in a defined benefit scheme,” he says.
Stefan Lundbergh, one of van Egmond’s supervisors and head of the innovation centre at APG, says defined contribution funds are essentially wealth management or active management solutions.
“That makes it easy to communicate that your wealth is growing,” Lundbergh says.
“A real pension solution delivers future cash flows, of which the net present value is much more volatile than just wealth accumulation. That’s a very difficult thing to communicate.”
Because defined contribution funds don’t have a pension payout mechanism, the member is subject to “conversion” risk when converting the pension wealth into an annuity at retirement.
The paper proposes a solution where interest rate and inflation derivatives protect the purchasing power of the defined contribution investment over time, making the conversion risk a non-factor.
Essentially, the paper describes a way to match long-term future benefits with investments now.
Van Egmond describes it as using a traditional lifecycle solution, with an allocation consisting of a safe and a risky asset. But instead of using bonds as the safe asset, an asset mix replicating a real deferred annuity is used.
“You know the price of the annuity will change as interest rates and expected inflation vary.,” he says.
“When you invest into the safe asset, the investment amount is translated into future real monthly pension payments, or at least into a very close approximation of these cash flows. The safe asset can be converted into a real annuity at retirement day since it uses an investment strategy that moves the same way as the real deferred annuity moves when market variables change.”
Van Egmond says that replicating a real deferred annuity is dependent on three factors: the interest rate; the inflation rate; and mortality rates. It uses financial instruments to hedge the first two, while explicitly saving more to pay for longevity increases.
Interest rate swaps are used to hedge inflation. The hedging model uses an insurance mindset, and moves away from the asset management mindset of hedging by looking for correlations with certain asset classes. The break-even inflation quoted for inflation swaps is identified as the inflation measure. This provides a cost-efficient hedging method, but it relies on liquidity in the inflation derivative market.
Lundbergh says that while APG is not necessarily producing a solution from this research, it is committed to a different way of looking at the pension payout problem in DC funds.
“There is a gap in the market between standard defined benefit and the more traditional defined contribution models,” he says.
“In the long run, it would be great to have a hybrid product that combines the best from DB and DC for those who only have access to the current DC models. As a mission-driven organisation we are going back to our roots when looking at this problem.”
Ruben Laros, another APG supervisor, says Netspar, the national network of pension practitioners and pension scientists, offers a master’s degree in the economics of finance of aging. Part of this degree is an internship at one of Netspar’s partners, such as APG.
APG has offered more than 30 students the opportunity to do in-depth research into pension related topics. Jens van Egmond is the most recent graduate.