Authors: Servaas Houben
Publisher, publication date: De Actuaris, 2016-11
The effects of longevity, and a persistent low interest environment have resulted in low funding ratios and increased attention from media and stakeholders on the setup of the current system. Besides lower pension fund benefits criticism centered around the lack of transparency in the asset selection process: more advanced asset management strategies involving derivatives usually involve over the counter products with banks which involve certain levels of confidentiality. Furthermore, tailor made assets strategies imply higher costs which accumulate over time. In these days and times in which consumers demand clarity on their products, it is time for a new framework for pension fund ALM.
From classical ALM to modern ALM
The classical version of ALM was used until the 2000s. The general idea behind it was that benefits were guaranteed, and that long term investing in equities was sufficient to provide the required return: as pension funds were long term investors they could survive business cycles and profit from a steady equity risk premium. Furthermore the return on government bonds was still at a reasonable level. Asset management was quite straightforward and transparent and the huge impact of longevity was not yet widely known. Therefore early retirement options, in hindsight for relative inexpensive prices, were not uncommon.
However this changed dramatically during the first decade of the 2000s: first the dotcom bubble in 2000 and then the financial crisis in 2008 made pension funds realize that there are not invulnerable to short term deviations. As Keynes already mentioned “The market can stay irrational longer than you can stay solvent.” This forced pension funds to reconsider their ALM model and focused their attention to limiting their interest rate risk. The solution seemed swaps and derivatives which provide protection against a low interest rate environment. The downside of this approach was a more complicated asset management approach, higher expenses and difficulties communicating results to participants. On the liability-side the overall policy can best be described as ad-hoc: pension schemes were changed again and again which resulted in several transition regimes. The overall effect was confusion for the participant.
Time for a push back to neo-classical ALM
The continuous process of updating both the asset and liability side of the balance sheet is not in line with the long term planning horizon of pension funds. Instead of pursuing a long-term buy and hold strategy most funds focused on short-term survival instead, thereby not using their long term strengths. Hence the appropriate time is there to shift back to the classical ALM approach with a twist. On the asset side, the main focus will be on minimizing (trading) expenses. Instead of choosing tailor-made asset optimization, a cost minimizing strategy is used, for example by using cheap exchange trading funds. These investments have the benefit of being liquid and transparent, reducing any potential costs of principal-agent problems. Furthermore, investing in transparent assets has the practical advantage that it is easier to explain to policyholders. On the liability side, there are no hard guarantees anymore and participants can choose a benefit level that can change during their retirement. Also depending on the returns of the fund and the effects of longevity, the benefit will change during retirement.
In general two objections exist against such a neo-classical approach:
- A passive investment strategy cannot beat the market benchmark: although one cannot beat the overall market index, this is not the appropriate question. The participants’ benchmark is not the overall market index, but the investment opportunities that exist for them. As most participants will have limited options investing in equities or real estate in a diversified manner, achieving the overall market return is already beating their index.
- Participants don’t like varying benefit levels: the classical and modern ALM methods claimed guaranteed benefit levels, which turned out to be much more uncertain than expected. Neo-classical ALM does not claim any fixed guarantees. This might be less of an issue than one would expect: in recessionary eras a lower benefit level, might be sufficient to buy the same basket of goods as in an expansionary era with a higher benefit level. Also because of the transparency of the system participants are more aware that there are no guarantees on benefits. Like the price of gasoline, they realize that their benefits are also sensitive to changes in the overall economic environment.
In tabular format, the three systems can be represented as follows:
|Characteristic||Classical (until 2000)||Modern (2000-2015)||Neo-classical (2016 onwards?)|
|Asset management||Long term equity risk premium||Interest rate instruments and derivatives||Long term equity risk premium focused on low trading expenses|
|Liability management||Guaranteed (hope for the best)||Ad hoc changes to premium and benefit levels||Variable benefits levels during retirement. Profit sharing only ex-post not ex-ante|
|Transparency and communication||In the long run everything will be OK||Pension fund boards know what is best.||No hidden agreements between pension fund board and external parties.|
Table 1: characteristics of the 3 methods
The classical and modern ALM approaches have served the system well for a certain period of time. However, as the trust in pension funds is decreasing there is a strong need for a robust long-term solution. This solution must create value for the participant on the long-term and must be fully transparent and easy to explain. A back to basic approach under the neo-classical approach which combines the long-term benefits for risk premiums from the classical approach, with the flexibility of liability management from the modern approach satisfies both requirements.