Defined contribution company plans began 2009 on the heels of a bruising year. The significant decline in capital markets coupled with extreme investment volatility raises many issues for companies with DC plans. There are numerous issues employers/plan trustees need to address when reviewing their plans this year. These range from the plan’s governance to the choice of low-risk investment options. Mercer’s Dublin office has prepared a 10 point plan that employers and trustees could potentially adopt as they re-evaluate their DC plans and related responsibilities in 2009.

  1. Review the adequacy of DC benefits and consider whether current pension provision is meeting employees’ needs. Economic conditions and future expectations have changed considerably since many DC arrangements were designed. Depending on their ages and time horizons, members may need to adjust their expectations of retirement income. Employers may also need to assess the workforce management implications.
  2. Review DC provider performance. The market for DC provision has evolved with new providers and products entering the market while others exit. Trustees should consider if the existing arrangements continue to meet the investment needs of all members and if performance continues to meet the objectives set when selected.
  3. Review the suitability of investment options. Poor investment choice is likely to be one of the main issues impacting members’ benefits and trustees should consider the current options available to members in light of new industry developments. If the investment range has not been reviewed for some time, consider the membership profile, how this might have changed, how members are making investment decisions and whether the existing range includes a facility for members to manage their investment needs over time.
  4. Review the default investment option. A feature of most DC plans is that the majority of members “end up” invested in the default option; this makes it crucially important for trustees and members. Is it effective in varying investment conditions and over time for members’ changing investment needs? Does it protect members who are close to retirement from annuity risk or market risk, while at the same time catering for members with longer time horizons? As DC schemes develop, the member population becomes more diversified, and consequently the existing default option may no longer cater for all groups of members. There may also be an opportunity to improve the efficiency of the default option (in terms of the risk/reward trade off), given the wider range of investment vehicles now available.
  5. Monitor the choices being made by individual plan members (not in aggregate). Review individual member asset allocations and/or individual members’ rates of return. This type of review can provide good insight into whether your DC plan is working, and can point out areas for improvement, such as member education or fund choices.
  6. Assess the effectiveness of your member communications strategy. This is a good time to revisit financial and investment education. Given the market turbulence and economic uncertainty, what information should be provided to plan participants?
  7. Review and revise your plan’s Statement of Investment Policy Principles (SIPP). In the current market environment, fiduciary risk is high and a review of the SIPP can help minimise this risk.
  8. Ascertain if your plan members are engaged at all. Are they knowledgeable about their savings and retirement plan choices? Given the recent market volatility and economic turmoil, this is a good time to revisit engagement and education about investing and retirement planning. Larger employers/trustees may wish to consider focus groups to find out what members see as their challenges, education needs and barriers to understanding.
  9. Assess what kind of retirement income or replacement ratio employees can expect from the plan. If this is projected to be lower than previously expected, action is required sooner rather than later. Consider revising the scheme design, allowing additional member contributions, or reinforcing the importance of saving more outside the plan in order to secure a comfortable retirement for members.
  10. Review the stability and risk exposures of investment managers in light of the current economic turmoil.  Consider the status of the plan’s investment managers(s) and their commitment to continue to develop their offerings to meet member needs.

Alternative asset investors, particularly hedge fund investors, must remember that investment performance of an asset manager should never be the sole or even primary consideration when making an investment decision. In fact, during recent years, qualitative factors have been the root cause of failure for nearly half of all hedge funds that have experienced forced liquidations.

In evaluating alternative investment managers, prospective and existing investors must consider the overall due diligence process as an integrated three-ponged approach in which risk-reward analysis is combined with investment thesis review as well as operational due diligence. This paper, by Ennis Knupp & Associates, provides investors with a top10 list of critical questions to ask when assessing hedge fund managers.

 

For institutions with access to professional advice and with long investment horizons, a fixed mix approach to asset allocation is “aiming too low”, according to Jeremy Grantham, outspoken chief of GMO, who argues instead for a more dynamic approach to asset allocation in times of severe mispricing.

“If the last 15 years has taught us anything, hasn’t it taught us that asset classes can be incredibly mispriced, along the lines of the 35 times inflated earnings for the S&P in 2000? Why would you ignore these opportunities to sidestep trouble?” Grantham ponders in his latest quarterly letter.

Grantham says it is sensible to be fairly static when pricing is normal, or even half way normal, but when very large mispricings occur, he asks whether it is more reasonable to move away from extremely overpriced assets towards more attractive ones.

“Markets are very mean reverting over longer horizons, and sophisticated clients always proclaim their patience,” he says, arguing that asset allocation based on serious action at the extremes and inactivity the rest of the time has a good record and can be done quite simply.

GMO puts its money where Grantham’s mouth is. Over the past 16 years, more than 60 per cent of the total outperformance and more than 60 per cent of the reduction in volatility in its global balanced asset allocation strategy has come from moving the mix of assets, rather than implementation.

“Asset allocation is simply much easier than adding alpha to a fund, since there is more to sink your teeth into,” he sys. “Counter-intuitively, asset classes are more inefficiently priced than stocks.”

Grantham says there is a large and relatively efficient arbitrage between stocks, and the career risk of picking one stock versus another is quite modest, but in contrast when picking one asset class against another it is very clear when mistakes have been made.

“This immense career risk makes it likely that there will always be great inefficiencies, for investors are reluctant to move money across asset boundaries. Consequently, there is great advantage to be had in getting out of the way of the freight train, rather than attempting to prove your discipline by facing it down. The advantage is in both higher return and lower risk.”

Diminishing returns from many hedge funds and the Madoff fraud have caused institutional investors to intensify their due diligence on hedge funds, and demand more liquidity, transparency and lower fees, according to research from alternatives specialist Preqin.

(more…)

The future of independent consulting firms in the US is under threat as one of the largest truly independent firms, Callan Associates, signs a definitive agreement to merge with global giant Mercer.

(more…)

AP7, the default fund within Sweden’s PPM system, is in for a shake-up with a raft of changes set to take effect in May next year. Kristen Paech talks to chief investment officer Richard Grottheim about the fund’s new remit and how its portfolio is tracking.

As the global crisis hits home, many pension funds are looking to de-leverage and reduce the amount of risk within their portfolios.

In this respect, Swedish pension fund Sjunde AP-Fonden might be in the minority.

From May next year, the default fund within Sweden’s Premium Pension system (PPM) will be looking to add more risk to its portfolio, and will also introduce lifecycle funds which take into account the age of savers.

To date, AP7 has operated under a remit from the Swedish government which requires it to deliver performance “in line with or better than the average of the private funds within the PPM system” (of which there are about 800), with lower risk than the average fund.

However as part of a review of the fund, the government has removed the restriction around risk and instructed AP7 to set up lifecycle funds which decrease the level of risk in the portfolio as savers get older.

“That’s a focus right now at AP7,” says Richard Grottheim, chief investment officer of the fund.

“Today we have 90 per cent in equities and we can increase that from May next year for younger people up to 100 per cent if we want to.”

That might sound high, but as Grottheim explains, the government pension must be considered as a whole. The PPM defined contribution system is just one part of the government pension, making up 20 per cent of a person’s pension.

The income pension – the pay-as-you-go part, financed by employer contributions – makes up about 80 per cent of the pension and is basically an index-linked bond.

“So it makes sense to have a lot of equities in [the PPM system],” Grottheim says.

Like most pension funds around the world, AP7 has suffered the wrath of the global market meltdown, returning -35 per cent in 2008, down from 5 per cent in 2007 and 10.5 per cent in 2006. The fund’s net asset value has fallen to SEK 65 billion ($US7.3 billion).

However Grottheim says the fund’s strategic asset allocation, which was altered in May 2007 – shortly before the crisis hit – stands it in good stead to participate in any market recovery.

“We felt we had too low risk in the portfolio compared to the average PPM fund, so we increased the emerging market exposure and we also increased the private equity allocation,” he says.

“In hindsight of course that was too early, but you have to look at investments on a horizon of 25 to 30 years.”

Despite the severely negative return in 2008, Grottheim says AP7’s performance since the inception of the PPM system in 2000 remains ahead of the average PPM fund.

Three years ago the fund introduced alpha/beta separation within the in-house managed Swedish equities portfolio, and AP7 now has six ‘alpha sources’ across Swedish equities, currency and European equity.

Grottheim says AP7 is planning to introduce more ‘alpha centres’ this year and is focusing on Japan, Asia and the emerging markets.

While some commentators argue that alpha will be hard to generate going forward, he does not agree.

“My observation is that during last year, which was a challenging year for everyone, if you looked at our active return for the portfolio, the long-only managers struggled as an aggregate and underperformed their benchmark but the six alpha centres delivered a positive return all in all,” he says.

Under the remit provided by AP7, the managers use their skill in picking stocks and in the case of equity managers, widen the universe by shorting.

“We talk about the three zeros – the cash zero: we don’t deliver any cash to the alpha centre; it is beta neutral, so it’s beta zero; and we look at the benchmark as starting from zero, so it’s an absolute return construction,” Grottheim explains.

“What we deliver is a risk budget, so if they potentially lose money we deliver that deficit on the account to a certain limit.”

For some time now, the fund has been disinvesting from its fund of hedge fund exposure and transitioning its 2 per cent allocation into hedge fund replication.

So far, the investment in hedge fund replication is with Goldman Sachs’ ART (Absolute Return Tracker) fund, however Grottheim says the fund will expand to one or two other replication products, with the hedge fund of fund exposure replaced completely by replication by mid-this year.

AP7 also plans to invest 3 per cent of its 8 per cent private equity allocation in clean technology, and appoint one manager for the Swedish and Nordic market, and one for the global market.

“We think that [clean technology] will be good return-wise for the savers,” Grottheim says.

“Going forward, these companies that are within that sector will be very profitable as this is a large problem for the global environment and the production of clean energy will be favourable.”