The value of Irish pension scheme assets dropped by 1.3% during 2007 to €86.6bn from €87.7bn at the end of 2006 according to the
Irish Association of Pension Funds (IAPF) annual asset allocation survey.
Patrick Burke, Chairman, IAPF said that while significant further losses have been recorded since the start of the year, the study indicates that pension fund trustees have, where possible, been actively reducing investment risk over recent years.
“Despite recent falls, the total value of assets managed by Irish pension funds has almost doubled from €44.8 billion in the five years since the end of 2002 reflecting strong investment returns in the years prior to 2007 and significant contributions following the market turmoil of 2001/2002, improved mortality and lower long term interest rates. Recent market falls have been very worrying for pension scheme trustees and will present funding standard and contribution rate difficulties for some.”
He said that for many years the strongest performing equity region for Irish pension schemes had been the Irish equity market.
“Nevertheless, since our adoption of the single European currency, Irish trustees have gradually moved to reduce their concentration in the Irish equity market down to a weighting of just over 8% at the end of 2007. This is down by almost 40% over the five years since the end of 2002.“
Burke said that the study reveals a number of important findings
“not least among which is continued evidence of the proliferation of defined contribution pension schemes in the private sector”. The survey shows that 20% of all pension scheme assets are now managed on behalf of Defined Contribution schemes representing a significant increase in Defined Contribution assets under management.
“While the defined contribution population can generally afford to take a longer term view of investment risk – many defined benefit scheme trustees and employers are pressurised by accounting and funding standards to take investment risk off the table and we are seeing the evidence of this under a number of headings in the IAPF Asset Allocation Survey for 2007.”
The report says that the costs associated with de-risking are material as higher investment return expectations, typically driven by higher long term returns on equities, must be sacrificed for the relative security of bonds and other assets.
“Lower equity allocations result in lower expected returns over the long term. This typically means one of three things - higher contribution rates, reduced benefits for members or a mixture of both. This trade-off results in a delicate compromise for the trustees, sponsoring employers and members of most defined benefit schemes. This compromise can be seen by the relatively stable allocation to equities and bonds during a period when trustees have taken significant steps in the management of other underlying risks.”
The report highlights a number of trends which illustrate how scheme trustees have been actively managing investment risk over recent years. For example, passive management is typically used by trustees unwilling to take investment manager selection risk – the risk that they will select and appoint an investment manager who subsequently underperforms their benchmark. Recent years has seen a steady increase in funds moving to passive management with the proportion of assets under passive management recorded at 28.5% at the end of 2007 - more than doubling from 12.6% of total assets in the five years since the end of 2002.
“Of equal significance is the extent to which pension schemes have altered the nature of their bond holdings in order to target a closer match for the movement in value of their liabilities to pensioners. Of the overall fixed interest holding, 42.1% were held in medium and long dated bonds, which more closely match pension scheme liabilities, compared with just 27.3% at the end of 2006. Given the long-term nature of pension scheme liabilities, this increase shows positive action on the part of pension scheme trustees to reduce volatility and to assume the challenges of Liability Driven Investing in a straightforward fashion.”
As access to alternative asset classes such as Hedge Funds, Commodities, Emerging Markets and European/Global Property has become more efficient IAPF expects that greater allocations will be made to Alternatives. “Increased allocations to alternatives will help trustees to better manage risk, by diversifying away from traditional asset classes where correlations are highest. To date allocations to Alternative assets are small with only 2.3% of total assets invested in such classes."
Of the €86.6bn of assets under management for Irish pension funds, approximately €42.8bn (49%) was managed according to scheme-specific benchmarks. That is, the trustees of these schemes' have given direction to the investment managers regarding the proportion of their funds that should be invested in each of the various asset classes. On average, the equity weighting of these assets was 56%, while the average allocation to bonds was 24% with 12.5% invested in property – further evidence that trustees are continuing to take risk off the table where they can afford to do so.
Given the widespread closure of defined benefit schemes to new members, IAPF expects that the resulting increase in the maturity of these schemes will fuel a continuation of this de-risking and diversification agenda with an increasing emphasis on Liability Driven Investing and diversification through Alternative asset classes. However, recent market losses may slow down the expected overall reduction in equity weightings (in favour of bonds) as defined benefit scheme trustees may prefer to wait - nervously - for a return of higher equity valuations rather than crystallising losses suffered over recent months.
The longer term investment horizon of defined contribution scheme members (due to the absence of Accounting and Funding Standards) allows for greater risk to be assumed in search of enhanced returns. Nevertheless, as with defined benefit schemes, the opportunity to improve the risk/return trade off for members – using efficient Alternative asset classes – remains compelling and IAPF expects to see further developments in this regard over the years to come.
