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By Serge Ejzenberg
Posted Apr. 13, 2005

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Today companies are questioning which class of assets will deliver sufficient return to cover mounting pension obligation.
Both analysts and investors want to know how companies are managing their risks effectively.

Some experts consider the traditional view that equity investment will provide the best returns over the long-term. But changes in accountancy rules and the of pension scheme deficits imply to have a look at the short-term.

With the recent introduction of IAS 19 early this year, any European company with a defined benefit scheme can expect probing question about its funding and risk strategy.
For Financial Directors the key factor is to reduce equity allocation and cut risk to avoid cash calls and balance sheet volatility under International Financial Reporting Standards (IFRS).
Other firms may be prepared to maintain high equity allocations in order to lower pension contributions and reduce deficits.
The real issue is to clearly define objectives based on funding level, future obligations and risk appetite.

No more nasty surprises

When companies have started to ask these sorts of question, many have become aware that they were running higher risks than they had thought. The principal cause for concern is that liability values may fluctuate according to movements in interest and inflation rates.
Firms are not running any more risk in the long-term but they may be exposed to high volatility and credit in the short-term.

Some experts consider the traditional view that equity investment will provide the best returns over the long-term. But changes in accountancy rules and the of pension scheme deficits imply to have a look at the short-term.

Match making

The for pension schemes is how to tackle the mismatch between the inflation exposure of their liabilities compared with that of their assets.
Generally speaking a typical pension scheme allocation, there is only a small proportion of assets explicitly linked to inflation.
A scenario can be to cut its equity allocation...a pension scheme with an equity allocation of about 70% can expect to get a return of just over seven per cent....
We can easily understand that everyone wants to cut their risk but no one wants to take a hit on expected return.
With a "financial cuisine" mixing swaps, derivative and high yielding asset classes, companies can keep up their expecting return while cutting risk.

Derivative ideas

Swaps are new to pension investment, they're widely used by life insurers. The basic idea behind this is the creation of a synthetic portfolio of inflation-linked corporate bonds that boost yields by taking credit rtisk on a diversified portfolio.

Life insurers have been using inflation protection and other similar techniques for optimising their asset mix for some time (although quite recently, 5 years ago).

Pension funds have been slower to respond, traditionally, they have been dominated by benchmarking portfolios in broad asset classes. But the trend is changing.
Financial products currently available are interest rate swaps, inflation swaps, equity index collars and other derivatives:

  • SWAPS: are over-the-counter derivative instruments that make it possible to convert a floating-rate asset or liability into a fixed-rate, or vice-versa. Two parties periodically exchange payments based on the value of one or more market indices.
  • INTEREST RATE SWAPS: are the most common form of Swap. This is where one party agrees to pay a fixed interest rate in return for receiving a floating interest rate from another party.
  • CURRENCY SWAPS: allow you to take advantage of the vast array of assets in the credit world outside your home currency. By exchanging interest rate as your liabilities, you can choose your level of credit risk. Life insurers commonly use this technique.
  • AN EQUITY COLLAR: makes it possible to keep a high equity allocation by limiting both the upside of equity market rises and the potential downside of market falls. It minimizes price/value volatility by "collaring" the stock position between a high and low value.

All fund managers want to be able to offer these technique but insurance firms have the experience to provide these solutions more readily...

Across Europe

Each country has different tradition of asset allocation, accounting practices, funding requirements, pension fund activism,...
The pace and direction of change is difficult to predict.
The most significant changes have been in the UK and the Netherlands, where there is a tradition of funded defined pensions. In the Dutch market, the Financieel Toetsingskader (FTK) is a new regulatory framework come into force in 2006 including stringent solvency rules that require companies to hold assets worth 105 % of liabilities.
This is already having a big effect on the investment markets. Pension schemes are getting ready to move ahead of the regulation and hedge funds are anticipating that they will move ahead.

In Sweden, the risks are even more complicated because there aren't any Krona-denominated swaps or assets, they face a mismatch between the interest rates in the two currencies...

In Germany, where pension liabilities are funded by company assets, not separate pension assets, the interest rate mismatch is also a problem. German corporate are starting to look for solutions...


Source: OECD (Survey of Investment Regulation of Pension Funds)

Pension Governance

A study led by the London Business School into the governance of UK pension schemes «The corporate Governance of Defined Benefit Pension Plans" highlighted conflict areas. It founds those «insider» trustees, who were also company directors, tended to have higher risk appetites than independent trustees. They allocated more assets to equities, made lower contributions to the fund and sometimes reduced contributions during company investment programs.
This lack of communication has been polarized over the past few years.

Another example: Hedge Funds; many people think that they are a good way to diversify asset risk in principle and want to invest about five per cent of their assets into them....but in practice, it takes a lot of due diligence, meetings, etc...

The risks of conservatism

Pension trustees have become more anxious about fund deficits since the stock market slump of 2000-2003, there is a danger of too much conservatism.
In the long-term, it is still the case that pension schemes have a far better chance of making up shortfalls and lowering pension costs by investing in equities.
However, finance directors may have a harder job justifying their position to trustees.

The challenge will again be placed on the level of communication: to which extend investors will be allowed to ask questions about risk management.
The answers are already there, but would the companies be willing to disclose them ?


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