How do pension funds and insurance companies match long-term objectives with short-term considerations?
Elisabeth BOURQUI – Head of Pension Management at ABB Group
Wim VERMEIR – Group Head of Investments at AGEAS
Bernard DESCREUX – Head of Asset Management at EDF S.A.
Frédéric SAMAMA – Co-Head Institutional Clients Coverage at Amundi
Moderated by Anthony HILTON – Economics and Business journalist
Post-crisis regulatory changes for investors with liabilities have pushed pension funds and Insurance companies to look for an equilibrium between short-term requirements and long-term objectives. As we enter a geopolitically unstable world, how will institutional investors manage? How are they reshaping their asset allocation and risk management, and what new asset classes are they exploring?
REGULATIONS ARE NOT HELPFUL FOR THE LONG TERM
Bernard Descreux laid out the problems for pension funds: Central bankers are keeping yields low to stimulate industry and long-term investment, while pension funds must deal with increasingly stringent regulations such the new EU IFRS9 accounting norm. This aims to prevent banks and volatile asset owners “from doing dangerous things,” by assessing the value of assets in order to be able to compare them to liabilities. The problem is that it does not make any provisions for long-term investment, so sub-sovereign funds do not have to comply, while listed companies must. “What is the problem of having full-fair market value on the asset? It is that the difference of your value goes into your net debt result, giving the impression of volatility, which has nothing to do with your main business, in our case, electricity production.” Furthermore, the norm does not consider diversification, with investments taken one-by-one, abstracted from the portfolio, Mr. Descreux lamented.
There are also problems for insurance companies, according to Wim Vermeir. Life insurance companies must invest for the long term and “drive through” volatility cycles, but regulations such as IFRS9 bring volatility into their investment framework. This also holds true for solvency. “The biggest issues we have are on the spread risk. It is our business, investing at a higher yield than the risk-free rate which, on top of it, is close to zero.” Insurers generally agree that the spread risk is not well-treated in Solvency 2, which has already pushed most of them out of equity. “If they are now pushed out of government bonds and corporate bonds, it becomes really difficult for us, for our clients, and for the financial system as a whole.”
Joining the discussion, Elisabeth Bourqui said that ABB has the additional problem of administering pension plans worldwide in different jurisdictions and with different pension structures. Some of theplans are linked to inflation, some have issues of demography, and many have different durations and liability profiles. In addition, ABB must report globally and list all the plans on its balance sheet. To deal with the challenge of facing local and global constraints simultaneously on a real-time basis, ABB has had to digitalize its operations as much as possible, she emphasized.
« The big difficulty is to make sure that we understand the market cycle and our own cycles as a corporation, in order to somehow surf the waves on top of our strategic asset allocation. »
THE NEED FOR STRATEGIC AND DYNAMIC ASSET ALLOCATION AND BUFFERS
ABB also counts on an ALM (assets and liabilities) study to come up with a strategic asset allocation that satisfies the long-term objective of protecting its beneficiaries, while dealing with the shorter-term issues faced by a listed company. “When you are in a corporate pension position you have to be solvent in every situation and in all market cycles, not only for the pension plans, but also on the corporate side.” This means establishing a dynamic asset allocation framework on top of a strategic allocation, affirmed Ms. Bourqui. It is updated every three to six months, according to market cycles and ABB’s own cycles. This has worked well; for example, when ABB’s liabilities and balance sheet were hit by the long-term low interest rates.
Mr. Vermeir agreed that dynamic asset allocation is also important for insurance companies. However, AGEAS uses a one-year horizon, and has the tactical leeway to move into new investments when the timing is right. Moreover, it tends to be over capitalised to have a buffer “to absorb the volatility shocks that are in the regulatory framework”.
Speaking for Amundi, Frédéric Samama, added another solution to dynamic allocation and buffers: “delegating the market experiences.” This has two parts, equity overlays and market exposure platforms. For equity overlays, Amundi has been able to reduce the maximum draw-downs by half, from 60% to 30%, while abandoning about 30% of the average up-sides. “It is a very flexible solution, meaning that we adjust the options based on market conditions, but can also adjust the hedging based on timing and the objectives of the clients. So, it’s really a kind of delegation of hedging,” he affirmed.
Market exposure platforms, on the other hand, benefit from Amundi’s size, bargaining power, and knowledge. This allows it to deal with a very wide range of products, including swaps, futures, and options. With market exposure platforms, clients can shift their exposures efficiently and cheaply.
« We have seen the disappearance of the risk premium; the only risk premium that remains is the risk premium on liquidity, so illiquid assets have pretty interesting qualities. »
ASSETS AND LIQUIDITY
Describing AGEAS’ strategy, Mr. Vermeir said that it matches its long-term liabilities with a long-term buy and hold strategy. It has been looking for alternatives to government bonds and corporate bonds, especially after the ECB started buying them. Since its liabilities are stable, it does not need much liquidity, so it has used direct lending as a countermeasure to low interest rates. It now has an important business lending directly to small companies, as well as to local authorities and regions. It has also done about €1.5 billion in fixed income infrastructure lending.
Mr. Descreux agreed that one of the few remaining risk premiums is that on liquidity. Therefore, illiquid assets are of interest, especially real estate and infrastructure. He pointed out that by buying such assets you are buying a business, in the case of infrastructure one with a business plan and probably a secured return. You can leverage this, benefiting from the low-yield environment and, with regular refinancing, enhance the base return.
Mr. Samama added that, while illiquid assets are a must-have in the low yield environment, they are complex. They depend on unstable incentives from governments, and grant limited access. Scaling them and fitting them in with investors’ constraints and objectives is an additional problem.
THE ASSET MANAGER AS STRATEGIC PARTNER
There are different business models for investing in infrastructure, Mr. Samama explained, be it co-investment, working with infrastructure funds, or platforms such as development finance institutions. Amundi has a unique model through its strategic partnership with EDF, whose experts can identify and repackage projects before bringing them to investors.
Turning to a different kind of strategic partner, the asset manager, Ms. Bourqui praised ABB’s partnership with Amundi; for example, its help in identifying risk factors to implement ABB’s diversification strategy. Mr. Vermeir agreed that the asset manager is a strategic partner, especially for illiquid assets. “For illiquid assets, I really want a model of originate to co-invest, I want the partner originating the deal to also put skin in the game.” In this spirit, AGEAS has partnered with a Belgian private equity firm as well as with investment banks who take their share of the exposure on the balance sheet, cementing their commitment and assuring continuity.
Mr. Samama summed up Amundi’s approach to partnership. You must bring in new partners as well as “the brains behind the products”. The Amundi partnership with EDF is one example, as is another with the French Atomic Energy Commission (CEA), which brings with it substantial research expertise. It is also important to sit down with clients to develop the products that fit their constraints, since there is no universal solution for risk factors, smart data, and the like, he said. “It’s a totally new approach, it’s very challenging, but it’s very exciting as well.”
« We must re-invent ourselves. We can summarise by saying that there are two main approaches: to bring in new players, and to bring to the table the brains behind the products. »