To win an award of any type is recognition that you stick out from your peers and have achieved excellence. To gain the ultimate accolade of Best Pension Scheme in Europe means you have worked magic and your level of innovation has resulted in something extra special. That sums up KBC’s recent review of its investment strategy perfectly. The KBC scheme is a small fund representing the workers of one of Belgium’s leading financial services and banking groups, KBC.
Small it may be, but its ambitions are big. It was actually perfectly happy with its investment strategy but outside forces wanted to gate-crash the party.
As elsewhere in Europe, recent volatility in the equity markets and the oscillating impact it has had on pension schemes’ level of funding and spiralling liabilities have led the Belgian authorities to take action. The pensions regulator has introduced a new regime that obliges sponsors - and therefore the scheme - to use a new accounting standard that radically alters the way both scheme and sponsor view their pensions arrangements.
The accounting standard forces companies to review their pensions liabilities each year and add them to the balance sheet. This has a knock-on effect on their financial position and can result in changes to contribution rates to control the risk the volatile nature of reviewing liabilities year in, year out poses.
In KBC’s case, there is the added problem that the sponsor is operating in the same industry. So if there are troubles in the investment markets and the scheme’s funded level suffers, cash injections and extra contributions are unlikely as the firm will be suffering a similar cash drain.
Some argue that there is no problem in asking a company to keep account of its pensions liabilities from year to year and indeed, it does offer a level of management that ensures pensioners will get their income. But it is the way the accounting standard requires them to value the liabilities that is causing a headache for many schemes - KBC included. It basically calls for the value of the liabilities to match bond values.
In essence the solution seems logical: switch to bonds. But it is a little more complex than that, as KBC fully understands. There are no bonds that come in durations of one year. Bonds offer less return potential than equities and given the fact pension schemes still have to take a long-term view of their position while grappling with annual liabilities, they need to invest to get better returns. Over long periods of time equities generally correct themselves, so they continue to be very attractive to pension funds.
KBC knows this and this is where it has performed magic. It has managed to devise a strategy that fully complies with the new law and thus reduces the risk to the sponsor. At the same time it has not had to increase its fixed income allocation and thus retains its high return objective of 6%.
Implementing the strategy allows it to overcome two key obstacles. First, with only 40% of its assets allocated to bonds but the law demanding that liabilities be valued in line with bond values, there is a serious mismatch between the assets and the liabilities.
Second, the average duration of the scheme’s liabilities is 12 years but the average duration of its bond portfolios is only seven. So how can it forecast the yearly values if the bonds do not cover all the years it needs to consider? Central to the law is a change to the way schemes set their discount rate. In the past, Belgian schemes enjoyed a generous fixed rate of 6%. Now they need to set a discount rate in line with the anticipated returns on their assets. Setting the discount rate allows them to view future liabilities at today’s values, so it can forecast their level for each year. Seven years of bonds do not match 12 years of liabilities.
KBC’s magic is an innovative but really rather simple concept. It has basically separated what needs to be matched from what it can expect from its equity investments and restructured other areas of the portfolio to fill any gaps. This has resulted in its overall portfolio being split into three subportfolios: the matching portfolio, the return portfolio and the matching and return portfolio.
In the matching portfolio, working with KBC Asset Management, the KBC scheme has replaced its 40% fixed income allocation with ‘liability-driven investment duration buckets’. This gets round the problem of not having bonds with sufficient duration, as KBC Asset Management has created a special UCITS III fund that contains bond investments with durations of 0-5 years, 5-10 years, 10-15 years and so on. Using interest rate swaps cleverly, KBC can hedge twice as many liabilities at less cost to the scheme.
The return portfolio is less dramatic. With no change to its equity investments whatsoever, which are basically split equally between the Euro-zone and the rest of the world, the equity mandates have simply found a new home in this portfolio.
The matching and return portfolio is special. Here, KBC has taken its 10% real estate weighting and restructured it so this is more diversified across a selection of property investment vehicles which offer less correlation with the equity markets. Add to that that real estate investments tend to be long-term in nature and linked to inflation, they offer a much better match for the liabilities.
So the clever KBC scheme can continue to expect 6% returns on its investments while restructuring its fixed income and property mandates to match the liabilities and help the sponsor manage the risk the liabilities pose each year on its balance sheet. Bearing this in mind, it’s easy to see why the judges decided KBC was Europe’s best pension scheme in 2007.
Skill, experience, innovation, a little cunning, commitment, dedication are qualities any member of any pension scheme would hope to find in those looking after their assets. The members of the small but dynamic KBC pension scheme have not only come up trumps with their scheme but they can add wizardry to the list.
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