A less risky endeavour

 

In late January, Canadian pension fund manager Caisse de dépôt et placement du Québec made a deceptively simple declaration: investment decisions will be based on “plain old common sense”. 

What does this mean? In a letter posted on their website, Caisse chief executive officer Michael Sabia said the pension manager will only invest in instruments staff understand and are able to master. Investments will be simpler and most importantly, investment decisions will be driven by taking the scheme’s liabilities into account. 

Sabia’s view of Caisse’s future investment practices exemplified two trends asset managers and scheme managers said will come to define the coming decade. Gone are the days of modeling asset allocations around return expectations, and in come the days where liability needs and risk management will take centre stage. 

Meanwhile, a decade from now, pension fund managers will be more nimble and better equipped to make quick decisions about opportunistic investments. 

BlackRock head of institutional business for Europe, Middle East and Africa Michael O’Brien said: “Looking at an investment-only approach will be confined to history. [Pension fund managers] will be looking at asset classes not only in the context of return generation, but also in terms of their liability-hedging characteristics.”

Officials at APG, the asset manager for Dutch pension fund Stichting Pensioenfonds ABP, agree. APG managing director of strategic portfolio management Ronald Wuijster said: “Liability-related investments will increase.”

He added: “(There will be) more transparency about what we do and what kind of risks we are taking. Risk budgeting will be more important. Pension funds will be more responsible about the risks they are taking.”

 

A demanding decade

The past decade was marked by strife. An ongoing war and two financial downturns, including the worst global financial crisis since the great depression has taken its toll on pension funds. Assets were lost by the billions, and this, combined with stricter funding requirements in many countries, led to wave after wave of defined benefit closures. However, the result is a greater awareness of risk management that will continue through the coming decade, most industry experts said. 

Hermes head of investment Saker Nusseibeh said risk management had been overlooked in the past. “One lesson we learnt from 2008 is that as an industry, we don’t have a good grasp of the risk taken in our investment portfolio. The trend I see is pension funds chasing much more risk-adjusted returns and investments of which they understand where the returns are coming from.”

Aviva Investors head of UK institutional business development Richard Warne also said there will be a much greater awareness of risk going forward. “This has definitely been highlighted by the experiences of the past couple of years. It is fair to say that pension funds took a long-term view in this crisis. Also, risk-adjusted returns will be increasingly looked at.”

Tied in to understanding risk is reducing risk exposure. Managers and pension fund officials said there will continue to be a move to reduce risk as pension funds look to match their assets with their liabilities. 

“With most defined benefit pension schemes closed to new members, and an increasing number closing to future accruals, the overall appetite for risk will diminish and therefore there will be an increase in managing risk with respect to liabilities,” said consultancy Redington Partners co-chief executive Robert Gardner. 

However, reducing risks does not mean pension funds will abandon their quest for returns. Matching assets with liabilities generally means taking risk off the table, and investing in lower volatility, lower return asset classes, like fixed income. 

There will, however, still be a portion of assets still invested in the market, and investors will continue to look for ways to make those assets work harder than ever. “With sponsors continuing to struggle with cash flows, at least in the short term, pension funds will still be keeping an eye out for opportunities to enhance or maintain returns,” said Gardner. 

Fidelity International head of UK institutional business Mark Miller called this a “return to returns”. 

Miller said investors have three options when trying to reduce their deficits: increasing contributions, changing their benefit accruals or increasing investment returns. “But to really resolve the deficit issue, they need to look at the return on assets. [Pension funds] will need more advanced return seeking solutions.”

As a result, there were will be a stronger focus on alpha and beta separation. Pension funds will look for “pure alpha” strategies, putting pressure on money managers to prove their worth. Scheme managers will turn to exchange-traded funds and other indexed strategies for beta, then look for true alpha from their managers. 

Hermes’ Nusseibeh said this will lead to a fundamental shift in the relationship between pension funds and their managers. “A lot of what managers offer lies in the middle and I believe this will have to disappear over time. Pension schemes will ask not only if managers have outperformed, but also if they’ve outperformed on a risk-adjusted basis.” 

BNY Mellon Asset Management vice chairman Jonathan Little said going forward, pension fund managers are unlikely to pay higher fees for anything other than basic alpha. He said they will want “genuine outperformance and nothing in between”. 

Pension funds will manage risk by “diversifying the alpha book”, said Little. He said many pension funds are considering strategies now that were viewed as being too esoteric three to five years ago, like commodities or farm land, and Little thinks this will continue. 

 

The changing nature of alternatives

Almost across the board, industry experts believed pension funds will continue to increase their use of alternatives as they look for risk-adjusted returns, though the definition of ‘alternative’ ten years down the road is in question and even caused BlackRock’s O’Brien to joke that investors may be exploring “moon real estate”. 

Fidelity’s Miller said many investment ideas considered left-wing now will become more mainstream, like farmland, soft commodities and wine. But today’s alternatives – hedge funds, real estate, private equity – will also continue to thrive. 

Christian Schmitt, managing director at risklab, a subsidiary of Allianz Global Investors said: “Alternative asset classes will be used more; more in terms of size and in terms of number of alternative asset classes. But only if more improved methods and procedures for risk measurement, risk controlling and risk management are in place.” 

Indeed, Little said pension funds’ relationships with their hedge fund managers will change as they begin to require more segregated accounts. “They will say, ‘I want that strategy, but I want you to create it for me.’ Pension funds won’t accept liquidity and contagion risk going forward,” he said. 

Hymans Robertson head of investment consulting John Dickson showed more caution over the growth of alternatives. He believed their growth would be short-lived as investors move towards completely removing risk from the table. 

“Private sector (defined benefit) schemes will want to diversify and chase returns, but on a long path to no risk. Therefore they will eventually move towards fixed income investments and the likes, and drop alternatives,” he said. 

Pension fund managers will have to move quickly, though, if they plan to take advantage of investment opportunities as they present themselves. Last year a major criticism lobbed on to pension fund managers was that their governance structure didn’t allow them to move quickly enough to take advantage of market movements. 

Some say they may have learned their lesson. BlackRock’s O’Brien expects one of the biggest changes in the way pension funds operate will be the speed with which they change their asset allocations to react to changes in the market. 

“A lot of institutional investors almost set in stone their asset allocation and didn’t recalibrate to changes in market conditions,” said O’Brien. But the ability to acknowledge an investment decision isn’t working will become embedded in corporate governance practices. 

“I hope this will bring an acceleration of better governance of pension funds, more focus on investment issues... and within that a more dynamic way of looking at investment opportunities,” agreed Fidelity’s Miller. 

 

The biggest source of uncertainty

Working against pension funds in the decade to come is the issue of government regulation, industry watchers said. Whether that be pension-specific regulation or overall market changes, many saw government tinkering as a detriment. 

bfinance director of business development, Canada, Peter Wright pinpointed government regulation and intervention as the most significant obstacle facing pension funds in the next decade. 

APG’s Wuijster said: “Legislation is the biggest source of uncertainty to pension funds. Restrictions that are not beneficial in the long run can be introduced. Right now there is this risk due to the crisis we just had and the legislative reactions that can follow it.” 

Pensions’ biggest advantage in the next decade: their size. 

“No-one can afford to ignore pension funds’ assets – defined benefit and defined contribution. There will continue to be product development and innovation which will continue to offer opportunities,” Gardner said.