DEVELOPMENTS IN PENSION FUND RISK MANAGEMENT IN SELECTED OECD AND ASIAN COUNTRIES

OECD Secretariat

I. Introduction

1. This note addresses issues relating to risk management of occupational pension funds in selected OECD and Asian countries. It was provided as background to the discussions on investment that took place during the third OECD/INPRS Conference on Private Pensions in Asia and the 2004 Asian-Pacific Regional INPRS Meeting Co-organised with the ADB to be held in Manila 30th March – 1st April 2004.

2. Risk management within pension funds was not widely discussed issue until the recent years. During the ‘golden decades’ of the 1980’s and 1990’s, when equities were delivering high returns, corporate pension funds continued to build up healthy surpluses and individuals (certainly in the developed world) did not to have to worry about retirement income. However, since the turn of the millennium, a ‘perfect storm’ has been brewing in the investment industry. Demographic concerns are becoming ever more pressing with governments attempting to spread responsibility for retirement saving more widely. At the same time as liabilities are rising, asset markets have also been proving less benign, with the ‘cult of equities’ being sorely challenged by recent market corrections, leaving many investors questioning whether these assets will be able to deliver adequate future returns. At the same time the low interest rate environment is ensuring that attractive alternative investments are not widely available in the fixed income markets. New attitudes to investment and risk arising from this challenging environment will be addressed in this document.

3. The paper opens with a brief overview of types of risk and types of pension plan, considering who bears risk in the different types of scheme. It then goes on to look at risk management at various stages of the investment process. Strategic asset allocation is first considered, whereby the broad investment policy of the fund is set, looking at how to match assets and liabilities in defined benefit schemes, and how to optimise returns most successfully in all funds, including defined contribution pension plans. Tactical asset allocation is then discussed, looking at the best way to achieve targeted returns, (passively, actively via derivatives), and ways to successfully diversify assets. Finally governance issues are examined, looking at ways to ensure that the investment process is both adequate and implemented properly, and limitations on current governance practices (in particular the prudent person rule and trustees) are considered. The paper finishes with a country survey, looking at risk management practices in selected OECD and Asian countries.

-- Delegates are invited to comment on the regulation of investment and asset-liability management in their countries and in particular to answer the following questions:

i. Does the regulatory framework address asset-liability matching? How is this matching defined?

ii. To what extent is the use of ALM models required by regulation? Are these models assessed by the supervisory authority?

iii. Is investment in alternative investments such as private equity, real estate and hedge funds permitted by the regulation? Does the supervisor pay specific attention to these less liquid investments?

II Pension Fund Risk and Responsibility

4. Pension funds collect, pool and invest funds contributed by beneficiaries and sponsors to provide for the future pensions of beneficiaries. They are a means for individuals to accumulate savings over their working lives to finance their needs in retirement. Consequently, the ultimate risk for pension plans is that asset returns will not be sufficient to meet promised benefits and required household needs. The most basic decision to be made by a pension fund is regarding how to allocate funds amongst various asset categories and available financial instruments to assure sufficient investment returns over time and that unnecessary

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volatility does not reduce asset values when liquidity needs arise. Risk management addresses these concerns.

5. Both the asset and liability side of the pension fund balance sheet can contribute to risk. Where liabilities are fixed, risks derive from ‘biometric’ factors (due to actuarial assumptions, notably on longevity) and financial issues (the greatest sensitivity being to the discount factor used in present value calculations). On the asset side, risks can involve both asset-liability mismatching (where assets are not adequately structured to meet benefits when they become due) and return related risks (where insufficient income is generated to cover liabilities). On top of these inherent risk factors, systemic risk can arise from a lack of governance for ensuring that a suitable investment process is in place and applied correctly. Different types of funds face different types of risk, and consequently have varying risk management control systems in place.

Pension Fund Models

6. Pension funds operate under fiduciary mandates, but the nature of these mandates may not be the same across different types of plans that they support1. Pension schemes consequently fall into several categories, distinguished by their different types of liabilities and who bears responsibility for meeting shortfalls in these liabilities. The three main structures are:

i. conventional defined benefit (DB) schemes: a pension scheme where the plan sponsor bears the investment, financial, longevity and other risks. This responsibility arises from the plan sponsor agreeing to provide plan members with a continuing flow of benefits upon retirement. There are several different types of structure within DB schemes, depending on how benefits are established. In ‘final salary’ schemes the pension benefit is based on the last salary achieved before retirement, whilst with a ‘final average earnings’ approach it is typically the earnings of the last few years prior to retirement that are used. The ‘flat rate’ system bases pension benefits on length of membership in the scheme and these benefits are not affected by earnings. In each case a contractual obligation is created on the part of the sponsor to make specific payments. Under these arrangements the sponsor assumes all the investment risk of generating sufficient income from plan assets to ensure that contractual funding obligations are met. Some risk may be shared with beneficiaries if employee contributions or benefits/accrual formulas can be altered. Only a small number of OECD countries (Canada, Japan, the UK, and USA) still make widespread use of defined benefit pension plans.

ii. hybrid DB: funds which combine elements of defined benefit schemes with a return guarantee, by which beneficiaries get the either the higher of a DB or a DC benefit. Pension plans such as these have been introduced in the US and UK markets in the form of ‘cash balance’ schemes, by which the pension benefit takes the form of a specified percentage of salary at retirement received by the beneficiary as a lump sum. The sponsoring company therefore bears the risk of the scheme during the employee’s working career, whilst the risk passes to the individual on retirement (or to an insurance company if they choose to purchase an annuity). The new occupational plans in Belgium are also structured in this way.

iii. defined contribution (DC) schemes: require the plan member to bear investment, financial and longevity risks, with the sponsor of the plan merely agreeing to invest the plan’s assets on behalf of the beneficiaries (in order to produce a stream of retirement income), thus having no specific obligation to generate a given investment result. Such schemes may be mandatory or voluntary. Beneficiaries may have a choice over how the funds are invested (such as in the 401k pension

1 From ‘Governance of and by Institutional Investors’.

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system in the US), or may not (as is the case with Spain’s ‘single portfolio model’ which ignores the greatly different risk tolerance of members, arising from their differing ages etc.). Though individuals bear the risk in the case of defined contribution schemes, it should be noted that they do have the ability to further manage this risk themselves, (for example ensuring retirement needs are met by taking out insurance products such as annuities).

iv. DC with guarantees: these are hybrid, sometimes called insurance style schemes, run in countries such as Denmark, Iceland, and to some extent in the Netherlands. Though defined contribution plans, (the employer’s liability is limited to making set contributions), they aim to provide benefits akin to those of defined benefit arrangements and contain an element of guaranteed return and sometimes also a guaranteed annuity rate. The employer’s obligation is limited to making contributions as stipulated in the arrangement, and the plan sponsor is not responsible for correcting imbalances between assets and liabilities. Households bear defined contribution style risk collectively in the form of changing parameters and even downward adjustments in benefits in order to keep liabilities in line with available assets. The type of guarantees offered by the funds varies, sometimes coming in the form of a guaranteed return handed over to the plan member in the form of a lump sum, whilst other schemes (such as those in Iceland) guarantee an annuity, which involves more risk for the pension fund. These funds are usually regulated as insurance undertakings.

Responsible Parties

Corporate Plan Sponsors

7. Corporate plan sponsors are the ones holding the ultimate responsibility for defined benefit pension plans, having to make up shortfalls from corporate cash flow if the fund is in deficit. Defined benefit schemes are subject to a wide range of risks including real labour earnings, interest rates, mortality risks, falling asset returns, changes in government regulation (such as indexation, portability, vesting and preservation), and the structure of the fund may determine which of these the plan sponsor is exposed to. For example, employers bear most risk with final salary schemes, followed by average salary and then flat rate arrangements, where the beneficiaries’ risk is highest (as they remain exposed to inflation). The nature of defined benefit schemes is changing, with structures tending to move towards a low base of benefits with a risk sharing approach.

8. The nature of defined benefit pension fund risk in relation to corporate plan sponsors, and how they perceive this risk, is also changing. This is partly due to the fact that, after a golden period of high investment returns, pension surpluses and contribution holidays, corporate sponsors are now facing, sometimes very large, deficits in their pension schemes2. These benefits have come about due to a ‘perfect storm’ within the investment climate. Liabilities are increasing (due to aging populations and early retirements) at the same time as contributions have been lowered (due to mergers, corporate downsizing). Meanwhile investment returns have also declined (due to the low inflation and interest rate environment, a decline of the equity risk premium and higher correlations between markets). After enjoying years of low pension contributions, corporate plan sponsors are now becoming aware of the risks and responsibilities posed by their DB pension schemes. Indeed they have realized that this risk is potentially ‘asymmetrical’, as plan beneficiaries argue that any surplus within the pension fund, like other assets, belongs to them, whilst corporate sponsors are required to cover any deficit. Is it any wonder they are shifting to DC plans and transferring the risk to individuals?

2 For example, according to the US Pension Benefit Guarantee Corporation (www.pbgc.gov) the total deficit of US

S&P 500 defined benefit schemes at around $350m.

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9. These problems faced by plan sponsors are being compounded by changes in accounting rules. These require corporations to publish details of these deficits at market value in their annual accounts, compared with the previous system where losses could be smoothed through the use of long-term, average valuations. These changes apply in the UK through the new FRS 17, which is mirrored by International Accounting Standard 19 (compulsory in EU countries by 2005-2007), with similar changes in US accounting regulations expected to follow in the coming years. Though such rules do introduce welcome transparency to pension accounting, there is great concern that where the pension fund represents a large percentage of the company’s market capitalisation, the firm’s share price will be driven by the inevitably increased volatility in the pension funds valuation, and ultimately could even force the bankruptcy of the company. Rating agencies have already warned that estimated deficits in company pension schemes are similar to debt, which has led to the downgrading of some firms. This new accounting is already having an impact on the risk appetite of plan sponsors, and on the investment decisions within their pension plans, with lower risk assets increasing as a percentage of the pension portfolio in order to reduce valuation volatility.

Beneficiaries

10. Given the demographic changes faced by many regions in the world, most countries have seen their pension systems move from a defined benefit to a defined contribution model, shifting responsibility from corporations to individuals, with few new defined benefit schemes now being set up. However, it also seems that risk is being subtly shifted towards beneficiaries even within defined benefit schemes as plan sponsors seek to escape from the asymmetrical risk that they face. Though corporations cannot remove assets or surpluses from pension plans, they have been able to take contribution holidays during the bull market years of the 1990’s, which arguably allowed them to acquire the benefits of market upside rather than the plan members (through improved benefits). Likewise, when facing deficits, some corporations have cut benefit levels rather than increase contributions (which effectively shifts risk toward active scheme members as benefits remain fixed for retired beneficiaries), and in extreme cases firms have walked away from their liabilities all together (though this loop hole has now been closed in UK law at least). In such cases can it really be argued that the corporate sponsor bears the investment risk?

11. The issue of who ‘owns’ or benefits from pension plan surpluses is an important one as it affects the risk appetite of those in charge of the investment process – i.e. the pension fund trustees3. If the beneficiaries represented by the trustees take none of the investment downside (with deficits covered by corporate plan sponsors), yet gain any upside where there are excess investment returns, then surely they will be incentivized take on as much risk as possible. If, however, they do not get any benefit from surpluses and risk the ultimate bankruptcy of the sponsoring firm if excess deficits arise, they will become highly risk adverse. The latter situation is becoming more predominant in many markets, adding to the already cautious investment climate.

12. On a more positive note for beneficiaries, compared with the shifting of risk towards beneficiaries within DB plans, there is some evidence of increased willingness for corporate sponsors at DC funds to share more of the investment risk. This can be seen in the trend towards the use of ‘hybrid’ style, DC with guarantee schemes. There is some evidence of such moves within the UK industry at least, (for example through so called ‘CARE’ funds, where a lump sum is handed over to the plan member on retirement, the plan sponsor taking on investment risk during the member’s active membership, but they resume inflation and longevity risk on retirement). Given more uncertain times, the trend going forward maybe to move away from the extremes of risk bearing represented by the pure DB and DC models.

3‘Strategy Ideas: How should DB pension funds allocate assets?’ HSBC Strategy Ideas, author Jason James, Global

Strategist

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Government

13. In some countries the party who bears ultimate responsibility for pension fund liabilities is the government. When a company enters bankruptcy in the US, for example, the Pension Benefit Guarantee Corporation honours the liabilities of the firm’s pension fund, up to certain levels. The current pension’s shortfall crisis is, however, also affecting this insurance body, which has fallen into deficit4. A similar scheme is due to be introduced into the UK under the new Pensions Act, with an insurance body being set up to take over the pension funds of bankrupt firms. Though generally supported, controversy over the system focuses mainly on how it is to be funded with the debate ranging between flat rate fees and risk adjusted payments according to the financial worth of member firms. Though avoiding ‘moral hazard’, the latter type of payment has proven politically difficult to impose in other countries, and the UK is proving no exception. There are also concerns that the current unstable funding position at many companies could threaten the early life of this scheme (if a series of large bankruptcies were to occur before full funding levels had been achieved).

III. Risk Management Techniques

Strategic Asset Allocation

14. Strategic asset allocation is used to tackle the ultimate risk facing pension funds – i.e. that requirements in retirement cannot be met. For defined contribution funds this is a relatively straightforward process, involving the identification of ‘optimum’ portfolio constructions that generate the highest possible returns within set risk profiles. However, the process is more complex for defined benefit schemes (and for defined contribution plans with guarantees), which have to generate not only a set rate of return, but which must also ensure that these returns are available when liabilities become due (setting up contradictory objectives, requiring both adequate returns and low volatility).

ALM Models

15. Asset-liability modelling is a financial risk assessment and asset planning tool, widely used by pension funds to help set long-term asset allocation strategies appropriate to the risk tolerance and liabilities of pension funds. Such mathematical models were developed by actuaries over the past 10 years or so and estimate the degree of investment and other risks faced by institutional investors. Pension fund trustees, certainly in more developed markets, now commission outside actuaries or consultants to estimate pension liabilities using such models on a fairly regular basis, (for example, every three years is currently standard practice in the UK).

16. With time the models have become more sophisticated, moving from the ‘static’ type to ‘dynamic’ models (covering multiple time periods), involving stochastic simulations of assets and liabilities (which run multiple ‘Monte Carlo’ simulations). Though dynamic models have proven a better fit for real world scenarios encountered by pension funds they do have their drawbacks, partly due to 4 ERISA Act of 1974 created the Pension Benefit Guaranty Corporation (PBGC) to protect pensions of participants in

private DB pension plans. Guarantees are provided up to a certain limit (c$44,000 in 2003, the guarantee limit being revised each year) for the beneficiaries of insolvent companies with under-funded plans. Around 32,000 companies were insured in 2003 (down from 110,000 in 1985 – the fall coming from the shift to DC, particularly 401k vehicles). All single-employer pension plans pay a basic flat-rate premium of $19 per participant per year, with under-funded plans paying an additional variable rate charge of $9 per $1000 of under-funded vested benefits. Premium payments are segregated into Revolving Funds, invested in fixed-income securities. Assets received from terminated funds are placed in Trust Funds, which may be invested in equities. The PBGC uses external fund managers to invest these funds, with their oversight. September 2002 liabilities were $29bn whilst assets reached only $25.4bn.

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becoming more complex making them harder for trustees to understand and interpret. Arguably investment oversight and trustee training have not been able to keep pace with improvements in the sophistication of mathematical modelling techniques.

17. Broader criticism these models centre on the fact that they are based on historical data and correlations and consequently are not necessarily reliable guides to the future. For example the UK Myner’s Review5 of the investment industry in 2001 claimed that:

“Asset-liability modelling is a complex number-driven process, in which it is difficult to incorporate asset classes without reasonably long historic time series data. The outcome of such a process is unlikely to be investment in new or poorly researched asset classes, such as private equity. Yet according to investment theory, it is precisely among poorly researched asset classes that greater opportunities for enhanced return are likely to exist… More importantly, the outcome of the asset-liability modelling process depends crucially on a number of prior decisions and qualitative judgments, such as assumptions about rates of return, and other economic indicators, an the division of assets into classes (an imprecise art, with elements of arbitrariness).”

18. Furthermore, it has also been argued that these models have been misused within the pension fund process, with the focus being on generating efficient portfolios (as required by DC funds), rather than strictly for asset-liability matching (which is the real requirement of DB funds and the DC with guarantees)6. This is said to have led to a bias towards high-risk, high-return assets within pension portfolios (as discussed in the bond/equity debate below). Taking these criticisms on board, it would seem that the next development within the pension industry, (in developing countries at least), will be an improvement in the application of models, as opposed to great technical developments within the models themselves.

Bond/Equity Debate

19. For defined benefit pension funds, a key part of ALM, and consequently the strategic asset allocation process, involves finding assets that suitably match the liabilities which it has been estimated that these funds face. This is currently an extremely hot investment topic in many countries, and focuses on the bond/equity debate. For many decades investors have been followers of the ‘cult of equity’, accepting the argument that, over the long-term, (the natural investment horizon for pension funds), equities deliver higher returns than bonds for limited extra risk, (equity volatility significantly declines if measured over a long enough period). Such an investment philosophy reached its zenith during the bull market of the 1990’s with funds in some Anglo-Saxon countries reaching around an 80% weighting in equities. Other countries followed the same trend, though never reached such dizzy heights (e.g. Dutch pension funds maintain around a 60% equity weighting, with Japanese pension schemes only 20-30% due to the troubles of their own equity market and the availability of a liquid government bond market).

20. Following the crash of global stock markets and the under-funding position that many corporate plan sponsors now find themselves in, this fundamental investment rule is being challenged. Much of the debate centres upon the ‘equity risk premium’ and whether equities really do deliver higher returns over the long-term; whether they will continue to do so; and whether the risk required to obtain these returns is

5 Complete review available at http://www.hm-treasury.gov.uk/media//843F0/31.pdf 6 See ‘Asset and Liability Modeling for Pension Funds’: paper by Jon Exley, Shyam Mehta, Andrew Smith, presented

to the Joint Institute and Faculty of Actuaries Investment Conference June 2000

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really justifiable for pension funds?7 Given the deficits faced by many firms, attention is also being refocused on the asset-liability matching question rather than the risk-return pay-off of assets. Defined benefit pension funds can be seen as simply a series of annuities for those who have retired and deferred annuities for those still working. It is therefore argued that these ‘bond-like’ payout structures make bonds rather than equities the best match for their liabilities. Such opinions have only been strengthened by recent accounting changes that make pension liabilities more transparent, allow them to directly impact the plan sponsor’s balance sheet, and which also increase the asset-liability mismatch from holding equities (given they use a corporate bond derived discount rate in valuing liabilities). The ‘pro-bond’ argument is further supported by the tax efficient nature of fixed income investing.

21. Equity holdings have certainly been declining at many major pension funds. The most headline-grabbing case being the UK pharmaceutical retail company Boots, which switched its entire 2.3bn sterling fund into bonds over an 18 month period during 2000 and 2001, despite this not being a particularly mature scheme (with around a 50% of the 72,000 members still active). John Ralfe8, fund trustee and head of corporate finance, has explained this decision as a risk reduction and cost saving exercise, allowing the company to lock in the healthy surplus built up during the bull market years, and reducing investment fees by 97.5% (to 250,000 sterling). Valuable management time was also freed up for operational matters. Though a supporter of the UK accounting changes affecting the disclosure of pension fund liabilities, Mr. Ralfe has claimed that these were not the main drivers behind the asset allocation move, despite the fact that the pension fund does represent a fairly large percentage of the firm’s market capitalisation (c40%). As a corporate financier, he was, however, conscious of the tax advantages of the switch, allowing both the corporate plan sponsor and pension plan members to benefit from the process of ‘balance sheet tax arbitrage’ (where the company issued debt and bought back company shares whilst moving the pension fund’s exposure in the opposite direction from equities to bonds). His views were heavily influenced by a controversial paper published by the Institute of Actuaries in 19979 which argued that there is no separation between the pension fund and the corporate sponsor and that the value of a defined benefit plan to employees is equal to the cost born by shareholders. They believe that equities cannot reduce the costs of a pension plan without adding risk simply because of the long-term and that pension fund investing should be about matching assets and liabilities and not about pursuing excess returns. The fund now holds exclusively AAA rated paper from a small number of quasi-sovereign sources (such as the World Bank), with maturity of 15 years upwards, 50% of which are index linked, (this level was increased from an initial 25% exposure during 2002).

22. Though the asset allocation move by Boots proved wildly successful (locking in a 250m sterling profit which it is estimated would have deteriorated into a 50m deficit if the prior equity weighting has been maintained in the subsequently years), both academic and practical concerns remain over this radical, 100% bond policy. To being with, no bonds are risk free, even AAA related paper, with significant 7 The argument centers on the equity premium paradox, according to which equity returns have historically exceeded

estimates of the compensation investors require for taking on extra equity risk. This has been explained by an undervaluing of corporate assets, a benign period for equity investment and an over cautious approach by investors. A these factors have corrected, equity valuations have risen, so that the high returns of the previous decades are large are said to be due to a one off, multiple expansion which is unlikely to be repeated in future. Elroy Dimson, Professor of financial economics at LBS, further argues that the past return on equities has been flattered by good luck, biased index construction and too short a time horizon used in estimations as well as re-rating. Going forward it is estimated that the ERP will be 2.5-4%, much lower than 7-8% post war. Global surveys also come up with a lower number than the usual UK/US focus. For more on the ERP see ‘Note on Issues for the regulation of the Investment of Pension Fund Assets’.

8 See www.johnralfe.com 9 ‘The Financial Theory of Pension Fund Schemes’: John Exley, Shyam Mehta, Andrew Smith, also available on

www.johnralfe.com

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reinvestment risk remaining (though the average duration of the portfolio is 25 years this is still below the average pension fund 40 year life span). With the liabilities of even the most mature pension funds being to some extent uncertain (notably longevity risk), these cannot be 100% matched and all risk cannot be removed. Even given the high quality of the issuers the fund has invested in, some regulators have expressed concern that such an asset allocation breaks the duty of diversification laid down by the ‘prudent person’ rule (see later discussion). There is also the aspect of inflation risk to consider as with any bond investment, given the real nature of pension fund liabilities (which are affected by increases in wages). Thought the Institute of Actuaries’ paper argued that there is no academic evidence that equities are a greater wage-inflation hedge than bonds (citing the ‘stagflation’ period of the 1970’s as proof), others still argue that over the long-term a mixed equity portfolio is the best match for pension funds facing wage-related liabilities10. Jeremy Bell, partner of the consultant actuarial firm Lane, Clarke and Peacock which openly criticised Mr. Ralfe’s decision, summarized these doubts as follows11:

“There is increasing pressure on finance directors to control the very real risks posed by defined benefit pension arrangements. This is being exacerbated by the imminent arrival of the new accounting standard FRS 17 as it will lead to more volatility in reported company results arising from pension provisions. However, we are not convinced that a decision to withdraw entirely from equity investments is in the best interest of either employees or shareholders. A 100% AAA bond strategy may appear sensible in terms of mitigating investment risk, but the company and its workforce may be assuming other risks as a result. Ultimately they may miss out on the superior long-term results that almost always accrue to long-term equity investors.”

23. Other aspects of concern regarding the Boots decision are of a more practical nature. To begin with, whatever the theoretical argument that beneficiaries and shareholders are symbiotically linked, many companies will not be willing to bear the higher contributions and costs which are a consequence of investing in lower return assets (the Boots fund now requiring a hefty 50m sterling annual contribution). The benefit may be found in other ways, such as in the higher credit rating that Boots now enjoys, but shareholders may not accept the more obvious impact on cash flow. A further practical constraint on other funds making such a dramatic allocation shift is that many are no longer in the luxurious position of having surpluses to secure but would be locking in deficits, a position which trustees and shareholders alike would undoubtedly regard with far less enthusiasm.

24. Even if it could be agreed that bonds are the best asset class for matching pension fund liabilities, another major hurdle to this ‘immunization’ process is found in the lack of sufficient indexed, liquid, government paper to meet demand that would be generated. In the US, aside from a liquid Treasury bond

10 Mirko Cardinale puts forward this argument in a technical paper for the consulting firm Watson Wyatt: ‘Co

integration and the Relationship between Pension Liabilities and Asset Prices’. Summarized on the Independent Pensions Europe website: www.ipe.com

“The main finding is that, while shorter-run correlation evidence is less consistent, there is indeed a long-run link between the evolution of salary-linked liabilities and asset prices.” The study also finds that this link is consistent with economic theory, and that “no asset has historically been a perfect hedge for salary-linked liabilities.” The best historic hedge –“was a composite portfolio which included besides conventional and index-linked bonds, also domestic and foreign equities and property.”

Such views are supported by Alistair Ross-Goobey, a highly respected industry figure and former chief executive of Hermes Pensions Management, speaking at the 2001 Pensions Institute Conference:

“It is difficult to argue against the idea that, since most of the liabilities of a pension fund are real, most of the assets should be real too.”

11 Comments available on www.johnralfe.com

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market, there is a great deal of ‘agency paper’ with a high degree of government support, and deep markets for mortgage related securities exist. Some governments do remain committed to maintaining liquid bond markets whatever their funding requirements (notably Singapore and Hong Kong). However, most countries in continental Europe, for example, have a little high quality non-government paper, whilst fixed-income markets are extremely thin in Asia (with the exception of Japan’s JGB market). Any move towards restructured government debt to provide non-volatile instruments for increasingly self-managed retirement savings probably requires more deliberate public policy attention and debate than has occurred to date. Mr. Ralfe has argued that this market is deeper than many investors think, sitting, for example, the 100m sterling issuance of the World Bank, which Boots subscribed to exclusively. Yet it is not feasible to suppose that such paper could be found for the pension fund market as a whole12.

25. Academics and consultants have argued that investors could use derivatives as a synthetic way to overcome this lack of government paper. It is argued that it is possible for private financial sector intermediaries, through portfolio diversification and hedging, to provide the equivalent of indexed government bonds to satisfy potential demand. For example, if there is an insufficient supply of sterling denominated long term assets to satisfy demand from UK institutions, similar assets can be purchased overseas and the currency risk removed with derivatives. Similarly investment banks can create derivative securities with reduced credit risk through securitization and credit derivatives. The swap market is seen as another source of a ‘derived benchmark’ yield curve. This may be possible in theory, but many pension fund trustees and investment managers still lack the knowledge and sophistication to make use of such investment tools, as discussed below.

26. Weightings have undoubtedly become skewed over the past 20 ‘golden years’ towards equities, and strategic asset allocation has become focused on return optimization rather than asset-liability matching. Such allocations do need a correction in favor of bonds, but to move 100% in this direction with not be risk-free and would be impractical. The real driver behind the Boots decision, apart from the extremely forward looking and astute one of locking in its surplus around the peak of the equity markets, seems to be a belief that excess returns are impossible to capture. The fund has not simply been shifted into bonds but is barely being actively managed at all. Many other investors, however, believe that investment skill can unlock excess returns in markets. Consequently for these investors a broad allocation approach, more mindful of liabilities than previously and with a broader diversification of risks and returns, seems to be the best-practice approach which the industry is moving towards, and which has strong theoretical support13:

“We favor holding stocks for the very long run. They are not a guaranteed superior performer over the investment horizon of most investors. They should be held as part of a diversified portfolio… Investors who fail to diversify efficiently and /or who overpay for asset management services can expect to erode their reward for equity risk exposure.”

Alpha Returns

27. Aside from the ALM process affecting defined benefit funds, the strategic allocation process for defined contribution schemes has also come under heavy criticism and is likely to undergo a shift in direction in coming years. These funds will also be affected by the death of the ‘cult of equities’ and will require a dramatic overhaul in their investment process and risk management to cope with what is likely to be a far less friendly investment climate in future - a climate which poses challenges for all types of pension funds. Corporations facing deficits will no longer be able to rely on the external environment to ‘bail them out’ of their current under-funded position, and will have to make dramatic internal changes as a 12 For example, according to the Myner’s Review, UK pension assets amount to 800bn sterling. 13 ‘The Triumph of Optimism’: Dimson, Marsh, Staunton (2002)

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consequence (events of this scale being unseen since the 1970’s). Funds with healthy surpluses (e.g. the US public pension fund CalPERS) and particularly acute deficits (such as that faced by US auto giant General Motors) are likely to lead the way, with others making small, opportunistic, but dramatic adjustments.

28. One major type of change is the move to seek out ‘alpha returns’ more consciously. Investment returns can be broken down into two parts: return attributed to market movements, known as beta, and residual returns, or value added over the market return, known as alpha. Strong equity performance during the 1980’s and 1990’s led to a preference for beta (index) risk over alpha (active) risk within pension plans. The old approach, which evolved over a period of 20 years and which pension consultants and academics based on ‘modern portfolio theory’, involved choosing between asset classes and a buy and hold strategy. The asset allocation decision was viewed as primary, with strategic weights based on long-term return and risk expectations. Alpha and active management were pursued, if at all, within an asset class and managers were judged relative to the asset class benchmarks (sometimes refined for style or capitalisation characteristics customised to managers).

29. This approach will need to be changed in a period of lower expected returns and bond return correlations. With lower beta returns available, investors will have to concentrate on extracting alpha returns. Active alpha investing builds on traditionally portfolio theory, desegregating sources of portfolio risk to identify additional return opportunities. Strategies with a low correlation to the largest current holdings (large-cap equities) and a high correlation to movements in liabilities will increase. These strategies rely heavily on products for managing index and interest rate exposure, and build on the growing availability of liquid index products, such as futures and exchange-traded funds (ETFs), and interest rate trading vehicles. Attention to alpha will require more short selling and short horizon strategies, with bottom-up investing replacing the macro approach. Strategic allocation is regaining in importance over tactical asset allocation, with categorisation by asset class developing into groups of similar strategies (such as delta-tilt, alpha, cross-market and overlay, flexible absolute returns, low liquidity and equity-tilt strategies, including index funds, long-only and long/short hedge funds).

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Figure 1

Potential new pension strategy allocation framework

Equity Tilt

Flex ab rtn

Cross-mktoverlayLow liquidity

Debt-tilt

Alphastrategies

Source Goldman Sachs14

Risk Budgeting

30. Complementing this new strategic allocation is a new approach to risk, know as ‘risk budgeting’. This involves the measurement of a portfolio’s potential risk exposure in each of several areas, followed by the allocation of a certain portion of the fund’s aggregate risk tolerance to each of these areas. The risk budget defines the extent to which the investor is willing to allow exposure to the portfolio to investment risk. As firms learn to juggle new objectives and target investments more accurately, risk will also come to be approached in a more forensic fashion. ‘Risk budgets’ will be drawn up, not simply looking at how much risk is tolerable and which assets are contributing to this risk, but delving deeper to analyse risk in more complex and interlocking formats and to see if it is being ‘spent’ for maximum return. Bob Litterman, Goldman Sach’s asset allocation guru, has described it as follows14:

“The whole idea of risk budgeting is to manage your active risk. It is not about limiting risk, but about generating more return by managing it…Funds need to crank up returns from active risk and the only way to do that is by strategies that have large amounts of active risk per unit of capital.”

Figure 2: Old and New style Risk Attribution

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14 Table taken from Goldman Sachs report: ‘Equity Derivatives Strategy: The new pension paradigm’ January 30th

2004, authors Joanne M. Hill, Meric Koksal

Old-style risk attribution

020406080

100

Equities Bonds Manager Skill% o

f ris

k (v

aria

nce)

New-style risk attribution

-4

-2

0

2

4

6

Equity RiskPremium

Duration Liquidty RiskPremium

Credit Manager Skill

risk

rela

tive

to li

abili

ties

(uni

ts)

Source: Watson Wyatt

31. These new alpha investing and risk budgeting tools are required not only because pension funds are facing a more challenging investment environment, but also because the are being confronted with a broader range of investment objectives, over and above generating maximum returns for minimum risk. Funding requirements, for example, will also have to be taken into consideration, this not an being an issue until the last few years, as the bulk of the portfolios, equities, offered high returns, outperforming bonds. This implies an increased focus on minimizing both the present value and volatility of contributions to fund benefits as well as a heightened awareness of ‘tracking risk’ of pension assets to pension liabilities. More attention will be required on keeping funding ratios above100% and favoring policies that reduce risk of variability of funded status. Pension policy is likely to be co-ordinated with earnings and cash flow cyclically specific to companies themselves. These goals are all aimed at avoiding the negative impact on credit ratings, cost of capital, cash flow and earning volatility, and ultimately the bankruptcy of corporate plan sponsor.

13

Table 1: Comparison of past and future pension priorities

Recent Priorities Futures Investment Priorities

Maximise relative return and asset allocation

Increase focus on total return and funded status

Rebalance to strategic allocation Revisit strategic allocation – impact of lower equity risk premium

Seek return from equity risk premium (beta risk)

Tilt return to source alpha risk because of uncertainty of equity risk premium

Slower growth in international investing

Declining $ reason to reconsider international and global asset allocation

Build process to improve risk management and risk budgeting

Greater attention to addressing risk exposures – further equity market declines, credit, stock/bond correlation

Source Goldman Sachs Quantitative Insights March 2003

32. Pension funds are already moving in this direction. In December 2003 PLANSPONSOR Magazine (in conjunction with Fidelity Research), as reported by Goldman Sachs15, published a survey of 233 defined-benefit plans in the US. As many as 90% of the respondents said they were considering new investment strategies to aid their funding situation. In terms of where asset allocations were headed, sponsors indicated that equity and fixed income holdings would be reduced in favour of non-US equity, real estate and alternative asset classes that reduce plan risk through diversification and low correlations with interest rate moves. Equities are, however, likely to remain the largest single asset class (over 85% of respondents saying that the risk premium benefit of equities justified these holdings). Extending the duration of fixed income holdings is being seriously considered (by around one third of sponsors) to reduce funded status risk. Strategies which favour both the objective of high risk adjusted returns and reducing risk relative to liabilities are amongst those being most interestingly examined – including those with a low correlation to equities and a high alpha quotient. The General Motors’ pension fund, one of the schemes with the worst funding positions in the US, is a particular example of a fund pursuing just such objectives:

“Increased allocation to asset classes where active management had generated significant excess alpha… This indicated:

− Increased commitment to ‘high alpha’ asset classes, such as emerging market equity and debt, domestic high yield, small cap equity, real estate and private equity.

15 Discussion taken from Goldman Sachs Equity Derivatives Strategy: Equity Indexes author Joanne M. Hill and

Meric Koksal January 30th 2004

14

− Higher allocations to ‘absolute return’ strategies that include equity long/short, relative value and event driven strategies.” 16

33. To some critics, the biggest potential drawback to this new framework is that it builds on the belief that positive alpha exists and is exploitable.17 Academics have debated this issue for decades, with no clear conclusions. What is certain is that investment management is entering a new phase, with solutions required to drawn more upon investing skills as markets offer less in the way of embedded returns and liabilities loom with lower interest rates. The positive aspect is that new tools and outlets are increasingly available (from quantitative models, to swaps etc. – all made able through complex technical products). The pension’s CIO job has, however, become more difficult.

Derivatives

34. The application of the new investment and risk strategies discussed above will depend heavily of the increased use of derivatives, another trend, which has been expected to rise within the asset allocation process of pension funds. These are financial instruments, (contracts between two parties), whose value is determined by reference to some other stock, bond, financial instrument or event. Academics and consultants have increasingly vigorously argued the benefits to funds, both in terms of risk reduction and return enhancement, alike18. These instruments can be used to provide insurance, hedging against currency or interest rate risk, to protect portfolios on the downside in case of extreme market moves, or to guarantee

16 Allen Reed, GM Asset Management’s CEO has elaborated further on the pension plan’s investment approach in

interviews. He has indicated that 30-40% of the assets committed to the new investment program are going to ‘broad scope mandates’, where fund managers have discretion to allocate dynamically across a range of investment strategies offered by their organization which have been selected by the GM pension fund. The reminded of new funds will be directed towards diversified, high alpha and absolute return strategies by specialist managers. See GM US Pension Review 12/2003, available on the corporation’s website: www.gm.com

17 John Plender, writing on GM’s pension policy in the ‘Financial Times’ December 19 2003:‘Standards that encourage delusion’:

“GM has now revealed that much of the new money will be invested in so-called alternative assets such as hedge funds, property, junk bonds and emerging market funds in an attempt to meet the demanding 9% return target. These are usually regarded as high-risk assets. Yet GM argues that its strategy does not involve higher risk because of the benefit of increased diversification and reduced volatility…The really big economic change, meantime, is in the increased risk that comes from borrowing to punt in markets, which is ultimately borne by shareholders and other stakeholders in GM, including the taxpayers who stand behind the Pension Benefit Guaranty Corporation, which underpins US employers' pension promises. Yet there is no escaping the fact that, by borrowing to invest in alternative assets, GM is no longer just a punt on the equity market. As John Ralfe, a British pension consultant, argues, it is also now a bet on the ability of its alternative asset managers to achieve superior, sustained performance without volatility.”

18 A study Cardano Risk Management and City University in London (see www.ipe.com) recently showed that options can be used to make defined benefit pension schemes more sustainable, and that properly constructed options can add substantial value to pension-fund management. It argues that the current pension’s crisis has focused more on cutting benefits or increasing contributions, rather than on the efficiency of the investment process and how to increase returns. The report points to ‘overwhelming’ evidence that active management adds only costs not value and that pension funds themselves are to blame for stubbornly sticking to traditional asset classes whilst ignoring newer management products. Vincent De Martel, AXA derivative product specialist from AXA Investment Management, backed this study:

“The function of derivatives is to reshape the risk/return profile of an asset; in other words, they take the returns of an asset and modify them in a way which is suitable for the investor…As such they can be used by pension schemes, in order to adapt returns of equities and bonds to match the liabilities of the scheme.”

15

the upside and enhance income. They are also useful for facilitating efficient transactions within portfolios (e.g. management of cash flows to minimize market impact), to reduce trading costs and to improve liquidity. They can also, vitally, provide a closer match to pension fund liabilities than bonds (through interest rate swaps, synthetic indexation etc.).

35. Yet the use of derivatives has been slower to spread that theory would suggest, and opinion remains divided over the safety of their application. Two heavy weight economic figures, in the form of Alan Greenspan and Warren Buffet, represent the two sides of this argument. Mr. Greenspan believes that the growth of derivatives has allowed risk to be spread, making financial markets more stable, whilst Mr. Buffet worries about ‘linkage’ between these instruments with one contract failure potential causing the whole system to unravel.

“Although the benefits and costs of derivatives remain the subject of spirited debate, the performance of the economy and financial system in recent years suggests that those benefits have materially exceeded the costs.”

36. Alan Greenspan – Chairman of the Federal Reserve Board Corporate Governance, remarks from the 2003 Conference on Bank Structure and Competition:

“Derivatives are the financial weapons of mass destruction…the dangers are now latent – but they could be lethal.”

Warren Buffet – Letter to shareholders, 2002 Annual Report of Berkshire Hathaway Inc.

37. Though Mr. Buffet’s caution stems largely from specific experiences within his own fund, and relates to OTC (unlisted) derivative instruments, he does reflect wider fears within the investment community, including those who think ‘Barings’, ‘Enron’ or ‘Orange County’ the moment the word derivative is mentioned. Yet it was not derivatives themselves but poor application and supervision that caused these scandals. Certainly, using derivatives requires greater understanding, training and more complex monitoring and risk management control than underlying instruments (as many are by their very nature incorporate leverage so that losses can accumulate more quickly). The Futures and Options Association has published a dossier, ‘Managing Derivatives Risk’, which acknowledges potential risks and helps users in their derivatives trading. One key recommendation is to create an effective policy for derivatives, including senior level risk management and audit programs across all products, consistent with the underlying strategy, objectives and risk appetite of the organization. Derivatives should be seen as a help rather than a hindrance in the context of pension portfolio management, and trustees and fund managers, rather than simply ignoring them, should look closely at where they might gain from their deployment.

Individual Risk Budgeting

38. A further important consequence for the pension industry stemming from this ‘perfect storm’ of an investment climate is that the shift from defined benefit to defined contribution schemes is here to stay. As risk is shifted to individuals they should, in theory at least, be conducting their own strategic asset allocation process. Each individual should be conducting their own ALM survey, assessing their liabilities (i.e. retirement needs), their risk tolerance and subsequently investing in matching assets that will generate a sufficient return. Many academic papers have laid out how their portfolios should be adapted over time in a ‘life cycle’ investment pattern, (according to changing labour income, also known as human capital, levels of risk tolerance etc.) 19. However, there remains a woeful lack of financial education and even the 19 For example, ‘Consumption and Portfolio Choice’ Cocoo J.F., Gomes F.J., Maenhout P.J. May 2001

http://pascal.iseg.utl.pt/~SPiE/papers/gomes.pdf

16

most advanced pension markets have failed to keep up increased demand for such services generated by the rise in DC funds. Individuals remain exposed to a greater and more complex pension risks than many still realize, with government action likely to be necessary in future to fill this gap. Furthermore, DC scheme members are accepting investment risk without making investment decisions. Where a choice of scheme is offered (though this is still not the case for around 25% of UK DC funds), the vast majority choose the default option (anecdotally 75% in the UK) – herd instincts clearly applying to individual as well as institutional investors. Concerns remain even when this choice is a so called ‘lifestyle option’ that gradually shifts from equities to bonds as the member matures, as expressed in the UK Myner’s Review (see footnote 5):

“The review is concerned that the equity-bond switch which is the key feature of the lifestyle funds is often undertaken mechanistically, without adequately taking into account factors such as increased longevity rates and different risk appetites.”

39. The US pension market can offer other countries in transition from DB to DC valuable experience in striking the correct balance between choice and guidance for individuals. The average US DC plan now offers 13 investment options (having started with only 2). Caution does, however, have to be exercised, as can be seen from the fact that many of these new options in the US were technology funds, offered at the height of the ‘dot com.’ bubble. DC trustees need to ensure that beneficiaries are not seduced away from long term investing goals by the latest investment fad. Equally, they have to ensure that proper adjustments are made as participant’s age. It has also been shown in the US that if faced with too much choice plan participation rates fall. Trustees of DC schemes need to think of ways help individuals get around such behavioural investment errors20

Figure 3: Number of fund choices in US DC plans

0

10

20

30

Nochoice

2 3 4 5 6+

No. of choices offered

% o

f fun

ds

Source: Watson Wyatt 2000 Pension Plan Design Survey

Tactical Asset Allocation

40. Once ‘strategic asset allocation’ has set out how to broadly match assets and liabilities, and what the structure of an optimal fund should be, ‘tactical allocation’ decides how to allocate pension fund assets within the various asset classes and financial instruments available. This is required both to ensure sufficient investment returns over time and to insure that unnecessary volatility does not result in a significant reduction in asset values at the time when the plan’s need for liquidity increases. Tactical allocation can be seen as process of reducing the return risk, using market timing and specialist research to take advantage of opportunities within and between the broad asset classes. Views on best-practice regarding tactical asset allocation have, however, also been changing.

17

20 One US scheme, for example, know as ‘Save More Tomorrow’ helps surmount the problem that people rarely

increase their pension participation rates sufficiently by committing a certain percentage of future pay rises in advance.

Passive Investing

41. Within the tactical asset allocation process, issues related to alpha investing and excess returns are reflected in the debate over active Vs passive investing. Rather than an argument over whether excess returns actually exist, the question revolves around whether pension fund investors are able to obtain them. Those who believe not follow the passive investment route. ‘Passive’ investors are those who simply try to match the returns from a broad average of securities at the lowest possible management fee, (whilst active investors buy or sell particular issues which they estimate the market has under or over-valued). The increase in passive funds stems from increasing disillusion over investment performance Vs benchmarks. The rational for this type of investing is that it is extremely difficult to consistently out-perform any market, given that all fund managers cannot statistically do so, and that it has proven extremely difficult to select a successful active manager, as can be seen from the performance of fund managers pre and post a mandate handover. Past performance certainly does not appear to be a good guide to future returns21.

Table 2: 10 year average return UK equity funds to 1998

Index Funds 16% p.a. Active Funds 15.6% p.a. FTSE All Share 15.9% p.a.

Source: WM

21 Roger Urwin, a top actuary at Watson Wyatt, quoted in ‘The Economist’ magazine:

“If you look at the top-performing fund managers in most asset classes in a recent period, 4 out of 5 will be there by chance rather than pure skill.”

18

Figure 4: Investment Performance during Manager Turnover UK

0102030405060708090

100

-5 -4 -3 -2 -1 0 1 2 3 4 5

Years before and after handover

% o

f man

ager

s be

atin

g av

erag

eOldNew

Source: Sloan Business School22

42. The best strategy has therefore often been seen as one that simply replicates the broad market index. Also, as institutional funds have become larger, liquidity has become more of an issue also pushing many towards indexing, with technological advances making this move possible. US and other pension funds have increased their exposure to index funds dramatically over the past 20 years. Given the much lower fee structure, passive investing is a legitimate strategy for an investor who values the tangible cost advantages over the possibility of achieving additional returns through superior stock selection. The greater one’s belief in the efficiency of markets, the more convincing this argument is likely to be.

Figure 5

Allocation to Indexed Funds (% of total US Pension Assets)

0102030

1981 1991 2001

Source: Goldman Sachs/ Pensions & Investments

Hedge Funds

43. For those who believe that excessive returns can be captured, the approach has been the complete opposite, arguing that investors have, in fact, been too constrained by benchmarks to take proper active bets23. The answer has therefore been to free a certain percentage of funds from benchmark considerations

22 Sloan Masters Individual Dissertation submitted by Mark Fawcett (former CIO Amex Asset Management

International): ‘Structural Problems in the UK Pension Fund Industry’ 23 See criticism in the UK Myner’s Review of quasi-benchmarking and hedging:

“many objectives are set which give managers unnecessary and artificial incentives to herd. So-called ‘peer group’ benchmarks, directly incentivising funds to copy other funds, remain common. And risk controls for

19

and take a properly active, absolute return approach to equity investing. Such a style is represented by ‘hedge funds’ and pension funds continue to increase their exposure to these investment vehicles. A survey by Goldman Sachs24 shows the dramatic rise of hedge fund investment, the sharpest amongst all the new alternative investments measured. 40% of respondents worldwide said they were already using them, with the average allocation in the US along up 40%. This comes despite acknowledgement that the risk of this asset class is challenging to measure and monitor. Intended allocations continue to rise in all regions (with US funds, for example, having doubled their exposure between 2001-2003 from 2.5% to 5%, with the intention of rising to 7.5% by 2005). The rational for using hedge funds is a combination of risk and return. Median hedge fund returns over the past three years were reported by survey participants to be 5% and expected to be 10% over the next three. Their low correlation to other asset classes only serves to heighten their appeal.

Figure 6: Allocation Alternative Investments (%)

US Pension Funds and Endowments

02468

10

Private Equity Hedge Funds Real Estate

Asset Class

% o

f tot

al a

sset

s

200120032005 (est)

Source: Goldman Sachs / Russell Investment Group

44. In regional terms, Japanese funds maintain the highest exposure to these vehicles, which is consistent with the low returns in their equity and fixed income markets over the past 10 years. As expected returns fall in other markets, exposure is likely to rise to these levels25. Given many US pension plans are saying that they are becoming more like endowments, with steady cash flows to fund their obligations, this trend is only likely to continue, given that hedge funds represent a stable 10-12% of assets for such endowments. Pension funds using hedge funds are doing so across a wide range of strategies, in a diversified manner, spreading their alpha or ‘skill-based’ bets across a group of managers and styles (even more so than in general asset allocation).

active managers are increasingly set in ways which give them little choice but to cling closely to stock market indices, making meaningful active management near-impossible.”

24 ‘Goldman Sachs Equity Derivatives Strategy: Equity Indexes’ January 30th 2004. Figures taken from survey published in PLANSPONSOR Magazine (with Fidelity Research) December 2003

25 The January 12th 2004 issue of Pensions & Investments confirmed this trend, identifying at least $6.4bn of additional expected contributions to existing hedge fund managers for 2004. However it should be noted that those investing in hedge funds are still in a minority (23% currently investing in these vehicles, 8% saying they are looking to in the next 2 years).

20

Figure 7: Regional Allocation to Hedge Funds

02468

10

North America Europe Japan

Region

% to

tal a

sset

s200120032005 (est)

Source: Goldman Sachs / Russell Investment Group

Figure 8: Hedge Fund Strategies in US (% funds using style)

0102030405060708090

100

Equity

long

/short

Distres

sed

Event

M&A

CB arb

Multi a

rb

Quant

mkt ne

utral

Mkt ne

utral

Stats a

rb

Sector

long

/short

Fixed i

ncom

e arb

Vol arb

Global

macro

Short

CTA

Source: Goldman Sachs/ Russell Investment Group

Private Equity

45. Another increasingly popular form of active, absolutely return investing is via private equity – i.e. investing in companies not listed on public markets. This asset class offers potential attractive, risk-adjusted returns, with relatively low correlation to other traditional assets. The risk of these investments is largely in their long-term, illiquid nature, but given the long life cycles of pension funds, many are increasing their exposure. Investment is via closed-end private equity funds, or fund-of-funds which are proving increasingly popular, (particularly in Europe), as these allow pension investors to diversify their holdings and are an attractive way to achieve international exposure in the field. Commitments made are drawn down in tranches as investments are made by the underlying manager. As the companies which are invested in develop, funds are extracted and returned to the original investors either through sale or listing on public markets. Most funds are still directed towards venture capital and management buy-in/out type investments (through ‘special situations’ are increasingly popular in Australia).

21

46. Following several years of spectacular returns, driven largely by the US ‘dot com’ phenomena, private equity returns have declined considerably in the past few years, and in some cases have turned negative. Yet pension funds in all regions remain committed to increasing their exposure to these vehicles, (even in Japan where only a small minority of pension funds as yet make such investments)26.

Figure 9: Trends in Private Equity Allocation by Region

0123456789

USA 2001

USA 2005

est

Europe

2001

Europe

2005

est

Austra

lia 20

01

Austra

lia 20

05es

et

Japa

n 200

1

Japa

n 200

5est

% to

tal a

sset

s

Source: Goldman Sachs/ Russell

International Investment

47. As the bond/equity debate has shown, in previous decades tactical asset allocations have been heavily skewed towards equities. Major changes in asset allocation structure have consequently been within this equity category, with the most prominent being the move towards international diversification. This has been the major trend over the previous 20 years, following the relaxation of foreign exchange controls in the 1980’s. Financial theory argues for international diversification as a useful risk management tool, improving the risk-adjusted returns by investing in asset classes that are not perfectly correlated27. In reality, the level of diversification does still vary by country. For example, though foreign holdings have increased considerably at US pension funds, (from 4% of assets in 1981 to 14% in 2001)28, they still remain a smaller part of overall portfolios than in other countries, (partly due to the large scale and diversity of the US economy). They form a more important part of pension funds in other Anglo-Saxon countries, such as UK, Australia and in particular Hong Kong.

26 According to the Goldman Sachs / Russell survey: ‘Alternative Investing by Tax Exempt Organizations 2003’

almost 70% of respondents in the US and Australia invest in private equity, Vs 58% in Europe and only 12% in Japan.

27 International diversification has also been argued to be most beneficial when the whole portfolio of retirement assets are taken into account, including non-traded assets such as human capital, as these are highly correlated with domestic financial returns. See Baxter M., King R.G.: ‘The role of international investment in a privatized social security system.’ 1999

28 Figures taken from Goldman Sachs Asset Management Research: ‘Two Decades of US pension Fund Investing’. Authors Thomas J. Healey CFA, Rossen Rozenov, October 2002

22

Table 3: Asset Allocation (%) – Major Pension Markets

Country Domestic

Equity

Internat.

Equity

Domestic

Bonds

Internat.

Bonds

Cash Real

Estate

Other

Australia 38 25 16 5 5 9 2

Japan 36 19 29 11 3 1 2

Netherlands 9 41 17 26 2 6 0

Sweden 19 15 42 14 2 8 0

Switzerland 19 16 27 15 8 12 3

UK 46 25 10 3 3 6 7

US 48 11 35 1 2 2 2

Source: UBS Global AM estimates end 2001(government and industry figures)29

48. Questions are now being raised as to how much further the international trend will go, particularly at US funds given these assets under-performed domestic ones at least through the 1990’s following only limited excess performance during 1981-1991 period. Increasing correlations between global equity markets are also raising questions in other pension markets, particularly as such correlations tend to rise most in periods of high volatility, reducing the benefits of diversification even further. It has also been speculated that US investors at least can achieve the benefits of international diversification through a portfolio of domestic securities. Such arguments will continue to reinforce the natural tendency for investors to maintain a ‘home country bias’. High weightings in domestic stocks have been explained by numerous factors, both practical (currency risk, inflation risk, costs and restrictions), though are probably now driven more importantly by psychological ones (‘comfort factor’, combined with the belief that domestic investors have better information and indeed proven ‘over confidence’ in the domestic market). The current weakness of the US dollar may, however, provoke further US overseas investment.

Figure 10

29 Taken from ‘Pension Fund Indicators 2003: A long-term perspective on pension fund investment’ UBS Global

Asset Management

23

Annual Average Returns on US and Int'l Stocks ($)

05

101520

1981-1991 1991-2001

%Int'l StocksLarge cap Stocks

Source Goldman Sachs: Ibbotson Associates30

Other Investment Trends

49. As well as diversifying amongst equity holdings, pension fund asset allocation has also shifted in recent years towards other asset classes. Real estate, which has always formed a core part of pension funds investment, has become more viable with the introduction of new investment vehicles. Outright investment has always offered liquidity and diversification problems, which can be overcome by indirect investment through listed property companies and investment funds, such as REITs. Long standing in the US market, these have been launched in Japan in recent years, as well as in several European countries, and it is hoped that a pan-European REIT market will follow soon.

50. As well as developments in such traditional asset classes, pension investors have also been carving new asset classes out of old groupings. For example, forestry investments, previous classed with property holdings, have become increasingly popular, as their long-term, stable returns offer a suitable match for pension fund liabilities31. Investing in currencies, independent from foreign exchange holdings that arise from investments in overseas equities or bonds, has also been increasing32.

Governance Issues

51. Risk to pension funds also comes from systemic factors, including the conflicts of interest that always occur when there is a split between management and ownership, (i.e. the agent/ principle problem). Governance controls in the form of legal and regulatory measures to have been discussed at length in

30 Figures taken from Goldman Sachs Asset Management Research: ‘Two Decades of US Pension Fund Investing’.

Authors Thomas J. Healey CFA, Rossen Rozenov, October 2002 31Though grouped with property, forestry investment most resembles index-linked bonds, with predictable output and

long-term price trends that have kept pace with inflation. Investment is most commonly via direct ownership, with limited partnerships being popular in the US, and unitized funds are becoming more widespread (offering liquidity, efficiency and reduced specific risks). Forestry also offers a low negative correlation with other asset classes and, due to renewable and sustainable characteristics, and fits well into socially responsible investment (SRI) portfolios. Comments taken from IPE paper on forestry investment www.ipe.com

32See IPE paper on currency investment www.ipe.com. Includes comments from Matthew Annenberg, global head of FX analytics and risk advisory with ABN AMRO in NY:

“For the pension fund industry, currency risk management and the opportunity to generate alpha is increasingly important. Currency managers’ track records are long and favorable enough for most diligent studies. Total return currency mandates have come of age, and deserve consideration along side other alternative assets.”

24

previous OECD papers and therefore will not be repeated here.33 Analysis of governance controls in the form of the prudent person rule and the role of trustees do, however, follow.

Prudent Person Rule

52. The broadest form of governance relating to risk management to which pension funds must subscribe is the ‘prudent person’ rule34. This applies in some form in most countries, and broadly states that a fiduciary (person with responsibility for the assets of another) must discharge his duties with the care that a ‘prudent person’ acting in a like capacity would use. Other specific duties, such as diversification, are also laid out in some interpretations, or are implicitly assumed to be an indicator of prudence. This rule has its origin in trust law, and its interpretation has developed over time. Historically, the reading of the rule was that investment should be undertaken on a highly cautious, risk avoidance basis. However, with developments in modern portfolio theory, focus shifted more to the investment process as opposed to investment outcomes, with the rule interpreted as requiring due care and diligence in investment decisions.

53. The rule is applied in different ways in different countries. The US investment industry, for example, is required (under ERISA legislation) to act in the manner of a ‘prudent expert’ arguably giving more scope that the ‘prudent person’ definition still used, for example, in UK pension regulation (though the 1991 Myner’s Review recommended changing to the US definition). The main difference between countries is as to whether the rule is applied in quantitative or qualitative terms. Rather than leaving discretion open to investment managers, requiring only that due care is taken in the investment process, some countries apply more concrete restrictions on investments and have strict diversification requirements. For example, some still limit the amount of equity investment that is possible, others the level of overseas holdings etc35.

33Including ‘Portfolio Regulation of Life Insurance Companies and Pension Funds’ and ‘Governance of and by

Institutional Investors’ 34 For more details on the prudent person rule see ‘“Prudent Person Rule” Standard for the Investment of Pension

Fund Assets’ 35 For example the European Union applies quantitative restrictions (e.g. no more than 5% of assets in a single

holding, no more than 30% in OTC securities, no more than 30% in external currency denominated assets), with a ‘prudent person’ overlay. See ‘Directive of he European Parliament and of the Council on the activities and supervision of institutions for occupational retirement provisions’, June 2003.

25

Table 4: Portfolio limits on OECD pension fund investment in selected domestic asset categories

Country Equity Real

Estate

Bonds Investment

Funds

Loans Bank

Deposits

Japan No limit No limit No limit No limit No limit No limit

Denmark 70% No limit

gilts

No limit

gilts

70% No limit

gilts

No limit

UK No limit No limit No limit No limit No

employer

loans

No limit

Source: Survey of investment regulation of pension funds Dec03

Table 5: Other Quantitative Regulations of Pension Fund Assets in Selected OECD Countries

Country Minimum Diversification requirements

Self-investment / conflicts of interest

Other quantitative rules

Ownership concentration limits

Japan EPF (employee pension fund): none, but pension legislation stipulates that each pension fund should endeavor to avoid concentration of investment on a specific asset category.

EPF: investment on securities with the purpose of pursuing interests of someone other than the pension fund is prohibited.

none none

Denmark Limits for any one investment depending on the sort of assets

Limits of 2% of the provisions for investment in any one enterprise (for company pension funds).

‘High-risk’ assets (domestic and foreign shares and unlisted securities) limited to 70%. Property and investment-trust holdings limited to 70%. Minimum 80% currency matching requirement. For EU currencies up to 50% of the liabilities can be covered by assets denominated in Euro.

Limit of 2% of the provisions for investment in any one enterprise (for company pension funds). Prohibited to exercise a controlling influence over the company in question.

UK General requirement for diversification and suitability.

Yes, employer-related investment limited to 5%.

No quantitative portfolio restrictions.

None

Source: Survey of investment regulation of pension funds Dec03

54. The prudent person rule has, however, come in for criticism. Some argue that, though designed to reduce pension fund risk, the rule has actually done harm by limiting returns, particularly where quantitative restrictions are applied. These are said to make asset-liability matching and the immunization process more difficult (or even impossible), as well as limiting diversification and restricting the use of derivatives. In the words of the European Commission such restrictions are:

26

“in the way of optimization of the asset allocation and security selection process and therefore may have led to sub-optimal return and risk taking.”

55. The prudent person rule is also seen as responsible for creating an over cautious investment community, leading to the ‘benchmarking’ and ‘herding’ behavior which may have actually harmed pension fund investors rather than reducing risk. Such criticisms were a core part of the Myner's Reviews published in the UK in 2001 (see footnote5). One of the basic flaws of the rule is the difficulty in judging when it has been broken, (as has been shown in the recent UK cases between clients and their investment managers, such as Merrill Lynch Asset Management and Unilever). Hence the tendency of investment managers to follow the behavior of their peers. Yet this is probably as much as criticism of the investment industry as financial regulation, which indeed has often gone further than the investment managers have been prepared to follow36.

Role of Trustees

56. The key players in terms of pension fund governance, with crucial oversight functions and the ultimate responsibility for pension fund risk management, are the fund’s trustees. It is therefore all the more worrying that these vital players have come in for the criticism, even in the most developed markets, that they do not possess the necessary skill set to fulfil these responsibilities. This was one of the key issues raised by the UK Myner’s Review (see footnote 5), which published the following alarming findings:

− 62% of trustees have no professional qualifications in finance or investment

− 77% have no in-house professionals to assist them

− over 50% received less than 3 days training

− 44% received no training after their first 12 months

− 49% spend less than 3 hours preparing for pension investment matters

57. Over 90% of investment returns are estimated to come from strategic allocation, decisions, (such as the choice of benchmark, the relative level of equity Vs bond holdings, passive Vs active management), and yet these are being left in the hands of these largely unqualified trustees. Their lack of knowledge is displayed by how little time and resources they spend on these vital issues Vs the great deal of effort spent trying to identify which active fund managers will outperform in future - a thankless and expensive task, and one which adds little to investment performance (as discussed in the section on passive investing)37.

36 For example, the 1995 Pension Law in the UK allowed trustees to invest in any asset they wished, subject only to

the prudent person law. Common law practice, however, proved much more cautious, debating, for example, the definition of an investment, whether this meant capital accumulation or solely an income stream, and whether futures and options could be included. Meanwhile the US Department of Labor clarified the use or derivatives for a skittish trustee community (in an Information Letter dated 21 March 1996), advising them to use the same analysis as with any other investment (such as how it fits within the portfolio and potential gains or losses).

37 According to UK consultant Watson Wyatt, UK pension fund trustees spent 0.27% of assets under management on investment management fees (+0.15% on commissions), yet only 0.015% on consultants (0.005% on investment policy advice – though the consultants are not without blame give that they receive large fees themselves for conducting manager ‘beauty parades’).

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58. How much more acute will the problem become as pension funds move towards more sophisticated investment instruments and risk control measures (or indeed are the unsophisticated trustees actually holding back such developments to the detriment of the beneficiaries they are supposed to be protecting)? The need for knowledgeable trustees is made all the more urgent by the move from balanced to specialist mandates. Balanced mandates are the model for managing pension funds whereby the trustees entrust the assets of the fund to a fund management company leaving both strategic asset allocation and security selection to them (manager performance being measured with reference to the relevant peer group). The customized benchmark model separates out decisions about strategic asset allocation from decisions about security selection, with trustees using specialized mandates and customized benchmarks. Stock selection remains with the manager, but trustees retain the strategic asset allocation function. As pension funds move from balanced mandates trustees will be forced to take more rigorous decisions – despite the fact that they have not been receiving any more training in preparation for this role.

Figure 11: % of Specialist/Customized mandates in the UK

020406080

100

Year19

93

Year19

94

Year19

95

Year19

96

Year19

97

Year19

98

Year19

99

Year20

00

Year20

01

Year20

02

Source: Russell/ Melon CAPS

59. Such concerns were outlined in a recent Sloan Business School paper38 that came to the following conclusions:

− The key investment decisions for a trustee are around strategic asset allocation, choice of benchmarks and manager selection (active/passive)

− Too little time is spent on the asset allocation decision

− For a number of reasons the role of trustee is becoming increasingly complex

− The investment strategy of the average UK pension fund has been sub-optimal (primarily because there has been insufficient diversification)

− The allocation of resources inefficient (because there has been insufficient attention paid to investment strategy and too great a use of active managers)

− Had trustees been fully aware and fully understood the conclusions and consequences of the body of research and incentives of the industry players, they would have been in a better position to make more rational investment decision.

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38 Sloan Masters Individual Dissertation submitted by Mark Fawcett (former CIO of American Express Asset

Management International): ‘Structural Problems in the UK Pension Fund Management Industry’

60. This points to a need for more and better training for trustees, which should possibly become mandatory. They do not need to become investment experts, but should have sufficient knowledge and confidence to challenge their advisers and to ensure that fund managers are adopting an appropriate level of shareholder activism. Creating an organization based on the Australian model that takes some investment strategy decisions away from the trustees, making their workload more manageable and less complex is also to be advised, as is the use of professional independent trustees. The Myner’s Review goes one step further and suggests that trustees should be paid, as well as recommending that they should, as in the US, have a legal requirement to be familiar with the issues when they take investment decisions (i.e. moving towards a ‘prudent expert’ approach).

61. It should also be noted that the role of trustees remains important, even with the move to defined contribution schemes, as under this system they are needed to ensure that appropriate investment vehicles are available in the fund range39.

“Under DC plans, sponsors tend to be a dispersed and disorganized group, making monitoring the management of their pension fund difficult. A solution is for a strong board of trustees to monitor the performance of the pension fund. The effectiveness of such as board depends on the existence of a well-defined job market for trustees and of the independence between trustees’ decisions and fund performance.”

New Forms of Governance Risk

62. As well as the new investment approach driven by the current challenging investment conditions, pension funds may also been seen as facing another new investment objective in the form of Corporate Social Responsibility. As social awareness has increased, it has become increasingly important for firms not only to achieve adequate returns on their investments, but also to do so in a way that is socially acceptable and promotes sustainable development. A new reputational risk may therefore have developed for companies if the form of negative brand feedback if their pension funds are seen to be investing in a non-acceptable fashion. Could this provoke a boycott from consumers, damaging the firm’s underlying business, cash flow and ability ultimately to make contributions to the pension fund?

63. Institutional investors are also coming under increasing pressure to step up their role in terms of corporate governance, fulfilling their responsibility as shareholders for management oversight, and thereby reducing investment risk (in terms of poor management decisions reflecting in lower share prices). Such as role has been encouraged in the UK since the Maxwell scandal and Cadbury Report of the 1990’s, and is being echoed in other countries following numerous corporate scandals coming out of the ‘dot com’ bubble market years. Requirements such as the publication of voting rights and shareholders ability to vote on executive compensation are being introduced, with the Californian public pension fund CalPERS taking the lead. Greater shareholder activism has been shown to lead to improved firm value (in terms of higher profits and sales growth, lower capex and fewer corporate acquisitions). In the case of US funds, the mere presence of some pension funds on the shareholders’ register can put pressure on management40. Studies in the UK41, on the other hand, however, have found no evidence that UK pension funds are adopting such an aggressive this role (given there is no evidence that firms with large holdings by pension funds have better corporate governance).

39 Besley and Prat (2003): ‘Pension fund governance and the choice between DB and DC plans’ Center for Economic

Policy and Research (Discussion Paper) 40 Faccio and Lasfer 2001: ‘Institutional Shareholders and Corporate Governance 41 The case of UK pensions funds’ Center for Research on pensions and welfare policies (working paper).

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64. Some Asian shareholders have, however, been improving their corporate governance track records since the regional crisis of the late 1990’s. According to Goldman Sach Asian Portfolio Strategist Timothy Moe42 this period represented a turning point for governance in the region. Evidence at both company and country level points to improved governance in the region (and indeed has pulled ahead of Japan, where a minimum level of independent directors is still not, for example, mandated, unlike in many Asian countries currently). Ironically, the disclosure from many Chinese companies is better than in HK (which has typically led the region with high standards of corporate governance):

“Following the Asian crisis of 1998, many Asian governments were desperate to attract global capital, and the only way to do this effectively was to develop one’s domestic capital markets by introducing global standards for corporate governance.”

42 See ‘Corporate Governance: A Quite Revolution?’ July 2002 editor Kathy Matsui, Goldman Sachs Japan Strategist

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Table 6: ‘What a difference a Crisis can make’

Before Asian Crisis After Asian Crisis

Only one official code of practice (HK) Nine official codes, with more in development

Independent directors mandated in 3

countries (HK, Singapore, Malaysia)

Mandated (or in use) in 11

Audit committee mandated only in

Singapore/Malaysia

Mandated in 8 places

Little Shareholder activism Growing, albeit still limited, organized shareholder

activism (mainly at retail level)

Source: Goldman Sachs

65. In summary, after several golden decades of equity investments delivering adequate returns, the topic of risk management has returned to the fore front of the pension industry given the now challenging funding and investment environment. The whole structure of how liabilities are valued, how assets are invested and how risk is managed is now under review. The focus in this new period will be on matching liabilities rather than maximizing returns, combined with a more targeted approach towards risky investments. As responsibility for providing adequate retirement income shifts back onto individuals, more education will be required and ultimately the role of government may have to increase again in future.

“Non-traditional investment solutions will become increasingly common as pension schemes seek to focus on the nature of their liabilities rather than comparison with indices and peer groups”43

Country Profiles

66. The following section consists of a survey of the investment risk conditions in selected OECD and Asian countries. In co-ordination with the above analysis, the following will be examined for each country:

i. An analysis of the structure of the pension market.

ii. An analysis of who bears responsibility for deficits in the country’s pension funds.

iii. Strategic Asset Allocation trends.

iv. An examination of the broad structure of the funds’ Tactical Asset Allocation and trends.

43 From UBS Global Asset Management: Pension Fund Indicators 2003

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v. A look at what governance is in place to control pension fund risk.

UK

Structure of the market

67. The UK pension system represents a greater balance between the three ‘pillars’ of pension provision than in many other countries (the first being the state pension, the second occupational schemes and the third private pensions)44. A voluntary regime of private pensions has grown up over the last 40 years in the UK through a combination of large stand-alone, self-administered schemes and insured occupational and personal provisions (with insurance companies playing a major role in the provision of insurance, administration and investment services). The state provision is made up of a basic flat-rate pension, which is reviewed annually, and a supplementary portion (SERPS) that operates on a pay-as-you-go, earnings related basis and which is also managed by the state. Total contributions go into the basic National Insurance (NI) fund from which expenses and pensions are paid. The basic pension is compulsory for employees and self-employed and NI is paid by everyone over a certain salary level. Unlike other countries, it is possible to ‘contract out’ of the supplementary part (some NI being rebated if investment is made in other forms of pension). Around 80% of private funded pension provision in the UK is via 2nd pillar through the voluntary sponsorship of pension schemes by employers, some exempting employees from contributions, with around half the working population in such schemes. DB still make up the vast bulk of occupational schemes and are generally run by larger companies (90% of defined benefit schemes are contracted out of SERPS), though as in other countries these are generally being replaced with DC plans45.

44 Comments on the structure of the UK market taken from speech given at the OECD 2000 meeting by John

Bowman Group Head of Pensions Development CGU plc: ‘Coverage of Private Pensions in the UK’ 45 Based on the National Association of Pension Funds (NAPF) survey, 13% of DB plans closed to new entrants in

2001, 19% in 2002 and 26% in 2003.

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Table 7: Role of 2nd Pillar Schemes in Pension Industry

Source European Commission

Country Assets of second pillar schemes (% of GDP)

Germany 16.3

France 6.6

Italy 2.6

Spain 7.0

Netherlands 111.1

Euro zone 15.4

EU15 29.2

UK 80.9

Bearer of Investment Risk

68. The issue of who bears investment risk is currently being clarified in the UK through a series of legislative changes (due to come into effect during 2005)46. These will introduce protection for pension scheme beneficiaries should their corporate plan sponsor go bankrupt, in the form of a fund which will effectively offer investment insurance. This will provide full pensions for those already retired and 90% of promised assets for those still working subject to an overall cap (somewhere between 40,000-60,000 sterling). Over 10 million members of occupational pension schemes will be covered, (though around 60,000 workers from 200 companies that went bankrupt in recent years will not be compensated). The fund is expected to raise 300m sterling a year, though the government has left the politically difficult decision regarding flat rate Vs risk adjusted contributions to the new board of the fund. The bill also introduces a new, much more active Pensions Regulator with powers to investigate and impose action. New codes of practice will come into effect requiring compliance, and threatening a range of punishments from the freezing of assets to the removal of trustees. Information and advise on pension positions will also improve, including forecasts for combined private and public pension income from a sophisticated new online forecaster, which is currently under development. Government figures estimate that employers could save around 130million sterling in pension and administrative costs, rising to 210million when taxes are simplified, though some funds will obviously suffer from having to pay out higher contributions to the new protection fund.

69. Though generally welcomed, the bill has mostly been criticized for what is left out. For example, further details were expected, but were not forthcoming, on a previously announced rule obliging solvent employers seeking to wind up schemes to ensure that there are enough funds to pay all promised pensions in full, (this not being the case with Danish shipping line Maersk, which wound up its pension scheme with funds available to cover only around 40% of benefits). Terry Faulkner, Chairman National Association of 46 Details and commentary on the new Pensions Bill taken from various ‘Financial Times’ articles 13th February 2004

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Pension Funds, for one feels that the legislation does not go far enough to deal with other fundamental problems in the UK pension system as a whole44:

“….but is there anything in (the) bill to simplify our archaic state pension system? Is there anything to encourage firms to offer decent pensions to their employees, or to keep existing schemes open? Are there new incentives to encourage people to save? Is there any real long-term vision, or a clear pension strategy to achieve that vision? Regrettably the answer to all these questions is no.”

70. Meanwhile, UK corporate plan sponsors face similar funding issues to their US counterparts, with current estimates of under-funding at FTSE 350 firms around 48bn sterling47. They will also be the first to face increased balance sheet volatility through the change from accounting rule SSAP24 to FRS17. US investment bank Morgan Stanley has estimated that the average UK balance sheet would be 15x more volatile under the new accounting regime, hence the continued shift into low-risk assets48.

Strategic Asset Allocation

71. ALM modelling is widespread amongst UK pension funds, with external consultants or actuaries running strategic asset allocation studies for trustees at least every few years. The most widely used model currently is the ‘Smith’ model, predicated on the belief that the ‘market knows best’ and drawing expectations on growth, correlation and volatility from the derivatives markets. As discussed in the ALM section earlier, criticism remains regarding these models, and indeed in regard to the consultant actuarial profession, for their misapplication and the role they played in guiding funds towards high equity exposure.

72. The strategic asset allocation shift towards bonds is continuing amongst UK pension funds, as seen in the table below. Some of the change in these weightings is due to the relative performance of the bond and equity markets, but asset allocaters continue to adjust their target weightings beyond these natural corrections. However, most are in a less fortunate position than Boots, having to make the move more cautiously to avoid locking in deficits rather than surpluses. Pension fund investors have been making use of recent market rebounds to execute this allocation shift, though many still have further to go to reach targeted levels.

47 See HSBC’s :‘UK Pension Funding: The Matrix Recalculated’ 6th October 2003 48 See Morgan Stanley Professional Pensions, October 2001, author Ian Martin

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Table 8: UK Pension Fund Asset Allocation Shifts

Asset Class Allocation 2002

Allocation 2001

Equities 60 66

Bonds 31 26

Property 5 2

Cash and Others 4 5

Source HSBC: Company Accounts

Asset Allocation

73. Given the time taken up debating the bond/equity switch, other asset classes are finding it hard to attract funds. The move to hedge fund investing, and the focus on alpha and risk budgeting is happening at the leading edge firms (such as the multinational corporations based in the UK), but most pension trustees remain cautious, low risk, and highly suspicious of derivatives and new strategies.

Governance

74. Following the ‘Maxwell scandal’ in the UK in the 1990’s the role of trustees has been more clearly outlined, though concerns still remain (as expressed in the Myner’s Report and discussed above). Contracted-out occupational pension plans are set up for tax reasons under a trust as a separate legal entity, subject to trust law which provides legally enforceable rights for the beneficiaries. At least one-third of the trustees must be elected from the members of the plan unless the membership agrees otherwise. Plans with over 100 members must have a minimum of two employee trustees and those with fewer than 100 members must have a minimum of one employee trustee. A person who has been convicted of an offence of dishonesty and deception, has been bankrupt, or has been disqualified as a director of a company, may not serve in the role. In all cases the trustees must draw up a "statement of investment principles", drawing on the advice of "investment experts", and following consultation with the sponsoring employer. This must cover the kinds of investments to be held, the balance between different kinds of investments, and the extent to which the trustees take into account ethical, social and other considerations in formulating investment decisions. Trustees have specific responsibilities under the Pensions Act 1995, of which the main ones include preserving the assets of the plan and applying them and the income there from in trust for plan members (fiduciary responsibilities), appointing the plan auditor and actuary, meeting auditing/actuarial/publication etc. requirements, establishing a set of investment principles and an internal dispute mechanism process and agreeing the level of contributions with the employer. The trustee role is certainly again under the spot light and more training may result.

75. Whilst the 1990 Social Security Act (now consolidated into later acts) established the Pensions Ombudsman, the Occupational Pensions Regulatory Authority (Opra) was set up under the 1995 Pensions Act. All managers of fund (in which plan assets are invested) must be approved under the Financial Services and Markets Act 2000 and the prudent person principle applies. The new Pension Act will increase regulatory powers, as discussed.

35

76. UK pension funds are also becoming more active in the corporate governance field, as witnessed by the recent voting down of large executive compensation packages at several UK companies (notably pharmaceutical company Glaxo). The style of UK governance does, however, remain different to the US market, with many institutional investors preferring ‘quiet discussions’ with management to public confrontation. The approach is more self-regulating than the legislative ‘box ticking’ of the US. It has, however, become more acceptable to vote against management and shareholder activism is, therefore, likely to increase in future.

Denmark

Structure of the Market

77. Denmark’s pension system is somewhat unusual, consisting of 4 pillars49:

− People’s Pension (non-contributory, universal State pension)

− ATP Supplementary Pension (obligatory, performance rather than wage based, with all those working over 9 hours a week contributing a flat rate, employers paying 2/3, employees 1/3. Administered by a board)

− Labor market and Company Pensions

− Private Savings and Insurance

78. Labor market pensions spread in Denmark post war, and consist of funded, earnings related schemes. These were established and financed by the social partners as part of the collective bargaining process, with the obligation to provide supplementary pensions being seen as the responsibility of both employers and employees. Though not compulsory in a statutory sense, they are not exactly voluntary, with membership often required as a condition of employment. Most are defined contribution schemes with guarantees / insurance. Participants are entitled to benefits determined by contributions and a share of returns. Pre the reforms of the 1990’s, the third pillar of occupational pension schemes covered around one third of workers, mostly from middle income brackets and the public sector. Following collective bargaining rounds in the 1990’s, schemes were introduced for all public sector employees and most blue-collar workers, with 85% coverage having now been achieved. Most are multi-employer, industry-wide schemes, set up through collective agreement, or through a contract with a life insurance company. Indeed these schemes are, with a few exceptions, subject to the same legal rules as mutual insurance companies and pension funds are considered as insurance entities. The total employer and employee contribution rates differ between 5% and 15% of salary depending on plan rules and the age of the scheme. Employees usually contribute 1/3 of total contributions, though a few plans require them to contribute 1/2. Benefits may be paid as annuities and/or lump sums (some allowing the beneficiary to select the respective proportions, within specific limits, though a minimum annuity will usually be provided and pure lump-sum plans are rare due to tax rules). Defined contribution plans provide at least a minimum old-age annuity based on contributions paid and a minimum interest rate. Though uncommon, especially in the case of DC plans, benefit adjustments do occur, with occupational schemes lowering their return rates from around 5-2% during the 1990’s. Some DB plans adjust benefits in line with the inflation rate. In one example, the government’s supplementary ATP scheme reduced its guaranteed rate of return from 4.5% to 2% in 2002

49 Details on the Danish pension industry taken from: ‘1st and 2nd Pillar DC-pensions in Denmark’ presented by Ole

Beier Sorensen at the CEE Regional INPRS seminar on Pension Fund Governance in Ljubljana, Slovenia 7-8th November 2002

36

and paid no bonus (for inflation adjusting) in 2003, though hopes to resume such payments once markets, and consequently its bonus reserve fund, recover.

Bearer of Investment Risk

79. Given that Danish pension schemes were set up as part of the collective bargaining process, their foundation is very much one of collective risk sharing. However, given the new low interest rate investment environment that confronts pension funds in Denmark just as much as in other countries, the whole nature of this collective risk-bearing scheme is currently coming under scrutiny. The issue is seen as a social rather than a technical one, with debate focused on how to allocate social and investment risks in a low return, less predictable environment, and how much risk the state is willing to leave with individuals.

Strategic Asset Allocation

80. The fund management industry in Denmark is highly sophisticated, and the early adoption of modern portfolio theory has kept foreign managers at bay. The regulatory structure in Denmark imposes strict asset-liability matching requirements on funds, with ‘market value principles’ being introduced during 2002. Assets must be valued at current market value, with liabilities at the market value discount rate, which is issued daily by the Supervisory Authority. In principle, absolute sovereignty is required on a daily basis and the new rules have shifted the focus from long-term stability to short-term sovereignty. Following the weak markets of recent years, derivatives have become more widely used, with occupational schemes and the government’s ATP now implement extensive interest rate hedging through the use of swaps, and equity hedging via options.

Asset Allocation Trends

81. The collective risk sharing, regulatory structure, and guarantee/insurance nature of the Danish system has led to funds being more conservatively managed than in other countries. They are, however, moving towards more absolute return investments, for example private equity50. In the case of plans implemented through the establishment of pension funds, these may manage the assets in-house or contract the asset management to external asset managers. The responsibility for formulating a general investment strategy rests with the fund's board of directors. In the case of insured plans, the life insurance company manages the assets. Trends have, however, followed international norms, particularly the rise of international investing. Long term equity targets remain around 50% but positions have been reduced short term following weak markets, poor funding positions and regulatory requirements, discussed below (e.g. the ATP’s equity holdings fell as low as 15% in Q4 2003).

50 Though slower than other regions, Scandinavian investors have shown an enthusiastic appetite for private equity in

recent years. The Danes were slower into the market than their Swedish neighbors but the APT (Denmark’s largest pension fund) have now set up a private equity subsidiary, with the aggressive target of investing 10% of funds in this asset class by 2007. Investment has followed the classic path of getting comfortable with regional investments before the diversifying the portfolio into European and US holdings.

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Figure 12

ATP Asset Allocation

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2000 2001 2002

Private Equity

Real Estate

Int Equity

Dom Equity

Index Linked

Int Bonds

Dom Bonds

Source: www.atp.dk

Governance Issues

82. The prudent person rule is applied in a fairly restrictive, quantitative fashion in Denmark. As a general rule, there must not be excessive reliance on any particular category of asset, investment market or investment. At least 30% of total assets covering technical provisions must be placed in low-risk investments such as government bonds, mortgage credit bonds and property. Correspondingly, a maximum of 70% of total assets covering technical provisions may be invested in equity and a maximum of 10% may be invested in listed shares outside OECD countries. Investment in a single company must not usually exceed 2% of all assets covering technical provisions.

83. The Consolidated Supervision of Company Pension Funds Act of 2002 regulates the establishment, operation and supervision of company pension funds and includes rules concerning investment, minimum funding, annual reporting and accounting. All plans must be registered with the Danish Commerce and Companies Agency and this registration is subject to the authorization of the Danish Financial Supervisory Authority (which reports to the Ministry of Economic Affairs). This organization issues licenses, approves directors, issues orders and can withdraw a license in cases of non-compliance. The authority also operates a controversial ‘traffic light’ system of stress testing. Under a ‘yellow scenario’ stress test, funds are tested against a 30% decline in equity prices and a 1% move in market interest rates, and if funding problems would result they are placed under surveillance. Under a ‘red scenario’ the limits are raised to a 12% equity and 0.7% bond move, and intensive surveillance can lead to the regulator forcing funds to sell equities and buy bonds in order to repair their balance sheet. Such requirements were enforced in the difficult market conditions of the last few years, taking average pension equity weightings to very low levels, which caused great criticism as funds were unable to take advantage

38

of market rebounds during 2003. As Claus Silfverberg, director of the Danish Shareholders Association51, articulated in October 2003:

“The rules of the present regulatory regime have the consequence that many pension savings companies do not have a balanced portfolio and they are investing far too little in shares. We are naturally very unhappy with that, not only for the sake of shareholders, but also for the sake of the future pensioners.”

84. Danish pension funds are move active in ‘green’ and other forms of socially responsibly investing than other countries, and more active shareholders in terms of collective governance (possibly due to the industry wide coverage of labor schemes and their social partnership foundations).

Japan

Structure of the market

85. Japan’s pension market comprises mainly of government and occupational schemes. The public sector makes up tier 1 of the system in the form of the National Basic Pension and tier 2 with the salary related Employees’ Pension Insurance (EPI) for private sector employees and a Mutual Insurance scheme for public sector workers. The 3rd tier of occupational schemes were originally set up in the 1960’s and consisted of Employees Pension Funds (EPFs) which managed funds contracted out of the EPI, and Tax Qualified Pension Plans (TQPP) with employer contributions made via an insurance contract. All schemes were defined benefit in structure and mostly paid out lump sums rather than annuities. Changes to the system have occurred in the last few years due to the poor corporate and investment climate experienced during the 1990’s. Defined contribution schemes were introduction in 2001, whilst in 2002 the Defined Benefit Corporate Pension Plan Law was passed. This allowed the contracted out portion of the EFPs to be paid back to the government, whilst the remainder of these funds are to be transferred into defined benefit schemes (either contract or fund type). Cash balance schemes were also introduced and have proven particularly popular with large corporations such as Hitachi and Toyota. Over the next 10 years the TQPPs will be transferred into these DB structures. A 4th tier of personal pensions does exist but is very small.

86. Reform of the pension system occurred during the 1990’s, as the cost of corporate pension funds became a heavy burden on both plan sponsors and their shareholders. Changes also reflect the move from a seniority based pay system to a more merit orientated structure. Previously the system was characterized by rigid regulations, locking in a highly conservative investment stance. Funds were required to earn at least a 5.5% annual return, yet were obliged to follow a strict asset allocation structure, known as the 5:3:3:2 rule (with 50% of the fund in low risk assets, up to 30% in equities, 30% in foreign securities and 20% in real estate). Only trust banks and insurance companies were authorized to manage pension funds. Defects of this system included an ambiguity of responsibilities and obligations of both pension fund managers and their trustee bodies, a lack of competition in pension fund management and a lack of transparency in terms of disclosure of both portfolio management policies and performance. The ultra strict asset allocation structure meant that they did not have to be careful about portfolio management outcomes (particularly during the bubble years when everything was going up!):52

“For them, paternalism for employees was the first priority but not fiduciary responsibilities as trustees… Pension funds were not required to disclose management policies, investment strategies and performance of portfolios to their subscribers and beneficiaries.”

51 Comments from IPE article: www.ipe.com 52 See ‘New Developments in Japanese Corporate Governance in the 1990’s – The Role of Corporate Pension Funds’.

Megumi Suto

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87. 1990’s reforms focused on the liberalization of fund management and strengthening of disclosure towards more efficiency and transparency. Regulation of asset allocation was finally abolished in 1998. Fiduciary responsibilities were clarified and laid out, including the point that pension fund managers have to make best efforts to undertake their duties, including monitoring the companies they invest in. However, the guidelines laid out do not cover the role of trustees (as these financial institutions remain regulated by the Ministry of Finance, not the Ministry of Welfare that covers pension funds). Foreign and other domestic firms have now been allowed to enter the pension management market. DC style schemes are gradually becoming more common, offering a choice of funds to plan members, whilst cash balance schemes have been adopted by several large corporations.

Bearer of Investment Risks

88. Given the paternalistic nature of the Japanese capitalist system, corporate plan sponsors and the government bear much the risk within the pension industry. The corporate under-funding issue hit Japan during the 1990’s, much earlier than other major industrial countries, due to the long-term declines experienced in domestic markets. Consequently, many companies have repaired the deficits at their corporate schemes, and are now looking far healthier than many overseas counterparts (also helped by rising stock markets and a bottoming out of interest rates). The most popular repair action taken has been to amortize the under funding and/or raise contributions53, though many DB schemes have been turned into DC and some have reduced benefits, requiring plan members to bear some of the under funding burden.

89. The government has also played is part through a system know as ‘Daiko Henjo’. When the new occupational schemes were set up a portion of the public pension, known as the substitute component, was handed over to the investment industry to manage, the idea being to create a flood of money into the investment industry to allow economies of scale. In reality, poor investment has meant a negative spread between actual and promised returns leaving occupational schemes with deficits to fund. Since 2002, fund managers have been allowed to hand back this substitute portion to the government, helping to spread the burden of investment risk between the public and private sectors54.

Strategic Allocation

90. ALM models remain relatively unsophisticated in Japan. Simple models are used, but given funds have been operating in a deflationary environment, these were not taken particularly seriously. Leading international companies such as Hitachi/ Toyota etc. do have regular, professional assessments of their liabilities, but they remain ahead of the curve and in the minority. The responsibility for pension plans has generally shifted from its traditional location within HR departments to finance departments, but the level of sophistication has not increased significantly, as can be witnessed by asset allocation trends discussed below. The bond/equity debate, though widely discussed overseas, does not feature highly in Japan. Some shift to equities has taken place since the deregulation of asset allocation structures, but higher bond weightings remain than in other countries, partly due to the existence of a liquid government

53According to the February 2002 Pension Fund Association survey over 50% of EPFs were considering raising

contributions from sponsor. See Goldman Sachs ‘Portfolio Strategy’, October 2002, author Japan strategist Kathy Matsui

54 Around 1/3 of the 1800 EPFs were considering returning this portion to the government according to a 2001 survey. Sharp is an example of a company that did so in 2002, returning around ¼ of its Y400bn fund. Once the funds have been transferred the liabilities and required reserves (PBO) disappear from the balance sheet, with any deficit being recognized as an extraordinary loss (and for some extraordinary gains). Comments also from Goldman’s Japan Strategy Research, as above.

40

(JGB) market. The move to equities should continue in the long run but short-term indicators are pointing in the other direction55.

Asset Allocation Trends

91. As the pension market has become more competitive, domestic investors have also been forced to move away from their zero-risk investment approach. Foreign fund managers have secured a fairly large amount of this business (estimated to be around 20% of institutional investments, down from a peak of c30%), but given the time consuming, bureaucratic nature of these mandates, it is questionable whether they would want this to go any higher. Asset allocation has come more into line with international norms in recent years56. Equity investment has risen, and, as mentioned, Japanese funds are more highly exposed to hedge fund products than their overseas peers. Yet despite the benefits of diversification, not all Japanese pension funds are able to take advantage of such global opportunities, and many maintain their highly conservative bias towards domestic bonds. The old legal investment restrictions may have gone, but these new investment trends introduce country, currency and corporate risks, which require strong organization, excellent staff and expensive systems to manage. Much of the awareness of new industry trends therefore remains talk rather than action.

92. Given the poor investment performance of pension fund managers (pension fund portfolios under performed the main Topix index in FY2001, 2002 and 2003), even since the reforms of the 1990’s, passive investment is proving increasingly popular in Japan57. Given the secular bear market, investment managers have been unable to deliver performance to justify active management fees. Also, as the big pubic pension funds have been moving in this direction, asset managers have had to offer passive funds in order to keep these major clients. Money that was previously managed by the Trust Fund Bureau under the FILP (Fiscal Investment and Loan Program) is finding its way into the stock market through the GPIF (Government Pension Investment Fund) which by 2009 plans to manage 70-80% of its funds passively. Postal savings funds (now ‘privatized’ but formerly the Kampo) are also negotiating a move to passive investment with the Trust Banks. Returning Welfare Pension money to the government has also encouraged the selling of active funds.

55 For example, the equity exposure of pension funds between March 1999 and January 2003 was reduced by over

11% (9% of this coming from domestic equities) according to a Nenkin Joho survey. Between March 2002 and March 2003 the Trust Banks (still the stewards of both public and private pension funds) reduced weightings by over 8% (5 coming from the home market). A Reuters survey saw recommended equity weightings peak in May 2002 at 52.5%.

56 JTB’s (Japan Tourist Board) pension fund provides a good example of the kind of restructuring which has been seen at Japanese funds. Pre 1997, the fund had a highly conservative structure, investing 65/35% in risk-free and ‘risky’ assets. 125 balanced funds were split between 7 trust banks, 6 life insurance companies and 3 investment advisors, operating a very traditional, conservative, low return allocation. Since the deregulation of investment rules in the 1990’s, specialist managers have been brought in to replace the trust banks and insurance companies, (e.g. at JTB 18% of funds are now in the hands of passive managers, 40% with global bond managers, 30% with 6 domestic equity managers and 20% with non hedged, foreign bond specialists). Details of changes in Japanese pension funds taken from Finance Asia article: www.financeasia.com

57 This rise is already having an effect on share prices. According to a Bank of Japan study, in 2000 87% of the movement in individual share prices was linked to specific fundamentals rather the market capitalization of the firm, yet this had declined to 70% by FY2002. From ‘Asia Business Watch’ 105/12/03: ‘The Death of Actively Managed Japanese Funds?’ author Darrel Whitten

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Table 9: EPF Asset Allocation and Asset Performance

Allocation FY2001 Avg. return (5 yrs)

Domestic Equities 31.98 -3.78

Domestic Bonds 21.97 2.9

Foreign Equities 19.61 7.29

Foreign Bonds 10.24 3.79

Others 16.2 NA

Source: Pension Fund Association

Figure 13: Japanese Pension Fund Management by Style

Active 62%Passive 335Value 23%Mkt Neutral 1%Small Cap 1%Quants/Active 1%

Source: Nenkin Joho, Asian Business Week

Governance Issues

93. EPF (Employer Pension Funds) do have a separate legal identity from the sponsor firm. Labour unions, personnel or finance departments run them, but the demarcation is fairly gray as staff tend to be simultaneously employed by both the union and the company. Trustees play little role in controlling investment decisions, with large chunks of money still being handed over to investment managers with loose mandates and little oversight (25% of assets still being held in the general accounts of life insurance companies). This is not to say that some improvements have not been made. For example Asia’s biggest institutional investor, the Government Insurance Fund (weighing in with over $200bn in assets) has implemented a radical overhaul of its fund manager structure since 1991, many managers being sacked when it was found that they were not following the investment style laid out in their mandates (many so called ‘value investors’ running portfolios with an aggressive ‘growth’ style tilt during the high-tech. Bull market period, leaving the fund far less diversified in style terms than it should have been once markets peaked).

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94. The awareness of corporate governance is also on the rise in Japan. Shareholder takeovers have been attempted at cash rich companies (such as Tokyo Style), and investors have been able to extract larger dividend payments from smaller companies. Due to the prolonged stagnant economy following the bursting of the bubble, relationships between companies and banks, in the form of cross-shareholding, have begun to change, accompanied by a move towards shareholder activism58. Though still highly concentrated on banks and affiliated companies, the ownership of the Japanese corporations has started to change (as bank, individual and corporate holdings have transferred to foreigners increasing the latter’s holdings in the market from under 5% to over 14% between 1990-1998). As with 1974 adoption of ERISA legislation in the US, the introduction of voting guidelines has caused Japanese institutional investors to exert more pressure on company management. These guidelines have come from the country’s largest pension organizations, including the GPIF (Government Pension Investment Fund) and the Pension Fund Association. Meanwhile, Japan’s Pension Fund Association, in charge of an influential $52bn of assets, has been studying CalPERS, and is looking to style itself as an institutional model for corporate governance in Japan. For example, in mid 2003 the organization formulated aggressive guidelines for proxy voting, including pushing corporations to have a minimum number of independent directors.

95. Yet cynics claim that such moves are limited and on the fringes, with little evidence that larger companies are really changing at all. For example, they point out that most of their ‘cross held’ shares in other companies have simply been moved to their pension funds, and there has not been any significant votes taken against company management. The corporate governance trend is also dampened by the increasing number of passive investors in Japan. Technical problems provide further barriers to shareholder activism due to the complex set up of Japanese pension funds, which do not give a clear picture as to who is responsible for voting rights. Corporate pension funds have so called ‘money trust contracts’ with trust banks, where pension funds are not legally allowed to give instructions regarding the buying and selling of individual stocks. Meanwhile, ‘investment advice contracts’ are made with investment advisors, who can give instructions to trust banks how to exercise voting rights. Consequently in Japan the legal rights to control companies and ownership of the pension funds are separated. Add cultural impediments (in the form of a corporatist capitalist model) into the mix and it is hard to see shareholder activism taking hold with the same force as in Anglo-Saxon markets.

“there is no explicit route for pension funds to execute voting rights in Japan. If the pension funds wish to execute their rights as shareholders to take their fiduciary responsibility, the only route is to put pressure on their trustee bodies to fulfill their obligation to increase the long-term value of pension assets, as far as is possible with the available measures.”56

Hong Kong

Structure of the market59

96. Given Hong Kong faced not only the challenges of a rapidly aging population, as with many other of the world’s major cities, but also the added problem of less than 30% of the 3 million workforce having any pension cover, the city’s authorities took action during the 1990’s. In 1995 the Mandatory Provident Fund Schemes Ordinance was passed, introducing a formal system of retirement protection through privately managed, employment related Mandatory Provident Fund (MPF) schemes. These required employers to arrange for all their employees to be affiliated to a scheme and self-employed

58 ‘New Development in the Japanese Corporate Governance in the 1990’s – The Role of the Corporate Pension

Funds’: Megumi Suto 59 For more detail on the HK pension market see www.mpfahk.org

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workers must also have coverage. They laid out defined minimum benefits that must be provided. Mandatory contributions of 5% of monthly income (with lower band exemptions and upper band limits) are required and are matched by employers, and additional voluntary contributions are allowed. Industry wide schemes also exist (e.g. for the catering and construction industries). All MPF schemes must be defined contribution in nature. Employers choose the trustee and the MPF scheme for their employees, while employees choose among the fund options offered under the chosen scheme. Most schemes offer 4 to 6 fund options varying from conservative to aggressive funds. ORSO schemes can be DB, DC or hybrid, with the choice of fund options (if any) determined by the governing rules of individual schemes. Most new funds being set up are now DC schemes (only around 15% are DB), with the trend amongst these moving towards insurance style defined contribution with some form of guarantees. The benefit structure is slightly different to, for example, European mandates in that these HK schemes do not pay out annuities, only lump sums, and not on retirement but on leaving a company’s service. This makes the time horizon for investing shorter than in other regions, and cash flow more volatile.

97. Aside from the Mandatory Provident Fund Schemes, exemption regulation allows for the setting up of voluntary schemes under the 1992 Occupational Retirement Schemes Ordinance (ORSO) that provides for the registration and exemption of voluntarily established occupational pension plans and contains rules aimed at protecting the rights of plan members. Some plans are regulated by an insurance arrangement, some being defined benefit. Pooled ORSO registered plans are those participating in a so-called pooling agreement under which the same plan rules apply to two or more individual occupational pension plans that are then administered by the same administrator. Employers sponsoring an ORSO registered plan may apply to the Mandatory Provident Fund Schemes Authority to contract-out of their obligation to affiliate all their employees to a mandatory provident fund scheme (so-called MPF exemption). If an employer sponsors an ORSO registered contracted-out plan, employees have the choice between joining this or an MPF. Participation in one or the other of the arrangements is however, compulsory. In order to be considered eligible for contracting-out, a plan must be registered with the Registrar and must governed by a trust and other requirements.

Bearer of Investment Risks

98. HK funds currently show an overall surplus, (though this hides c17% of funds with an average deficit of over 6%). However, rules over who owns the surplus at HK pensions are even less clear than in other markets. No rule exists to prevent sponsors withdrawing excess assets from DB schemes. Contributions are on a ’balance of cost basis’ – i.e. after employee contributions and recording investment income. The company therefore receives the benefit of investment out-performance through reduced contributions or with-drawls though must cover deficits on the downside. This suggests that individuals bear more risk than in other pension systems.

Strategic Allocation

99. Given the prevalence of DC schemes, ALM is not as important in Hong Kong as in other markets. The larger defined benefit funds do undertaking asset-liability modeling, but not at particularly sophisticated level. MPF schemes are highly restricted in their asset choices and may not invest in hedge funds or private equity. New investment trends such as alpha investing and risk budgeting remain largely talk.

Asset Allocation Trends

100. The Hong Kong market provides domestic pension investors with a particular challenge due to its highly skewed sector balance. ‘Home bias’ leaves them particularly exposed to diversified industrials (such as Hutchinson Whampoa) and property (which forms 19% of the HK index, Vs less than 2% of the global).

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Hong Kong investors have consequently had traditionally higher overseas weightings than pension investors in other markets. According to the MPFA, as of the 30th September 2003, MFA funds had an average allocation of 30% bonds, 49% equities, Vs ORSO (MPF exempted) funds at 35% and 42% respectively.

101. Hong Kong’s largest pension fund, the Hospital Authority, provides a good example of the asset allocation diversification that has been undertaken by the city’s pension funds over recent years. The $2.3bn fund manages its own asset allocation, with external consultation, using a diversified, multi-manager structure. They originally invested in large–capitalization stocks and government bonds, branching out in time to a broader range of securities, to the rest of Asia during the 1990’s, onto emerging markets, and in 1995 to property (though this is uniquely challenging market in Hong Kong due to high prices and the presence of many fast moving speculators). The fund now has the goal of investing up to 10% of its assets in alternative investments, currently holding 2.5% in private equity and 2.5% in hedge funds (via a fund-of-funds structure). They have also moved 5% of their bond exposure to high-yield fixed income instruments (previously passively investing in government bonds and HK$ debt). This is a welcome trend, which it is hoped other fund in the city and region will follow, as Asian investors have largely been missing out in the venture capital/ private equity bonanza of the region. However, the Hospital Authority is possibly the only fund that has dedicated funds for alternative investments. The smaller funds do not yet have a fixed allocation to this asset class, but may allow their managers to invest in such areas on an ad hoc basis.

Governance Issues

102. In the case of MPFs, the prudent person rule is applied with strict quantitative limits. The trustees must appoint an asset manager to manage the investment of the scheme assets. A maximum of 10% may be in securities and other permissible investments issued by any one person, a minimum of 30% must be held in Hong Kong Dollar, sovereign level debt. Funds are also allowed to invest in debt securities listed on a recognized stock exchange, of if unlisted ones that satisfy a minimum credit rating set by the MPFA. Equities, convertible debt securities, warrants, bank deposits, IPOs, listed futures and options contracts (for hedging and with limited leverage) are also allowed. Not more than 10% may be in shares listed on a non approved stock exchange, with no more than 5% in warrants, and no more than 25% may be in cash deposits (if the total market value of the constituent fund is less than HKD 8 Million and not more than 10% in any other case).

103. There are, however, no quantitative limits for occupational schemes, other than those concerning self-investment (with not more than 10% of the plan assets being in so-called restricted investments, i.e. those issued by the sponsoring employer). If the trustees appoint an asset manager, the MPFA must be given notice of this appointment, and the assets must be managed under the prudent person rule with due diversification. Furthermore the asset manager must ensure that derivatives are not used in such a way as to result in the assets of the plan becoming leveraged. Strict limits apply to the amount of money that may be borrowed.

104. Pension funds in HK do have a trustee structure, some being individual and some corporate trustees. Trustees appoint independent investment managers and play an important monitoring role, but do not in general participate actively in asset allocation debates. Consultants do have influence over external fund managers, but tend to have less influence than in say some European countries.

105. The governing authority of the MFP (MFPA) was set up in 1998 to overseas the new pension system. Key governance features include approval and registration for those operating MPF schemes (and their trustees), as well as stringent requirements regarding capital adequacy, financial soundness, fitness and propriety needed to run funds. Prescribed standards covering internal controls, the investment of

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scheme assets etc., must also be followed. Even if not explicitly written, the governing rules by law include the provision that the trustees will comply with the prudent person rule, act only in the interest of the scheme members and ensure that the funds of the scheme are invested in different investments so as to minimize the risk of losses of those funds. The MFPA ensures compliance with legal requirements, registers provident fund schemes, approves qualified persons to be trustees of registered schemes, and ensure that schemes are administered by approved trustees in a prudent manner. Ongoing monitoring of system operations and trustee compliance with statutory regulations also takes place, and the authority may hold inspections or audits as required and may suspend/ terminate trustees approval. A safety net is required for all funds, with insurance or other means required indemnifying losses. The trustees must manage the contribution and benefit administration themselves, appoint a custodian to hold the scheme assets, establish a separate individual account for each scheme member, and ensure that each member's account is kept in such a manner that the market value of the accrued benefits of a member can be ascertained at least once a month.

106. The Mandatory Provident Fund Schemes Authority also registers and supervises complementary occupational plans and mandatory provident fund schemes. The MPFA may require an auditor to prepare a special report and/or require an actuary to prepare a special actuarial report if the MPFA if it receives a written request from the consultative committee formed by the plan members or a request signed by not less than 20% or 100, whichever is less, of the plan members.

107. There is much awareness of the need for shareholder activism in HK, and improvements have been made since the Asian crisis. Yet this trend is unlikely to move much further forward whilst trustees maintain such a passive presence in the investment structure.