Balancing act between risk and costs

Pension funds face costs and constraints if a new approach to asset risk is implemented

Greg Langley

Borrowing heavily from the principles of Solvency II, the EU’s capital requirements rules for the insurance industry, the European Insurance & Occupational Pensions Authority (EIOPA) is looking to introduce a similar risk- based approach to the way pension funds allocate their assets. The proposal came about following the European Commission’s request to EIOPA in April for advice on its review of the Institutions for Occupational Retirement Provision (IORP) Directive II.

The aim of the Commission was to bring in a risk-based prudential regime for IORPs that achieves “a level of harmonization where EU legislation does not need additional requirements at a national level.” Among the Commission’s aims is to encourage cross-border activity of IORPs. It wants to allow IORPs to benefit from risk- based supervision while ensuring regulatory consistency across the EU.

However, a study called Long-term Pension Investment Strategies Under Risk-based Regulation by risklab, the investment and risk advisory expert of AllianzGI Global Solutions, carried out a simulation as to how the proposed approach could impact pension funds and their performance. The study uncovered a classic case of unintended consequences. Crucially, the new approach would incentivize the European pensions industry not to use diversification.

FINDING THE RIGHT CORRELATIONS

The three authors, Christian Schmitt, Gerhard Scheuenstuhl and Andreas Reuss, found that the risk-based approach proposed by EIOPA would force a de-risking of portfolios, typically by reducing the attractiveness of more risky asset classes. But as these asset classes have higher return expectations, this approach could reduce return on investment. And that could have an impact on the potential pay-outs to future pensioners, of which there will be a growing number as Europe’s population ages.

EIOPA is suggesting a regime, billed as the “holistic balance sheet,” which would push pension funds to set aside more capital to cover for assets perceived to be risky. Different asset classes, from European government bonds through to equities, would carry weightings based on their risk.

However, there is debate as to whether those risk weightings are appropriate for what are essentially very long-term investment horizons. The aim, a laudable one, is to reduce the potential of capital loss within portfolios due to exposure to riskier assets. But those are often the very same assets which tend to generate the highest returns over the long haul.

For instance, European sovereign bonds would carry a zero risk weighting, while high-yield bonds would carry 30% and European equities 39%. Assets classified as “other equities” could carry risk weightings of 49%, making them expensive to invest in. For government bonds, EIOPA is making no assumption for market risk, which has shown to be a possibility by the euro-zone crisis.

There is also little differentiation under the definition “other equities,” which includes private equity, infrastructure equity, emerging market equities, hedge funds and commodities.

Real estate, a favored asset for many pension funds, also does not come out well, attracting a risk weighting of 25%. The perception of higher risk is due to the illiquid nature of this asset, meaning an investor cannot exit quickly – a potentially important point during times of financial distress. There are no daily prices and there is a lot less market data available than there is for bonds and equities, which makes coming up with a risk profile for real estate harder.

Under the proposed regime strange effects start to creep in as well. So, for risk purposes, emerging market sovereign bonds with the same credit rating as corporate bonds manage to attract a lower risk weighting. In fact, to attract equal risk weightings, corporate bonds need to be one credit quality step higher than emerging market sovereign bonds.

Balancing act between risk and costs

Pension funds face costs and constraints if a new approach to asset risk is implemented

Greg Langley

Balancing act between risk and costs

Pension funds face costs and constraints if a new approach to asset risk is implemented

Greg Langley

Chinese economic takeaways

To whom it may concern

Summer sell-off sends a warning signal

Pension Atlas