Funds' perfect storm

The Irish asset management market is changing, according to Ollie Fahey, head of pensions marketing at AIB IM. And it is doing so in response to what he calls "the perfect storm for Irish pension funds".

The drivers of the perfect storm are easily identifiable, he adds. "Poor market performance during the past decade, Euro-zone interest rates falling to all-time lows and so driving up the cost of annuities and pensions, people living longer, new financial reporting standards and new regulations from the Pension Board have all combined to make it extremely difficult for Irish companies to keep defined benefit (DB) schemes."

"The change in the regulatory environment introducing a statutory funding requirement made pension schemes aware of short-term risks for the first time," says Paul Droop, senior investment consultant at Watson Wyatt in Dublin. "It made them look at short-term funding measures and highlighted the potential short-term volatility in funding levels."

And those factors forced pension schemes to look at their investment strategies, he adds. "Schemes had moved into a long-term time horizon in the 1980s and 1990s, they appointed managers on a balanced mandate and said ‘just deliver returns that we might expect or better over time, and feel free to move the asset allocation around and to actively invest'. But with short-term risks being much more explicit, schemes have had to take responsibility for monitoring, controlling and managing their short-term risks. And the primary driver of short-term risk in a scheme is the asset allocation and exposure to different asset classes that may or may not match the short-term value of their liabilities very well."

The response has been dramatic. "Some 15 years ago Ireland was very much a balanced fund DB market and trustees and sponsors were happy with that," says Fahey. "The key representatives on a trustee committee from the sponsor were HR, but that has completely turned round and the sponsor representative now is generally the finance director."

The change in representatives has resulted in both a change in the asset management profile of the schemes and the structure of pension provision.

"Schemes have begun to shift away from a typical balanced manager into the specialist space where they control, monitor and change their asset allocation more directly," says Droop.

"There has also been a trend towards defined contribution (DC)," says Jennifer Richards, head of Standard Life Investments, Ireland. "A lot of DC schemes are being set up and the DB schemes are being closed to new members."

"The move from DB to DC is probably the largest seismic shift we are seeing on an ongoing basis," says Peter Wood, head of Irish customer business at Bank of Ireland AM (BIAM). "It's still very much in its infancy in terms of assets under management but nearly all, if not all, schemes being set up are DC. We are also seeing some of our larger schemes closing to new entrants."

"We haven't seen the blanket closing of DB schemes and their replacement with DC schemes seen elsewhere, notably in the UK," says Richards. "My project this year is to ask pension funds before they close DB schemes whether they have looked at strategies that would calm the employer down, like interest rate hedging opportunities. Generally industry in Ireland would be very pro DB and most employees, employers, consultants and fund managers feel that they have done very well for their members and so would like to see them continue."

"We've seen the Irish economy generate 1m jobs over the last 10 years, and those jobs that have pension plans attached to them have almost exclusively been DC schemes," says Fahey. "More than 40% of DB schemes have closed to new members and almost all have at least considered their profile and options. So effectively that has crystallised the problem because by closing a plan one has an automatically ageing structure and increasing lack of flexibility in what risk one can take on the investment side."

"DB and DC schemes have different requirements," says Brendan Johnston, pensions director Eagle Star Assurance Co of Ireland. "So the type of business we are seeing is changing away from a mixture of segregated and non-segregated to the non-segregated at the expense of the segregated."

"In Ireland the default tends to take more than 50% of the money," says Paul McCarville, director Setanta AM. "So if you are the specialist equity provider you are fishing in the shallow end. But that's where our expertise is."

But Sean Hawkshaw, CEO KBC Asset Management, says it is difficult to generalise. "Although smaller DCs tend to default towards consensus-type products, we have small DC clients that are very advanced and want to have 11 or 12 choices on the ticket and then we have some very traditional ones that just want a passive and an active mandate. And in many cases it depends both on the trustees and the industry they are in, with financial, tech and pharmaceutical companies being a bit more advanced and manufacturing companies being a little more traditional."

"Consensus funds are as popular as ever because by their structure they almost guarantee a mid-table outcome and lower second quartile over the longer term, and because they have a lower fee," says McCarville. "That has to be attractive to trustees because it
means they are never going to be in the firing line. In many cases consensus funds are the default option and they take in a lot of money. Lifecycle funds have barely emerged over here and although as a provider I understand the difficulties of constructing a sensible lifestyle offering, that has always puzzled me."

"But the issue on the DC side is around the contribution rate," says Hawkshaw. "There's lots of industry evidence to suggest that at 8-10% the contribution rate is too low to meet expectations in 20 years. DC in itself isn't better or worse than DB, it depends on the contributions."

However, DB schemes hold most assets. "There are now more than 82,000 DC schemes and they represent more than €6bn of assets, a huge increase on six years ago," says Wood. "But there is €72bn with DB schemes."

And the Irish pensions industry has been particularly successful, he adds. "Assets under management have risen substantially over the years and the size of the bigger funds has allowed them to look at specialisation. In addition, consultancies have grown in importance and the global way that they look at investment management community means that they are urging clients to look at specialising their structures."

"We have moved out of the balanced approach and more into the specialist arena," says Hawkshaw. "Three or four years ago our business was based on a single product and a number of derivatives arising from that but on a single process. We have been trying to move ourselves from a producer mindset into a customer mindset and examine what our clients are looking for. We believe that pension funds need a true form of diversification. In the 1990s a pension fund thought diversification was that if was with us and BIAM."

"There's a huge struggle in terms of addressing the needs of pension funds and I'm not sure that they themselves are too sure of where they stand," says McCarville. "Their hands are tied by the accounting changes and the solvency situation and they are being shoehorned towards LDI-type solutions where they are essentially putting more and money into assets which are unlikely to help to pay the pensions down the road. I think that the DB scene is very confused and there are some serious contradictions in what funds are doing. It's not a very happy condition."

"Pension funds are looking at their liabilities and asking whether they are matched against them," notes Johnston. "Some consultants are advising much more in bonds and there has been a lot of talk about shifting to long bonds to lock in deficits. But trustees feel that if they go into bonds they would probably lose money as the equity market has been very strong for the past four years. So the general trend is not to make a major shift from high equity to bonds but only to let the new cash flow change the portfolio."

"Most of the large DB funds have moved from balanced," says Mick James, director, business development at Irish Life Investment Management. "We see evidence of some higher bond weightings, although it doesn't come through in all the surveys. I would see the whole bond arena and risk management as being where most trustees of DB schemes are."

"It's an ongoing process," says Droop. "There are a lot of schemes here that still have balanced mandates, even schemes of €100m and more that are big enough to warrant a specialist structure. The primary reason for this is that the scheme's investment strategies are still managed by bodies of non-expert individuals, and so there is perhaps a governance shortfall in a number of areas."

"Some of the smaller- and medium-sized DB schemes are still going down the balanced fund route," agrees Fahey. "Whether that's by accident or design is a moot point and the way things have developed over the past few years it has not done them any harm because the equity markets have recovered and more recently bond yields have begun to tick up. But there are still significant issues out there for DB plans as to what their structures are and what would be the right one."

And it is not only pension fund trustees that are doubtful, there are also sceptics in the asset manager camp. "Increased specialisation at the top end of the market is to be welcomed," says Kevin Gallacher, joint CEO and head of business development at Oppenheim Investment Managers. "Clearly, if one has scale then it makes sense to diversify and take advantage of specialist managers. But although a lot of criticism has been levelled at the concept of balanced management it remains the appropriate route for the large number of smaller funds simply because it is the most cost effective way that they can invest their money."

But Droop sees a shift in the perception of what represents a market portfolio. "The adoption of the euro changed Irish pension funds' perception of what is a domestic asset class," he says. "They see that there is no exchange rate risk and realise they are part of a larger monetary area, so Euro-zone equities or euro bonds are considered as a domestic asset class in most cases. And while there are some schemes that have a high Irish equity allocation, increasingly schemes are moving out of that."

"Most pension funds reviewing their equity exposure would see the Euro-zone as their domestic market," says James. "Over the last five years most of the large funds have seen a large growth in mandates that would have exited completely or gradually from Irish equities. There is a large stock-specific risk, with the top seven or eight companies accounting for 80-90% of the market. But the Irish market has been one of the top performers so with trustees needing to squeeze whatever performance they can from their asset base there has been a reluctance to exit from Irish equities."

"A balanced fund in Ireland still has 75-80% in equities," says Richards. "We have had very few clients who have said that they want to go to a 50:50 equity-bonds position. There is certainly some increase in the percentage weighting in bonds but again not a huge shift and after a year when average funds are up 13% and bond yields have fallen the solvency of pension funds is a lot better than it was and so there is less pressure than there was a year ago."

Droop concedes that many schemes retain a domestic equity bias on tactical grounds but is unhappy with it. "They say that at the moment Ireland is enjoying a very strong cycle which is very positive for earnings," he says. "But people don't rationalise it that way in a strategic sense."

Again Gallacher is sceptical. "The most fundamental liability facing any form of pension fund is inflation," he asserts. "And over the longer term real assets are the best hedge against inflation, with equities being the most liquid of real assets. It's a very simple equation that pension funds assets should be invested in equities. The problem is that as a consequence of this short-termism there has been an increasing focus on the liability side and one of the trends evident across the market as a whole is the question of reducing the domestic bias. Arguably, when Ireland joined the single European monetary system the domestic asset class ceased to be Irish assets and became Euro-zone assets. But while monetary union may have removed currency risk there has been no harmonisation of inflation across the Euro-zone. I would argue that Irish assets, particularly Irish equities, are a far better inflationary hedge for Irish pension schemes that Euro-zone assets because the rate of economic growth in Ireland is far higher than in core Europe and yet it is core Europe that is driving interest rate policy. And a lot of the bigger pension funds have seen the unfavourable consequences of having been advised to diversify out of Irish equities and into Euro-zone equities."

Hawkshaw agrees. "They blame us, and the consultants who have been telling them for the past few years that they should have 2-3% in Irish equity have run for the hills."

Nevertheless, international managers have a firm foothold in Ireland. "Historically Irish domiciled managers enjoyed something of a ring-fenced market," recalls Droop. "Given the scale foreign managers were not interested in moving into the Irish market. But the establishment of pooled unitised arrangements that can be passported across Europe has given incredible economies of scale with relatively low marginal costs for servicing new clients. Consequently, we have started to see new managers interested in the relatively small pools of money available in the Irish market. Even relatively small Irish schemes now have access to a pool of investment managers, which is a bigger challenge and more competition for the domestic players."

"I've been around long enough to remember when people thought the asset management business in Dublin would disappear," says McCarville. "This was largely due forecasts of the demise of Irish equity and the belief was that with no local assets in the fund the large international players would eventually eat our lunch. But quite a lot of the plans that went with big overseas players have been very disappointed by the experience. There is now a belief, backed by surveys, that big is not necessarily beautiful, the faraway hills are not greener and the delivery of service and brand recognition is where the rubber hits the road."

"Trustees want to feel that they can have tailored, individual bespoke solutions and that's not always feasible or even offered internationally," agrees Wood. "And fees are extremely competitive here. It's fair to say that the Irish industry has been very far behind the curve for fees, particularly for active management. Irish managers sell international equity management far cheaper than international players even when the international players are coming into this market. But the international players are targeting the large players."

And international players have failed to change one of the Irish market's key characteristics. "When consultants started to introduce overseas managers they were supposed to be a kind of panacea for the merry-go-round, where clients who had been with us historically actively, then gone to Standard Life, been unhappy there and so gone to BIAM and so on," says James. "But it hasn't actually worked out like that. Some of those international managers no longer have the ‘A' rating they had when they were appointed so we are seeing some monies flow back."

"Eventually trustees get fed up with the merry-go-round and start looking for a fund that gives average performance, and that is how consensus funds grew," Fahey adds. "An index core was put in place to deliver a lower risk outturn and the risk that was saved in that part of the portfolio could be used by giving a more aggressive mandate to an active equity manager, and we've seen a huge growth in passive management over the past decade."

"The largest single trend that I have seen apart from specialisation of product is the continuing growth of index management," says James. "At one stage we believed that indexed assets would top out at 20-25% of the market, we now believe it will probably get to 40% and possibly 50%."

Nevertheless, the merry-go-round continues, powered by perceived results and performance surveys. "The league table is the elephant in the room for asset managers," says Fahey. "Managers live and die by their relative performance. Managers and consultants appreciate that there are peaks and troughs in active management but trustees can be influenced by surveys."

"One of the biggest mistakes pension fund trustees make is turning over portfolio managers," says Wood. "It can cost a lot of money. Typically you fire a manager when they have reached the end stage in their cycle when they're picking up. And who do you hire? The manager who has peaked."

This is a particularly sensitive issue for Wood because December's Hewitt Managed Fund Performance survey and Coyle Hamilton Willis Investment Manager survey showed BIAM, a flagship Irish manager with a global presence, performing badly on the year-to-date and over the last three years.

"The last three years have been very bad for us, there's no hiding that," concedes Wood. "Part of the underperformance was because we stuck with our value focus. The core part of our portfolio, 70%-plus, is value large cap stocks - we're a bottom-up stock picker - and over the last three years large market caps have underperformed worldwide. We also underestimated the pace of economic growth over the last three years, the implications of China particularly on the resource, mining, oil and we were underweight on those."

But the main beating BIAM took was in the US, where the $27bn it had under management at the peak has fallen to $7bn, but that was linked to the defection of the team managing its EAFE global ex-US mandate. "The US market is particularly sensitive to a change in people on the asset management side and they tend to fire and move on," says Wood. "That period also coincided with uncertainty regarding our CIO, who was due to retire."

BIAM has since changed its structure, dropped the CIO position and recruited three managing directors to focus on fixed interest, research and global equities (see page 87). It has also lost its independence, moving from a freestanding division into part of the Bank of Ireland's capital market division, a position shared by AIB IM.

Competitors suggest that BIAM still has some way to go. They claim that many of its active clients have switched from in-house active management to passive, it has a relationship with State Street, without going through a beauty parade process so while in its books the asset management numbers look the same the switch will have had a significant fee impact. They add it is now trying to tap into the investment banking side on the LDI front.

And with the closure of DB schemes to new members LDI is seen as a growth area. "With DB schemes it's a case of just sticking the remaining members somewhere and not having to think about them," says Hawkshaw. "So this is where the whole idea of matching cash flows and using derivatives on top of swaps to create an asset structure comes from. If there's a young age profile with lots of money coming in it's questionable whether LDI is really any use but that kind of ageing scenario is exactly where LDI has a market. Most people we have spoken to who have an appetite for very long duration assets, typically swaps with derivatives on top of them, want to match the ageing liabilities in a DB scheme. But in Ireland there's a reluctance to go completely down the LDI route and to use hedge fund or alpha strategies on top of that, people just want to match the liabilities, park it and forget about it."

"The other area that people are looking at is alternatives," says Johnston. "But while hedge funds have been successful elsewhere they have not yet caught on with Irish investors."

"You have to make it easy for them to make that decision," says Hawkshaw. "We found that people want to talk to you and learn about alternatives but they baulk when it comes to committing the 5% or 10%, and when you ask why it's because it's too complex. There's an endless menu of alternatives and they don't know which one to pick and why is one better than another. So we launched Innovator, which is a bundle of alternative strategies, so rather than trying to sell hedge funds or emerging markets, which is a hard sell to a group of trustees, we have made that decision for them by bundling four or five of those alternative strategies into one product."