Looking for more diversification

The civil servants’ scheme is searching for both an investment consultant and a new CEO to lead a diversification of its investment universe. George Coats reports

The €4.7bn French civil service additional pension scheme, the Etablissement de Retraite Additionnelle de la Fonction Publique (ERAFP), has appointed Mercer Investment Consulting to advise on the diversification of its portfolio.

“The financial regulations on our investment universe are too strict and so our investment universe is narrow,” says deputy CEO Isabelle Szendy. (pictured left) “Currently we are poorly diversified, with a bond exposure of 86% of our portfolio and an equity exposure of 14%. However, we have decided to increase our equities allocation to 25% of inflows, mainly international in developed countries, and to introduce credit bonds by investing up to 20% in euro-denominated investment grade credit.”

Mercer will oversee the preparation and the management of the requests for proposals for both. The diversification should be implemented by the end of the year, says Szendy.

The fund is also looking for a new CEO after its second head, Louis Nakamura, the former CIO at the French pensions reserve fund, the Fonds de réserve pour les retraites (FRR), left at the beginning of March after less than six months in the job to join Lombard Odier Darier Hentsch (LODH). He succeeded the first CEO, Philippe Caïla, who left last June to become President Nicolas Sarkozy’s deputy chief of staff with responsibility for the civil service.

To misquote Oscar Wilde, to lose one CEO may be regarded as a misfortune, but to lose two looks like carelessness, and it is clear that Nakamura’s departure was seen as a huge embarrassment. It is expected that the hunt for his successor will be considerably more difficult than appointing an investment consultant.

The fund was established in 2004 and, like the FRR, it represented a new departure for France. Whereas most other French pension vehicles are principally PAYG, the ERAFP is funded.

The ERAFP is a compulsory defined contribution scheme for those with the status of a French public servant, including members of the armed services. “We have nearly 4.5m members,” says Szendy.

“Relatively speaking it is a huge scheme to manage because it is decentralised and relies on the declarations of more than 50,000 public employers. Some are large with a human resources staff but others are very small, rural communes for example.”

French public servants’ pay consists of two major components, their wage and additional bonuses. “Until 2005 the bonuses were not included when calculating pension rights,” says Szendy. “But within the scope of the 2003 reforms the government created the ERAFP to be funded by these bonuses as the members’ contributions. The contributions are converted into points which serve to calculate the pension benefit. Their value is decided every year by the fund’s board of trustees in order to balance the regime and to be sure that it will never be under-funded.”

Just like the rest of the pension system the ERAFP will come within the scope of this year’s review of the 2003 reform.

“I expect the Rendezvous with Pensions will result in a broad change of regulation for the public workers’ pensions scheme,” says Szendy.

The fund operates under a government decree that would have to be amended to allow changes to its administrative and financial management.

“We would like to introduce new asset classes by 2009,” says Szendy. “We want to further improve our portfolio’s diversification with a review of the regulation that prevents us from investing more than 25% in assets other than bonds and from buying alternatives. Now, for example, we cannot invest in real estate but real estate is a good asset against inflation risk. We also want to include allocations to hedge funds, private equity and commodities.

“And while we can invest abroad and in the euro-zone, we are not entitled to use derivative products, so we cannot hedge the currency risk, which discourages the diversification internationally. In addition, we cannot buy trust funds or UCITS directly, which is also a problem.

“So if our board of trustees agrees we will present a package of proposals to change our regulations to enable a broadening of our investment universe to the minister of finance. It does not mean that we will invest in these products but just that we will have the possibility to do so.

“And this is very important because our annual asset allocation simulation exercise is based only on the products we are allowed to invest in. So if we don’t have the right to invest in them we have to exclude them from our simulation and consequently the result of the simulation is distorted. We have to assess whether there is an opportunity cost or an opportunity gain in not being allowed to invest in that range of products, but I guess it is more cost than a gain.”

The fund is implementing an SRI strategy for 100% of its assets. Does this also act as a restriction?

“It could be restrictive if it were implemented in exactly the same way on all categories of assets,” says Szendy.

“The board of trustees decided this consideration be taken into account across the whole set of assets and was very involved in the preliminary definition of the strategy and the organisation of the scheme. We had a succession of meetings, maybe 40 or so, which produced very detailed guidelines for each category of assets, starting with equities, then government bonds, local authority bonds and even supranational insurers’ bonds. And they set very precise definitions of what they believe to be the best social and environmental behaviour.

“That was a very good point because one of the weaknesses of SRI is that, if investors don’t define what SRI is for them and let the markets implement SRI on their behalf, they may end up with something very different from what the beneficiaries of the scheme would consider as being socially responsible.

“But within the board of trustee’s guidelines, we propose the precise new way of implementing the strategies. We will have to be pragmatic in the implementation and see how we can take this dimension into consideration in ways that are specific for each asset category. For example, I believe that we cannot implement an SRI policy on large cap euros and equities in the same way that we could do on credits and real estate. So we will try to do it in a way that is as close as possible to market possibilities because to be in advance of the market in terms of the SRI could be a good thing, but if you are too far in advance then you do not have the practical means to implement the strategy.

“A key issue here is that while it was decided to outsource active asset management mandates to companies specialising in SRI processes, these companies have their own definition of SRI and their own SRI asset management processes that might not perfectly fit with the ERAFP’s specific SRI guidelines. So at what point is the board of trustees entitled to ask these companies to take into account their own guidelines? Until that point we have to respect the freedom of the investment manager who was appointed months earlier to manage our assets. In my opinion that is the first tough question relating to implementation.

“After that comes the question of benchmarking. We want to benchmark very precisely the cost of our policy compared with a common benchmark and a non-SRI benchmark.”

The ERAFP has a long-term horizon. “The fund is expected to reach maturity between 2045 and 2050,” says Szendy.

“So volatility is not much of a concern for us. We are still at the start of our reserve building. We received €1.6bn in contributions in 2007 and currently only pay out €70m in pensions, and this gap means we can cope with volatility much more easily than funds that are not in such a fortunate position.”

But Szendy sees other challenges: “We are at the very beginning now, so the additional pension rights accumulated through this regime will be very low until 2012, maybe 2015,” she says.

“But the employee contribution is doubled by a contribution from the public employer. That may mean that, from the point of view of the beneficiary, the return on their own contribution is very high even if the financial management is poor. We are determined not let this kind of reasoning be an excuse for easing the pressure on us to be efficient in asset management.”