How to invest your pension savings ?

Lord Keynes already recognised that "in the long run we are all dead". Nonetheless pension money is invested for the long run.  Some Canadian pension funds, like PSP Investments or Caisse de Dépôt et de Placement du Quebec have time horizons of 75 years or more. These pension funds invest first pillar pension money which are organised by Social Security In Europe. They have a very long term horizon because 1) social security pensions are paid out as a life annuity and not a lump sum and 2) early redemptions of pension rights are not allowed as it is often the case for occupational pensions.

Every investor of course tries to maximize the risk-return dilemma. Long term investors like pension funds and insurance companies have another concern which is minimising the duration gap between assets and liabilities. This is not easy because very long term assets are hard  to find. Some Governments issue long term bonds over 30, 50  or even 100 years but the returns in the markets today are discouraging and lead long term institutional investors to look for other (illiquid) assets like real estate, loan portfolios or infrastructure.

The duration of occupational pension plans is much shorter. Benefits can often be paid out as a lump sum (in Luxembourg for instance) so that the effective term age of a benefit rarely exceeds age 60 or 65. On the other hand, redemptions of pension rights are possible in some particular circumstances. Experience in Luxembourg shows that pension right redemptions are rather frequent in Luxembourg. Average durations of occupational pension schemes are much shorter and a range of 10 – 15 years is realistic.

THE big question is how occupational pensions should be invested. With the disappearance of defined benefit schemes and the rise of defined contribution plans, the investment risk is now borne by plan members. Investments in traditional insurance contracts were popular in the past but unit-linked products, either in pension funds or in insurance contracts are becoming increasingly popular. Interest rates in insurance contracts are continuously decreasing for new premiums invested in pension schemes. In Luxembourg the interest rate is currently set at 75 basis points (before costs), in France the rate is 0,50 %. These desperate low interest rates increase the risk appetite of pension savers. In a unit-linked contract, the affiliate can choose how his/her pension money should be invested. Many pension savers wonder how they should invest these pension savings.
 

Stocks for the long run ?

Stocks for the long run is the title of a book published by Jeremy Siegel, professor of finance at the Wharton School. The book is sometimes referred to as the "buy and hold bible" and his findings show that stocks have returned (mainly in the US) on average between 6,5 and 7 % after inflation over the last 200 years. In an interview with the Wall Street Journal Professor Siegel conceded that his thesis is not true anymore for the 21^st century so far. Bonds indeed, with ever falling interest rates, have outperformed stock markets since the year 2000. This will not continue over the years to come as it is not likely that long term interest rates will sink deeper into negative territory. Dimson, Marsh and Stauton (London Business School) point out in "Triumph of the Optimist" that mostly the over-performance of stocks refers to data in the US. Their compiled data analysis covering 22 countries show that investors in stock markets can suffer hard times. The longest period of negative return in the US was 16 years. But it was 19 years for global equities. It was 51 years for Japan, 55 for Germany or 66 years for France. This goes far beyond a "normal" pension savings horizon and blind investments in stocks should be avoided.
 

Asset allocation is key

The driver for return is the appropriate asset allocation. This evidence has been proven and discussed now for decades. The first major investigation in this field goes back to the year 1986 and  a study by Brinson, Hood and Beebower (referred to as BHB in the literature). In their landmark article entitled "Determinants of portfolio performance", they claimed that 93,6 % of the average return in a portfolio can be explained by the policy mix (or the asset allocation). Since then, the affirmation that 90 % of a portfolio can be explained by asset allocation has become like general wisdom. Ibbotson and others have pointed out that BHB were misinterpreted; they have not claimed that the level of return but the variance of return is explained by asset allocation.  The return can be split between the passive return (or beta) and active return (the remainder of the return or alpha). Ibbotson and his research partners point out that return is the result of 3 main components: 1) market movement in the underlying asset class, 2) asset allocation policy decision and 3) security selection. 75 % of the return is explained by the market movement.

The big question is how asset allocation should be dealt with in practice and who decides on asset allocation. Is it determined by the employer or by the employee and what are the guiding principles ?
 

Life cycle investments

One example on how the employer can help in the definition of the asset allocation is by offering a life-cycle model. The objective is to balance risk and return for plan members based on the number of years remaining until retirement. Younger affiliates would invest more in growth assets while mature members would transfer their assets to more conservative asset classes. There is no individual asset allocation by members. The plan administrator proceeds to automatic readjustments.

In North-America, and partially also in the UK, life-cycle investments are becoming increasingly the default option investments in DC (defined contribution) plans. The life cycle investment is ideal for plan members who are unable or not willing to make their own investment choices by adopting a reasonable risk-return profile. Experience has shown that plan members do not always do the appropriate choices when they take investment decisions themselves as they lack the required knowledge about the functioning of capital markets. Within life-cycle investments there can be more dynamic approaches or more conservative approaches. Hereafter we show an example of a conservative portfolio.

Example of a life-cycle pension investment (conservative portfolio)

In a dynamic portfolio, the equity part would typically be higher in earlier years. Apart from equity, the growth part could also invest in real estate for example. Life-cycle strategies are not designed to maximize returns, rather to balance risk and return.

It is worthwhile to point out that the Luxembourg legislator has set limits on investments in stocks for 3^rd pillar pensions. The limits are as follows:

Multi-asset funds

An alternative to the life-cycle model could be the multi-asset fund opportunity. Here the employer would help each employee to define his/her own risk profile (with a MIFID type questionnaire for example) and then guide them to a portfolio composed of several asset classes (typically stocks and bonds). The weightings on the stocks and bonds would differ with the risk appetite of each individual plan member. They could go from conservative (20 % stocks, 80 % bonds) to dynamic (80 % stocks, 20 % bonds). There is no automatic rebalancing; members need to manage their profiles, once they get closer to retirement.
 

Individual asset allocation by members

Sometimes plan members want to have their own say in asset allocation. In this case, the employer just makes sure to provide an appropriate choice of asset classes allowing each member to proceed with his/her own asset allocation. These asset classes could include for example:

• Stocks worldwide
• Stocks US
• Stocks Europe
• Stocks Emerging markets
• Bonds EUR
• Bonds USD
• Bonds Emerging Markets
• Real estate
• Money markets

These type of asset allocations need a higher involvement from employers and consultants as it is not sure if all plan members have the appropriate knowledge to take the right decisions and go for the optimal risk-return profile.

In this type of asset allocations, switches from one asset class to another appear to be more frequent. It is not obvious if this model is the most efficient one in the long run, even if it seems to have the preference of many employers and also affiliates. The most tricky issue in individual asset allocation models is the transition or gradual risk reduction from the accumulation (growth) period to the pay-out period. Vanguard for example has reported that in the US, 9 % of plan participants traded their investment choices in their pension plan on a yearly basis which raises the question of the added value of individual asset allocations.
 

Actively managed funds or ETFs ?

In early 2016, the global ETF market represented some 2'700 Bn EUR in more than 4'200 funds. ETFs in Europe stood at 450 Bn EUR. ETFs are funds who target the replication of the performance of a stock index.

The merits of passive versus active management have been debated for many years. In a study conducted by S&P Dow Jones and mentioned in the Financial Times on 20 march 2016, 86 % of actively managed equity funds underperformed the benchmark over the past decade, raising questions about the value of stock-picking. In the Netherlands, 100 % of actively managed funds failed to beat the benchmark over the last 5 years. For Switzerland, the figure is 95 %, for Denmark 88 %. The results have shown that active managers are able to outperform the index over 1 year, maybe over 2 or 3 but not in the long run. In the UK, a typical investor could have increased his return by 1,44 % p.a. over 10 years by investing in a UK equity index tracker instead of an actively managed fund.

Pension assets are invested for the very long term. That is why we believe that ETFs are worthwhile candidates to be included in pension schemes. The use of ETFs raises the question on burden sharing of costs in funds. Insurance companies typically receive rebates in actively managed funds. So the use of ETFs requires a reset of fees to be charged to employers and employees (fees on premiums, fees on assets under management, cancellation of units,….)
 

Governance is lacking in most pension schemes

The objective of an occupational pension scheme should be to add value over and above what an individual could do for himself.

The OECD has defined guidelines for pension fund Governance back in 2009. The governing body seems to be absent in many pension schemes on the continent. It is supposed to administer the pension scheme in the best interest of plan members and beneficiaries.

We realise that employers set up a pension scheme at a certain point of time. They pick a couple of investment choices and then let things run. Fund and performance reviews are more common in North America and in the UK then in Continental Europe. The culture of Governance around Defined Contribution plans still needs to make its way in Continental Europe. A regular review on investment principles and investment funds would certainly help to improve the pension Governance.