Reinforcing the Foundations of the Individually Funded Pension System to ensure its Sustainability Pension Funds Investment Returns and Risk Management Graham Goodhew - Director & Conducting Officer JPMorgan Asset Management (Europe) Sarl FIAP - XII Seminario Internacional AAFP - I Congreso Internacional May 15 16 2014 Cusco, Peru
The Interaction between the Pension Funds Investment Regulatory Regime, the Fiduciary Responsibility of Fund Managers and the Expertise Requirements of Fund Managers With the move from State Funded Pension Schemes ( pay as you go ) and from Defined Benefits Schemes (where often the Employer took the investment risk) most Countries have implemented, or will implement, Defined Contribution Schemes Each Jurisdiction will establish its own Regulatory Regime which it considers Appropriate for its Citizens Mandatory or Voluntary Often a combination of both Investor, Employer, Government Contributions Employees may have an Individual Retirement Account (IRA) or invest in Pension Funds On which they take the Investment Risk The Average Employee does not have the expertise to manage their IRA so they look to Pension Fund Managers or Investment Advisors for Advice and help in making the right decisions The Regulatory Regime must support an Appropriate level of Risk Taking by the Investor so they can endeavour to achieve their investment objectives Advisors must have the same Long Term view of the investment objectives as the Investors Advisors must have the expertise to advise Investors on a Broad range of potential investments across Asset Classes and Geographically Costs charged for managing IRA becomes an important factor and how Advisors get paid must be structured to avoid any potential Conflicts of Interest
The Measurement of Fund Performance and Consistency of Simultaneous use of Investment Benchmarks and Asset Class Exposures Limits Employees have differing requirements for their IRA throughout their working life Their ability to take Risk Exposure varies according to Age, how close they are to Retirement and Other Financial Commitments This clearly means that the exposure to different Asset Classes must be considered over what will be typically a 30 to 40 year investment horizon with different limits being applied during the life cycle to ensure the right Risk Profile of Investments Youth = Higher Risk Growth Strategies (Equities, International Investments, Currency, etc.) Maturity = Lower Risk Capital Preservation (Fixed Income, Government Bonds, Domestic Investments, Inflation Linked, etc.) Many Countries/Fund Managers have adopted categorisation to group the pension investors into pre-defined Risk Profiles Examples include: A to E rating where A may be the most Conservative and therefore aimed at those closer to Retirement and E is Riskier and designed for Younger investors who can accept more risk as they are further from drawing on their Pension Groupings may also be done based on Age with Risk Profiles of the Funds offered to each Group Decreasing as the Investor moves into an Older Group (<26, 27-45, 46-59, >60)
The Measurement of Fund Performance and Consistency of Simultaneous use of Investment Benchmarks and Asset Class Exposures Limits Pension Funds must consider a long investment horizon and take a structured view and not respond to short term market movements Simply safeguarding of Capital is not adequate, while speculation and inappropriate levels of investment risk are also unacceptable This also suggests that diversity of investment is very important to ensure negative effects in some investments are offset by other positive returns and Capital Preservation can be Balanced against Income Growth Volatility concerns all Investors and a sharp drop in a market will tend to drive a flight to safety e.g. Equities to Government Bonds. This is not necessarily the right response when considering the Long Term. In 2008 the Dow saw 4 of its 5 WORST days ever, it also saw 4 of its 5 BEST days The First big drop was on 29 September 2008 with a 6.98% Fall. At 1 st October 2008 the Index was at 10,831, it fell eventually to 6,547 on 9 th March 2009 The First big rise was on 13 October 2008 with a 11.08% Rise. On the 7 th May 2014 the Index stood at 16,519. An Investor selling after the First big drop and investing in Fixed income at 2% would have earned 12.61% over the period, if they had been able to invest at 5% they would have earned 34%. If they had stayed invested in Equities (Dow) they would have seen a growth of 52.5%. The important point is that the right Asset Class Exposures must be considered and appropriate Risk Exposure taken relative to the Investors Risk Appetite.
The Measurement of Fund Performance and Consistency of Simultaneous use of Investment Benchmarks and Asset Class Exposures Limits If Riskier Assets are allowed to be held as part of Pension Funds how do we ensure that the Investor is adequately protected? Are there types of Assets/Investments that should be specifically restricted, or even banned? Should those restrictions be driven by Regulators or by Appropriate Risk Assessments and Risk Limits? Do Investors have enough Transparency and Disclosure regarding Investments, before they buy. Are they being Properly and Impartially Advised? Regulations and Controls must consider Point of Sale regulation as well as product regulation and investment limits. Investor Education is a Global problem
The use of Derivatives and Alternative Investments In March 2014 the European Commission issued a Communication from the Commission to the Council and the European Parliament on Long - Term Financing of the European Economy The Commission welcomes that pension funds are increasingly turning to alternative investments such as private equity and infrastructure to diversify portfolios and provide higher returns However it goes on to quote a recent OECD survey (18 October 2013*) of 86 large pension funds and public pension reserve funds that found only 1% of their assets were invested in unlisted infrastructure investments and 12-15% were invested in other alternative investments (the rest of the assets were invested in fixed income, cash and listed equity) The use of Alternatives is growing within Pension Plans as Long Term Returns are sought to meet the Long Term Liabilities of the Funds Many Regulators currently see Derivatives as only being suitable for Pension Funds if their use is limited to hedging or efficient portfolio management. This is perhaps missing out on the investment opportunities that made be afforded by the use of these types of assets The use of Derivatives requires the use of suitable Risk Modelling on the portfolio of the Pension Fund, typically VaR, Stress Testing and Back Testing. * https://www.oecd.org/daf/fin/private-pensions/survey-large-pension-funds.htm
Infrastructure Investment Modalities used by Pension Funds across Countries with Individual Capitalisation Systems There is a growing recognition of an opportunity to match the Long Term investment requirements of Personal Pension Plans with the need to Finance Infrastructure Projects with Private Funding rather than Tax Revenue In March 2014 the European Commission issued a Communication from the Commission to the Council and the European Parliament on Long - Term Financing of the European Economy Two of the stated objectives being; creating a single market for personal pensions and potentially mobilizing more personal pension savings for long term financing and ensuring that Institutions for Occupational Retirement Provision (IORP) will not be prevented from investing in long-term assets. In November 2012 the EU Commission invited the European Insurance and Occupational Pension Authority (EIOPA) to prepare technical advice on the development of a EU-wide framework for the activities and supervision of Personal Pension Products. This would represent an opportunity to mobilise more savings for financing longterm investment, thereby fostering both retirement income adequacy and economic growth Participation in Infrastructure by Pension Funds often takes one of the following forms: Purchase of debt issued by Infrastructure Operators Unlisted Investment Institutions (e.g. PE) Equities of Listed Infrastructure Companies or through Infrastructure Funds Joint Ventures with Other Companies to Operate the Investment (Project Finance)