RESEARCH INSIGHTS - SUMMER 2012

16 | EDHEC-Risk Institute Research Insights such as sovereign bonds with negative infla- tion-adjusted returns, thus producing savings with no prospect of long-term performance – a pension fund would be rendered pointless with •

ees, who would reduce their participation in such retirement systems and potentially question their perception of their overall remuneration. A level of professional and trustworthy management is needed to give credibility to the promises made to employees – promises that are an integral part of the employees’ remuneration and employment contracts. Participants are first and foremost exposed to inflation risk and longevity risk, and DC funds need to adopt an asset-liability manage- ment strategy in the manner that DB funds do. Today, DC funds are under-diversified and they need to stop solely investing in equities and government bonds, thus observing the

uncontrolled risks to fund participants and today, the first generations of target date funds are rightly being called into question. In order to address these obvious oversights, the fiduciary duties of trustees have been reinforced in a number of countries, as have the advisory responsibilities of those promot- ing the funds. The EU Directive on pensions (commonly referred to as the IORP Direc- tive) facilitates the adoption of professional financial management practices and econo- mies of scale. In particular, this directive allows for the creation of pension funds that regroup multiple countries or employers, as well as asset management structures that are common across multiple funds. For valuation reasons, these groupings will firstly occur in DC funds, particularly in the UK where the regulator is very active. The new Pension Act requires auto-enrolment of employees in pen- sion plans, and introduces the government’s National Employment Savings Trust (NEST) – a professionally managed structure with controlled costs that offers a default option. This should raise awareness in the industry on pension fund management. In summary, the most significant develop- ments to institutional pension systems in the short-term will likely be seen in DC funds. It is firstly important to create DC funds that address the need for retirement savings and can then serve as default investment options in existing plans. In the UK, companies are now required to provide their employees with a retirement savings plan and many will need to have ready-made pension plans to hand. Secondly, we should expect to see some consolidation of DB and hybrid funds in the market as economies of scale are possible, particularly where the industry is highly fragmented. The research from which this article was drawn was supported by AXA Investment Managers as part of the Regulation and Institutional Investment Management research chair at EDHEC-Risk Institute.

such poor performance. Demographic and market pressures therefore require a reduc- tion in the level of guarantees and for risk to be increasingly transferred to the savers (ie, a shift towards more hybrid funds). The Netherlands, the most innovative country with respect to hybrid pension plans, is already embracing prudential reform via FTK2, which focuses on lower guarantees. This reform provides reassurance of continental Europe’s capacity to adapt the regulation of its institu- tional investors. The structure of pension funds in the UK and the US differs from that of continental Europe, as these funds are either traditional defined benefit (DB) funds or DC funds. In traditional DB funds, the risk lies with the sponsor as long as stable conditions exist. How- ever, should their employer or ex-employer go bankrupt, participants lose the majority of their pension rights. Funds need to be insured against sponsor risk by means of a specific insurance policy, that not only protects employees against the risk of their sponsor defaulting (which a sophisticated put option would offer), but that also limits agency conflicts. Traditional DB funds are now in decline, notably due to demographic factors. Addition- ally, the developments in accounting stand- ards which have increased the overall cost of pensions on company balance sheets have had a catalyst effect. In the UK and the US, many entitlements fall under DC plans, where employees bear all the financial risk and where no guarantees are offered by the sponsor or by prudential regulation. However, the lack of guarantees and trans- parency could lead to a problem of trust – it is thus important that some guarantees are offered in DC funds and that their costs are clearly explained in order to avoid creating a biased risk/return illusion. This would lead to future disappointment amongst employ-

“The lack of guarantees and transparency could lead to a problem of trust – it is thus important that some guarantees are offered in DC funds and that their costs are clearly explained in order to avoid creating a biased risk/return illusion”

first principle of modern portfolio theory. Such a diversification of asset classes should allow them to invest in illiquid assets. It is necessary to adopt professional risk manage- ment practices, because when the investment horizon, liabilities and eventual guarantees are taken into account, such (dynamic) risk management strategies need to be put in place. It is certainly the financial industry’s responsibility to create and market retire- ment products. However, regulators can also contribute to the adoption of professional management practices for pension funds. In their review of DC systems, regulators under- stood the dangers associated with transferring

How investors can respond to the shifting pension landscape Erwan Boscher , Head of LDI & Fiduciary Management, AXA Investment Managers

E DHEC’s study illustrates the tectonic shift that the pension sector is undergoing, with a move away from traditional defined benefit (DB) schemes, often secured by the sponsor through explicit or implicit guaran- tees, to a system that entails more flexibility, focusing less on guarantees and liabilities This move away from traditional guarantees leaves pension investors with an unfulfilled need for certainty in pensions. In part, the study highlights how standard defined contribution (DC) ‘asset only’ investments may not fully address pensioners’ need for a pension that sufficiently replaces part of their income. We agree with the diagnosis that changes must be made to ensure the sustainability of pensions. Sponsors, trustees and plan participants broadly recognise that the status quo is untenable: reinforcing the search for ways to reduce uncertainty in pension provision. Investors in defined benefit, defined contribution, and hybrid schemes have an array of tools at their disposal to help cope with the shift. For DB schemes across Europe, de-risking is a predominant topic for consideration. DB schemes will need to take a careful look at how best to approach de-risking, and examine how and when to time implementation. In the case of individual DC accounts, we expect the focus to be on three main themes. First, the implicit objective of managing towards a pension will be paramount. This will create the need for outcome-based products, such as life-cycle or target date funds. We see a future in a new generation of life-cycle products that can make use of risk management techniques used in asset liability management (ALM), such as dynamic strategies. Second,

despite the absence of a liability, protection against inflation will remain key. Hence, investors will require strategies that target an absolute return above inflation, in place of nominal absolute return funds. This could take the form of dynamic, multi-asset funds, or an innovative mix of alternative assets, such as infrastructure and real estate debt. Third, in light of the absence of a sponsor guarantee, investors may look to ‘protected’ products that aim at protecting a minimum level of assets, or a set ‘funding ratio’, in order to re- create a kind of guarantee. When it comes to collective defined contribution (CDC), a common structure for hybrid schemes, investors’ needs are similar. CDC differs from traditional DC in that collective DC plans are institutional investors with governance that often allows for a more sophisticated investment approach. A collective DC scheme may or may not have an explicit liability. Rather, the hallmark of a hybrid scheme is to target an informal liability, ‘defined ambi- tion’ or even a long-term return objective over inflation. Once the objectives are known, ALM techniques can then be applied, starting with the long-term economic modelling of either a static or dynamic, rules-based asset allocation. In the future, CDC and hybrid schemes may apply liability driven investment (LDI) techniques in order to control their risks, but without the constraint of the short-term, mark-to-market prudential and accounting framework which has made defined-benefit schemes less attractive or too expensive. With some freedom from short-term regulatory constraints, hybrid schemes may be able to pursue a more diversified asset allocation, which is ultimately more consistent with their long-term focus.

INVESTMENT & PENSIONS EUROPE SUMMER 2012