November 2009

IRISH PENSION FUNDS: a bad starting point

Managed pension funds in Ireland have posted seven months of successive growth. Nicholas Pratt is in Dublin to ask if this signals the start of a recovery – or if it is a cause for further concern.
Ever the model of consistency, Ireland has embraced the recession as warmly as it did the boom years of the early 1990s. In previous years, economic surveys typically placed Dublin and Ireland near the top of those spurious wealth/happiness indices where expensive house prices are equated to a higher standard of living.

Now the surveys paint a very different picture, particularly when it comes to pension funds. According to a survey carried out by Paris-based think tank the Organisation for Economic Cooperation and Development (OECD), pension fund losses in Ireland were the highest in the world with the average retirement plan losing more than a third of its value.

Figures from Dublin-based Rubicon Investment Consulting showed that the top ten managed pension funds in Ireland lost €27bn during 2008 – equivalent to 34.8% of their value. Over-exposure to the Irish equities market, which lost 65% of its value in 2008, was cited as the principal cause of these losses with the average pension fund spending 14% of total assets on domestic stocks.

The mood at the annual Irish Association of Pension Funds (IAPF) congress earlier this year was certainly bleak with the only upbeat note being that a recession may eventually lead to a higher mortality rate which will go some way to shortening the massive deficits facing most pension schemes.

Positive developments?
But in recent months the news from the pensions industry has been more positive. The latest figures from Rubicon show that the returns from managed Irish pension funds have enjoyed seven successive months of positive returns culminating in the latest figures for September 2009 which showed an average return of 2.6%. The third quarter for 2009 had an average return of 11.6%, which is the most positive return seen in Ireland for almost a decade (the fourth quarter of 1999), while the average returns for the year to date is 17.9%. 

In terms of individual managers, the best performing fund for September 2009 was Irish Life Investment Managers, which returned 3.1%, while the lowest performing fund was that of Friends First/F&C which returned an increase of 2.1% for the month. Merrion Investment Managers has the best return for the year to date at 26.1%, while the lowest is AIB Investment Managers at 11.6%.

So do these figures suggest that a recovery is well under way in the Irish pensions market? Not according to Paul Droop, senior investment consultant with Watson Wyatt. Instead he says the Rubicon figures are a cause for yet more concern. The fact that pension funds are experiencing this kind of volatility is not good and the fact that the results of the last quarter have been positive rather than negative is down to luck.
“Pension funds should not be investing with luck but with proper care, governance and risk management,” says Droop. The latest results may look like good news but it is only because the equity markets have had a good quarter, he says. And even these positive returns still come nowhere near equalling the level of losses experienced in the last 18 months.

The overall majority of Irish pension funds are still investing too big a proportion in the equity markets, says Droop, and this is a recipe for volatility. Pension fund trustees should instead be looking to measure the level of risk that they are exposed to, look at the factors which may influence the volatility and then decide whether the risk and the volatility is at an appropriate level for the fund. There are still many trustees that have not taken this vital step, says Droop – even though there has never been a more pressing need to manage this risk. Not only are pension funds facing massive deficits, but a number of companies in Ireland are going bankrupt, meaning that workers may lose their job as well as their pension.

The investment managers contracted by trustees may be held accountable for some of these losses, but the ultimate responsibility lies with the trustees, says Droop. “The investment managers are only working to the mandate they are given by the trustees.”

The Rubicon survey shows how much importance is placed on returns by trustees when they are mandating their investment managers, so it is no surprise, says Droop, that managers gravitate towards the riskier assets in order to get these returns.

Risk managment
Given the nature of the pension funds market and the fact that each scheme is different makes it difficult to be too prescriptive when offering investment advice, but it is clear that the one-size-fits-all approach of the type of managed funds featured in the Rubicon survey are clearly unsuitable for pension funds. And little has changed in the last 18 months.

“The trustees have simply not put enough effort into proper risk management. All trustee boards have to lift their game in terms of governance. Do they have sufficient knowledge of their risk? Have they given serious and objective consideration as to their risk tolerance? Are they able to back up any deficit that may exist in their scheme?”

Obviously different pension boards will have different levels of resources, but as Droop says, if you don’t have the time, resources or expertise to take on a lot of risk, then you shouldn’t do so. “There are simple steps that can be taken by smaller schemes – reduce the amount of equities, increase the amount of bonds and matching hedges, cut out risk where it does not need to be taken – for example, the use of active managers – and look to reduce the amount paid in fees or lost in transactional slippage.”

For the bigger funds there can be no such excuses – they should be employing a resource to manage the risks and exploring a wider range of assets including more sophisticated instruments such as those featured in liability-driven investment (LDI) strategies so that they can take a more targeted approach to risk management.

A lot of these principles are featured in the investment guidelines that were produced by the IAPF in April 2008. These include regular and formal discussions on investment matters; an insistence on regular presentations from investment managers on the assets under management and any relevant market developments; and an allocation of sufficient resources in order to adopt consistent governance.

“The response to the guidelines has been good and a number of the big consultancy firms have requested copies which they have sent to their clients,” says Jerry Moriaty, director of policy at the IAPF. The association has subsequently issued a booklet, Guidance on Compliance for Defined Benefit Schemes, which showed trustees the steps they need to take to comply with the original guidelines, and work is being finalised on a similar booklet for defined contribution schemes. “I think the recent market bounce has provided some grounds for optimism but I doubt that too many trustees are getting carried away with that as they realise they still have many issues to deal with to provide a sustainable long-term solution.”

The long game
According to Brian O’Kelly, principal at QED Equity, a Dublin-based private equity firm, the results of the Rubicon survey should not be overstated given that a pension is the ultimate long-term investment and should therefore be indifferent to short-term market behaviour. “Just as one swallow does not make a summer, one good summer of returns does not solve a pension problem, even if it does lessen the damage. Asset allocation is key. If you’re dependent on the next market rally for your pension, your strategy is wrong. I’m much more interested in five- and ten-year performance than the short-term periods like those mentioned by Rubicon.”

There is an increasing body of research, says O’Kelly, that suggests, since your future cash flows are known, then the appropriate asset class should have similarly known cash flows – something which automatically suggests high-grade fixed income securities as the asset class of choice. “In other words, the default position is that we invest everything in fixed income and all other assets are measured against what a fixed income asset would offer. Liability-driven investment also scores well because it keeps the potential for underperformance very low, albeit at the cost of removing any potential outperformance.”

Most investment managers employed by Irish pension funds are managing against a benchmark, says O’Kelly, and the majority of them are keeping any tracking error to a minimum. “The few active managers that were given a mandate have performed poorly but I expect this is not the key problem. The real problem is that all asset classes – hedge funds, equities, commodities, property, high-yield bonds – were highly correlated and all underperformed.”

Anecdotal evidence, says O’Kelly, suggests that risk management is indeed top of all stakeholders’ agendas. However, it would have been more helpful if it had been as high a priority before the current crisis. “Sadly it was never thus,” says O’Kelly. “We only get exercised about the issue when we’ve got a problem, such as the plan sponsor having to make extra contributions, or the trustees suggesting modifications to the benefits.”

It brings to mind the old joke about asking for directions in rural outposts. A US tourist stops his car to ask a local farmer for directions to Kilarney. “Kilarney?” says the farmer. “Well I wouldn’t start from here.” It is a similar tale for Irish pension funds, says Watson Wyatt’s Droop. “If you want to get to a point where Irish pension funds are well funded, you would not start from here.”

©2009 Funds Europe

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