Recently, I have been invited to propose some solution to manage the pension of a European organisation. The pension industry is across all countries under huge pressures. The storm of regulation started in 2008 is making the job to manage pension very complicated in three different ways. First of all, they increase the direct cost to manage pension. For instance in Europe, from 2017, EMIR directive will introduce a central clearing system for derivatives. Pension huge derivatives for hedging their liabilities against inflation, interest rate or currency risk. It will improve the stability of the European market by improving transparency and reducing risk. But it will increase the cost of execution and could lead to higher liquidity risk as more liquid assets will be required as collateral. Secondly, it makes the pension governance more complicated. The Credit rating Agency (2013) forced pension to make their own assessment on credit rating to limit the weight of the credit agency. A solvency 2 should come up soon for the pension industry as it came for the insurance industry. The IORP 2 likely to be applied from this summer established rules for governance and member schemes communication. Finally, regulation limits considerably asset allocation and potential solutions. For instance, under the AIMFD directive, in one hand the governments want to facilitate investment in infrastructure and debt instrument to make it easier for an institution to find yield . But this can be done only under UCITS vehicles.
But regulation is not the main threat to the industry. The current monetary policy worldwide, the risk of deflation and a negative interest rate at least in two main part of the world: Europe and Japan are weighing on the pension liabilities. Clearly, the low-interest rate policy has a devastating effect on the pension. Pension have to hold more assets to back their long-term payout projections. Low-interest rates are lowering the discount rate that is applied to calculate the fund liabilities. Future cash flows are discounted to account for the effect of inflation. So, when the discount rate decreases, liabilities increase. In average, one percent decrease in the discount rate is equivalent to an increase of twenty percent liabilities. In Europe, the accounting IAS 19 requires fund to measure report and rectify any funding deficit they may have on valuation of liabilities and assets.
Finally, the current macroeconomic environment is not and will not be favorable to the pension industry. A come back to a normal situation in term of the monetary policy is unlikely at short or medium term. The volatility will increase due to an uncertain economic outlook and an increase of economic and geopolitical factors. Taking advantage of the “beta” or the market is going to be difficult for long-term investors. At the end of 2015, in the US the pension deficit was estimated around 80% versus 85% in the UK and 91% in Canada. In Europe, regarding the difference of legislation it was difficult to make a global estimation, however in Germany and France, the pension deficit could be estimated around 65%, an awful figure.
Clearly, the pension industry is facing huge challenges and the time for the status quo is passed. Most of the pension fund needs to implement measures in term of governance, investment process and risk management. The priority is to put in equation the risk with the return looking for. Secondly, the universe of asset class needs to be extended: increasing the size of more illiquid assets: real estate, infrastructures, private debt, including some “alpha” using alternatives with a focus on systematic strategies. Pension needs to find a balance between the ability to capture value on short term movement and our long-term objectives in term of liabilities and risk, this includes developing Tactical Asset Allocation (TAA). The diversification of the fixed income portfolio is a basic and it has been already implemented by most of the pension fund in the UK.
Presenting such measures to a board of a European institutional managing about 6 billion euros pension with over 6 billion liabilities in the balance sheet was quite an experience. It was like making a speech in Chinese to Nigerian students. The investment process was coming from the nineteen centuries. They were beating a benchmark with no relation to their liabilities and they did not want change this benchmark management despite a continual increase of the pension deficit. The making decision process was indeed driven under different committees, no clear responsibilities could be identified. Three of five members were close to being pensioner and I was like a Martian discovering the prehistoric world. Indeed, this institution will not collapse, European taxpayers will fill the deficit gap. But I could summarise this meeting by this beautiful sentence from Boorstin, D. J. “The greatest obstacle to discovery is not ignorance, it is the illusion of knowledge”. This ignorance has a cost for European taxpayers and such inefficiency can explain the disaffection for the European project.