Optimal Pension Fund Investment Returns

How to manage a pension fund investment portfolio in economic uncertain times and shifting financial markets? Let's try to answer this question from a more practical point of view instead of a pure scientific approach......

Historical Performance

Let's take a look at the performance of two large and leading Dutch pension funds

First of all we take a look at the historical (1993-2014) yearly returns of both pension funds and try to figure what n-year moving averages results in a stable and mostly non-negative yearly performance.

  
Smoothing Returns

If our goal is to 'smooth' returns to pension fund members and to prevent negative returns as much as possible, a '3-year moving average return approach' as basis for sharing returns to pension fund members, could be a practical start. 

In this approach, a single maximum cut of around 3.3% is largely compensated by the returns in other years as the next chart of  '3 Year Backward moving Average Yearly Return' shows:

Of course if we want to protect pension members also against systemic risk and crises, an additional investment reserve of around 15%-20% would be necessary.

The  next slide gives an impression of the effects of a 10 year moving average approach. I'll leave the conclusions up to the readers. of this blog.

Main conclusion is that the analysed pension funds ABP and PFZW are able to generate a relative stable overall portfolio return over time. They manage to do so, despite the fact that their liabilities yearly fluctuate as a result of the fact that they have to be discounted by a risk-free rate. 

A risk free rate that itself isn't risk free at all and - on top of - is continuously 'shaped'(manipulated ) by the central banks to artificially low interest levels.



Managing Volatility instead of Confidence Levels
A strategy based on managing the funding ratio of a pension fund given a certain confidence level and given the actual method of risk-free discounting of liabilities, is doomed to fail in a low interest environment. Discussions about confidence levels are also a waste of time, as long time confidence - at any confidence level - eventually will turn out to be an illusion.

As long as pension funds are able to demonstrate that that they are able to manage and control the volatility of their assets within chosen limits (risk attitude 1; e.g. 10%) and within a chosen time horizon (risk attitude 2; e.g. 20 years) , they will be able to fulfill their pension obligations, or to timely adapt their chosen risk-return strategy to structural market changes.


How to curb volatility?
Managing the volatility of an pension fund investment portfolio within a certain risk attitude is one of the greatest challenges of a pension fund board.

In short, the traditional instruments to curb volatility are:

1. Diversification
   With the help of diversification the asset mix of a  pension fund can be tuned to optimize long term risk-return in relatively 'normal' market circumstances.
    
2. Capital Requirements & Management
   By defining and maintaining a well quantitative risk-based capital and investment reserve policy, a relatively smooth yearly return available for pension fund members can be achieved in a systematical risk environment.
    
3. Economic Scenarios
   By studying portfolio outcomes under different economic scenarios, a short term 'best fitting' near future volatility asset strategy can be developed.
    
4. Trigger points
   By defining asset portfolio actions that will 'fire' once particular trigger points of specific asset classes are met, all measures based on 'damage control' are in place.
    

Unfortunately the above measures all fall short in case of systemic market events.

In case of crises, like the current Greece crisis, agent based models, also called behavioral models, can help to manage systematic volatility.


Behavioral Asset Management
A way to minimize systemic volatility in an investment portfolio is to apply new 'Behavioral Economic Stress Test' models. These kind of tools, as provided y a FinTech50 2015 company called Symetrics, enable pension boards and investment managers to model and to anticipate crises.

More is explained in the next short presentation "The value of economic scenarios from a risk perspective" by Jos Berkemeijer, one of the four managing partners of Symetrics.

Used Links
- Agent based Models
- Behavioral Models by Symetrics
- Spreadsheet wit data used in this blog
- Presentation: The value of economic scenarios from a risk perspective

Sylvester: ABP, Cut Pensions?

At the end of 2011, let's take a short view on the madness around cutting pensions.

As a leading example, I'll discuss ABP, a Dutch 240 billion pension fund and one of the largest pension funds in the world.

Being fanatic blog readers and actuaries, you're probably 'in' for a teasing joke on Sylvester or 'New Years Eve'.

As you all know communication is key in the pension business. However, as pension investment results get more volatile and complex (in  time) to explain, communication about pension issues becomes more and more Chinese for ordinary pension members.

The latest threat, cutting pension benefits, urges board members to develop themselves to a kind of  'five-legged sheep' ....  The new 'normal' pension board member is undoubtedly the ideal combination of an actuary, accountant, investment specialist, communication expert, ICT specialist and - on top of - a keen psychologist.

Communication is a Profession
I'll give a short slightly exaggerated demonstration to all pension board members and actuaries of how difficult reading and understanding a well meant pension board message is, to an average pension member.

In order to 'save what can be saved' ABP's Vice-Chair Joop van Lunteren pleads for political help in ABP's 2011 Q3 Press Release.
Besides the question if a press release is indeed the right place for such a call, most pension members will have a hard time to understand what Mr. Van Lunteren wants so rightfully to express. For these pension members Mr. van Lunteren's message is more like Chinese...

ABP's Q3 Results: Cutting Pensions?
Now to more serious business...  Altough ABP's Q3 results are indeed not splendid,

the call for a more long term sustainable valuation system that makes pension funds less dependent upon volatile interest rates makes sense!

Also, there no need for panic (direct cutting measures), as from the 2010 annual report we can find that the annual benefits payments summed up to around € 7.5 billion on a total of assets of around € 240 Billion. If ABP would be allowed to wait for the effects of taken measures en developing markets for another five years, a 10% cutting of benefits would only have an impact of around € 4 to 6 billion on the total assets of around € 240 mln.
More info about Cutting Pension rights on Actuary Info....

Happy Silvester and good luck ABP!


Sources/Links:
- ABP Q3 Press Release
- ABP Annual Report 2010 
- Ming Imperial Fonts

Dutch Pension Muppet Show

There's a lot of fuzz about the performance of the largest (€ 246 billion assets) Dutch Pension Funds ABP and the somewhat smaller (€ 91 billion) PFZW (former PGGM). According the Dutch television program Zembla and Bureau Bosch Asset Consultants, Dutch pension funds would have consistently underperformed.

ABP commented: "The yearly return of 7.1% on average since 1993 is much higher than returns on government bonds would have been and is in part thanks to our equity investments."

PFZW overshoots ABP wit the comment: "PFZW's calculations show a return of 8.4% on average during the past 20 years which is much higher than the 10-year Dutch government bonds of 5.3% on average during the same period."

Great statements, but who's right?

Performance Test
Let's quickly "do the proof" by comparing (benchmarking) the 'modest' yearly performance of ABP with the yearly performance of 10 year Government Euro Bond Yield Benchmark as provided by the ECB.

Both pension funds are not limited to  the Dutch market, therefore  performance is not related to Dutch Government Bonds, but to 10-Y Euro Government Bonds.

As the yearly performance of ABP in a particular year is in fact a kind of 'compound performance' of the years before, it's more realistic to relate ABP's (yearly) performance to the 10-years moving average of 10-Y Euro Bonds.  

What becomes clear from is that ABP's volatility overshadows the 10-year Bond's volatility by far. As a consequence ABP's out-performance should be significant.

Let's test this by looking at the YTD (Year To Date) performance of ABP on the long run:

The average performance of ABP 1993-2010 indeed turns out exactly 7.1% as published, but hardly outperforms the 10-year Euro Bonds Moving average of 6.8%.

0.3% '18-years out-performance' (OP-18) for such a high volatility is strongly discussable. The long term out-performance 1994-2010 (OP-17) was 0.0%. The out-performances of shorter periods (OP-[18-x]) are not stable and strongly swap from positive to negative.

Benchmarking Pension funds performance with Euro Bonds 0f 20 years or longer would be even more adequate and in line with the duration of pension fund's liabilities. Taken into account that 20 year Bonds on average score a 0.25% à 1.00% higher return than 10 year Bonds, it can be concluded that Dutch pension funds on average do not out-perform Government Bonds. Not to mention the influence of the yearly investment-costs of at least 0.2% on the returns.....

Pension Fund PFZW

Pension Fund PFZW is completely lost on their non-transparent and backwards changing performance of 8.4% over the last 20 years.

From their annual (inconsistent) accounts it can be concluded that their 2001-2010 performance came down to 4,8%. This performance is exactly the same as the performance op ABP in that period and underperforms the moving average 10-years Euro Bonds with 0.7% !!!

Conclusion

It's clear that pension funds don't convince in the outperformance of Government Bonds and that the pension industry is in desperate need for an impartial benchmark with regard to out or underperformance of Bonds.

The comments from ABP and PFZW, Boenders and Cocken are like 'shooting from the hip' and must be qualified as highly unprofessional.

Dutch pension fund members are watching an extra edition of the Muppet show. Who's gonna stop this pension media madness and bring some order in the pension room?


Related Links and Sources:

- Source: 10 year Government Euro Bond Yield Benchmark
- 'grave miscalculations' in Zembla (Boender aand Kocken
- Watch: Zembla 
- Download: Spreadsheet with calculations as presented
- IPE: Heavyweights ABP, PFZW come out swinging against Zembla
- Bloomberg: 10-year, - -  30-year performance Gv. Bonds

ABP Pension Fund ROI Travesty

What is a 'good' return on investment?

Dutch Pension Fund ABP, the industry-wide pension fund for employers and employees ( 2.8 million participants) in government and educational institutions in the Netherlands and the world’s third largest pension fund, reported a 20.2% return on investment in 2009.

In the 2nd half 2009 Press Release, ABP qualifies it's own performance as a 'Good Rate of Return'.
Now theologists as well as actuaries are familiar with the risk of calling something 'Good' ....

ABP ROI Stress Test
Let's put the ABP investment strategy to the test.

In the same Press Release,  ABP publishes the long-term rate of return from 1993 to 2009. ABP's average annual rate of return over this period of 17 years is 6.7%.

ABP's 'Signs of Hope Strategy'
To achieve this phenomenal return, ABP has developed a spectacular - every three years changing - Investment Strategy Plan (latest plan is confidently called: 'Signs of Hope') with a strong diversified 'winning' (?)  investment mix in combination with zero transparency or accountability information with regard to 'investment costs'.

Alternative T-Bond Strategy
Alternatively, ABP would have been better of if it would have applied a no-risky defensive European (10 years) Treasury Bond Strategy from the start. In this case the yearly average 1993-2009 ROI would have been around 6.9%.

Take a look at the next chart and decide for yourself. What pension fund would you prefer, Red or Blue?

ABP stated in their objectives that, in order to keep pensions affordable in the future, the return on investments must attain an average of 7% per year. It's clear that this objective will never be met on basis of the developed investment strategies in the past.

ABP's Future perspective?
Let's 'hope' that, after the recent step down of Ed Nijpels, ABP's new to be appointed chairman will have enough power, (pension) experience and time available to resist and combat the opportunistic and risky plans of the headstrong APG investment specialists.
Anyhow, the new chairman should be at least someone who knows how to spell the word 'Risk Management' and is experienced in (ac)counting from 1 to 10.... maybe an actuary?

Solution
Perhaps the best thing to do is to:

• turn the ABP scheme into a "pay as you go system",
  
• transfer the ABP administration to the efficient Dutch Social Insurance Bank,
  
• fire most of the ABP Asset Management Department (APG) (as they are confused about time and cannot tell the difference between Tomorrow and Today anyway) and finally,
  
• use the € 208 billion on assets to reduce most of the Dutch National Debt ( € 375 billion)

Good Luck ABP!

Links
- Top 10 largest pension funds in the world
- ABP Press release 2nd half 2009
- APG: Tomorrow is Today 
- Joshua Maggid: Excel ABP (.xls) 

Pension Fund Market Valuation ParaDox

Is Market Valuation (MV) the right tool for pension funds?

Mid 2009, the new appointed ABP chairman Nijpels and - previously - the ABP CFO ten Damme (picture on the right), stated that the relatively new method of MV is inadequate for pension funds.

Both think that valuation of pension funds could be better based on a (seven year) moving average interest rate.
Nijpels en Ten Damme are supported in their view by Albert Röell, Chairman of KAS BANK, who advises the Dutch regulator DNB to reassess its policy.

Nevertheless DNB doesn't seem to respond.
Neither Roëll nor the world's third-biggest pension fund gets an answer. Is ABP crying over spilt milk?

Why MV?
At first sight, there seems nothing wrong in calculating the value of a pension fund, on MV basis. Market (consistent) valuation implies that the value of an asset or liability is defined by it's market price. If the market is too thin, a mark-to-model approach can be used....

Clearly MV increased the transparency and accountability of pension funds. However, 2008/2009 show that MV, based on the actual term structure of interest rates, leads to excessive volatility in funding ratios.

Is MV the best method?
Of course MV can be a best practice method in helping to define the pension fund value in case of a merger, a takeover or with regard to managing assets. But is MV also the best method for managing the pension fund as a whole, from a board, regulator or 'pension fund member' perspective?

• Future certainty
  The first fundamental question is :
  
  
  can we define the value of long-term
  ( 60 years or more) cash flows at all?
  
  
  The answer is: No, we can't!. Just take a look at an average CFO, who's proud to present his next quarterly company result with 60% certainty. What would be the certainty of the long-term company result of - let's say - 20 years ahead. Exactly: Almost zero.
  
  It's impossible for anyone, no Nostradamus Actuary included, to predict the compound and correlated long term effects of interest rate, stock market, derivates, inflation, salary increases, mortality, disability, longevity and costs. Therefore, if it's not possible....., don't pretent you can.
  
  
• Pension fund: Not for Sale
  Second important subject for consideration is that a pension fund (in general) is not listed on the stock market. Also, in general, it is not for sale on the market. Therefore, the hourly, daily or monthly calculated MV is only of limited interest with regard to the pension fund's strategy, policy or control.
  
  Neither is MV the right base for monthly adjusting of the contribution rates, funding rates or indexation capacity.

Principles
Simply stated, it's important that a pension fund:

1. can meet its obligations "on the long-term"
2. is sufficiently liquid to pay his annuities "on the short-term"

Moving average
The first statement implies that if you take the funding ratio as steering/testing parameter (there are more!), there is - given the mentioned long term uncertainty - no other option than to base the valuation on a more (term dependent) 'moving average' of interest rates in combination with the moving average value development of other asset classes. The choice of the moving average period is critical.

Dead Money
Even more, if the pension fund is forced to act on basis of MV, it has to keep extra (non-volatile) buffers to withstand the possible effects of non-relevant short-term market fluctuations. On top of this many pension funds tried to downplay their indexation ambition.

The consequence of all this is that MV generates a substantial amount of structural "dead" capital into the balance sheet. "Dead" capital that - besides - is withdrawn from the national economy and therefore weakens the pension fund's country position in the international level playing field.

Paradoxical measures
In case - due to market developments - the MV goes down , short-term prudential constraints (as enforced or stimulated by the regulator) will moreover endanger the long-term objectives of pension funds. Consequently leading pension funds from the frying-pan into the fire.

There's another interesting aspect that pleads against MV. In general (Dutch) pension funds cannot go bankrupt, as they are allowed to cut back on the participants’ entitlements in extreme (emergency) situations. So the key question is what kind of minimum security level we enforce upon ourselves. Just an example to illustrate this:

Example
What would you prefer:

1. 100% of the yearly pension that you have been promised, on basis of a 125% funding ratio
2. 125% of the yearly pension that you have been originally promised, at a 100% funding ratio target

Remember there is no ultimate warranty whatsoever in either situation.

The only difference is that in scenario A the chance that your entitlements will be cut down is slightly smaller than in scenario B. But this last situation is as hypothetic as it can be, as contributions will be raised first, before any cut down scenarios will be considered.

So its better to use the funding ratio surplus for legalized controlled indexation and pension benefits improvement than as 'dead' money.

A final argument in the war against MV for pension funds is the next illustration .....

ParaDox
Let's take a look at a company called ParaDox.... ParaDox produces parasols (sunshades) for the high season.

In winter, ParaDox produces at full speed in order to achieve a top level inventory at the start of the summer.

In winter, however, hardly any parasols are sold. During this cold season the price of the parasols on the market (in the shops) drops to about 50% of the summer price. Even more, parasols sales go 80% down in winter (cf. long-term investment market).

If ParaDox would apply MV based techniques, it would have to depreciate their current stock to 50% of the (summer)value. Surely ParaDox would go bankrupt. No, every sensible human being, including actuaries, would decide that in this situation it's best to value the stock of ParaDox on basis of the 'moving average' (realized) sales price over one or more recent years.
N.B. Even if ParaDox would have one or two 'bad summers', deprecation would not be considered.

If in this ParaDox case it's clear that market valuation (i.c. deprecation) is unwise, the more it must be clear that in a company with long-term obligations and high uncertainties , like a pension fund is, it's naive to operate and steer on basis of MV.

Moving Average Period
Now that's illustrated that the Moving Average Method (MAM) is preferable above the MV method (MVM) for pension funds, there's still one thing to decide: the 'MAM period'.

If the MAM period is chosen too short, it will suffer the same disadvantages as the MVM.

If it's chosen too long, there's the risk of not being able to adapt fast enough to realistic contribution levels, if needed. In this situation there's also the risk of unintentional intergenerational financial effects. However, these effects can be yearly calculated and translated into a sound policy.

From this perspective it seems reasonable to fix the MAM periode to the average duration of nominal pension liabilities, which is (in The Netherlands) about fifteen years (in real terms, it is even longer).

Hope
Let's trust that DNB listens to ABP and KAS BANK, so that 'pension funds' and 'pension fun' become one again!

Related links:
- P&I/Watson Wyatt World 300 Largest Pension Funds
- Market-consistent valuation of pension liabilities (must read!)