Evasive Action

So how can pension funds address these challenges? Many schemes are changing their thinking on both asset and liability management. Two of the four worst bear markets of the past 100 years occurred in the most recent decade, according to CREATE-Research. Those bear markets have side-lined conventional wisdom on risk premia and diversification and have changed the business models of many schemes. Prior to the bear markets, 80% of portfolio returns came from intelligent asset allocation. Now, the figure has reportedly fallen to 50%, with the rest of the alpha being attributed to implementation, according to the firm’s research report The Alpha behind Alpha: Rebooting the Pension Business Models.

CREATE-Research surveyed 190 pension plans across Europe with combined assets under management (AUM) totalling €1.9 trillion. At least one-quarter were upgrading their governance practices: 63% proposed to bring in more clarity in plan mission and goals; 60% were pushing for more clarity in investment beliefs and time horizons; 42% were adding investment expertise to their board; 33% were bringing more clarity to the roles of the board and full-time executives; 31% were bringing in a dedicated, in-house chief investment officer; 27% were using more in-house investing; and 25% were delegating more authority to full-time executives.

The survey also found that pension funds are focusing on "softer" issues, such as mission, goals, beliefs, and time horizons. Many are adding specialist investment professionals to their trustee boards or organising sub-committees to enable faster decision making. For trustees, it is a high-wire act between delegating their authority to full-time executives and not losing control, given their own fiduciary responsibilities. But they also walk a fine line between personal accountability and career risk, and Rajan says they must be more mindful of their obligations.

"At a time when asset prices are so distorted by central bank action, trustees have understandably become ultra risk adverse," he argues. "But risk aversion carries its own risk. Trustees should think more about portfolio risk and less about career risk. Trustees now agonise and [become] paralysed about every good idea, in case it’s a bad idea."

One way to help ease the pressure is to bring down costs, and pension fund trustees have been applying more scrutiny to both internal and external charges. Many have re-thought their hedge fund allocations as a result, citing high fees, disappointing performance, and complexity as some of their concerns. In the UK, the £22 billion railway workers plan RPMI was the first to divest. In the Netherlands, three schemes have all chosen to at least partially walk away from hedge funds: PMT (the €63 billion industry scheme for Dutch metalworkers), PME (another Dutch metalworkers’ fund, with assets of €41.5 billion), and PFZW (the €178 billion health and welfare sector scheme).

Austria’s €6 billion VBV scheme was also one of the first to decide that hedge funds didn’t add value. "Since Autumn 2015, we no longer subscribe to the belief that hedge fund managers will be able to deliver relevant positive returns in a somewhat consistent way," explains Günther Schiendl, the scheme’s chief investment officer. Schiendl also says that "traditional" fixed income, like government bonds, is "by and large dead." Instead, the fund has dynamic, separate corporate bond investments in European, US, and emerging market high-yield bonds. "‘Dynamic’ means we can vary between zero and strategic allocation within a few weeks or so," he explains.

The plan’s major new strategy is an allocation to private markets. As Schiendl explains, "By this we mean that we invest in funds run by specialists who invest in corporate loans—project and infrastructure finance. We will invest into the full spectrum of capital structure, from equity, mezzanine, to senior-secured debt."

Other costs that both pension funds and regulators are scrutinising include the implicit costs embedded in transactions, which are not always transparent and harder to quantify. These include broker research costs, custodian ticket fees, stamp duty, turnover costs, and market impact and spread. But the information on these costs is hard to come by, and regulation is still being developed to provide specific disclosure requirements. Industry participants point out that sometimes pension funds will miss the big picture by focusing on the minutiae. They also believe that such efforts may not bear fruit.

"It’s useful to understand and get transparency around costs like transaction costs, but there’s a downside to the approach—and that’s that some of the costs and difficulty associated with getting that transparency outweigh the benefits of doing it," explains Mark Austin, senior vice president of corporate and institutional services at Northern Trust. Austin heads a team of relationship managers and is also a trustee of Northern Trust’s combined defined-benefit and defined-contribution scheme.

Austin believes that pension sponsors need to get people out of defined-benefit schemes as much as possible. "Pension schemes are entering the decumulation phase," he says. "That will speed up and up. This will become a real problem when trying to deal with the deficits they have."

Austin continues, "It is a bit like a farmer being asked to grow more food while selling land. Pension funds can either make their assets grow faster or they can make their liabilities shrink in some way—or from a corporate standpoint, preferably [do] both. But addressing the liability side of the question is the one that gives you the most potential uplift. On the asset side, you can drive down some costs, but you’re really spending time with the pension scheme money flowing out rather than in, so this becomes a more difficult proposition without significant deficit repair payments from the sponsor."

There are key areas to target, however. "The four horsemen of pension destruction are interest rates, inflation, longevity, and market performance," says Austin. "Those are the four things that can really hurt pension schemes. So, looking at those things is where pension schemes are investing their efforts, by using longevity swaps and looking at interest rate protection, for example, or using LDI [liability-driven investment] mandates."

Pension funds also have to rethink portfolio construction, according to Nico Marais, CFA, global head of multi-asset investing and portfolio solutions at Schroders Investment Management. "Most pension funds have most of their resources allocated to picking managers rather than focusing on strengthening the overall outcome of the fund through improved portfolio construction and downside risk management," he says. "For many, portfolio construction and fund exposures are still being done in dollars and pounds rather than in the risk space. Many investors are still managing in terms of a 60/40 split between equities and bonds, with asset classes rather than the more granular and precise risk premia as building blocks. There are some relatively easy wins simply shifting from a capital-based to a risk-based approach."

For the approach taken by Schroders, a focus on risk premia is essential. "We have forty-five people who just look at risk premia," says Marais. "You could say that treasuries are expensive or not expensive, but that’s a very simple and unsatisfactory analysis. If you can break a treasury into a term premium, a liquidity premium, an inflation premium, and even (for certain countries) a political premium, then suddenly your toolbox is that much more robust."

Pension funds are also turning to low-cost solutions. Mercer’s European Asset Allocation Survey 2015 reveals that the use of passive management within traditional equity and bond portfolios has increased at the same time that average performance targets for alternative allocations, as well as the size of those allocations, have risen. "This suggests that investors increasingly prefer to seek returns from manager skill (or ‘alpha’) within alternatives mandates, whilst harvesting cheap ‘beta’ in the core equity and bond portfolios," suggests the firm.

But nothing can replace skill, according to Nathan Gelber, chief investment officer and founder of Stamford Associates. "There are really no new paradigms in the investment world," he says. "There may be a proliferation of new strategies, but from where we are, the identification of superior investment talent remains at the focus of our efforts, because we believe individuals who are particularly skilful have a better chance to add value. These exceptional people are extremely hard to find."

He says funds have to be conscious of the "art of the possible" when it comes to portfolio construction (taking into account risk tolerance and time horizons), rely on fundamentals to assert themselves over time, and apply a clearly defined rebalancing discipline. "A well-considered allocation linked to a rebalancing discipline, to us, represents a superior approach, because it realises profits and puts additional capital into areas that have recently done poorly," he argues.

Pension funds can, of course, outsource the pain to a fiduciary manager. Aon Hewitt’s survey of defined-benefit schemes in the UK with total AUM of £181 billion revealed that take-up rates rose from 18% in 2011 to 46% in 2015. The strong growth in the 2014–2015 period was from schemes with more than £1 billion in assets. However, the firm says that full fiduciary management remains more common among pension schemes with assets of £500 million or less, while partial fiduciary management is more frequently found among schemes with assets of £1 billion or more.

Jeffrey Levi, a partner at asset management consultants Casey Quirk, suggests that this is a tale of two trends. "There is a trend towards outsourcing, and in the other extreme, in reverse, is the trend towards in-sourcing for larger institutions [that] decide that they can find and attract skilled people to do things for themselves."

According to Levi, illiquid investments remain quite interesting for a lot of well-funded defined-benefit plans (given their illiquidity premium) because mark-to-market rules tend to benefit reporting asset values and there isn’t much volatility in the portfolio.

"Frankly, the performance of illiquids has been better than a lot of liquid asset classes," says Levi.

He also points out that many funds are starting to collaborate and cooperate more. Last year, the £5.5 billion Lancashire County Pension Fund announced that it was joining hands with the London Pension Fund Authority to form a £10 billion asset liability management partnership covering all aspects of pension fund management, from jointly managed administration to pooled asset and liability management activities. The combined Lancashire and London Pensions Partnership (LLPP) hopes to have more negotiating power as well as to bring in cost reductions and more effective liability management.

Ultimately, there are no easy solutions to any aspect of the challenges European pension funds face, but pension funds are tackling the crisis in a multitude of different ways.