DB DC plans - ISSA · This decade has been exceptionally turbulent for pension funds worldwide. A...

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DB & DC plans: Strengthening their delivery

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Author: Prof. Amin Rajan First published in 2008 by: CREATE-Research Vauxhall Lane Tunbridge Wells TN4 0XD United Kingdom Telephone: +44 (0) 1892 526 757 Fax: +44 (0) 1892 542 988 Email: [email protected] © CREATE Limited, 2008 All rights reserved. This report may not be lent, hired out or otherwise disposed of by way of trade in any form, binding or cover other than in which it is published, without prior consent of the author.

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Foreword

Investment & Pensions Europe is pleased to have offered its research platform in support of this report, which Prof. Rajan authored this autumn. At the start of the project, we had little idea how far profound would be the effect of the global credit crisis. Equity markets roared back into gear last autumn, and while there was a strong consensus that the credit impasse of last summer would have an effect on the real economy, most parties – buy-side, sell-side or advisers – had little inkling how profound the crisis would become. The talk was of a shake-out of the credit system that would persist into 2008. But by now, it has become clear that this shake-out will be a longer process, and the consequences have already been felt by the vast majority of investors. So, these dramatic events only serve to underline the strong message of this report, which is that the consulting and investment management communities need to go further in meeting the needs of European pension funds. The focus of the report has been defined benefit and defined contribution schemes. The pension systems of Europe are diverse, but there are clearly inefficiencies that are common to all large scale investors, such as solvency and funding rules that promote a short term view. These form a key backdrop to the issues raised. Our hope is that by shining a light on some of the inefficiencies in the system, this report will serve as a reminder that business is unlikely to continue as usual. Those parties able to meet the new demands of pension funds – demands that are shaping now as investors reconfigure their approach to factors as diverse as equity risk premium and counterparty risk – are likely to be the winners in the second decade of what is shaping up to be a turbulent financial century. This report is also a call to arms to all participants in the institutional investment value chain to make positive recommendations for change. Our intention over the coming months is that the pages of IPE will be the forum for that debate, and your input will be invaluable.

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Liam Kennedy Editor Investment & Pensions Europe

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Acknowledgements

This report is the latest in an ongoing research programme, which highlights the key changes in global investment. Now in its 16th year, the programme has produced numerous widely acclaimed research reports, white papers, and articles to be found at www.create-research.co.uk. Brief details are given on the back cover of this report. Pension funds have been hit by two severe bouts of volatility in a short span of eight years on top of regulatory and accounting changes that have created unprecedented funding challenges for them in this decade. This report highlights the nature and scale of these challenges and the responses required to address them. I am deeply grateful to three groups of people who have made this report possible. The first group covers top executives in 222 pension funds and asset managers in 15 countries across Europe who participated in our two surveys. 60 of them also went on to participate in our post-survey structured interviews, thereby adding the necessary breadth, depth and rigour to our findings. They are part of a growing army of thought leaders who have profoundly influenced the content of our reports. In the process, they have helped to create an impartial research platform that is now widely used by players in every area of the value chain of investment management – both on the buy and the sell side. The second group covers Investments & Pensions Europe, our media partner. They helped with the survey design and analysis. I’m especially grateful to Liam Kennedy and Fennell Betson for their insights, enthusiasm and support on this occasion as well as on countless occasions in the past. Finally, I would like to record special appreciation to my following colleagues at every stage of the study: Dr. Elizabeth Goodhew, Naz Rajan, Leanne Perry and Vickie Martin. After all the help that I have received, if there are any errors and omissions in this report, I am solely responsible for them.

Prof. Amin Rajan Project Leader CREATE-Research

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Foreword i Acknowledgements ii Table of contents

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1 EXECUTIVE SUMMARYAims and background of this report

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2 PENSION FUNDS SURVEYHow and why is the pension world changing?

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3 ASSET MANAGERS SURVEYWhat do they need to do?

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This decade has been exceptionally turbulent for pension funds worldwide. A series of tidal waves now threatens their long term viability. This study is a call to arms. In the coming months, it aims to kick start a constructive debate in Investments & Pensions Europe. The debate will discuss who needs to do what in order to arrest and reverse the tide, so as to ensure a comfortable retirement for current and future generations of employees. The study’s main focus is on defined benefit (final salary) and defined contribution (money purchase) plans in Europe, where the pronounced diversity in practices has long concealed the true significance of the crisis brewing up below the surface. Tackling it requires concerted responses from numerous players, including governments, regulators and accounting bodies. As the debate unfolds, we shall no doubt draw them in. This study starts the process with pension funds and their two key sets of service providers: pension consultants and asset managers, both with substantive roles in generating investment returns that ultimately deliver the pension promise.

It addresses five questions:

How have the events of this decade shaped the investment priorities of pension funds, offering DB and DC plans in the ‘Old World’?

Why has their approach to risk changed, and how is this reflected in the goals which they are now pursuing?

How do they rate the value added by consultants and managers in the challenging environment of this decade?

In what areas do these service providers need to up their game, if they are to become credible partners in delivering decent benefits to today’s and tomorrow’s retirees?

What other actions are necessary to tackle the systemic problems that perpetuate mediocre returns for the majority of end-clients?

This report’s assessment is based on results from two separate postal surveys, jointly involving 222 organisations: one covering pension funds, the other covering asset managers. Further details are given in the Appendix. These were followed up by structured interviews with a cross-section of senior executives from 60 pension funds, pension consultancies and asset managers. Together, they had €22 trillion of assets (see below) in 15 countries, namely, Austria, Belgium, Demark, Finland, France, Germany, Italy, Ireland, the Netherlands, Sweden, Switzerland, Poland, Portugal, Spain and the UK.

“The best thing about the future is that it comes one day at a time”

President Abraham Lincoln

111 EEEXXXEEECCCUUUTTTIIIVVVEEE SSSUUUMMMMMMAAARRRYYYAims and background of this report

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What is the amount of your organisation’s current AuM?

Source: CREATE-Research 2008

AuM: survey of pension funds AuM: survey of asset managers

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♦ This decade has seen more pain than gain for most pension funds in Europe. Due to a series of shockwaves, they no longer manage risk; they manage uncertainty. One relies on known probabilities of expected returns on different asset classes; the other on pure guesswork.

♦ Most of them were overweight in equities in the raging bull market of the 1990s. The end of the tech bubble duly sparked a funding crisis. This was exacerbated by the unintended consequences of the resulting regulatory and accounting changes. The ensuing diversification into alternatives came at a time when their peak returns were history. That’s not all.

♦ Asset values are now dropping like a stone, as the new mark-to-market rules have turned the US sub prime crisis into a global ‘black hole’ that is deeper, darker and scarier than first imagined.

♦ Together, these events have triggered numerous discontinuities (Figure 1.0): the risk-return features of most asset classes have become hugely volatile; the correlation between old and new asset classes has gone through the roof; strategic asset allocation looks like a casino game; and new products verge on financial alchemy.

♦ On the accounting side, the mark-to-market rules have also injected an unpalatable degree of volatility into the balance sheets of DB plan sponsors in the private sector across Europe. Undue short-termism, as well as large cash injections, is the norm, promoting further plan closures and accelerated buy outs. Covenant risk has emerged like a bolt from the blue.

♦ So has reputation risk in the DC plans, managed individually or collectively. Plans where individuals bear all the risks suffer from visible fault lines exposed by low enrolment rate, low financial literacy, poor investment choices, a dearth of viable products and poor returns. Plans which pool risks or offer guarantees, too,

suffered low returns prior to the latest financial tsunami.

♦ The emergence of these new risks has challenged the old certainties and exposed new weaknesses in different parts of the pension value chain. Pension funds can no longer count on their consultants and asset managers to help them navigate through uncharted waters without purposive action from three sets of players.

♦ First, pension funds need to enhance their own governance structures and investment skills to create a clear investment philosophy based on sound instincts instead of the herd mentality that is responsible for poor asset allocation calls.

♦ Second, pension consultants need to re-think their time-honoured approaches to asset allocation and manager selection at a time when no one gets the benefit of the doubt anymore.

♦ Third, asset managers must stop selling what they have and start selling what their clients need by creating products that are fit for purpose, not copycats. There can be no return to business as usual.

♦ Such improvements are necessary but not sufficient. All three sets of players also need to collaborate ever more. The prevailing approach that pigeon holes people subtracts rather than creates value. Examples of good practices are there. But they are few and far between.

♦ At the end of a traumatic decade, the mounting crisis cannot be resolved at the same level of thinking as that which gave rise to it. Market recovery will ease the crisis, not solve it. Without a sea change, Europe’s pension promise will remain long on intentions and short on deliverables.

In the rest of the Executive Summary, these messages are developed in detail via ten specific themes that have emerged from our research.

Headline messages

Figure 1.0 Key discontinuities in the occupational pension landscape

Risk return characteristics:

Regulatory & accounting changes:

Asset classes:

Asset allocation:

Investment approach:

Product base:

FROM: TO:Unusually volatileModerately stable

Unintended outcomesBenign intent

CorrelatedUncorrelated

DynamicStrategic

Quarterly targetsLong-term commitment

Broad and complexNarrow and simple

Risk return characteristics:

Regulatory & accounting changes:

Asset classes:

Asset allocation:


Product base:

FROM: TO:Unusually volatileModerately stable

Unintended outcomesBenign intent

CorrelatedUncorrelated

DynamicStrategic

Quarterly targetsLong-term commitment

Broad and complexNarrow and simple Source: CREATE-Research 2008

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Currently, total pension assets in Europe are estimated at €3.5 trillion. Around 75% are in DB plans and the rest in DC plans, according to our two surveys. But the DC plans are now in sharp ascendancy, as the old DB plans are restructured and new DC plans are created (Figure 1.1). The trend towards the closure of DB schemes is well established in the hitherto strong DB markets such as Ireland, Switzerland and the UK. There, DB plans are being closed to new employees and DC plans are superceding them in an effort to minimise the pain from the emerging funding crisis and new accounting rules. Additionally, in the Netherlands, for example, pure DB schemes have been renegotiated to acquire a more hybrid form under which DB plans also have a DC element beyond a certain level of income. In Denmark, for example, DB plans have been turned into DC plans which are administered collectively, with some schemes investing only in deferred annuities. Finally, in Germany, for example, the traditional book reserve schemes are now being converted into DC plans with various guarantees on contribution and returns. Alongside this restructuring, there is also an

organic growth resulting from the creation of new schemes (Italy), extension of the existing state schemes (Sweden and Poland), and rebranding of traditional funds (France). Governments everywhere have been promoting new DC plans so as to ease the mounting burden on welfare budgets from ageing populations. Another contributory factor is the ‘grass is greener on the other side’ phenomenon. This remorseless shift towards DC plans will accelerate due to the latest bear market. Two thirds of the DB plans in our survey had funding levels below 100% in April 2008; around two-thirds of the plans needed returns of 7% or below to meet their long term liabilities. Both these numbers had risen sharply by October 2008, before the implementation of the latest Solvency II rules. However, irrespective of the nature of plans and who bears the investment risk, one overriding imperative jumps out from our research: problems faced by today’s DB and DC plans stem from a variety of sources, but without decent investment returns no pension plan has a future. The spotlight is turned on pension consultants and asset managers like never before.

THEME 1 Europe’s pension landscape is diverse but it isunited in pursuit of decent investment returns

Figure 1.1 Growth in DC schemes due to restructuring and organic effects

Closureof

DB schemes

Restructuringof

DB schemes

Shift from book reserves

schemes

Creationof

new schemes

Extensionto the

state schemes

Rebrandingof traditional

funds

• Hybrid DB and DC• Protected DC• Collective DC• Pure DC

DC schemes:

Res

truc

turin

g effect

Organic effect

Closureof

DB schemes

Closureof

DB schemes

Restructuringof

DB schemes

Restructuringof

DB schemes


schemes


schemes

Creationof

new schemes

Creationof

new schemes

Extensionto the

state schemes

Extensionto the

state schemes


funds


funds

• Hybrid DB and DC• Protected DC• Collective DC• Pure DC

DC schemes:

Res

truc

turin

g effect

Organic effect

Source: CREATE-Research 2008 INTERVIEW QUOTES:

“Sponsors with frayed nerves have been strained to breaking point by the current crisis.”

“90% of our DC plan members use default options in their investment choices; the industry average in Europe is 78%.”

“The total deficit of UK pension schemes would soar by €165 billion if the new accounting standards on liability calculation are implemented.”

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With the unfolding of events in this decade, DB plans have been increasingly exposed to covenant risk, investment risk, reputational risk, regulatory risk, mortality risk and liquidity risk. In turn, their sponsors have espoused four main goals, as identified in Section 2 (p.14): improving funding levels; living with new regulatory and accounting changes; securing good returns via better asset allocation and manager selection; and strengthening the covenant with sponsors. Being inter-connected, these aims require holistic solutions. In contrast, asset managers see these goals through product lenses that magnify the importance of alpha-beta separation, or alternatives, or LDI (Section 3; p.28). The link between these solutions and the risks now flashing on clients’ dashboards is, at best, tenuous. Consequently, there is some disconnect between the two sides in the areas that present major challenges and where further actions are vital (Figure 1.2). Both have identified areas like market volatility; the skills base of plan trustees and their professional executives; contribution rates, benefit rates, plan costs; funds’ governance; and the unpredictable nature of liabilities.

By their very nature, these are not the areas where asset managers can exercise major influence, individually or collectively. However, there are others where they can. They include: product complexity, asset valuations, tactical asset allocation, performance monitoring and evaluation. Notably, they have been highlighted more prominently by pension funds than asset managers. The same applies to the activities normally covered by pension consultants. Far more pension funds than asset managers single out investment advice and manager selection as major areas requiring improvements. The implications are clear. Asset managers see their clients’ problems as either unique to their world or outcomes of excessive market volatility beyond anyone’s control. Pension funds agree with this analysis. But they go even further by being more vocal about things that still need fixing at the service provider end to improve investment returns. Only a small minority of asset managers see the world through the eyes of their clients. The rest continue to reflect the supply-driven nature of their industry where caveat emptor holds, in good times or bad.

THEME 2 On DB plans, asset managers have yet to develop a shared understanding of their clients’ dreams and nightmares

Figure 1.2 In order to achieve the identified goals, which areas present major challenges in Defined Benefit plans currently?

80 70 60 50 40 30 20 10 0 10 20 30 40 50 60 70 80

Pension funds’ surveyAsset managers’ survey

% of respondents

Volatile market environmentAsset liability modelling in a fast changing environment

The skill/expertise amongst pension fundsInvestment advice from consultants

Manager selectionProduct complexity

Uncertainty around the value of our investmentsContribution rates, benefit rates and plan costs

Tactical asset allocationThe fund's governance structure

Unpredictable nature of liabilities due to accounting changesUnpredictable nature of liabilities due to market changes

Performance monitoring and evaluation

80 70 60 50 40 30 20 10 0 10 20 30 40 50 60 70 80

Pension funds’ surveyAsset managers’ survey Pension funds’ surveyAsset managers’ survey

% of respondents

Volatile market environmentAsset liability modelling in a fast changing environment

The skill/expertise amongst pension fundsInvestment advice from consultants

Manager selectionProduct complexity

Uncertainty around the value of our investmentsContribution rates, benefit rates and plan costs

Tactical asset allocationThe fund's governance structure

Unpredictable nature of liabilities due to accounting changesUnpredictable nature of liabilities due to market changes



INTERVIEW QUOTES:

“The 4 standard deviation events are too frequent. The biggest risk we carry is the one we don’t know.”

“This is the mother of all crises.”

“Products that come on the market are creations of fancy simulation models; few have any track record.”

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Across Europe, DC plans have taken the form of either personal contracts or pooled vehicles. The former have entirely transferred investment choices along with their risks to the individual member. In contrast, the latter have pooled the risk and created trustee boards to provide the necessary oversight and advice. There are exceptions: Denmark, for example, has pooled expertise, while providing deferred annuities via separately managed accounts. The key goals which their sponsors have pursued include: better asset allocation, good risk adjusted returns, comfortable retirement, and customised products that reflect clients’ risk profiles (Section 2; p.16). Asset managers, too, see these as the main priorities (Section 3; p.30). There is also agreement on what areas currently present maximum challenges so that they can be singled out for action (see Figure 1.3). Investor education, retirement preparedness, life cycle funds, target date funds and managed accounts top their lists. However, there are three areas which a far smaller proportion of asset managers find challenging. They are: fees, fiduciary responsibility of asset providers, and

administration issues like enrolment, contribution rates and default options. The last of these is the preserve of plan sponsors; but the first two are not. In particular, pension funds strongly believe that unless asset managers take on a strong fiduciary role, DC plans will soon encounter powerful headwinds. Fees are a vexed issue. From the sponsors’ point of view, concerns stem from unfavourable experiences with the last and current generation of DC products, which have not delivered acceptable returns in many cases, due to overly conservative investment choices. They aimed to provide capital protection at the expense of growth. But what they have actually achieved is a low headline risk for plan sponsors. Both sides believe that the new generation of target date retirement funds – or variants of them – are superior. Their fees should be assessed in relation to the value they generate. Time will tell whether current concerns about their fee levels are justified or not. For now, the vast majority of pension funds and their fund managers see the current generation of pre- and post-retirement products as woefully inadequate in delivering decent retirement incomes (p.20; p.34).

THEME 3 DC plans suffer from excessive risk aversion and poor investment choices

Figure 1.3 In order to achieve the identified goals, which areas present major challenges in Defined Contribution plans currently?


INTERVIEW QUOTES:

“As trustees, we have moved from managing risks to coping with uncertainty, irrespective of whether you manage DB or DC plans.”

“As more and more DC members approach retirement, we shall see the true dimensions of the looming time bomb.”

DC plans may well create the biggest mis-selling scandal in the next decade, when a significant number of them mature.”

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When assessing the overall contribution of asset managers towards helping their clients to meet their goals, nearly one in every two pension funds has rated it as ‘good’ or ‘excellent’ (left chart Figure 1.4). As disaggregated scores in Section 2 (p.20) show, the highest scores were in areas like stock selection and risk management. The worst scores were in the delivery of pre- and post-retirement products. In between, 55% of pension funds did not get the investment returns they were led to expect. When asset managers were asked to rate themselves on the same basis, they were decidedly more lenient (right chart Figure 1.4). At the disaggregated level, too, the majority of them believe that they have performed better than their clients acknowledged. Yet only 6% of managers report that they have delivered ‘excellent’ returns (Section 3; p.34). But they still believe that they have done well in value creating activities like asset allocation, portfolio construction and stock selection, providing viable access to new asset classes. As for consultants, just under half the pension funds in the study awarded them ‘good’ or

‘excellent’ rating (left chart Figure 1.4). At the level of individual activities, their strongest suits include ALM, investment advice, and performance monitoring. The weakest ones include strategic asset allocation and strategy implementation and selection (Section 2; p.18). In contrast, asset managers accord notably higher ratings to consultants: both in overall contribution (right chart Figure 1.4) and also in a number of individual activities (Section 3; p.32). Such differences prompt two key points. First, the ratings accorded by pension funds are indicative of the more demanding expectations set by the tough climate of this decade: old ways of doing things are being increasingly rendered obsolete. Only 5% of pension funds award ‘excellent’ rating to anything which consultants and managers do (Section 2; p.18 and p.20). Second, these 5% with ‘excellent’ rating have upped their game, as the case studies in this report show. But they remain a tiny minority. At the service provider end, the difference between the best and the rest remains huge.

THEME 4 Pension funds find their service providers deficient in activities that matter most

Figure 1.4 Overall, how do you rate the contribution of Pension Consultants and Asset Managers in helping to meet the challenges that DB and DC plans have experienced in this decade?


INTERVIEW QUOTES:

“The old ways of doing things have landed trustees into an ever deeper hole. Managers and consultants can’t get us out of it with their existing tools.”

“Risk models are more a therapy than anything useful.”

“Fees are higher now than five years ago at a time when 70% of products have failed to add value after charges.”

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The current downturn has turned the spotlight on three observations that have been gaining traction since the end of the tech bubble at the start of this decade. First, asset allocation is the single biggest source of returns; it is more an art than a science. Second, correlation between asset classes is asymmetrical; low in the upturn, high in the downturn. Third, risk return characteristics of asset classes are hard to ascertain except over very long periods. Accordingly, the bar has been raised on the quality of advice that pension funds need from their professional advisers. Technical skills need to be blended with special insights. Pension funds and asset managers have separately identified the specific areas where consultants need to go for step improvements. Strategic asset allocation and manager selection feature highly on both lists (see Figure 1.5). From the pension fund perspective, two areas raise concerns: understanding and delivering clients’ long term needs; and delivering insights that give a competitive edge in this age of market fluidity and regulatory creep. On the one hand, consultants are seen as being in an invidious position. As professionals, their

counsel is sought and taken seriously on a variety of issues. On the other hand, the quality of advice now sought requires expertise that can only be accumulated over time through experiential learning. Like asset managers, they are climbing a series of new learning curves – some steeper than others. In the meantime, their approaches in areas like ALM and asset allocation are deemed out-dated by trustees who are forced to shift from calendar time to real time owing to too many unpredictable events. Their expectations are raised to levels to which only a minority of consultants are accustomed. The successful ones are usually one step ahead: they understand, anticipate and articulate their clients’ needs in ways that clients themselves cannot do. Intangibles, like professional rapport and deep insights, differentiate the outstanding from the mediocre. Not surprisingly, there are no commonly accepted key performance indicators for consultants. Their contribution is more observable than measurable. Clients know it when they see it.

THEME 5 Pension consultants need to widen & deepen their understanding of their clients’ long term goals & short term pressures

Figure 1.5 In which areas do pension consultants need to make significant improvements if they are to receive mandates from their clients in the future?

70 60 50 40 30 20 10 0 10 20 30 40 50 60 70


% of respondents

Understanding and delivering clients' long-term needs

Strategic asset allocation

Delivering special insights that give a competitive edge

Manager selection

Governance expertise

Investment expertise

Performance monitoring & attribution analysis


INTERVIEW QUOTES:

“Instead of following the proverbial two-handed approach of economists, pension consultants need to take a clear stance on a number of controversial issues.”

“While the past may be our best guide to the future, it is still a pretty bad one.”

“As intermediaries, consultants ensure that the moat between the end-client and their asset manager is deep and wide.”

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Like consultants, asset managers need to make significant improvements. Before highlighting the key areas, it is essential to narrate pension funds’ experiences which have influenced their ratings. To start with, those who diversified outside their traditional long only funds did so because they either believed the uncorrelated returns story from their asset managers or they were enticed by the prospect of the much publicised ‘prime mover’ advantage, which has turned the Yale and Harvard endowment funds into world class icons. In the process, as we shall soon see, too many products were flooded on to the market without due regard to client needs. Many were neither tried nor tested, by time or events. Over time, there were mounting concerns about the viability of the risk models in use: the decade had experienced too many ‘fat tail’ risks, which were not factored into the models. Many hedge funds, for example, were seen as running a Ferrari with a Citroen’s brakes. Their

replicators went a step further and promised to deliver outsized returns of hedge funds at a fraction of the cost. Risk was stacked up like a wedding cake. Against this sobering background, pension funds have identified areas that need major improvements. They cover specific attributes of managers’ products as well as their fee structure (see right of Figure 1.6). On the product side, attributes that need urgent attention include: transparency, risk-return features, liquidity, volatility, complexity, and correlation. On the fee side, product charges are deemed too high in relation to the intrinsic value that they deliver. Asset managers duly endorse this assessment, but only a minority see fees as an issue. Looking at these numbers on product features and replaying the ‘inner voices’ of the senior executives involved in our interviews, it is hard to avoid their stark subliminal message – there is nothing specific that clients want to change; they want to change everything!

THEME 6 Asset managers should push out only those products that are fit for purpose

Figure 1.6 In which areas do asset managers need to make significant improvements, if they are to receive mandates from their clients in future?

Pension funds’ surveyAsset managers’ survey

% of respondents

70 60 50 40 30 20 10 0 10 20 30 40 50 60 70

Fee structure

Transparency of their investment process

Risk-return features of their investment strategies

Liquidity features of their investment strategies

Volatility of their investment strategies

Delivery of uncorrelated absolute returns

Complexity of their investment strategies


% of respondents

70 60 50 40 30 20 10 0 10 20 30 40 50 60 70

Fee structure

Transparency of their investment process

Risk-return features of their investment strategies

Liquidity features of their investment strategies

Volatility of their investment strategies

Delivery of uncorrelated absolute returns

Complexity of their investment strategies


INTERVIEW QUOTES:

“95% of our returns come from asset allocation; active management is a noise in the risk-return context.”

“Alpha is everywhere except in performance numbers.”

“There’s a huge gap between the cutting edge and the rest.”

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In this decade, most DB plans have diversified their proverbial 60:40 equity-bond portfolios in pursuit of high returns (see Figure 1.7). Their asset managers have duly responded. Some have used swaps and other tools to immunise the unrewarded risks. Some have diversified into different asset classes in the long only, alternatives or ‘exotic’ spaces. While their outcomes are clouded by the current market turmoil, one thing is clear: diversification for its own sake is not a panacea. Its success rests on understanding the interplay between different asset classes at the most granular level; duly focusing on critical features like risks, returns, volatility, transparency and liquidity. It is unwise to put all eggs in one basket. But it is foolish to spread them over bottomless baskets. Too many new products have been rushed out without much regard to their inherent value. Many are simply the resprayed version of the old. On the upside, examples of genuine improvement are emerging from asset

managers who have focused on their core capabilities, deepened their expertise base and involved clients as innovation partners. For them, innovation means creating new ideas that add value to clients. Many similar examples are needed in DC plans as well, as the tide rapidly flows in their direction. Innovations that underpin the design of DC funds have to deliver capital protection as well as targeted growth. They also have to ensure a far greater fiduciary role for their managers. Across Europe, there are real concerns that if the new generation of DC products fails to meet these two imperatives, the regulatory backlash could be crippling, at a time when governments are weaning their citizens off state run pension schemes. In the next fifteen years, DB plans may well become the preserve of public sectors in Europe. It is up to asset managers to ensure that DC plans do not suffer a similar fate.

THEME 7 Innovation is a much used, mis-used and abused word in the investment lexicon

Figure 1.7 A stylised version of changing mix of assets for DB plans: 2000-08


INTERVIEW QUOTES:

“The problems facing pension funds are virtually the same across Europe, arising from low returns and regulatory creep.”

“Without good manager selection skills, diversification is like putting chips on every table in a casino.”

“No longer is it possible for asset managers to hide behind broad brush numbers: granularity and transparency are the name of the game.”

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To chart the way forward, this study pursued three specific questions with pension funds, their consultants and their managers: first, what factors would feature strongly in pension funds’ choice of their asset managers: second, what do asset managers need to do to add more value; and third, what actions are needed by the three sets of players in the investment value chain. To the first question, the answer was unanimous: good returns, backed by quality people with quality processes, and alignment of interest to ensure their sustainability into the future. The feast and famine mentality of the past has done credit to nobody. On the second question also there was unanimity: asset managers and pension consultants need to embrace their clients. The current arms-length approach is not conducive to understanding clients’ true predicament. On the third question, the predominant view was that this aloofness is the cause and the symptom of a cycle of shortcomings that

prevail in each link in the investment value chain, as illustrated with respect to DB plans (see Figure 1.8). Internal shortcomings have caused external disconnects and mutual misunderstandings. Accordingly, pension funds need to tackle the prevailing skills and governance gaps that have for too long promoted herd instinct and rear view mirror decision-making. Pension consultants need to orient their professionalism towards fresh ideas and insights that create an edge at a time when new opportunity sets are desperately needed. Asset managers must sell what their clients need, not what they have, as the basis of a new alignment of interest. Above all, each party needs to interact directly with the others regularly to exchange ideas, review progress, do course corrections, and monitor outcomes. Consultants’ current gatekeeper role pigeon-holes managers and retards creativity when it is most needed.

THEME 8 New uncertainties require more joined-up thinking

Figure 1.8 A cycle of shortcomings have created ruptures in the investment value chain

• Overly product driven

• Low alignment of interests

• Arms-length approach to end clients

• Weak culture of quality assurance

• Variable performance

Assetmanagers

• Weak big picture understanding of client needs

• Modelling techniques challenged by excess volatility

• Inadequate expertise in alternatives

• Arms-length approach to asset managers

Pensionconsultants

• Gaps in skill sets and governance structures

• Too many vested interests

• Slow decision making processes

• Overly influenced by the past

• Herd instinct

Trusteeboards






Assetmanagers






Assetmanagers





Pensionconsultants





Pensionconsultants





• Herd instinct

Trusteeboards





• Herd instinct

Trusteeboards


INTERVIEW QUOTES:

“Consultants and asset managers should talk a lot more in the future because neither has the monopoly of wisdom.”

“In spite of the drumbeat of calls for increased dialogue, nothing has changed.”

“Managers and consultants must eat their own cooking.”

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In an era where old certainties no longer hold, the systemic weaknesses highlighted under Theme 8 risk turning Europe’s pension dream into a nightmare. To prevent that scenario, each set of players needs to make step changes in their existing approaches (see Figure 1.9). Shifts required by pension funds focus on two areas. The first covers board composition, decision-making and investment expertise. Currently, vested interests are over-represented and outside experts under-represented. It is time for a better balance so as to ensure that key decisions are driven by strong investment beliefs rather than herd instincts. The full-time executives need to have a breadth of skills that allows them to operate in real time. The second area of action covers relationships with their two sets of service providers: they must use pension consultants as thinking partners, not hand holders; they must use asset managers as strategic partners, not distant vendors.

Shifts required by pension consultants also focus on two areas. The first is their core competency: it should centre on forward looking personal insights, not models that are backward looking. Their recommendations on manager selection and asset diversification need to be driven by high conviction logic rather than past performance and vendor hype. The second area of focus is relationship with pension funds: consultants need to be trusted independent advisors, rather than gatekeepers who create deep blue sea between asset managers and their end-clients. Finally, shifts required by asset managers focus on two areas. The first relates to returns: they need to ensure that innovation delivers better returns with better alignment of interest, not the same old products re-packaged in the lingo of absolute returns. The second area is about relationship with end-clients: asset managers need to go from product providers to trusted fiduciaries.

THEME 9 Without a sea change in the existing practices, pension funds will continue to stumble from one crisis to another

Figure 1.9 Responses required by pension funds, consultants and managers

Necessary gatekeepers

Models relying on past

Simplistic rationale

Broad brush awareness

Past performance

FROM: TO:

Trustee boards:

Executive capabilities:


Relationship with asset managers:

Relationship with consultants:

pens

ion

fund

spe

nsio

nco

nsul

tant

s

Role:

Core competency:

Diversification approaches:

Clients’ challenges:

Manager selection:

asse

tm

anag

ers

Value proposition:

Innovation:

Investment returns:

Fees:

Relationship with pension funds:

Vested interests

Limited expertise

Follow the herd

Distant service providers

Reputation protectors

Broad-based expertise

Breadth of specialist skills

Follow the instincts

Strategic partners

Thinking partners

Trusted independent advisors

Foresight based on experience

High conviction logic

Granular familiarity

Future potential

Tenuous promises

Copycat products

Periodic

Unbalanced interests

Distant contacts

Hard deliverables

Improved products

Sustainable

Aligned interests

Fiduciary role

Necessary gatekeepers

Models relying on past

Simplistic rationale

Broad brush awareness

Past performance

FROM: TO:

Trustee boards:

Executive capabilities:


Relationship with asset managers:

Relationship with consultants:

pens

ion

fund

spe

nsio

nco

nsul

tant

s

Role:

Core competency:

Diversification approaches:

Clients’ challenges:

Manager selection:

asse

tm

anag

ers

Value proposition:

Innovation:

Investment returns:

Fees:

Relationship with pension funds:

Vested interests

Limited expertise

Follow the herd

Distant service providers

Reputation protectors

Broad-based expertise

Breadth of specialist skills

Follow the instincts

Strategic partners

Thinking partners

Trusted independent advisors

Foresight based on experience

High conviction logic

Granular familiarity

Future potential

Tenuous promises

Copycat products

Periodic

Unbalanced interests

Distant contacts

Hard deliverables

Improved products

Sustainable

Aligned interests

Fiduciary role


INTERVIEW QUOTES:

“Currently, the trustee model detracts value rather than adds it.”

“Governance is the alpha behind alpha.”

“We can no longer rely on sticking plaster solutions.”

12

The immediate cause of the current funding crisis is, of course, the bear market. When it recovers, the crisis will ease, but it will not disappear. Previous recoveries have merely concealed the deep seated problems in every part of the pension value chain and postponed the root and branch changes that have been long overdue. Here we highlight things that pension consultants and asset managers need to do in their respective areas. Pension funds have identified ten things that can have a material impact on their funding levels, either directly or indirectly. Some of them are about doing old things better. Others are about doing new things (see Figure 1.10). Together, they can go a long way towards restoring the trust which has been a major casualty in the current crisis. In turn, trust may be restored only when service providers deliver products that have a good track record; manufactured by firms that have the necessary business stability which increases the probability

of replicating the past successes; firms that are run by people who promote a strong alignment of interests with their clients; all this within a business model that eschews hype and jargon in its product propositions. These four imperatives require service providers to do old things better: things like asset allocation, manager selection, portfolio construction, stock selection and tactical asset allocation. Alongside, there is also a crying need to do new things that ensure that client needs are much better understood and any product innovation genuinely enhances the core product features like risk-returns, volatility, liquidity, transparency, simplicity and customisation. With the help of thought leaders and practitioners who have participated in this study, we hope to drill deeper into the areas highlighted in Figure 10 in the forthcoming debate in Investment & Pension Europe, starting in the November 2008 issue.

THEME 10 Market recovery will ease the pension crisis but not solve it

Figure 1.10 A manifesto for change


INTERVIEW QUOTES:

“Consultants must stop being rigorous about wrong things.”

“Managers must have an eye for things to come.”

“We need an outbreak of mass sanity.”

13

OverviewThis study is based on two pan-European surveys, involving two distinct sets of players within the investment value chain. This section presents the views of 87 pension funds in their role as clients. As shown in the Appendix, they span a wide cross-section: some operate DB plans, others DC plans; some are in the private sector, others in the public sector; some are open, others are closed; some are small, some intermediate and others are very large. When presenting the survey results, this section highlights the dominant trends emerging from the responses of all the survey participants taken together. However, where there are differences by the nature of plans, their sectoral background, their status, or their size, these are highlighted here. Our overall analysis is based on two parallel sources of information: the survey and the follow-up structured interviews with senior trustees and executives in 30 organisations. The latter aimed to gain deeper insights into the survey results. Together, they suggest a number of core messages which are summarised here. In this decade, two bouts of extreme volatility in a short span of eight years has promoted the view that the world of investment has veered into uncharted waters where none of the old certainties about risks and returns appear to hold true any more. The funding crisis, sparked by the equity bear market of 2000-3, triggered a host of accounting and regulatory changes which, via their

unintended consequences, exacerbated the initial impact. They were not helped by the ensuing large scale defensive diversification into absolute returns strategies aimed at moving away from the time-honoured combination of equities and bonds. But the growing correlation within and between asset classes in the past five years has exposed the risks associated with going into anything untested by time or events. With funding levels hit once again in the wake of the current credit crunch, two new risks have emerged across Europe: covenant risk in DB plans and headline risk in DC plans. In DB plans, a significant part of the improvement in the period 2003-7 had been secured by increased contributions and large one-off cash injections by plan sponsors, who have become ever more demanding of their trustees. Likewise, in DC plans, a host of administrative and investment issues have come to the fore: partly as more and more employers have switched to such plans solely to shift the pension liabilities off their balance sheets and partly as a result of dissatisfaction with the current generation of pre- and post-retirement products. Accordingly, pension funds’ satisfaction rating of pension consultants and asset managers is highly variable. It is indicative of more demanding expectations in a new environment which has exposed serious fault lines in the existing industry dynamics. They require lasting improvements in a range of core activities undertaken by these service providers.

INTERVIEW QUOTES:

“I’ve seen the end of the world many times in my life. Like other crises, this one will pass. But its pain will long endure.”

“Trustees are driving down a road that is getting narrower and narrower, thanks to regulation.”

“One extra year of life expectancy adds 3% to the value of pension liabilities.”

“It is better to avoid predictions,

especially about the future” Neils Bohr

How and why is the pensions world changing? 222 PPPEEENNNSSSIIIOOONNN FFFUUUNNNDDDSSS SSSUUURRRVVVEEEYYY

14

Getting highest risk adjusted returns has always been the main goal of pension funds now operating DB plans. In this decade, this goal has proved challenging, thereby crystallising two sets of priorities. The immediate one is to raise the funding levels hit by the combination of the two large market downswings in this decade, alongside a raft of regulatory changes. The second is to achieve better returns on their portfolios in the medium term via improved asset allocation. Taking each in turn, across Europe, three regulatory and accounting changes have proved challenging, especially for pension funds sponsored by quoted companies: they have to be at least 100% funded within a specified period; they cannot smooth assets and liabilities over time; and they have to mark-to-market all their investments. Benign in their intent, such changes have inadvertently proved malign in their impact. They have raised pension funds’ liabilities even when their overall investments had been doing well. They have also imparted an unusual degree of volatility in the balance sheets of plan sponsors directly and their share prices indirectly. Around 50% of private sector pension funds have had to make sizeable one off cash contributions to meet the solvency criteria; some 40% have also had to increase their annual contributions, according to our post-survey interviews. As a result, covenant risk has emerged as a new challenge that was unheard of at the start of this decade. In the Netherlands, the indexation of benefits is now discretionary and annual contributions are adjusted to meet the stipulated funding ratio at all times. Such challenges have been felt more acutely by small private sector pension funds that have hitherto lacked the expertise and governance to cope with all these unexpected developments. They have been less acute for the public sector DB plans or those plans closed to new members. In contrast, their core concerns have been to improve their asset allocation approaches and find investment options that offer quality, simplicity and safety. Overall, irrespective of sectoral status, size or nature of plans, three points were emphasised in our post-survey interviews.

What are the key priorities of your DB pension plan?

% of respondents0 10 20 30 40 50 60 70 80

Addres s ing funding levels

Improving as s et allocation

Achieving cons is tent returns and capital protec tion

Minimis ing finanical s tatement volatility

S earching for highes t ris k‐adjus ted abs olute returns

S eeking quality and s implicity in our inves tment choices

C oping with regulatory & accounting changes

L iability matching

P roviding comfortable retirement for our members

S eparating alpha and beta

Divers ifying into alternative inves tments in s earch of higher returns

F inding new products focus ing on lifes tyle/age‐bas ed profiles

E xploiting c ros s ‐border inves tment opportunities

Dealing with potential retirement income s hort‐fall from current DC s chemes

DB P lans Source: CREATE-Research 2008

Improving the funding levels of DB plans is the top priority, in the face of low returns and accounting changes

INTERVIEW QUOTES:

“60% of the DB schemes in the UK are contemplating buy-outs. 50% of plan sponsors don’t think their schemes will be there in 20 years.”

“The Netherlands, Sweden andDenmark are leading in the LDI space.”

“Strategic asset allocation is no longer a three year plan; tactical switches are inevitable.”

15

First, the unusual volatility in returns in this decade has raised doubts about the stability of risk return characteristics of different asset classes as much as the probability of their actual outcomes. Strategic asset allocation has been turned into something far more dynamic than pension funds have hitherto been accustomed. Second, pension funds outside the public sector have perforce become short termist in their investment outlook. This perverse opportunism sits uncomfortably alongside their fiduciary role as long term investors. Third, on the upside, the volatile climate of this decade has thrown up many investment opportunities which require better governance structures and investment expertise to make the right calls at the right time and monitor them with the right tools. Outside the large plans, these have not been the norm, such that the emerging opportunities have either remained unexplored or delivered sub-optimal returns. “We must improve our funding level if we are to survive. Our problems started in the 1990s, when equity markets were raging and we were severely overweight with 80% allocation. We were led to believe that this was the smart thing to do, since equity risk premium will always remain hefty enough to take care of all our future liabilities. At the time, this seemed credible because our funding ratio had raced up to 119%. Our plan sponsor was even advised to have a ‘pension holiday’ for 3 years. Then, disaster struck when the markets tanked in 2000. Funding levels went into free fall, hitting an all-time-low of 67% in 2002. In response, we were advised to do a number of new things, which we did. To start with, we switched to government bonds and started immunising the inflation and interest rate risks via swaps. Thus we got into bonds when everybody else was doing it. Also, the equity component of our portfolio was deliberately halved at a time when markets were especially jittery due to the war in Iraq. We switched 10% of our portfolio to real estate and private equity. In the meantime, the near 50% recovery in the equity markets since the war passed us by like a ship in the night. Our total portfolio has averaged 2.5% returns (net of charges) since 2002. In retrospect, we have learnt two lessons. First, the timing of our radical switch as well as its rationale was

wrong. Second, the risk-return characteristics of the new asset classes were always a matter of conjecture. But it seems as if the same now applies to traditional asset classes as well. Meanwhile, just as our funding ratio started to recover, a new set of regulations and accounting rules hit us like a bolt out of the blue. They have injected an unacceptable degree of volatility into the balance sheets of our plan sponsors, who are none too pleased about that; nor are they comfortable about new rules that gave trustees the power to veto a number activities in which all corporate sponsors usually engage, like share buy-backs, leveraged M&As and large dividends. In the 1990s, market risk was the only one we had to contend with. Now the range and intensity of risk has increased - the biggest and the latest being the covenant risk. I’m not sure whether we’re managing risk or uncertainty. Our sponsor has made a series of cash injections to the tune of €3bn on the condition that the plan’s benefits are renegotiated. Employees have fiercely resisted this idea. We are not unique in this respect: UK plan sponsors’ average cash contribution has risen from 16% of pay in 2004 to 22% in 2007.” ~ A UK private sector pension fund

INTERVIEW QUOTES:

“Occupational pensions in the UK today deliver a yearly retirement income of £15k; and this is the lucky generation.”

“Across Europe, DB schemes will become the preserve of the public sector over time.”

“Pension funds are in a conundrum: equity risk premium in the traditional markets has been negligible; but there is no certainty that alternatives will fare any better either.”

VIEW FROM THE TOP…

16

As the challenges faced by DB plans have multiplied across Europe, two outcomes have ensued: the closure of DB plans to new members and the switch towards DC plans. Closures have been especially notable in countries like Ireland and the UK. Even in countries like France, Germany, Italy, Spain and Sweden – where the first pillar state pension schemes have been very generous by international standards – employers have been encouraged to start DC plans in the face of ageing populations that have strained welfare budgets. Either way, DC plans have taken off, creating their own challenges. The first relates to investment choices. As the number of DC plans has multiplied, issues around optimum asset allocation and acceptable returns have come to the fore, especially in those plans that are classed as ‘private’ or ‘contract-based’. Typically, such plans entirely transfer the choices along with their risks to the individual. In contrast, challenges associated with the so-called ‘trust-based’ DC plans have been less challenging. Popular in countries like Denmark, France, Germany and Sweden, they have hitherto provided the necessary oversight and advice via dedicated boards of trustees. Many such plans on the Continent have also pooled their investments or invested in deferred annuities. A minority have also gone a step further and promoted risk sharing between employers and employees. In the majority of cases, however, returns after fees have fallen well short of expectations. The second set of challenges relates to plan administration. They apply mainly to private plans. Typically, they do not have auto-enrolment: members have to opt-in as a matter of personal choice. This has produced unacceptably low enrolment rates: usually less than 50% across Europe. They are also conditional: employers only put money on the table when employees match the contribution; often making the contributions smaller than warranted. Finally, the investment choices on offer are overly conservative for young employees: they involve insurance contracts, indexed funds and bonds, or cash-plus products; resulting in a slow build-up in the size of individual retirement pots. The final set of challenges relates to fiduciary matters. Until 2006, across Europe, there was a dearth of products that are now sold under the generic headings of life cycle products, life style products or target date retirement funds. Such products have had an explosive growth in the US, since they explicitly take

What are the key priorities of your DC pension plan?

% of respondents0 10 20 30 40 50 60 70

Improving as s et allocation

S earching for highes t ris k‐adjus ted abs olute returns

S eeking quality and s implic ity in our inves tment choices

Achieving cons is tent returns and capital protec tion

P roviding comfortable retirement for our members

F inding new products focus ing on lifes tyle/age‐based profiles

Dealing with potential retirement income s hort‐fall from current DC s chemes

Divers ifying into alternative inves tments in s earch of high returns

Addres s ing funding levels

Minimis ing finanical s tatement volatility

L iability matching


E xploiting c ros s ‐border inves tment opportunities


DC P lans Source: CREATE-Research 2008

Better asset allocation and high returns are the top priority in DC plans via quality investment choices

INTERVIEW QUOTES:

“Our DC plan members suffer from a cycle of low contributions, low returns and an unwillingness to annuitise.”

“Europe should learn from the US which has made a lot of mistakes in the DC space over the past 25 years.”

“Savings systems need to be holistic; otherwise youngsters won’t go near them.”

17

into account a host of factors unique to individuals: e.g. age, needs, retirement timing as much as changing life styles when individuals approach retirement. Such products are now marketed in the Netherlands, Switzerland and UK. However, they still require an infrastructure of advice which is slowly developing. Plan sponsors – especially those who have closed their DB plans - are unwilling to accept any risks arising from wrong choices: a question of once bitten twice shy. They and others expect product providers to take on a fiduciary role which few are able to discharge currently. “Across the main countries in Europe, the first pillar pension system works well. But it is very costly. So, governments are encouraging employers to introduce DC plans in order to relieve the pressure on central finances. In addition, in our case, the second pillar DB plan also has its own challenges. As a result, we have closed it to new entrants who are encouraged to go into our DC plans. In the process, we have experienced two distinct sets of problems. The first set applies to the administration of the schemes. The rules do not allow auto enrolment: employees have to opt in as a matter of personal choice. Only 35% choose to do so. One of the main reasons is high staff turnover rates in distribution centres where a vast majority of plan members work across Europe. They also have to contribute 5% of their own salaries to earn a matching contribution. For many, this is a disincentive. The second set applies to investment choices. They can buy a pension plan with a life company; or invest in indexed funds; or invest in funds biased towards cash and bonds. Most of them go for indexed funds but they are overly influenced by the latest fads in the choice of indices. The administration system disenfranchises the majority and the investment choices suit only a minority. Going forward, we are now exploring the new generation of target date retirement funds,

which have taken off in the US in the last 5 years. In particular, we are looking for funds which can cater for the needs of people with very different risk profiles due to cultural differences. On the Continent, the equity culture is still weak among a large segment of employees: they want bond-based funds which give them a steady build up that is least exposed to market events. In the UK and Ireland, the reverse applies: employees there like being overweight in equities at the outset, switching into bonds later in their professional lives. Our plan is contract-based. Members have complete charge from the day of enrolment. We did consider creating a trust-based plan of the sort that prevails in Denmark, Germany, Netherlands and Sweden, where employers either share part of the investment risks with employees or at the very least provide a fiduciary oversight which enables members to make the right choices or pool their investments. With 35,000 members in the plans, we have the critical mass to do it. We rejected this option mainly because – as in the DB world - we fear regulatory creep in the DC space over time, as the current generation of members increasingly realise that the returns from their investments are inadequate to buy decent annuities in retirement.”

~ A pan European pension fund

INTERVIEW QUOTES:

“DC schemes suffer from two weaknesses: members lack investment acumen and fund managers are unwilling to offer advice for fear of legal action.”

“Plain vanilla DC funds short-changeclients. The target date funds are a step in the right direction.”

“Asset managers must never forget their fiduciary responsibility to clients who are not financially savvy.”

VIEW FROM THE TOP...

18

For pension funds, the funding crisis has triggered a new interest in the idea of uncorrelated absolute returns. The well-publicised success of hedge funds in the 2000-3 market turmoil held out the promise of new sources of absolute returns unrelated to the vagaries of market movements. The old 60:40 equity-bond model was seen as passé. Diversification inside and outside the long only funds became the new mantra. Yet, as we shall soon see, outcomes thus far have fallen short of expectations.

So, when evaluating the contribution of pension consultants, our survey paints a mixed picture. On the whole, in every one of the activities in the chart above, there are notable incidences of favourable ratings under the labels of ‘good’ and ‘excellent’ (on the right hand side of the chart). This is notably the case in areas like asset liability modelling, investment advice and performance monitoring. At the other end, there are also notable unfavourable ratings under the labels of ‘poor’ or ‘limited’ (on the left hand side) in vital activities like strategic asset allocation, manager selection, and implementation of strategy and selection. At the disaggregated level, these results broadly hold, but they also reveal a few mild tilts. For example, in the public sector, the incidence of unfavourable ratings exceeds those of the favourable ones in virtually all areas. Pension funds there appear to have had much higher expectations of their consultants than their peers in private sectors; reflecting the differences in their respective base of internal expertise. Likewise, open funds tend to have a proportionately higher incidence of unfavourable ratings than those with closed plans; reflecting the differences in the severity and immediacy of the challenges they face. As for the nature of plans, those who run DB plans again have a higher incidence of unfavourable ratings than those who run DC plans; reflecting the differences in the level of their dependencies on consultants. Finally, smaller pension funds register a higher incidence of dissatisfaction compared to medium and larger ones; reflecting the differences in the quality of their respective internal governance structures and investment expertise. Notable as they are, these differences do not detract from the overriding message that emerged from our post-survey interviews: in this decade, pension funds, too, have been rapidly pushed into uncharted territory. As plan sponsors have raised the bar on their trustees, trustees have raised their expectations to levels to which consultants have not been accustomed.

How do you rate the contribution of your pension consultants in helping you to meet the challenges that your pension plan faces?

Cumulative % of respondents

Asset liability modelling


Investment advice


Manager selection


Implementation of strategy and selection

5

32

28 45

43

35

5

3

35

39

24

28

30 38

48

33

3

5

3

2

21

40 50 6010 0 10 20 30

31

30

203040506070

22

30

28

27

27

Poor Limited Good Excellent


The contribution of pension consultants is variable: good in some areas and not in others

INTERVIEW QUOTES:

“In the US, our sales people have greater proximity to institutional clients, even though the selection has been done by consultants. In the UK, this is impossible.”

“The consultancy market has extremes of excellence and mediocrity.”

“Our surplus of €6 billion has turned into a deficit of €1billion in this decade. Now, we need 400 bips over cash each year: this requires a different advisory framework.”

19

The unfavourable ratings are indicative of the emergence of new urgencies as much as the prevalence of inherent weaknesses. In any event, consultants specialising over a narrow area have developed greater proximity to their clients, especially in Continental countries. They are perceived as adding greater value than their larger peers with expertise across the entire water front. The key differentiator, however, is not size but the quality of the relationship with clients. Here quality has been described in terms of: the breadth and depth of understanding of clients’ challenges; the degree of professionalism and objectivity that is applied to cope with them; a track-record of successful outcomes; an organisational stability that enhances the prospect of sustaining past successes in the future; an avoidance of conflict of interest; and an alignment of interest. The most successful consultants had narrow specialisms, which avoided cross-selling of services, which has been a principal source of conflict in multi-service consultancy firms.

“We have always relied on outside advice. In the process, we have also learnt that the more the world of investment changes, the more it remains the same. For sure, changes are very evident around us. They are driven by globalisation, the internet, the emergence of BRIC economies, unfolding demographics and many other mega trends. In the geo-political sphere, we have seen the gradual but relentless shift in the centre of gravity towards Asia Pacific. In the investment arena, we have seen their cumulative impacts through the emergence of new asset classes, new markets, and new opportunity sets as the old asset classes are being combined with the new tools of hedging. Yet, I don’t see that the models used by pension consultants are any different. Nor do I get the feeling that new tools of analysis are being created by them at a time when anywhere between 50-80% of returns stem from smart asset allocation choices. Nor do I see signs of special insights which help our trustees to understand the unfolding dynamics of the investment scene. As trustees, the bar has been raised for us by a combination of poor returns, new regulations,

new accounting rules, financial statement volatility and large cash injections. Plan sponsors are no longer indulging their fund trustees, who are perceived as having got the sponsors into the mess in the first place. If we are critical of consultants, it is not because they are inherently inept; it’s because we are only relaying down the supply chain the same demanding expectations that our board is exposed to in this new environment. If most consultants are not living up to our expectations, it’s not only because we’re forced to become very demanding but also because they are losing their relevance in our ever harsher world. ‘Business as usual’ is not an option for us; or for them. For consultants to retain their currency, they need to up their game in two areas: strategic asset allocation and investment advice. We see risk as a dynamic concept until risk-return characteristics show signs of reverting to their long term mean. At a time when the risk premia of asset classes are so unstable, we need people with special insights to help us navigate through the uncertainty that has gripped the investment world in this decade.”

~ A French pension fund

INTERVIEW QUOTES:

“Our sponsors have injected new cash as a quid pro quo for scaling back the benefits. We either face an employee strike or improve our returns”

“All ALM studies tell the same story: there’s no out-of-box thinking.”

“It’s a myth that consultants are looking after clients’ interests. Clients get a raw deal but they stick around and live in hope. This is not the way to manage the crisis.”


20

When asked to rate the contribution of their asset managers in helping them to meet the challenges of this decade, pension funds’ assessment has been decidedly mixed once again. The favourable ratings are much more evident in activities such as stock selection, portfolio construction and risk management. But in the critical area of returns, 55% of the respondents rate them as ‘poor’ or ‘limited’. Unfavourable ratings become more pronounced in other areas like strategic or tactical asset allocation, access to new asset classes and investor activism. They become most pronounced when it comes to pre-retirement, post-retirement and capital protection products. At the disaggregated level, the dissatisfaction with respect to returns and asset allocation is more pronounced in private sector plans and open plans; reflecting the nature and scale of funding pressures. Unsurprisingly, the incidence of dissatisfaction is also a lot higher with respect to pre-retirement, post-retirement and capital guarantee products amongst respondents offering DC plans. For those offering DB plans, the incidence of dissatisfaction is more obvious with respect to asset allocation and returns. In terms of asset size, medium and larger pension funds register higher dissatisfaction than their smaller peers, although the differences are not so stark. More notable are four general points that emerged from our interviews. First, those pension funds that have diversified did so because they either accepted the uncorrelated returns story from their managers as an article of faith; or they were enticed by the prospect of the much publicised ‘prime mover’ advantage which has turned the Yale and Harvard endowment funds into world-class icons. . Second, in retrospect, as the funding crisis unfolded, the response of asset managers was overly product-oriented: there was not enough understanding of the nature of either the crisis or the responses it required. The large scale switch into bonds and credit products was too precipitous. The LDI solutions were right for some pension funds that were maturing and had good funding levels; but not for others to the extent that funding levels may yet again come under fresh attack when real interest rates return to their historical levels. Overall, notable diversification has seemed long on expectations, but short on results.

How do you rate the contribution of your asset managers in helping you to meet challenges that your pension plan faces?



Tactical asset allocation

Stock selection and portfolio construction

Providing viable access to new asset classes

Risk management

Returns on their investments

Pre-retirement products in the DC space

Post-retirement products in the DC space 3

Capital protection products

Investor activism


40

23

10

22

50

71

2

5

2

2

2

2

2

2

50

31

50

5

2

29

29

9

9

43

39

24

49

46

31

35

17

70 60 50

31

35

38

33

50 60

38

38

10 20 30 40

26

25

40 30 20 10 0


The contribution of asset managers has been variable: good in their traditional areas but not in the new ones

INTERVIEW QUOTES:

“High charges, low returns and frequent manager switches means rising deadweight costs.”

“In the last 2 years, the bloom has come off the hedge fund rose.”

“The credit crunch has shown that risk modelling is more an art than a science. There is no substitute for common sense.”

21

Third, returns in this decade have shown evidence of ‘fat tail’ risks, casting doubts about the viability of the current generation of risk models used by managers. There have been more extreme events than are catered for by the backward looking nature of the models in use. Finally, as in the case of consultants, the reported dissatisfaction has to do with the fact that the expectation bar for asset managers has been raised to a level to which they are not accustomed, as much as systemic weakness in the ways that asset managers operate.

“Ten years ago, we were essentially in two asset classes: equities and bonds, both with a strong domestic orientation. Today, we have a diversified portfolio, which has taken us into new asset classes like forestry, commodities, private equity, emerging market debt and equities, and themed funds like environment and infrastructure. Nearly 25% of our assets are now diversified. This shift was justified on the grounds that the traditional asset classes can no longer produce absolute uncorrelated returns and so we have to venture further afield to fish alpha. Has our diversification succeeded? The answer is: we don’t know. Even before the current market volatility, the correlation between the old and new asset classes was rising to the extent that one lesson from the current crisis is that the uncorrelated classes are few and far between. All that glitters is not gold. Even returns in infrastructure funds have been affected by the significant deleveraging that is in progress in the world’s banking system. Now, funds marketed as uncorrelated have delivered returns no higher than the traditional long only funds; yet they have attracted much higher fees for their managers. Some managers even attribute market driven beta to managerial skills. What kind of

research process underpinned these funds that were meant to deliver good returns in good times and bad? How were these funds stress tested? Who provided the seal of approval? What was the quality assurance process that brought a bewildering range of new products on the market, without regard to their underlying risk return characteristics? Investment banks are rightly accused of engaging in financial alchemy with their CDOs and CLOs. Over time, we shall see that some asset managers have also gone down that route with a new generation of untested products with long lock-ins. Admittedly, new asset classes pose a major dilemma. On the one hand, many of them offer prime mover advantage before opportunities are arbitraged away. They also help with diversification. On the other hand, they are not properly tested: so when pursuing alpha, you have to accept that you may end up with big losses. Like car companies, asset managers need to push out only those products that are fit for purpose. There are too many ‘me-too’ products rushed out in the name of innovation. They should also permit outside experts to do independent attribution analysis of performance to separate the market effect from skill effect.” ~ A Danish pension fund

INTERVIEW QUOTES:

“In 130:30 funds, fees eat up a large part of returns.”

“This alpha thing is overdone. We look for attractive returns that match our long term liabilities.”

“Regulations and accounting changes have trapped trustees in a pressure cooker environment. So they expect a lot from their consultants and managers.”


22

In the evolving environment of this decade, the ability to secure good returns within a value-for- money fee structure has become paramount in order to jack-up the funding levels in DB plans and minimise the headline risk in DC plans. Pension funds have also been keen on three other factors that now influence their choice of asset managers, as revealed by our interviews. To start with, they want their managers to be good at spotting long term investment opportunities. There is a widespread belief that the current generation of absolute return strategies that rely on active trading, shorting, derivatives and leverage are of a zero sum nature. Targeted at exploiting the short term mis-pricings of assets, many of them miss out on the longer term wealth creation dynamic in the global economy. As the case study on the facing page shows, pension funds expect asset managers to come up with new ideas on uncorrelated assets that capitalise on the untold potential of a variety of intellectual and physical assets on top of the traditional financial assets. The second factor is alignment of interests. There is a widespread perception in the pension world that the investment industry is perverse in one crucial sense: its food chain operates in reverse, with service providers at the top and clients at the bottom. Agents fare better than principals. In Europe, average fees have reportedly gone up by nearly 50% in the past four years, as the search for absolute returns has intensified. In the absence of good returns, many clients have felt short-changed. A value-for money fee structure has become an important factor in its own right. The final factor is trust. For pension funds, it means having confidence in the outcome of a situation. Trust is based on risk, since it is accorded on the basis of limited information. It grows when the expected outcomes are duly delivered. Central to its delivery and its sustainability are fundamentals like a deep talent pool, scalable strategies, asset allocation capabilities and superior client service. On the Continent, many pension funds are also increasingly venturing into longer term strategic partnerships with their managers, as we shall see in Section 3. In this context, if there was one overriding message conveyed in our interviews, it was this: pension funds are interested not only in the ends, but also in the quality of means that deliver them.

In the near future, what factors will feature strongly in your choice of asset managers?


Ability to deliver investment basics will differentiate winners from losers in the next round of mandates

INTERVIEW QUOTES:

“Fear and uncertainty are toxic.”

“The Dutch and Danish pension funds are more successful because they are good at forming partnerships for co-investing.”

“Despite a wide choice, outcomes rarely meet expectations.”

23

Looking at the disaggregated results, there are differences in emphasis on the critical success factors identified in the chart above. Pension funds in the public sector are especially interested in a state-of-the-art infrastructure as a mark of quality assurance; those running a mix of DB and DC plans in co-investing and strategic partnerships in order to underpin the viability of their long term approaches.; and in large plans in a value-for-money fee structure, in order to ensure that their diversification is cost effective. “It is a well worn cliché to say that we select asset managers on the basis of performance, talent, fees and service. But you have to know the context of our pension fund to understand what these clever words mean in practice. We’re one of the largest pension funds in the world, with strong governance and investment expertise to do ALM, strategic asset allocation, in-house investing and performance measurement. Durational liabilities are our biggest risk with the result that we are able to exploit illiquidity premium through long term investing. Also, under Dutch law, our funding levels have to exceed 105% at all times, with the precise funding level at one time depending upon our mix of asset classes. Given our size, we need to diversify: we’re not only into all asset classes but we’ve also diversified into exotic things like patent rights, tourism and shipping. What this means is that without good consistent returns, our funding levels can soon get into the danger zone, with only a limited period of one year in which to improve the levels. So, we’ve got to get things right the first time. We have strategic partnerships with a small group of external managers, with a deep talent pool, established pedigree, good performance over cycle and a stable investment culture.

They also have a skin in the game by co-investing with us and sharing the profits. This alignment of interest and organisational stability are the foundation of our partnership in which each side relies on the other to win. You have to accept that the investment universe is becoming more complex, with too many moving parts. Alliances make sense. We have an innovation committee which constantly receives fresh ideas from our portfolio managers, research analysts and product specialists. They are encouraged to look for new opportunities that are likely to deliver non-correlated returns in the short as well as the long term, from physical, intellectual and financial assets. The committee selects the ideas that are worth escalating, while banking the rest for the future. We always pre-test all of our strategies, by using seed corn capital within incubator funds before pouring money into them. This also applies to new strategies developed by our external partners. These points are worth labouring because we can’t rely on the feast and famine mentality of the markets to meet our contractual liabilities. We need an infrastructure of skills and professionalism that enhances the probability of repeating our past successes. That means working only with those external asset managers who share our ethos, care about our success and live up to our expectations.”

~ A Dutch pension fund

INTERVIEW QUOTES:

“Over caution carries its own risks.”

“The speed at which investment opportunities open and close is accelerating.”

“The WAP law of 2006 in Belgium has stimulated demand for professional advice and expertise.”


24

Pension funds have identified three sets of generic changes that asset managers need to undertake in order to promote a vibrant pension industry in the longer term. The first set relates to investment strategies. These should aim to deliver sustainable returns within transparent structures, avoiding hype and unrealistic claims. As pension funds have been forced into uncharted waters in this decade, trustees have been increasingly required to rely more on personal judgement and less on risk models and outside advice. Excessive hype and unrealistic claims on the part of managers have detracted from sound judgement, as have those new products not tested prior to sale. Speed to market cannot override duty of care. The second set relates to investment activities. These need a robust ‘fit for purpose’ quality assurance process which delivers integrity and simplicity, backed by risk controls especially for volatile investments. Pension funds offering DC plans have been especially strong on this point. Reportedly, many managers sell what serves their own interests not what their clients need. Needs analysis should be routine at the pre and post mandate stages. Capabilities should be developed around the long term needs of clients, not just short term gains for their managers. There is clear scope for a better balance. The third set relates to manager incentives. These should be linked to outcomes. Some pension funds would like to see symmetrical performance-based fees: high rewards for high risk-adjusted returns, and no fees for poor returns. The public pension funds are especially keen on performance-based fees.

Less conspicuously, a minority of pension funds also believe that changes that promote the newly-emerging fiduciary management model, one-stop-shop arrangements or multi-manager solutions can also benefit the industry. The emergence of the fiduciary model – that is gaining traction in the Netherlands - is of special interest to large pension funds keen to in-source services from their smaller peers across Europe.

INVESTMENT RELATED CHANGES:Sustainable returns within transparent strategies

Avoidance of unrealistic claims about returnsBetter understanding of clients’ goals and challenges

‘Stress testing’ new products before selling themNo hype and jargon around investment activities

Focus on quality and simplicityFocus on low volatility excess returns

Increased trust and transparency around investment activitiesProviding strategic asset allocation services

Ready access to asset classes that clients wantDeveloping sub-advisory mandates

BUSINESS-MODEL RELATED CHANGES:Focus on core capabilities

Becoming clients' strategic partners Proliferation of boutiques with acknowledged specialisations

Offering performance-based incentives to investment professionalsMore products with performance–based fees

Sustainable returns within transparent strategiesGrowth of fiduciary managers, (e.g. the Dutch model)

A one-stop-shop offering a wide range of solutionsDeveloping proprietary multi-manager platforms

Increased regulationFurther industry consolidation

Pensions consultants venturing into multi-manager platforms

What specific changes by asset managers will help the pension fund industry most?

% of respondents0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75


Asset managers need to avoid unrealistic claims about their products and get closer to their clients

INTERVIEW QUOTES:

“Neither past performance nor heuristics help much with manager selection. Trustees have to make judgement calls.”

“I doubt if most consultants or managers can run the fiduciary model with their existing skill sets and track records.”

“In Switzerland, benefits are transferred when people change jobs. So, the funding levels have to be healthy at all the times. You have to consider all outsourcing options”

25

At the other extreme, no more than a handful of pension funds believe that more regulation or consolidation at the asset management end will generate any lasting benefits for them. These are seen as an irrelevance or a distraction. In summary, pension funds want asset managers to try new things. But they also want them to do existing things better.

“What goes around comes around. That’s how we feel about the new fiduciary management model pioneered in the Netherlands. In the last decade, balanced mandates were the norm. We used to give our assets to managers with a single target return for the whole portfolio. They allocated the assets and managed the funds internally. In this decade came the core satellite model under which we allocated a fixed sum to indexed funds and the rest to specialist managers who had a good track record in their areas of expertise. In the process, we relied on pension consultants to do our asset allocation and manager selection. Under the fiduciary management model, the separate role of pension consultants and asset managers is being combined. Too often, in the past, pension funds’ resources have been thinly spread across all the asset classes, exposing them to the ‘key person’ risk. The fiduciary model enables pension funds to focus on strategic benchmarks but outsource the surrounding activities that deliver them. As a small house with limited investment expertise and governance structure, we find the concept very appealing. Italy’s pension market is not so well developed and the pool of skills needed to underpin our projected growth of assets is somewhat limited. So we may well go down this route as a part of our growth strategy. But this will be a matter of mini steps rather than giant leaps. To start with, we have short-listed a big Dutch pension fund to see if they would run our plan. We prefer to go to players with a good understanding of the pension business and a

good track record. Via our RFP process, it was clear that many asset managers and pension consultants would not be able to meet our criteria. However, we are concerned about turning over our entire fund to a third party: if things go wrong, it will be a nightmare scenario to reverse the process, not to speak of the reputational damage. So, we are going to outsource investment first before giving over ALM, asset allocation and performance monitoring. Finally, we are not sure about the scalability of investment strategies at the supplier end. Our experience with large UK-based asset managers shows that strategies do not scale beyond a certain point. Yet success until that point attracts a flood of money which dilutes the returns. We are not sure whether large pension funds or asset managers can deliver results on top of what they are doing for themselves or others. Likewise, those who use multi-manager platforms involving sub-advisors are prone to the mean reversion effect. Most of our multi-manager funds have done no more than closet tracking. So, the key concern is whether the new fiduciary management model is a resprayed version of the old balanced mandates approach or something new. We have decided to go down this route in the belief that large pension houses outside Italy are better at managing pensions than we are. It’s a complex game and you have to swallow your pride and try new things one step at a time.” ~ An Italian pension fund

INTERVIEW QUOTES:

“There are over 200 pension funds with less than €15 million in assets in Belgium, with no critical mass. The fiduciary model is ripe for such a market.”

“The Dutch have been more successful at running the DB plans than the Brits. That’s why they are targeting the UK market via the fiduciary management model.”

“Without a supervisory board representing the interests of members and a professional executive to handle day-to-day issues, pension funds will always under-perform.”


26

27

Overview This section presents information emerging from two sources: a postal survey of 135 asset managers spread across Europe with a strong institutional client base; and a round of follow-up structured interviews with top executives in 30 firms who provided detailed comments on the survey results, as described in the Executive Summary. As in Section 2, we present the dominant trends emerging from these complementary sources of information. Where there are notable differences in the assessment provided by asset managers of different sizes, these are also highlighted in the appropriate places. The key messages emerging from our analysis are summarised below before delving into the details. Like their institutional clients, asset managers, too, have felt challenged by the unusual market volatility in this decade. Many long established practices have come under the spotlight. The required improvements are under way. So far, their scale has been restricted by two factors inherent in the existing business models: under-emphasis on client relationships and over-emphasis on product sales. On the whole, asset managers are not close enough to their pension fund clients to understand the true scale and gravity of the problems besetting them. Dealings with clients are conducted via pension consultants.

Once a predominately Anglo-Irish phenomenon, this arms-length approach is now spreading to the Continent as the demand for professional advice has accelerated. The second factor stems from the time-honoured practice of fixing incipient problems by creating yet more new products, instead of crafting holistic solutions that target the newly emerging array of risks, without due regard to their track record or future viability. While prone to over-stating their own achievements, the majority of asset managers have identified areas where fresh actions are needed, both in DB and DC plans across Europe. Some are more daunting than others. But examples of good practices are already there in crucial areas like product innovation, alignment of interests, strategic partnerships, client proximity and fiduciary responsibilities. These aim to anticipate, understand and deliver client needs in an environment defined by notable discontinuities. Only time will tell whether such improvements mark a tipping point. Much will depend on how far pension funds and their consultants are able to tackle some of the newly emerging challenges in their own part of the investment value chain. These are circular and cumulative. Actions by one set of players are necessary but not sufficient. .

INTERVIEW QUOTES:

“Greed and fear will never go away. But they are increasingly tinged with a dose of rationality forced by the reality of appalling numbers.”

“Most risk models are built on sand.” “In Italy nearly 80% of employees declined to transfer their TFR savings into DC plans because of questionable investment decisions.”

“Discovery consists of seeing what

everybody has seen and thinking what nobody has thought”

Albert Szent-Gyorgyl

What do they need to do? 333 AAASSSSSSEEETTT MMMAAANNNAAAGGGEEERRRSSS SSSUUURRRVVVEEEYYY

28

When asked to identify the key goals of their pension fund clients who offer DB plans, asset managers tend to express them in terms of overt product solutions that are seemingly disconnected from the priorities of their clients. Admittedly, two in every three managers have highlighted liability matching and addressing funding levels. But other important goals like minimising balance sheet volatility, and coping with regulatory and accounting changes have been identified only by a minority. As we saw in Section 2, these are part of a self-feeding process that has recently created daunting challenges for pension funds. The process has thrown a bundle of risks that were not previously there for most pension funds across Europe. Few asset managers genuinely believe that separation of alpha and beta, or for that matter the alternatives, constitute panaceas in any sense. Our interviews have highlighted a whole raft of risks which feature prominently on the radar screens of their DB clients. Some are highly significant, others less so; some are new, others not so new. The significant ones include: sponsor covenant risk, reputational risk, regulatory risk, mortality risk, liquidity risk, alternative assets risk, equity risk, inflation risk and interest rate risk. The less significant ones include: operation risk, expenses risk, salary increase risk, and key person risk. The extent of their inter-play depends upon the circumstances of individual pension plans. However, the substantive point is that whereas some can be immunised with traditional hedging tools, others require a multiplicity of approaches that are not open to solutions based on mass produced products. They require customised solutions which have proved difficult for asset managers to deliver for three reasons. These apply more to small and medium sized asset managers than the large ones. First, the newness of these risks has been a major factor. Their nature and inter-dependencies have been hard to fathom at a time when the stability of risk-return characteristics of the old asset classes themselves have come into question. Whether the market volatility experienced so far this decade is the start of a new era or a temporary departure from the old is unclear.

Second, the urge to invent new products in the wake of the 2000-3 equity bear market was irresistible as clients increasingly demanded funds with uncorrelated absolute returns in the face of mounting losses. Over time, managers have learnt that it is very hard to achieve a radical change in their product-mix INTERVIEW QUOTES:

“In the UK, two thirds of the DB schemes are closed to new members and 5% to the existing ones .Poor returns has been a key factor.”

“Our portable alpha experiment failed because of high correlation between alpha and beta”

“Much of product diversification outside the core area is no more than a marketing gimmick.”

What are the five main goals on the priority list of your DB pension fund clients?

% of res pondents

0 5 10 15 20 25 30 35 40 45 50 55 60 65 70

L iability matching

Address ing funding levels

Improving asset allocation

D ivers ifying into alternative inves tments in search of high returns

S earching for highest risk‐adjus ted absolute returns


Minimis ing financial s tatement volatility


Achieving cons is tent returns and capital protection

P roviding comfortable retirement for members

S eeking quality and s implicity in inves tment choices

E xploiting cross ‐border investment opportunities

F inding new products focusing on lifes tyle/age‐based profiles

Dealing with potential retirement income short‐fall from current DC schemes


Asset managers express their DB clients’ goals more in terms of products than holistic solutions

29

because of the lack of the requisite investment skills and infrastructure support. Arguably, they have ended up addressing the symptoms more than the causes of the problems that have gripped the pension world. Third, most importantly, the current role of pension consultants is fully justified in terms of giving clients independent advice without conflicts of interest. As an unintended consequence, however, it has created a physical and intellectual distance between asset managers and their end-clients that is not conducive to the interests of either party. Most marked in the UK and Ireland, this separation is spreading across Europe as more and more pension plans are obliged to seek professional advice in the face of mounting product complexity and regulation. Only a small minority of managers have been able to cultivate a rapport with their end-clients to a degree which allows them to deliver solutions.

“The rhetoric of the investment world is solutions, but the reality is products. Yes, asset managers are moving towards outcome-oriented products. But progress is slow because investment is a cyclical business, driven by greed and fear. Investors are always chasing the next rainbow. Hence, making promises is a lot easier than delivering them. When one strategy fails to deliver, the temptation is to do something different in the name of innovation, as has happened with alternatives in this decade. The speed at which many asset managers have switched from relative to absolute returns has been breath-taking. Many of the underlying products are re-packaged versions of the old ones; the only difference being higher fees. There will always be some investors lining up to buy them. They are unlikely to include many pension funds. The recent accounting and regulatory changes have released secular changes under which they can no longer afford losses. Some DB plans have resorted to LDI solutions because their liabilities were fast maturing and they had reasonably healthy funding levels. More notably, others have done the same in the belief that the old and new asset classes are unlikely to deliver returns to cover their long term contractual liabilities. In part, LDI reflects the perceived failure of active management as much as failure of actuarial assumptions.

Either way, the emergence of LDI reflects the nature of the complexity with which pension funds are grappling. I doubt if many asset managers really understand their dilemmas. Part of our problem is that we get engaged with trustees after the mandate, not before it, when the key decisions on asset allocations are made; and even then, our contacts with them are mostly through consultants. That’s because we sell products, not solutions, under the existing arrangements in the UK and Ireland. We don’t know enough about the circumstances of individual pension plans, their strategies and their funding levels to devise a solution. We’re given a mandate within our area of specialism, with little guidance on how we fit into the wider picture. We find this worrying because we are one of the largest institutional managers in the world with broad capabilities. Yet, we are pigeon-holed with very little contact with end-clients or the other managers serving them. In a sense, that suits us: we get greater operating leverage from selling products than solutions, since products are scalable across a number of clients whereas solutions are uniquely customised. But we could create a lot more value if we had deeper relationships with our clients. The current crisis requires a more joined up approach.” ~ A UK asset manager

INTERVIEW QUOTES:

“If you can’t drive, don’t use a car. Similarly, if you don’t understand a product, don’t buy it.”

“There’s no free lunch with any asset class; nor with diversification.”

“Investors’ costs per € under management have gone up 50% in the past five years. But returns have been mainly market-driven.”


30

Growth in DC plans is likely to be strong across Europe, especially in countries like Belgium, Denmark, France, Germany, Italy, Ireland, Poland, Sweden and the UK. Currently, the share of assets held in DC plans is around 15% out of the total pension assets of around €3.5 trillion. However, over the next 10 years, this share is predicted to treble, according to the assessment presented in the interviews. Whatever the ultimate outcome, one thing is certain: over time, DC plans will replace DB plans as the main source of pensions outside the traditional pay-as-you-go first pillar systems run by national governments. In the UK and Ireland, much of the growth will be in plans that are managed privately and on the Continent it will be in both private and pooled plans. In any event, on both sides of the English Channel, investment returns remain the core concern. However, new opportunities are unlikely to come without their own challenges. Asset managers recognise that consistent returns and capital protection will differentiate winners from losers. Under the first generation of private DC plans in Ireland, Switzerland and UK, the default options were overly conservative: capital protection was more important than asset growth. In the absence of auto-enrolment, the enrolment rates were also unacceptably low. The current generation of private DC plans in these and other countries such as Poland and Sweden, aims to offer a wide range of investment choices so that members can optimise their capital growth. On the flip side, more choice has caused more confusion than clarity: the necessary breadth and depth of financial literacy to make sensible decisions has been absent. Accordingly, asset managers are now devising products with two clear merits. First, they are introducing a new generation of target date retirement funds – or variants of them - that take into account the unique personal, professional and financial circumstances of individual members. Second, they provide the necessary quality, simplicity and flexibility to incorporate members’ changing profiles as they progress through their working lives. Due to their scale and reach, large fund managers have been more active in each of these areas than small and medium-sized managers. These improvements have been widely welcomed. But there is a potential hurdle. Asset managers will need to ensure that their new suite of products is superior in practice as much as in theory. The evidence so far is positive, but these are early days in which to make a definitive judgement.

DC plans members want products with embedded solutions that give correct choices and consistent returns

What are the five main goals on the priority list of your DC plan clients?

% of respondents0 10 20 30 40 50 60 70 80 90 100

Achieving cons is tent returns and capita l protection

S eeking quality and s implicity in inves tment choices

F inding new products focus ing on lifes tyle/age‐based profiles

Improving asset allocation

Dealing with potentia l retirement income short‐fa ll from current DC schemes

P roviding comfortable retirement for members

S earching for highes t ris k‐adjusted absolute returns

D ivers ifying into alternative inves tments in search of high returns



E xploiting cross ‐border inves tment opportunities

Minimis ing financia l statement volatility

L iability matching

Addressing funding levels


INTERVIEW QUOTES:

“In the US, 66% of the workforce is covered by DC plans worth $4.4 trillion. Europe will follow suit.”

“Significant DC plans in France are less than 5 years old.”

“Over 40% of employees in Sweden do not make a choice because of a large array of 780 funds to choose from. Their contributions are channelled into low risk funds.”

31

The UK’s new Personal Accounts Delivery Authority, charged with creating the biggest DC plan in the world over time, has shown a keen interest in target date funds which have grown rapidly in the US over the past five years. On the flip side, asset managers operating in Europe will have to assume a far greater fiduciary role than in the recent past. Under the latest legislation in the US, managers have been accorded ‘safe harbour’ status by law in order to avoid litigation in the event of unsatisfactory outcomes. In Europe, there are no plans as yet to offer such a blanket cover. Hence, asset managers may well need to create for themselves a new infrastructure of advice and guidance, or work ever more closely with financial advisers at the client-facing end. The larger managers are better placed in this respect than others.

“The shift from DB to DC plans is well established in Europe. But that is not the same as saying that it will endure or succeed. The problems encountered in Europe have been similar to those in US: low enrolment, low financial IQ, poor asset allocation choices, lack of advice and inadequate contributions. No wonder there’s still a lot of resistance amongst employers to offer DC plans for reputational reasons, especially in France, Germany, Italy and Greece. As asset managers, we can’t act on all the reported shortcomings. But there’s one thing we can do which would vastly enhance the appeal of DC plans and ensure their long term viability: namely, design the right products. Products must avoid the ‘one size fits all’ approach and take into account the unique circumstances of each plan member. We now have two product sets in the DC space. Each of them initially relies on the Monte Carlo scenario generation technique to create a large number of future scenarios for a range of macro-economic risk factors (e.g. GDP growth, inflation). Then the assets and liabilities are modelled as a function of these risk factors. Out of the analysis, various combinations of asset classes emerge to reflect different risk profiles in our two sets of DC products associated with the pre-defined target date of retirement. They offer two contrasting choices: decreases in risk appetite over time

until the target date; or increase in risk appetite till that time. The latter option allows for the fact that a younger worker has a higher uncertainty about many personal factors such as marital status, home ownership and family size. It also allows for behavioural biases against losses in early years. Our products are initially targeted at the ‘contract’ DC market across Europe and the US, where individuals traditionally have had too much choice and no one to turn to. Over time, we aim to penetrate the ‘trust’ DC market, which offers better oversight and support to plan members. The current pooling of investments in the latter market will meet the needs of some individuals but not others. However, we are aware that these target date funds are relatively new on both sides of the Atlantic. Doubtless, as we gain experience with these products, we shall make refinements. We are conscious of the fact that, whether we like it or not, asset managers will have to accept more fiduciary responsibility with these new products, which are increasingly receiving blessings from national governments. At this stage, they are widely perceived as superior to insurance contracts, or bond funds which have dominated the DC market across Europe.”

~ An Italian asset manager

INTERVIEW QUOTES:

“It is critical to understand the nuances of DC plans and provide products that simplify decisions for participants while meeting the needs of plan sponsors.”

“Over time, the UK’s Personal Accounts Delivery Authority will run the largest DC plan in the world with 7 million members and assets in excess of €180 billion.”

“In target date funds, age should not be the only variable; factors like liabilities and intellectual capital should be taken into account to tailor the solutions.”


32

On the whole, asset managers rate pension consultants more favourably than pension funds have done (Section 2; p.18). Medium and large asset managers tend to offer better ratings compared to the small ones, who often need to build a track record and the right pedigree before they go on consultants’ lists. Even so, performance in each activity has been variable. The favourable ratings – ‘good’ or ‘excellent’ on the right hand side of the chart – have been accorded to activities such as asset liability modelling, governance expertise, and performance monitoring and evaluation. The unfavourable ratings – ‘limited’ or ‘poor’ on the left hand side of the chart – are notably confined to high value-added activities such as strategic asset allocation, investment advice, manager selection, and implemented consulting (covering overall design and execution of investment strategies). Our interviews served to shed further light on these results by underlining a number of observations. To start with, asset managers agree with pension funds that the unprecedented funding challenges of this decade have turned up the pressure for all key players in the investment value chain: consultants being no exception. As a result, expectations have been set at levels to which consultants have yet to rise. In high value-added activities, their achievements require special insights which can only be developed through experiential learning over time. Furthermore, consultants have also suffered a significant talent drain to asset managers, investment banks and new start ups in every major financial centre in Europe; as these players have increasingly ventured into areas that were hitherto the preserve of consultants. The areas in question include asset allocation, manager selection, risk modelling and strategy implementation. Unwittingly, consultants have ended up as a seed-bed of skills for their putative rivals. In France, the Netherlands and Germany, for example, large asset managers have been creating a business model characterised by centralised dedicated capability in ALM, asset allocation and multi-manager funds, via alliances with best-of-breed boutiques providing access to multi-asset specialisms. Such offerings are being delivered via the evolving fiduciary management arrangements or as part of a drive towards delivering one-stop-shop solutions. Either way, there is fresh convergence in the investment value chain. It is also helped by large consultancy houses diversifying into asset management, most recently spawned by the new interest in target date portfolios.

The quality of contribution by pension consultants is

perceived as highly variable How do you rate the contribution of consultants in helping their pension fund clients to

meet the identified challenges?


Asset liability modelling


Investment advice


Manager selection


Implementation of strategy and selection


23

19

12

13

22

3

11

60 70

23 47

32 44

50 80

719

3

4

17

2

24 54

43 41

46 28

37 37

23 5115

10 0 10 20 30 4070 60 50 40 30 20


INTERVIEW QUOTES:

“We had to develop a 3 year track record in Europe before consultants would consider us. Money is now pouring in through direct channels. So we’ve shut the door on consultants.”

“Consultants are becoming involved in DC work because their knowledge about the marketplace is of value to clients. They are also great on due diligence work generally”.

“In the UK, by focusing on products,pension consultants have dis-intermediated asset managers. We’re a component supplier of an end product we do not understand.”

33

Finally, the core satellite model favoured by consultants at the start of this decade marked a major departure from the old style mandates at a speed which soon exposed shortcomings in areas like investment expertise, physical presence in far flung locations, and CRM capabilities. The fiduciary model and such one-stop-shop arrangements reflect the swing of the pendulum as much as the emerging niches in the market place where professional advice commands a premium. Either way, the unfavourable ratings here are doubtless influenced by these wider considerations as well. “For too long, pension consultants have put more emphasis on manager selection than on strategic asset allocation. The latter is the main source of returns. So, if consultants had paid more attention to it, things may have been different. However, it is easy for me to say this in hindsight, since asset managers were even guiltier in believing that they had the Midas touch when returns were good. We have been too quick to attribute good returns to our skills and bad ones to market downturns. The current downturn has turned the spotlight on to three fundamental issues. The first is that asset allocation is absolutely critical as a source of returns. Second, the correlation between asset classes is asymmetrical: low in the upturn, high in the downturn. This makes it very difficult to ascertain the risk return characteristics of major asset classes over definable time periods in which tranches of liabilities mature. Third, asset allocation is more an art than a science: within broad strategic benchmarks, you have to do periodic course corrections to your asset mix. Timing is everything. It is not clear whether this form of opportunism has come about as a result of mark-to-market accounting rules or whether the major global trends have changed the time-honoured relationships between risk and returns. It’s probably both. Markets are adaptive and strategies change, as do risk profiles. So, what we have seen in this decade is nothing new. This does not mean that

markets can’t deliver. It means all of us in the value creation process have to work together to find solutions; especially as the longevity risk is also getting serious. Consultants are in an invidious position. On the one hand, they are seen as experts whose advice is taken seriously especially in periods of turmoil. On the other hand, they do not have the necessary expertise to design solutions. In investment, expertise comes from experience: but much of what we have experienced in this decade is new. So, all the players in the investment world are climbing a new learning curve, which has been steep for consultants and managers alike. They are at that stage in history where the choices have become binary. For example, should consultants have broad-based capabilities or become specialists; should they go into the fiduciary management or retain arms-length dealings with asset managers; should they become strategic partners with strong mutuality of interests with clients and managers or should they remain service providers? Whatever choices are made, one thing is clear: any business model is as good as the expertise on which it is based. People make a difference. Consultants have lost a lot of good people in this decade: some to investment banks, and some to new start-ups. They need to deepen their talent pool, regardless of the choice.”

~ A French asset manager

INTERVIEW QUOTES:

“Many consultants don’t have wide networks outside the main markets to understand local nuances when doing asset allocation on a global basis”.

“Pension consultants have no incentives for forward thinking.”

“Consultants are conflicted: they make money when their clients do new things.”


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If asset managers have been hard on their assessment of pension consultants, they have been overly lenient on themselves in some areas more than others. On the whole, small asset managers have rated themselves more favourably than medium or large players. Favourable ratings have been accorded to key activities like strategic asset allocation, stock selection and portfolio construction, access to new asset classes, risk management, and investment returns. Notably, though, in each of these areas, asset managers have awarded themselves scores that are significantly higher than those accorded by their pension clients (Section 2; p.20). For example, 63% of managers report that their returns have been ‘good’ or ‘excellent’. The corresponding figure reported by pension funds is 45%. Another area of striking difference concerns access to new asset classes. The respective figures are 74% against 36%. For stock selection and portfolio construction, the respective figures are 79% against 52%. These differences tell that proverbial “tale of two cities”, describing the best of times and the worst of times. They are symptomatic of a deep gulf in the perceptions of sellers and buyers in the investment market place. Differences between the two surveys, however, disappear quickly in areas where asset managers have awarded themselves unfavourable ratings. These include pre- and post-retirement products in the DC space, capital protection products and investor activism. In each of these areas managers report ‘work in progress’. There are two features of these findings that are noteworthy. One relates to DC products. Across Europe, the industry is poised for massive growth, as governments in countries as far apart as Finland and Greece are reforming their national pension systems in ways that open up huge opportunities for asset managers. But, asset managers are not geared up, especially the large ones who already have the necessary scale and reach. Nor are they geared up to meet the needs of Europe’s estimated 60 million ‘baby boomers’ who expect to retire over the next 10 years, with sizeable savings accumulated in their insurance contracts. The other feature relates to investor activism. Many pension funds favour a high degree of activism not only because it makes good governance sense, but also because many of today’s high conviction strategies

INTERVIEW QUOTES:

“Too much diversification is risky; we don’t carpet bomb every asset class.”

“Products that come on the market are creations of simulation models; few have any track record.”

“Alpha and beta are part of the same regression model: can you really separate them?”

How do you rate the contribution of asset managers in helping their pension fund clients to meet the identified challenges?


Asset managers rate themselves highly in their critical activities - more highly than their clients

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in alternatives, as well as long only funds, require a close rapport with companies in which investments are made. Successful Dutch and Scandinavian pension funds, who partly manage their own funds in-house, use activism as a tool for getting ever closer to their target companies as one of the means to deliver secure, good returns in their long only equity funds. “Hedge funds did notably well in the bear market of 2000-3, consistently outperforming normal benchmarks like S&P 500 or the FTSE 100. Their success sparked a worldwide interest in the concept of absolute uncorrelated returns. Client expectations were raised to levels which were grossly unrealistic. Aggressive returns were also demanded by pension consultants acting as their advisors. New strategies based on leverage, shorting and derivatives proliferated as did new asset classes. Many hedge funds were running a Ferrari with a Citroen’s brakes. Their replicators promised to deliver outsized returns of hedge funds at a fraction of the cost. In the current down-turn, we are seeing the outcomes. I suspect that long only value-driven strategies will emerge the real winners in a decade where product innovation was marked more by hype than by substance. Outwardly, most asset managers are weathering the storm calmly and stoically, like serenely floating ducks. They believe that they have done well for their clients until the sub-prime crisis spoilt the party. But make no mistake about one thing. Under the surface, the current crisis is yet another humbling experience for them. When the dust has settled, it will be interesting to see how their absolute returns strategies have fared over the last five years in terms of returns and market correlation. I suspect we may well see a flight to quality and simplicity on the part of pension funds: quality in terms of returns and capital protection; simplicity in terms of transparency and liquidity. The next market bounce may be

driven by long only equities. For now, we have learnt two lessons. The first one concerns our new absolute returns strategies. It is clear that a large element of their performance is random or, at least, outside the control of portfolio managers. Returns show evidence of fat tails: the implication is that there are more extreme events than normal distribution allows. Bad news gets disproportionately amplified over good news. Risk models are thus reduced to offering no more than therapy. The second lesson is about information asymmetry. Managers knew more than customers about what was going on. Clients didn’t know what they didn’t know. But clients are wising up for sure. Themselves under intense pressure, pension clients are asking challenging questions and moving towards zero tolerance for mediocrity. One of the lasting legacies of the marked volatility in this decade may well be a bifurcation between asset managers, separating those who do genuine innovation from those who peddle fads; those who are focused on their clients from those focused on products; those who have the stability to emulate past performance from those who go through regular upheavals that produce inconsistent returns. In one respect, the current crisis is a mixed blessing: losses will be painful but mediocrity will be exposed.”

~ A global asset manager operating across Europe

INTERVIEW QUOTES:

“Anything that adds complexity adds costs, too”.

“Clients want to be compensated for risks. They don’t care about alpha and beta.”

“Trustees need to understand what they are voting on. They are far too remote from what we do.”


36

Asset managers have identified two sets of factors as critical in winning new mandates: one focusing on investment outcomes, the other on the means that deliver them. Returns feature very highly in the first set: as does their consistency over time, their absolute size and their uncorrelated nature. Service quality also features highly, both in its own right and as a viable mechanism for understanding client needs. On the input side, human capital also features highly. The ability to attract, retain, motivate and deploy talent is seen as the main source of value creation in activities as varied as investing, co-investing with clients, forming strategic partnerships, crafting scaleable investment strategies, identifying long-term opportunities and so on. They not only influence outcomes, but also their consistency and sustainability over time. A value-for-money fee structure is thus a measure both of the size of returns and their quality. Its delivery is increasingly channelling asset managers into product and organisational innovations, according to our interviews. In the DB space, as clients have diversified their assets, some managers have used swaps and other tools to immunise the risks that are not rewarded. Some have diversified into different asset classes in the long only and alternatives sectors to generate uncorrelated returns. Some have ventured into newer areas like forestry, infrastructure, patents and physical assets to deliver exotic beta. In the DC space, some are experimenting with a new generation of target date funds, as shown earlier. In the process, asset managers are being forced to make one of two choices: either stick to the knitting, deepen the expertise base, and do the old things better; or widen the expertise base and do new things. Most of the viable product innovations in this decade have been in the first camp, involving large pure play managers and independent boutiques, operating in Ireland, Sweden, the Netherlands and the UK. Concentrating on their core competencies, they have aimed to deliver bolt-on improvements in features like volatility, liquidity and transparency via excessive use of derivatives on the one hand and intensive

In the near future, what factors will feature strongly in pension funds’ choice of asset managers?


Good returns and strategic partnerships are seen as critical success factors

INTERVIEW QUOTES:

“Many early adopters of 130:30 funds have failed to deliver due to lack of shorting skills. We are using our own money to build a track record before going live.”

“Innovation must mean better products, nothing else.”

“As a CIO, I meet key clients regularly, share ideas with them in the presence of consultants and describe the reality at the coal-face.”

37

use of internal research engines on the other. The key differentiators between the early innovators and late followers are: a deep talent pool and a client-centric culture. Most of the viable organisational innovations have been in the second camp, involving large bancassurance-owned managers in France, Germany, Netherlands and Switzerland. They are creating new centres of expertise in upstream activities like ALM, asset allocation and manager selection. Via proprietary multi-manager platforms, they are also gaining access to an expanding array of asset classes in stand alone or packaged forms. They aim to compete head-to-head with consultants on the one hand and pure play managers on the other. The key differentiators here are brand leverage and strategic alliances. “For years, asset management has been supply-led: clients bought what we offered. Lately, the balance has been changing, as clients have wised up to the fact that markets can no longer generate the double digit returns that prevailed in the 1990s. This recognition is having a profound impact on the future of DB and DC plans. On the DB side, the pace of closures will accelerate. Across Europe, it is possible that within ten years, DB plans may be the sole preserve of the public sector, as in Australia. On the DC side, equally, the nascent revolution may fizzle out, if returns fall short of expectations. Without decent returns, long term retirement planning is impossible. This recognition is at the core of our approach. Our European DB plan clients fall into three categories: those who are overweight in long only funds delivering out-performance, those who are overweight in multi-asset class products that offer diversification with low correlation, and those who are overweight in indexed funds. As a broad generalisation, most private sector plans fall in the first category, very large private and public sector plans fall in the second, and small and medium sized plans in the public sector fall in the third category. For each of them, alpha is in the eye of the beholder. They want ‘solutions alpha’ in preference to ‘product alpha’. The first is about meeting clients’ expressed needs, the

second about hitting arbitrary benchmarks. We offer the former within a narrow volatility margin at realistic fees. We do a lot of research on clients; identifying their overall strategies, their needs, their risk tolerances and package our products accordingly. We have a deep research capability which constantly unearths new ideas. We also have regular forums where we table our ideas to our clients and get their feedback. Before converting ideas into products, we seed them with our own capital to develop a track record. Our time-to-market process is slow but thorough. It is based on the slogan that “performance is the product.” We have not diversified into alternatives, nor do we use hedging tools to any notable extent. Our growth relies on product-deepening, not product-widening. That means constantly refining and enhancing our existing capabilities rather than creating new ones. We’ve become a touchstone of excellence in our core areas of equities and fixed income. Despite the current market turbulence, our net inflows are positive, as they have been since 2002, thanks to our consistent returns. Our success shows that investment is not about luck; it’s about getting the basics right in a culture of quality assurance that puts clients at the heart of everything we do.”

~ A US Asset manager with a strong European presence

INTERVIEW QUOTES:

“Derivatives are not weapons of mass financial destruction. If properly used, they can improve returns and liquidity.”

“We have an innovation council that solicits new ideas, assesses them and implements the chosen ones.”

“Average pension fund returns in the current decade have been well below 4%. Why should they trust us?”


38

Asset managers need to do two things: stop selling what they have and start selling what clients need. This is the overriding message from the survey. On the investment side, that means getting closer to clients, developing a deeper understanding of their dreams and nightmares, designing products that are fit for purpose, road-testing them before their sale, and avoiding false claims and undue hype. Their outcomes have to deliver sustainable, low volatility returns via transparent strategies and replicable processes within a culture of quality and simplicity. On the business model side, that means having partnerships with clients underpinned by a strong alignment of interest. It is less material whether the model concentrates on core competencies or multiple competencies, so long as it is guided by client interest as much as corporate imperatives. Of course, this is easier said than done, according to our interviews. Asset managers on their part also require strong, credible, external drivers to deliver sustainable internal change. These have been diluted by the weaknesses that continue to prevail in two other areas of the investment value chain. The first area concerns pension funds. Across Europe, the quality of their governance structures leaves much to be desired, especially in Ireland, Switzerland and in the UK. Trustees and their full time professional staff lack the skills that are essential for making sound judgement calls as risks have become more dynamic. Too much emphasis is put on past performance and too little on mean reversion. Those in the public sector have too many vested interests represented on the board to the extent that decision making is often slow and overly influenced by the lowest common factor. Herd instinct remains strong.

The second area concerns pension consultants. While their role as the guardians of client interests remains sacrosanct, they are perceived as lacking the big picture understanding of client needs; their modelling tools are overly backward looking, their expertise in new asset classes is limited and their relationship

INTERVIEW QUOTES:

“Whether asset managers’ product base is wide or narrow is immaterial, so long as they deliver their promise.”

“We have a base fee plus profit sharing once the hurdle rate of return is achieved.”

“Trustees can no longer run their portfolio with 4 meetings a year even if they have an investment committee which also meets four times a year.”

Understanding, anticipating and delivering client needs is becoming critical to survival of the pension industry

What specific changes by asset managers will help the pension fund industry most?

% of respondents0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75


INVESTMENT RELATED CHANGES:Better understanding of clients’ goals and challenges

Avoidance of unrealistic claims about returnsSustainable returns within transparent strategiesNo hype and jargon around investment activities

Focus on quality and simplicityIncreased trust and transparency around investment activities

Focus on low volatility excess returnsReady access to asset classes that clients want

Providing strategic asset allocation services ‘Stress testing’ new products before selling them

Developing sub-advisory mandates

BUSINESS-MODEL RELATED CHANGES:Becoming clients' strategic partners

Focus on core capabilitiesProliferation of boutiques with acknowledged specialisations

A one-stop-shop offering a wide range of solutionsOffering performance-based incentives to investment professionals

More products with performance–based feesGrowth of fiduciary managers, (e.g. the Dutch model)

Developing proprietary multi-manager platformsIncreased regulation

Further industry consolidationPensions consultants venturing into multi-manager platforms


39

with asset managers is at arms-length and least conducive to the generation of new ideas and the implementation of new approaches. Admittedly, progress has been evident in both areas recently. More and more pension funds in every major centre in Europe are recruiting full time chief investment officers and also beefing up their boards with independent experts capable of providing much needed expertise and overview. On the consultants’ side, too, new specialisms are being developed in high value added activities such as asset allocation, investment advice, manager selection and strategy implementation. But the pace needs to accelerate in order to avoid a vicious circle, in which everyone blames everyone else.

“The concept of strategic partnership is not new to us. It is based on the ethos that our clients’ business is our business. We have partnerships with DB clients in Scandinavia and UK that date back to the last decade. Our approach uses the metaphor of a three-legged stool. The seat of the stool sets out the short, medium and long term goals that clients are pursuing alongside the investment strategies which are being used to deliver them. Thereafter, the first leg of the stool focuses on investment transparency. Our investments are based on a disciplined process well-honed over the past 20 years. The process is backed by an elaborate MIS which delivers simple, accurate and timely information. It also involves regular reviews with our partners, highlights deviations from the benchmarks, offers explanations, and agrees corrective actions. As a part of investment transparency, we seek best execution and offer full disclosure of its costs. The second leg rests on client interests. We have a special internal partner interest panel whose main task is to provide a regular oversight of all partner-related activities to ensure that they put partners’ interests first. It ensures that sales and investment professionals understand partners’ expressed needs and risk tolerances and are providing appropriate solutions. The panel also organises regular forums where senior executives from both

sides meet to review investments and monitor outcomes. We get so close to the partners that we are able to understand, articulate and deliver their needs. The panel is also used as a sounding board for new investment ideas and co-investments. The third leg rests on the nuts & bolts of day-to-day business governance. The main pre-occupation here is to avoid conflicts of interest, artificial distortion of prices, and artificial distortion of trading volumes. In addition, cost comparisons are frequently undertaken to benchmark against industry standards. There is also full disclosure of staff compensation. With most of our partners, we have a low base fee and share of profits once the hurdle rate of return is achieved. For some of our new products, we also do joint seeding. All along, we seek to generate new insights that open up new opportunities for our partners. This approach enables us to have fewer clients but deeper relationships. It has served us well. As a spin off, partnerships have been a source of symbiotic branding, as big names have been involved in them. Much of this is common sense and can be copied by pension consultants, after modifications.

~ A Dutch fund manager

INTERVIEW QUOTES:

“As asset managers, we have a moral obligation to have periodic no-holds-barred conversations with trustees.”

“We do annual DNA checks on clients and their consultants to assess what’s going on in their minds.”

“We are a sovereign pension fund with strong internal expertise and external partnerships with peers in Europe and America.”


40

Appendix: Characteristics of the pension fund sample

64%

36%

What sector does your pension plan cover?

What is the natureof your plan?

What is the current statusof your DB plan?

56%

44%

PrivatPublic % of respondents

% of respondents Open Closed % of respondents

48%

24%

28%

Pure DB Pure DC Mixed

Private Public

What is your current funding level? What annual returns on your total investments will meet your long-term funding levels?

05

101520253035404550

3-5% 5-7% 7-9% 9-11%

05

10152025303540

Below

70%

70‐80%

81‐90%

91‐100%

101 ‐110%

111 ‐120%

121 ‐130%

131 ‐140%

Over 140%

% of respondents % of respondents

If you offer a DC plan, in which year did it start?

1970s 1980s 1990s 2000s0

5

10

15

20

25

30

35

40

45

50 % of respondents

Fund managers are using a variety of avenues to globalise their business

41

The following reports and numerous articles and papers on the emerging trends in global investments are available free at www.create-research.co.uk

♦ Global fund distribution: Bridging new frontiers (2008) ♦ Globalisation of Funds: Challenges and Opportunities (2007) ♦ Convergence and divergence between alternatives and long only funds (2007) ♦ Towards enhanced business governance (2006) ♦ Tomorrow’s products for tomorrow’s clients (2006) ♦ Comply and prosper: A risk-based approach to regulation (2006) ♦ Hedge funds: a catalyst reshaping global investment (2005) ♦ Raising the performance bar (2004) ♦ Revolutionary shifts, evolutionary responses (2003) ♦ Harnessing creativity to improve the bottom line (2001) ♦ Tomorrow’s organisation: new mindsets, new skills (2001) ♦ Fund management: new skills for a new age (2000) ♦ Good practices in knowledge creation and exchange (1999) ♦ Competing through skills (1999) ♦ Leading People (1996) Contact details: Prof. Amin Rajan

[email protected] Telephone: +44 (0) 1892 52 67 57

Mobile/Cell: +44 (0) 7703 44 47 70

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