Three years ago, Amin Rajan, the CEO of CREATE-Research, prepared a study of the way that pension plans had reacted to the global financial crisis and to the subsequent financial conditions. His study continues to be worthy of attention in 2017.
The study included a survey of 190 pension plans throughout Europe. In his acknowledgements, Rajan thanked the management of those plans and says he was “struck by their candor and desire to do better at a time when markets are stalked by all manner of macro risks that have not been experienced in living memory.”
The report is organized around eight themes.
- Eclectic asset allocation models are the new normal;
- Alpha returns now rely on a symbiotic interaction among governance practices, asset allocation, and strategy execution;
- Changes in the business model of pensions remains a work in progress, with roughly one third of respondents saying that are “unsure” about the outcomes;
- Thanks to the market rally of 2013, pensions are in better shape than they were in the period 2009-11, but there continues to be a need for aggressive return targets;
- The first cohort of Baby Boomers is entering retirement, and the demographics act as an important constraint;
- Given the demand for risk taking suggested by theme (4) and the restraints on risk taking of theme (5), there can be no one-size-fits-all approach to pension management;
- There has been of late an intensified search for cross-over assets “with equity-like returns and bond-like features”;
- Managers are intensely aware of “implementation leakage,” that is, of the difference between what a strategy could do for them on paper and what it will in fact deliver in practice.
One way of tackling the issue of implementation leakage head on is by making a commitment to passive investment vehicles. Rajan says that such vehicles are “likely to rise from 20% of total portfolio allocations currently to 40% by the end of this decade.” Pension managers now regard both passive funds and multi-asset class funds as special vehicles “for reducing the leakage.”
As a consequence of the utility of such funds in this regard, the distinctions among asset classes and their vehicles are becoming sharper over time.
Smart beta has risen in importance as “a device for extracting alpha returns at beta risk.”
Also, implementation leakage have pressed managements to shine a spotlight on the commissions, fees, spreads, etc. of their portfolio funds, along with market impact, portfolio drift, and the opportunity costs of trading.
Some Telling Quotations
One manager interviewed said, “Before 2008, most of alpha was leveraged beta. Why couldn’t our advisors see that?”
Another interviewee asked, “Will today’s new approaches prove to be just another costly phase in our industry’s history?”
Management of a Swedish fund said, ““The conventional wisdom on diversification came unhinged when it was needed most: namely, in the global financial crisis of 2008. The Yale model favoring alternatives did just as badly as the long-only model, favoring mainstream assets. It was a cathartic moment.”
Since the catharsis, and in the word of governance, and apropos of (2) above, the post-crisis era of introspection has encompassed a plan’s mission and goals, the underlying investment beliefs and time horizon, the level of investment expertise on the board, the level of expertise in-house, and the delegation of authority.
Before the dotcom bust and the resulting bear market at the turn of the millennium, most plans had a formulaic approach to asset allocation. Often the formula was 60% equity, 40% bonds. As asset allocation, driven by both risk management and (a different matter) uncertainty management, has become more customized, governance practices have been upgraded.
A governance structure has to be “nimble,” that is, in a position to exploit an early mover advantage as it arises. It also has to have clear exit strategies and early warning systems. It may have to use tools that pension management once shunned, including derivatives, short positions, and leverage.
Trustees have to “walk the fine line between their fiduciary role and executive empowerment,” just as the full time executives have to walk their own fine line “between personal accountability and career risk.”