Strategic Transitions in European Investment Governance

Pensions in Europe:Strategic transitions in investment governance

Kees Koedijk

Structure of the presentation

• The need for change in the European pension market

• Macro economic & institutional pension changes

• Micro economic & organizational changes

• Digression: investment beliefs as case study in organizational change

• Assessment

The world is complicated enough as it is...

… while pensions as an issue loom in the background

• Pension expenditure set to rise in European Union

• Wide diversity between countries in

• pension expenditures

• pension buildup (first, second, third pillar)

• Unfunded pension liabilities: long-term challenge economic stability

• governments already under strain to manage government deficits and kick start economic growth

• Changes necessary, and underway

Increase in old-age dependency ratio in the EU countries constant factor for years to come

15

20

25

30

35

40

45

50

55

2005 2010 2015 2020 2025 2030 2035 2040 2045 2050

EU15

EU25

EU10

Old-age dependency ratio: 65+ age group as a share of 15-64 age groupSource: Eurostat

The change in old-age dependency ratio and the situation in 2050 is spread unevenly throughout the European Union

EU-25 average Source: Eurostat

FRBE

UKLV

EE

DKSE

LU

NL

LTFI

MT

HU

DE

IT

BGEL PT

ATRO

CYIE

SI CZ

PL

ES

SK

30

35

40

45

50

55

60

65

70

30 50 70 90 110 130 150 170 190 210

Percentual change of elderly dependency ratio 2004-2050, %

Eld

erly

dep

ende

ncy

ratio

205

0, %

Public pension expenditure as a share of GDP set to rise further between 2004 and 2050

4

5

6

7

8

9

10

11

12

13

14

2004 2010 2015 2020 2025 2030 2035 2040 2045 2050

% o

f G

DP

EU15

EU10

Source:EPC/AWG-calculations 2006

Countries deal with pensions in different ways

Third pillar: private pension

Second pillar: collectively organized pension

First pillar: public pension

Size of pension liabilities overshadows government debt

Spain

Belgium

Netherla

nds

France Ita

ly

German

y

United Kindgo

m

Sweden

0

100

200

300

400

500

600

Implicit public debt re-lated to future costs of aging, % GDP

Offical public debt, % GDP





• Digression: investment beliefs as a case study in organizational change

• Assessment

Transition agenda

• Pension sector set to transform in the coming years on a macro economic/institutional and organizational/pension fund level

• Macro economic level

• Creating private pensions

• Embedding longevity

• Absorbing financial risk

• Organizational / Pension fund Level

• Pension funds come to grips with new financial complexity

• Working with new changing investment paradigms

Create Private

Pensions

• Separate implicit pension claims from explicit government claims

• European division: Netherlands, Sweden, UK, Norway, Denmark have capital based systems, Southern Countries PAYGO

Embed Longevity

• Link retirement age to longevity

• More or less implemeted in European countries

• Question: how to stimulate labour participation for older workers

Absorb financial shocks

• Shift from DB to (Collective) DC

• European employers: stability and predictability pension contributions key

Macro economic transition

Organizational transition

New investment frameworks

Complexity financial industry

Principal Agent issues

Shifting investment paradigms

Organizational transition – Complexity financial industry

Financial sector is highly innovative• However, most innovations have been

supply based; • focus on diversfiying balance and income

of financial institutions

Complexity has created new interlinkages that transform accepted investment paradigms: • correlation between assets have been

rising, creating the need for new investment “shelters”

Regulators, suppliers, pension funds as buyers have to strike a new, sustainable balance in product innovation

Organizational transition – Principal agent issues

• Increasing awareness: principal (pension fund board) not always the same agenda as the asset manager (agent)

• New, more assertive role of pension funds underway

Pension fund Asset manager

Risk diversification

Risk premiums

Responsible Investments

Goals

Inefficiencies

Active management

Teams and staff

Focus

Impact

Risk man.

Koedijk and Slager (2006, 2008)

Organizational transition – Shifting investment paradigms

• Challenges up ahead; aging on asset pricing

(cf. Working paper Elod Takats, Bank of International Setttlements)

• “Disinvesting”, retiring generation increases in importance relative to “investing”, working generation

• Negative effect on stock markets and house prices?

• Challenges existing beliefs that the only way is up, such as positive long term equity risk premium

• Funds have to develop new investment frameworks to deal with these debates






• Assessment

A new investment framework has to deal with a lot of unresolved questions

• Is the equity premium dead or alive?

• What is risk to us or our participants?

• How long should long term horizon be?

• Does active management pay off?

• What is real diversification?

• How much faith do I place in emerging markets?

• Is mean reversion a true “constant” in financial markets?

Questions…

• … pension funds and investment managers deal with day in day out

• Answers…

• Are difficult to give. Investing is not a hard science despite the econometric advances

• Depend on what you believe and matters for you

Unresolved, because finance & investments are young disciplines

• Humans get in the way (Gray, 1997)• No “hard” scientific laws, parameters• Humans are not monotone in their behavior• Humans influence predictions

• We fit behavior into models, instead of the other way around (Taleb)

• We have not yet found a way to reach firm conclusions about the major debates in finance

• Neither should we expect it in the near term• Embedding behavioral finance promising avenue

• We have therefore to articulate the investment beliefs behind the debates and choices

But…

• If investment results influence the success or failure of pension funds

• And investment choices are (partly) based on beliefs

• Then thinking about, embedding and evaluating the consequences of investment beliefs are important to pension fund governance

Just as any other organisation would do

• Strategic Management Similarities

• Companies communicate their vision and strategy (USPs; proposition) for their clients, articulating why certain choices are made

• Especially in markets where different visions co-exist

• If not

• It becomes difficult for trustees to evaluate new developments, and whether to embed them in their own strategies

• More likely to “join the herd”, increasing costs and opportunity costs along the way

Strategic management rationale

1. Clear framework based on investment

beliefs to guide investment choices

2. Disciplined investment process to

counter/minimize behavioral biases

3. Management of the investment

process as a tightly knit supply chain,

instead of assembling parts after

delivery

4. Clear understanding and organization

of needed skills and resources for the

required governance level

1. Implicit dependance on financial

structuring to deliver the expected

results

2. Leaning on external advice, following

the herd – what are my peers doing?

3. Poorly developed managerial

framework to assess which strategies

will (not) work, how, and under what

circumstances they help achieving add

value to the fund’s goals

Authors: Ellis, Ambachtsheer, Rajan, Koedijk and Slager

Best practice funds: “WHY”Muddling through: “HOW”

Upward potential

• Upward potential for good governed pension funds, best governed pension funds focus on coherence, process and people

• Urwin & Clark: long term performance differential between well- governed and less well-governed funds amounts to 1-2% per year

• Committees investigating pension funds in several European countries after the financial crises: ample room to improve investment governance

Investment beliefs

Financial markets beliefs

•Risk premium

•Risk diversification

•(In)efficiencies in financial markets,

asset pricing

•Horizon

Investment process beliefs

•Impact, focus on management decisions

•Risk management

•Investment management style

•Costs

Sustainability and Governance

•Role Sustainability and corporate

governance in asset pricing

•Role in investment process

Organizational beliefs

•Teams, role of investment managers

•Out vs. insourcing

•Experience

•Implementatiion / execution

Focus on a number of beliefs

To be published in the Anthology Project, AP2 Fonden

Best practice investment process

•Observes behavior in the financial marketplace•Frames why the organization deals with this in a sophisticated way.

•Theoretical basis behind the investment belief. •What is it about that mechanism•Is it a structural, repeatable phenomenon

•Describes how the investment belief can be practically put to use.

•Organization to successfully exploit the investment strategy.•Links the exploitation of the investment beliefs to performance measures.

Belief: Investors overreact

Theory: Stocks that have had bad news announcements will be under priced relative to stocks that have good news announcement.

Investment strategy:•Buy (sell short) stocks after bad (good) earnings announcements. •Alternatively, buy (sell short) stocks after big stock price declines (increases).

Organization:•Trading strategy with short term horizon. •Good versus bad news announcements have to be identified.

Investment Belief Theory Investment Strategy Organization

Governance approach

• Identify basic beliefs

• Make consequences explicit

• Check if the governance is in place to understand and manage it

• Create environment to challenge assumptions; adaptation to new realities is key

A starter’s set of investment beliefs

1. Strategic asset allocation is the most important choice in the investment process

2. Active management does not pay off

3. Costs determine net return

4. There are only a select number of risk premiums worth pursuing

5. Simplicity pays off: we match governance and strategies

6. We only invest if we agree on when to exit

7. Sustainability is an opportunity, not a necessity






• Assessment

Going forward

• The European pension sector is embarking on an ambitious agenda for change

• Macro economic changes underway or envisaged

• Private Pensions

• Longevity

• Reallocating financial risk

• Micro economic change at the fund level challenge for management and trustees

• Pension funds will professionalize further to act as the right counterparty and partner of financial institutions

• Simultaneously the need for flexible investment frameworks to incorporate uncertainties in the financial markets increases: investment beliefs help

More background on investment beliefs

www.investmentbeliefs.org. Blog posting insights and governance related research

Koedijk and Slager, 2010, Investment Beliefs, Palgrave Macmillan. Fleshing out the investment debates in more detail.

[email protected]

http://www.investmentbeliefs.org/

Strategic Transitions in European Investment Governance

Business

Transcript of Strategic Transitions in European Investment Governance