Are Pension Funds taking too much Risk ?

Institutional Seminar

Jan Longeval
Managing Director
March 27, 2009
A closer look at the numbers

Annual returns Belgian Pension Funds (as of end 2008)

Pension funds – Pension funds –

Nominal Real

15 years 4.4% 2.4%

Source : BVPI/ABIP

2 Are Pension Funds taking too much Risk ?

A closer look at the numbers

Annual returns Belgian Pension Funds (as of end 2008) vs Government bonds

Pension Gov. Pension Gov.

funds - Bonds – funds – Bonds –
Nominal Nominal Real Real

15 years 4.4% 6.1% 2.4% 4.1%

Source : BVPI/ABIP, Bloomberg

3 Are Pension Funds taking too much Risk ?

A closer look at the numbers

Nominal return Belgian Pension Funds (15 years) 4.4%

Standard deviation 11.2%

Nominal return Government Bonds (15 years) 6.1%

Standard deviation 5.4%

4 Are Pension Funds taking too much Risk ?

How can this be?
Euro Govt 10 Year Yield

9%

8%

7%

6%

5%

4%

3%

2%

1%
1993 1996 1999 2002 2005 2008

5 Are Pension Funds taking too much Risk ?

How can this be?

MSCI Europe vs MSCI US (Local Curr.)

400

350

300

250

200

150

100

50
1993 1996 1999 2002 2005 2008

MSCI EUROPE ND MSCI USA ND

6 Are Pension Funds taking too much Risk ?

 Questions to be asked

1. Did we do something wrong ?

7 Are Pension Funds taking too much Risk ?

 Some 25% of all Belgian Pension Funds have filed

a herstelplan de redressement with the CBFA

8 Are Pension Funds taking too much Risk ?

Some 75% of all Belgian Pension Funds have NOT filed

a herstelplan de redressement with the CBFA

9 Are Pension Funds taking too much Risk ?

History tends to repeat itself
Evolution of S&P 500
from De ce m be r 1965 till De ce m be r 1979

120
110
100
90
80
70
60
50
40
1965 1967 1969 1971 1973 1975 1977 1979

S&P 500 S&P 500 CPI Adjusted

10 Are Pension Funds taking too much Risk ?

Nothing normal about this distribution
Expected daily returns on the European stock market

1 out of 4,000,000 years

6

1 out of 125 years

4

-2

-4
1 out of 125 years

-6
1 out of 4,000,000 years

-8
2001 2001 2002 2003 2004 2004 2005 2006 2007 2007 2008

11 Are Pension Funds taking too much Risk ?

Reminder: Long term investment really means long term!
Dow Jones Industrials (since inception)

16000

14000

12000

10000

8000
Starting level = 40.9
6000

4000

2000

0
26/05/1896 1913 1931 1949 1966 1984 2001

Quiz question: what level if Dow Jones was a return index instead of a price index?

12 Are Pension Funds taking too much Risk ?

 Investing in equities … delivers a risk premium

But [sometimes] requires a very long time

horizon (longer than 10, 15 even 20 years)

Stock market volatility can be very scary

ALM studies PROBABLY have underestimated

both minimum investment periods and risk

… and so did all of us

13 Are Pension Funds taking too much Risk ?
 Questions to be asked

2. Should we change anything ?

14 Are Pension Funds taking too much Risk ?

 Very long investment horizons

High volatility

IAS 19 / FRS 17

Minimum return guarantee in DC plans

Higher accountability of Pension Board (WIP)

15 Are Pension Funds taking too much Risk ?

 Pension funds don’t even have to invest in
risky assets in order to be more advantageous
than group insurance !

Group insurance presents returns on contributions

NET OF FEES

16 Are Pension Funds taking too much Risk ?

 Take a bigger safety margin!

17 Are Pension Funds taking too much Risk ?

 Take a bigger safety margin!

Revise strategic asset allocation less equities

less listed real estate

more (corporate) bonds

more inflation-linked bonds

more LDI

KISS

Can ALM studies quantify this ?

18 Are Pension Funds taking too much Risk ?

Sell equities now?
Expected risk premium European Equities

19 Are Pension Funds taking too much Risk ?

Warren Buffet’s view
THE financial world is a mess, both in the United States and abroad. Its
problems, moreover, have been leaking into the general economy, and the
leaks are now turning into a gusher. In the near term, unemployment will
rise, business activity will falter and headlines will continue to be scary.
So ... I’ve been buying American stocks. This is my personal account I’m
talking about, in which I previously owned nothing but United States
government bonds. (This description leaves aside my Berkshire Hathaway
holdings, which are all committed to philanthropy.) If prices keep looking
attractive, my non-Berkshire net worth will soon be 100 percent in United
States equities.
Why?
A simple rule dictates my buying: Be fearful when others
are greedy, and be greedy when others are fearful. And most
certainly, fear is now widespread, gripping even seasoned investors. To be
sure, investors are right to be wary of highly leveraged entities or businesses
in weak competitive positions. But fears regarding the long-term prosperity
of the nation’s many sound companies make no sense. These businesses will
indeed suffer earnings hiccups, as they always have. But most major
companies will be setting new profit records 5, 10 and 20 years from now.
Let me be clear on one point: I can’t predict the short-term movements of
the stock market. I haven’t the faintest idea as to whether stocks will be
higher or lower a month — or a year — from now. What is likely, however,
is that the market will move higher, perhaps substantially so, well before
either sentiment or the economy turns up. So if you wait for the robins,
spring will be over.
A little history here: During the Depression, the Dow hit its low, 41, on July
8, 1932. Economic conditions, though, kept deteriorating until Franklin D.
Roosevelt took office in March 1933. By that time, the market had already
advanced 30 percent. Or think back to the early days of World War II, when
things were going badly for the United States in Europe and the Pacific.
20 Are Pension Funds taking too much Risk ?
The market hit bottom in April 1942, well before Allied fortunes turned.
Again, in the early 1980s, the time to buy stocks was when inflation raged
and the economy was in the tank. In short, bad news is an investor’s best
friend. It lets you buy a slice of America’s future at a marked-down price.
Over the long term, the stock market news will be good. In the 20th century,
the United States endured two world wars and other traumatic and expensive
military conflicts; the Depression; a dozen or so recessions and financial
panics; oil shocks; a flu epidemic; and the resignation of a disgraced
president. Yet the Dow rose from 66 to 11,497.
You might think it would have been impossible for an investor to lose
money during a century marked by such an extraordinary gain. But some
investors did. The hapless ones bought stocks only when they felt comfort in
doing so and then proceeded to sell when the headlines made them queasy.
Today people who hold cash equivalents feel comfortable.
They shouldn’t. They have opted for a terrible long-term asset, one that
pays virtually nothing and is certain to depreciate in value. Indeed, the
policies that government will follow in its efforts to alleviate the current
crisis will probably prove inflationary and therefore accelerate declines in
the real value of cash accounts.
Equities will almost certainly outperform cash over the next decade,
probably by a substantial degree. Those investors who cling now to cash are
betting they can efficiently time their move away from it later. In waiting for
the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I
skate to where the puck is going to be, not to where it has been.”
I don’t like to opine on the stock market, and again I emphasize that I have
no idea what the market will do in the short term. Nevertheless, I’ll follow
the lead of a restaurant that opened in an empty bank building and then
advertised: “Put your mouth where your money was.” Today my money and
my mouth both say equities.
Source : The New York Times, October 17, 2008
Sell equities now?

Performance 2008 Expected risk

premium today

Equities -45% 6%

Corporate bonds -4% 3%

21 Are Pension Funds taking too much Risk ?

Sell equities now?
Evolution Asset Allocation Belgian Pension Funds
(s ource : BVPI/ABIP)

60%

50%

40%

30%

20%

10%

0%
1985 1988 1991 1994 1997 2000 2003 2006

Equities + Real Estate Bonds Other Cash

22 Are Pension Funds taking too much Risk ?

Sell equities now?
Evolution of S&P 500
from De ce m be r 1979 till De ce m be r 1989

400

350

300

250

200

150

100

50
1979 1981 1982 1984 1985 1987 1988

23 Are Pension Funds taking too much Risk ?

Old versus New medium Risk profile

Old New Current

EMU 25% 20% 20%
Equities Global ex-EMU incl Emerging 25% 20% 23%
markets
Subtotal 50% 40% 43%
EMU 32.5% 37.5% 32%
Bonds EMU Corporate 10% 17.5% 18%
Subtotal 42.5% 55% 50%
Real Estate EMU 7.5% 5% 5%
Cash - - 2%
Total 100% 100% 100%

24 Are Pension Funds taking too much Risk ?

Conclusions
Risk assets need long periods to deliver a risk premium and their
volatility can be scary

Changing environment makes pension funds more risk adverse

Pension funds don’t even have to take risk to outperform group

insurance

ALM studies should be updated

Take a bigger safety margin!

25 Are Pension Funds taking too much Risk ?