Impact of accounting and prudential regulation on pensions

"A long-term view involves short-term risk, whereas a short-sighted strategy involves increased risk over the long term."

EDHEC just released its impressive report Impact of Regulation on the ALM of European Pension Funds. Even though we disagree in some instances, we think this is mandatory reading for anyone in the pensions investment space because it highlights those areas of regulation which will be of increasing consequence for pension funds' investment strategies in the near future, as we have continued to stress over the recent past.

At the core of the report is the development of an asset allocation model in the presence of liability constraints. The solution involves the components cash, risky assets and the liability hedging portfolio. The state of the art model takes inflation and longevity risk management into account as well.

There is not enough space nor time for an in-depth review of this valuable piece. Nevertheless, I would like to mention two issues that have slightly moderated my enthusiasm for the report:

• There seem to be a few at least implicit factual inaccuracies in the parts describing the regulatory environment. The most glaring of which may be the assumption that the EU pensions directive is applicable in Switzerland - it is not.
• Accounting standards seem to be understood to effectively determine investment action. While it is not unheard of that managements structure transactions in such ways as to optimise their reporting, this clearly goes one step too far. We are well aware of the interdependence between perception (qua accounting standards) and (economic) reality, but at least in an academic report, the latter needs to retain some vestige of predominance over the former. Remember: pension funds' long-term time horizon, as accounting standards can and do change.

The tyranny of the present

In a recent issue of its flagship publication Sigma, SwissRe described Scenario analysis in insurance, identifying scenario analysis as a key tool to analyse fat-tail risks and their impact on profitability and competitive position of insurers. One of the pioneering sources of scenario analysis is the approach developed by Shell. Whereas scenario analysis is referred to as a key tool for both strategic planning as well as enterprise risk management of insurance, Sigma reports with some degree of astonishment that banks do not use it to assess their total enterprise risk exposure.

Applying the concept of scenario analysis to pension funds should be self-evident, not least if you think of a pension fund as the insurance subsidiary of your firm. It faces a set of opportunities, threats and parameters quite similar to those of an insurance, yet scenario analysis is not common in the pensions industry. Nevertheless, a number of pensions-specific scenarios easily come to mind: a jump in longevity due to unexpected medical progress, prolonged negative real interest rates, a pandemic (as explained in Sigma), regulatory changes to the competitive landscape ...

The Economist Intelligence Unit has just come up with its own bleak exercise in scenario analysis (hat tip Global Guerrillas). Its central forecast of stabilisation is assigned a probability of just 60%, whereas the more disruptive instability scenarios are assigned 30% (de-globalisation) and 10% (collapse in USD) respectively. Scenario analysis has been posted as a means to escape the tyranny of the present, but being where we are today, we are not so sure this is a good thing.

Innovative ways of financing retirement

In this day and age where financial innovation is (wrongly!) blamed for the end of capitalism and the world as we know it lock, stock and barrel, the title of SwissRe's latest edition of Sigma is courageous. Nevertheless, it is a comprehensive assessment of the growing role that insurance will have to play in the provision of old age retirement funding, where insurance is to be understood in a functional rather than an institutional sense.�

An important section of the study is dedicated to managing retirement product risks. Longevity risk is identified as prominent among them, but its management is limited by the rather shallow depth and breadth of longevity risk markets. Notably absent from that section, however, are considerations on valuation techniques. If there is one thing that we can learn from the current crisis, then it is how crucially important it is to value & stress test innovative products properly over their entire life cycle.

CEIOPS State of Pensions Report

CEIOPS'�Report on financial conditions and financial stability in the European Insurance and Occupational pension fund sectors has a good section (starting p. 22) about recent developments in the European pension funds market, giving insights into last year's changes in a number of countries and a statistical overview, based on Eurostat.

ILMA news

While the recently founded Institutional Life Markets Association (ILMA) still seems to have no proper website, a document containing its guiding principles has surfaced on the web. It's interesting to glean from it that the Association is explicitly positioned in opposition to Defined Benefit pension funds.

Ask the economist

The OECD has published an interesting protocol of an online debate with OECD economists about the pensions challenge. There's plenty of materials and food for thought there, especially in the background readings listed, or the annuity debate; one wonders whether the lack of private annuity products may not to some extent be due to an effective crowding out by mispriced public policy alternatives - but unfortunately that question is not touched upon.

Annuities: a private solution to longevity risk

Its title may appear a bit facetious, but the latest issue of SwissRe's Sigma is anything but. It contains a comprehensive overview of the challenges to capital based retirement provision arising from increasing longevity. The prime focus of the publication is on insurers and insurance products, naturally, but most of its considerations and precepts are directly applicable to non-insurance pensions providers. A very worthwhile read for everyone in the retirement business!

Liechtenstein attracts IORPs

IPE has an interesting story about German insurance LV 1871 bringing its pan-European pension fund to Liechtenstein. Other institutions are also confirmed to be interested in this location, which is entirely in line with our assessment of Liechtenstein as one of the competitive locations for European IORPs.

Early birds

There is no more appropriate way to start the first post of the year than by dedicating it to an early bird, even though the year is well advanced already. The early bird in question is Allianz with its European ComPension product, the first product that has been designed with a pan-European pensions market in mind. Meanwhile, we've had a bit of time to look at this interesting solution, which is only the first of several products that are currently under development, as we hear.

European ComPension is a fairly plain-vanilla insurance retirement product that is available through Allianz's international network, but only in France, Italy and Germany for now. Unsurprisingly, it offers only DC solutions, although this entails a guaranteed minimum return in Germany. The pricing reflects the first mover advantage. Assets are invested in one of two new Luxemburg based Allianz Global Investors European Pension funds Dynamic or Balanced which invest in an opportunistic combination of Euro area stocks and bonds.

Given the somewhat moderate pace of the market, I am not sure whether the first mover advantage is really that big in the case in point. European ComPension has obviously been designed from a network perspective so as to not cannibalise the network's incumbent business. As it is our view that the pan-European pensions market has the potential to disrupt insurance networks in that specific segment, it is probably unwise to choose such a development approach.

While the choice of the development approach may be ill advised but comprehensible, it is hard to understand the investment strategy of the funds on offer. The geographic limitation of investments to the Euro area appears to present such a strong impediment to the portfolio's potential efficiency that one may wonder whether this is in line with the Prudent Person Rule at all.