Learning to live with volatility

As pension funds adapt to a new regulatory structure and deal with market instability, asset managers are having to assess how funds may respond, writes Rachel Fixsen

For Belgium's pension funds, investment matters have taken a back seat in the last year as the new organisation for financing pensions (OFP) legal structure made its debut. Being ahead of the game in solvency terms, the country's pension schemes are perhaps some of the few in Europe that could afford to let investment take second place.

The OFP vehicle was introduced in 2007 to spearhead Belgium's push to become a pension domicile under the EU's pension directive. Light on regulatory intervention, the hope is that it will attract the pension interests of multinationals and foreign institutions.

Francis Heymans (pictured right), director, institutional sales and marketing at Petercam Institutional Asset Management, says making the structural change to the OFP vehicle was the most important issue for Belgian pension funds last year. "So we were not expecting any great change for pension funds on the asset side," he says. "My guess is that this will now stabilise and things will change."

But Pol Pierret, country manager for Benelux at AXA Investment Managers, sees activity on the switchover to OFPs keeping pension funds busy into this year as well.

Meanwhile, the crisis in the financial markets and the resulting steep falls in the prices for many securities are unlikely to be disastrous for the solvency ratios of Belgian schemes, he says. "The majority of Belgian pension funds have had quite high solvency ratios for the last three years," at an average of 144% at the end of 2006.

It took quite some time for pension funds to be able to act on switching over to the new OFP, according to Kristof Woutters, pension solutions expert at Dexia Asset Management. "Typically in Belgium, a law is supplemented by several royal decrees," he explains. "A problem with this new law is that some royal decrees were published later than expected or are still missing. This might be due to the fact that we didn't have a proper government for six months last year."

He adds: "We recently also saw the introduction of a new Belgian institutional SICAV allowing for more flexibility and lower costs. I guess that's also something that's going to keep Belgian pension funds busy for a while."

Apart from this, Belgian pension funds are still getting to grips with the new law passed towards the end of 2007 on the prudential supervision of pension institutions, he adds.

Apart from the activity surrounding implementation of the OFP legislation, it is the reality of the ups and downs of the financial markets that is occupying people managing pensions money, according to Jan Longeval (pictured left), managing director of Bank Degroof in Brussels. "The main issue for pension asset managers currently is dealing with a world where extreme outbursts of volatility occur often," he says. "In order to deal with this world of volatility, pension asset managers will have to be able to offer sophisticated solutions beyond traditional tools and asset classes and to educate and convince customers about this way forward. Risk management is a priority on both sides."

If there are lessons to learn from the latest downturn in the markets, Heymans maintains it is to go with the flow. "You need to go through the cycles rather than react to the cycles," he says.

The main lesson to learn from the current market rout is one of caution, says Woutters. "Never let your guard down. Our investment process is based on risk budgeting that allows us to continuously keep the total risk in our portfolios at acceptable levels. As a result, we never started investing in more risky products, such as CDOs, nor did we lower the average credit quality of our bond portfolios at times that risk premiums were compressed such as we have seen during 2005 and 2006."

This, he contends, would have been a typical mistake for asset managers that focus too much on short-term alpha while ignoring total risk exposure.

In Belgium, pension funds have on average 45% in equities and 48% in bonds, with 7-10% in real estate. With more than 90% of bond investment is in euros, diversification only exists for equity investments.

Woutters has not seen any big changes in asset allocation. "However, the use of more alternative products is slowly gaining ground," he observes. "Over the last two-to-three years we have been discussing with our clients the inclusion of alternative products in their balanced portfolios as a way of increasing diversification and also taking into account the very low yield levels on bond portfolios. Clients who have followed suit are very pleased with the results achieved."

But one reason why the move towards more alternative products is not advancing more rapidly is that Belgian pension funds are relatively small and mainly managed by HR directors who do not have the time to analyse these multi-faceted products in detail, Woutters says.

Pierret agrees: "We don't see any big changes happening [in the next few months] because Belgian pension funds are quite stable in their asset allocation," he says. "On the whole, they do not tend to invest in alternatives, although there is a small pocket in the market using diversified assets including unquoted real estate and infrastructure."

Belgium's largest pension fund, Suez-Tractebel, is using new asset classes such as commodities, but this kind of investment policy is limited to the major pension funds, with the majority being too small for such moves, says Pierret.

Longeval has a different view, predicting the volatility likely to be seen this year will probably accelerate a migration of pensions assets towards alternatives. "There is indeed an emerging shift, mainly towards low-volatility funds of hedge funds that are considered as a substitute for bonds," he says. "Private equity remains, unfortunately, quite absent."

Olivier Lafont, head of institutional relationship management at Fortis Investments, says that although Belgian pension funds are very widely diversified geographically, new asset classes are not spread broadly enough. "We think the diversification through new asset classes is still too low," he says. "We have been implementing broad diversification in our balanced strategy for the last five years and have benefited from lower volatility and additional return thanks to the presence of some asset classes in the portfolio we manage."

Bank Degroof's approach to pensions asset management advocates giving a higher weight to alternatives, including the full range of instruments - funds of hedge funds, private equity and structured products, he says. "At the same time, we do not recommend bringing the allocation to funds of hedge funds far above 5%," says Longeval.

But, in Lafont's view, hedge funds are not being weighed as an option in the pensions market to the extent they should be. "The exposure is increasing, but it is still low or not even considered by many pension funds," he says. "We think those strategies should have a decent allocation in all balanced strategies, especially given the current fixed income environment."

"Absolute returns come at a price," says Longeval. In order to offer stability, the market risk premium - which comes ‘for free' in a traditional long-only portfolio - is sacrificed and replaced by uncertain excess returns leveraged up in order to be significant.

"Structured products are more interesting as they can combine protection and upward potential without sacrificing the whole market risk premium," he says.

One lesson asset managers can learn from the weakness in world markets is the difference between good and bad diversification, Longeval says. "Pension funds and their managers should not be lured into investing in overly complex instruments - CDOs and the like - that lack transparency. If you don't understand the product, it's better to stay clear than to become the market fool."

Since the introduction of the euro in 1999, the typical Belgian pension fund considers the euro-zone as its natural home market, says Longeval. "So against the MSCI World, this zone is clearly overweight - typically at least half of the equity portfolio. The other half is mainly invested in US equities and to a minor extent in Japanese equities. Emerging markets are often only a satellite investment."

That said, diversification could still be improved by increasing the weight in emerging markets, he suggests. "The best way to ensure this would be to integrate emerging markets in the strategic benchmark."

Convertibles, absolute return strategies and emerging debt - in local currencies - are the three main examples of this, he adds. "We also focus on Asian real estate, for instance, as we feel the market there is still very attractive."

Woutters says Belgian pension funds are already well diversified geographically in their equity portfolios - and among the most geographically diversified worldwide. "This has been historically the case, mainly because the Belgian financial markets are relatively small and do not allow for sufficient diversification." The BEL20 stock index holds just 20 stocks, the majority being mid to small caps, leaving too much exposure to only a handful of large caps, he says.

In terms of geographical spread, Heymans says that Belgian pension funds have been underweight in the US for some years, and overweight in the Asian market - where growth companies are likely to be found. "Most of them still have their liabilities in euro," he points out, and this means their investment too is more geared towards this region. "Most of the smaller pension funds cannot afford to have too much exposure to countries outside, because they cannot afford currency overlay."

Belgian pension funds are also investing in niche areas. "A lot of pension funds are moving towards socially responsible investment," he adds. "That's quite clear, and it is the same as in the Dutch market." In Belgium, the law now forbids investment in the producers of anti-personnel landmines, he points out. "So there is a philosophy which is evolving, for the retail business too; if you look at the €250bn of retail funds in Belgium, more than 6% of that is invested under the label of SRI." This compares to an average of 1% for Europe as a whole, he says. "Pension funds are looking at this quite closely."

Pierret notes that the French reserve fund, the Fonds de Reserve de les Retraites (FRR), has awarded several SRI mandates, and that this has become a reference for funds in Europe.

"LDI is not as common as it is in the Netherlands," and hedge funds find little favour with pension funds in Belgium, Pierret continues, explaining: "They don't want to invest in something they don't understand."

Heymans finds that in the Belgian pensions scene, where there are a handful of large schemes and a majority of much smaller funds, LDI is not really top of the agenda. "We think LDI is not a good way of looking at asset management," he says. "Even in LDI structures, we at Petercam will be the ones to go for active mandates where there is more freedom."

Woutters also sees the move towards LDI as a minor one for Belgium. "Contrary to most other European countries, the Belgian prudential supervision does not force pension funds to use market interest rates to discount future liabilities when calculating the present value of their total liability," he says. "This effectively removes the need for so-called LDI solutions that are primarily based on the removal of interest rate risk."

Only those pension funds of listed corporate sponsors might be interested in duration-matching techniques, he says, because IAS 19 forces market interest rates to be used to discount future liabilities on the sponsor's balance sheet.

Longeval says that though some of the largest funds have moved towards LDI solutions, "in Belgium, unlike in many other countries, there have never been any serious funding problems, even not at the market bottom in 2003. So LDI is not a top priority."

He adds Bank Degroof agrees with the basic principle that the bond portfolio should be benchmarked to liabilities rather than some market benchmark. "As most Belgian pension funds are modest in size, a state-of-the-art LDI approach, including risk budgeting exercises and swaps and other sophisticated derivatives, is out of their league." So he recommends keeping things simple by making room for bonds with long maturities, especially inflation-protected bonds.

However, Edwin De Boeck (pictured right), managing director of KBC Asset Management, does foresee more interest in LDI for defined benefit pension plans. "We see more interest in structured solutions, based on derivatives or portfolio insurance, for DC plans," he adds. "We see less interest in hedge funds and have the impression that the credit crunch has not infected the pension fund assets, although some asset managers consistently take too much credit risk."

KBC's approach is to analyse LDI solutions for DB plans - an approach that De Boeck says has won several awards for its own KBC pension fund. Last year, Pensioenfonds KBC was named Best European Pension Fund at the IPE Awards.

"However, we think each LDI solution must be tailor-made to the needs of the client," he says. "For most pension funds in Belgium, a UCITS solution seems to be the best practice.

"We introduce dynamic portfolio insurance techniques for DC plans in order to link the asset allocation with the 3.2 % investment target."

Within active equity and bond mandates, KBC brings in a core-satellite approach. "It's more transparent for the client and we have more flexibility to introduce themes like water, alternative energy, climate change, European financial institutions, central European equities for equity mandates or high interest, inflation linked, convertibles for the fixed income mandates," he says.

The issue of how to calculate the level of technical provisions a pension fund should make is another matter looming large right now for some funds, according to De Boeck. "The Belgian law doesn't prescribe any precise rules any more - except for minimum technical provisions - and each pension fund has to set up its own rules," he says. "They have to be consistent however with the statement of investment principles and the funding plan, and have to be defended by some sort of a continuity test."

Even though the funding plan, statement of investment principles and the calculation of technical provisions have to be consistent, De Boeck believes that thinking about one of these will prompt a pension fund to consider the other matters too. "So defining his own technical provisions might for some pension funds be an incentive to review its investments policy."

De Boeck points out that the defined contribution pension system in Belgium includes a guarantee of 3.25%, which he says influences the asset allocation and drives asset managers to implement structured solutions. "The current volatility in the equity markets and the relatively poor returns of 2007 decrease the funding ratios. At this moment, some pension funds will be underfunded and their sponsors will be forced to contribute more - and immediately."

New governance rules in Belgium are putting more of a burden on pension funds, and particularly on the smaller ones, De Boeck adds. "Pension funds have to set up their own internal control and appoint a compliance officer. We believe appointing an internal auditor - which might be outsourced - is a useful step for larger pension funds, but for a lot of smaller pension funds in Belgium this will be a burden."

In practice, De Boeck believes there will be an overlap between the work of the compliance officer and that of existing service providers such as actuaries, accountants, consultants, legal advisers and auditors. "Of course the [regulator] CBFA recognises this problem and has indicated that smaller funds can take into account their size and risk-profile when applying these measures, but just the fact one has to appoint each of these persons/functions is already a burden for smaller funds."

But De Boeck emphasises it is positive that board members have a CBFA-provided checklist to make sure they are aware of all the functions that should be considered for a pension fund. "But maybe it should have been better to make a distinction between larger and smaller pension funds," he adds.