Fit for purpose and ready for the future

LDI, CEIOPS, IORP, ETFs, portable alpha, inflation-linked swaps - no IPE story would be complete without them.

It just goes to show how much has changed that an imaginary reader from 1997 fast-forwarded to today would struggle to know what we were talking about. "Immunise a portfolio? Call a doctor!"

If a week is a long time in politics, then a decade is almost a geological era in the financial world. You have to put yourself in a world where the dot-com boom and subsequent bust had not yet happened.

There had been no Enron and the other financial scandals. The tragic events of September 11 2001 and the resulting War on Terror and the invasion of Iraq were in the future. There was no euro and no European Central Bank. There was still such a thing as a defined benefit pension fund! Companies took contribution holidays. New international accounting standards were still in development. Who would have got exited by the term IAS19 10 years ago?

In some ways it seems a lot longer ago than just a decade. We live in a different world in the broadest sense as well as a completely different investing environment.

Much has changed in the European pensions field. Perhaps the greatest new factors are the focus on liabilities, the ever-worsening demographics and on more sophisticated investment techniques.

One of the seismic shifts in the past decade is doubtless new mark-to-market accounting and regulatory standards that have shone new light on liabilities and forced plan sponsors to take action. When was the last time someone mentioned "actuarial smoothing"? This change has fundamentally changed the landscape for corporate pensions, with the matter in many cases rising to the top of finance directors' agenda, where previously it had been a human resources issue. Who would have predicted that pensions would have become a factor in corporate takeovers, for example?

The increased transparency came at a bad time for the pensions community, coming at the time of the equity market bust and as increasing longevity started to become an issue for the first time.

Suddenly it was all out in the open and investors and the wider stakeholders clamoured for action, where previously problems had been to an extent swept under the carpet. Who would have understood the term employer covenant back in 1997?

What strikes you now, thumbing through some of the back numbers of IPE, is just how much more sophisticated the pension investment universe appears now. It's not just the terminology. It's probably too glib to stay there's too much jargon out there, but it is definitely the case that new challenges need new solutions.

At the macro economic level, the equity bust coupled with the following low bond yield situation and the increasing focus on liabilities led to perhaps the key development in the last few years - Liability Driven Investing. A reader from 1997 would no doubt understand the term, although how much actual meaning would it have? Whether LDI is here to stay is a moot point - especially perhaps given the fact that inflation and interest rates appear to be on the rise again. But unless people stop living longer, it would on balance appear that it's a mode of thinking that could be set to stay.

LDI, and other terms such as structured products and interest-rate swaps, represent a brave new world for pension investment managers in the first decade of the 21st century that did not exist just a decade before.

What this means is that for the 10 years of its existence IPE has effectively covered the long lingering death not just of the ‘cult of equity' but also the decline of the traditional approach to fixed income investing. That the defined benefit scheme is becoming a thing of the past almost doesn't need to be mentioned. A true sea change in the way pension funds has occurred over this period in a way that only really comes apparent when you take the long view.

Ten years ago, the focus was almost exclusively on returns in a way that seems naïve today. Pension investment managers spoke of investing in individual companies in a way that seems very dated now - an indication that at least some of the black arts of portfolio construction have filtered across to the mainstream.

Given all that has happened in the wider financial world in the past 10 years, it's perhaps no surprise that the concept of risk is now firmly centre stage. The increasing prevalence of the term ‘risk budget' must be a good thing for all concerned.

Another aspect that has gone is the balanced mandate, despite a rearguard action from so-called multi-asset providers. But it will be interesting to see whether the triumph of the specialists is set in stone or whether the balanced brief could ever make a comeback.

 

iduciary management has been another growth area in the last decade. This is where a pension fund outsources its operations to a third party. This trend, especially in the Netherlands, seems to be unstoppable. But the longer-term consequences for beneficiaries and concentration of assets may be interested to observe. One constant in the pensions industry is that decisions taken for short-term advantage may not turn out to be beneficial in the long term.

At the European level, the most significant new kid on the block is IORP - the directive on Institutions for Occupational Retirement Provision, occupational pension fund directive. This measure was little more than a twinkle in the eye a decade ago, and now here it is a bouncing infant approaching its fourth (official) birthday.

Despite some teething troubles, there is no denying its existence - and the fact that it is being used as the basis for some very interesting ideas on pan-European pension provision by players such as PensPlan's Michael Atzwanger. So while it is still not fully realised, the dream of a European pensions market is appreciably closer than could have been hoped a decade ago. One critical feature of the IORP directive is that it introduced the ‘prudent person' investment approach into the DNA of European pensions.

And that's before the new developments in pension portability are taking into account. If this proposed directive has as long a gestation period as IORP we may have to wait another decade or so - though this in reality seems unlikely, despite the inevitably problems, because people genuinely seem to back the directive's broad thrust. As ever, the devil is in the detail but the will exists to get something substantial on the European statute book so that will be something to watch closely in the coming period.

So the upshot is that a playing field where level is the operative word, might, just might not be entirely out of the question.

There's so much more that has occurred. There's the national pension reserve funds in Ireland, France Norway and Sweden which have done so much to influence some of the thinking of the rest of us.

There's been new asset areas such as infrastructure, foreign exchange and ETFs.

Private equity has exploded. SRI and corporate governance have just about entered the mainstream. The European Court of Justice has made some key rulings on pension taxation which have, again, brought forward the harmonisation of European pensions.

The last 10 years have been ones of unprecedented challenge for European pensions. But the sector has evolved new techniques and new ideas and it could be argued that it is in very strong shape indeed for whatever is to come in the next 10 years.