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Germany Versus The Regulator

From aiCIO Europe's December issue: The complicated nature of Germany's pension system and its even more complex regulatory mechanisms. Charlie Thomas reports.

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“Germany’s pensions system has been around for more than 100 years and has seen off two world wars and hyperinflation. But pension funds are worried that this could kill off the entire system.”

That was the devastating analysis by PensionsEurope’s Secretary General  Matti Leppälä speaking at the UK’s National Association of Pension Funds conference in Manchester earlier this year. He was talking about one of the European pension regulator’s latest initiatives, ORSA—the Own Risk and Solvency Assessment—a process designed to assess the overall solvency needs of specific risk profiles of insurance companies.

After much lobbying from the UK, the Netherlands, and Germany, the Solvency II-style funding requirements were formally postponed for pension funds. But the governance and risk-reporting elements were preserved—and it’s this that the proposed ORSA would fall under.

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“ORSA could be translated into the pensions environment as an assessment conducted by the IORP [Institutions for Occupational Retirement Provision] of the risks faced by the undertaking and reconciliation of those risks with the available security mechanisms (including capital but also sponsor support),” the European Insurance and Occupational Pensions Authority (EIOPA) stated.

The ORSA does not in itself create a capital requirement but will pose difficulties for companies with weaker solvency and significant defined benefit (DB) liabilities—and there is a genuine fear that the proposals will lead to a “back door” form of solvency provisions. “The ORSA must not be used to introduce the solvency framework,” says Leppälä. “This risk-based solvency capital framework would put such a need for more capital on the balance sheets that it would be impossible for the sponsor companies to come up with that capital. That means the DB pension funds, as they exist today, would not be able to survive.”

Georg Thurnes, a partner at consultants Aon Hewitt in Germany, agrees that the German pension fund industry is “very concerned” about the issue.

Due to the complicated nature of Germany’s pension system (more on that later), some funds that are subsidiaries of one of the country’s many insurance companies will already fall under the first phase of Solvency II because they are integrated into the group reporting rules.

And even independent pension funds will very soon have to implement everything related to Pillars 2 and 3 of Solvency II, including the ORSA reporting requirements.

“It is our expectation that, at some point in the future [the independent pension funds] will also have to comply with the Pillar 1 approach, in terms of valuation of the balance sheet and solvency capital requirement,” warns Lutz Morjan, senior director of client solutions at ING Investment Management International. “There’s still some hope that won’t happen, but it’s not the opinion of our house. It may have been delayed by [European Commissioner Michel] Barnier for good reasons, but it is just a delay and EIOPA won’t give up on having this implemented.”

Unlike in other countries, corporate pensions are very much voluntary in Germany. Sponsors decide to offer a pension for their employees either from a social responsibility perspective or just to be attractive in the labour market.

The concern is, if the extra reporting requirements lead to increased costs and complexity—and a potential Solvency II-style capital requirement is hinted at—sponsors will find that frustrating, says Morjan. “We are very resilient, and we will make it work. What I’m concerned about is that the social security system will be decreased over the next decade, so that the government can pay less in public pensions. That means we have to find other sources of pension, so that millions of people aren’t left poor when they become old. If we make [the requirements] too complex and too costly, [the system] might not die, but you won’t see any expansion of the occupational schemes, which will be a big challenge for the German society.”

It is not just the ORSA proposal that threatens to burden German corporate pension funds, however. Alf Gohdes, chief actuary at Towers Watson in Germany, headed up the German Institute of Actuaries working group charged with transforming the commission’s instructions for the quantitative impact study, conducted at the end of last year. He notes this is just a small part of the overall picture.

“The ORSA is an isolated point being picked up from a whole bunch of factors relevant under the Pillar 2 and 3 studies carried out around the middle of this year,” he says. “It doesn’t make sense without connecting it with the others. You can’t build a car while just thinking about the quality of the tyres.”

As an example, Solvency II-type regulations could well put further restrictions on equity investments—a challenging issue for a country that historically invests very little in the asset class already.

The financial transaction tax is also causing headaches across Germany, as is the wider issue of European Market Infrastructure Regulation (EMIR) and central clearing. And that’s before you get on to domestic regulatory concerns.

Before we continue, it’s worth laying out exactly who we’re talking about when we say “German pension investors”. Most are insurance-regulated, hence the problems with Solvency II and other regulations above. But one is not.

The first group is the nonregulated “direct pension promise”, or “direct commitment” pension fund, which sits on the corporate sponsor balance sheet. It is the most free-form pension type in terms of regulation and investment strategy and requires only that all money entering the plan be guaranteed nominally by the employer until the retirement date.

Next you have the “pension fund”, an insurance-regulated product set up by individual employers, employer associations, or insurance companies. Again, the sponsoring employer remains secondarily liable and must step in if the pension fund fails to meet the pension liabilities—but it has a better tax profile.

Third are “pensionskassen”, another insurance-regulated version that has more limits on what it can invest in. These are usually set up for one specific employer or for a certain industry.

Finally, there are support funds, set up as subsidiaries of the sponsoring employer as a registered association. These are typically set up for groups of employers or as an industrywide pension fund. Here, the employer remains the primary debtor of the liabilities and only uses the support fund as a paying agent.

There is also a pension lifeboat vehicle similar to the UK’s Pension Protection Fund, called the Pensions-Sicherungs-Verein (PSV), funded by fees from direct commitment, support fund, and “pension fund” vehicles.

Employers using “pension fund” vehicles pay 80% less PSV premiums than the others, which has seen a number of employers switch to this vehicle in recent years, according to Sabine Mahnert, senior investment consultant at Towers Watson in Germany.

Each of these different types of pension has a different investment profile, but all struggle with the current low-yield, low-rate environment. Across the board, German investors are heavily invested in bonds—a large proportion of which are corporate bond issues.

“About 15 years ago, a typical equity/bond split would have been 30/70,” says Mahnert. “That has gone down now to 20/80 in the corporate pension space. With insurers, the equity allocation has reduced further: 5/95 or even less.”

While the recent rally in equity markets has prompted some tactical shifts towards the asset class, that’s as far as the stocks story goes in Germany. “The biggest challenge for German institutional investors is to achieve their long-term return target of around 4% given the current yield levels and market outlook,” says Frank Witt, PIMCO’s head of institutional client service in Germany. “At the moment, 10-year yields stand at 1.7% for German Bunds… in recent years, investors have realized that traditional approaches may not be sufficient to meet their long term objectives.”

The “direct pension promise” funds are taking advantage of their lack of regulation and allocating more risk into their funds. Funding levels of these sorts of vehicles are around 60%, according to ING’s Morjan, but they are willing to allocate more to equities, alternatives, and real estate. Up to 30% is typically invested in stocks, although Klaus Mössle, head of Fidelity’s institutional business in Germany, says he had clients with up to 60% in equities. 

For the insurance-regulated pension funds, it’s more about diversification throughout their fixed-income portfolios and chasing different risk premia.

For example, while the majority have divested from banks, other financial assets are attractive. And, while many ran away from asset-backed securities—particularly mortgage-based ones
—they’re very happy to invest in senior loans.

There’s a lot of interest in infrastructure debt, but not much money has been allocated to it yet, according to Towers Watsons’ Mahnert. Equity investments in infrastructure are less popular, as German investors prefer stable, fixed-income-type returns. Those investors seeking equity infrastructure will consider direct investments or, if not, investments that allow them a great deal of transparency and involvement at the target investment level. Emerging market and high-yield debt are also popular, with interest growing in senior secured loans.

Strategy-wise, German investors are adapting their risk management processes following the financial crisis and now recognise that investing needs to start with an asset-liability framework, Mahnert continues. Many direct pension promise funds have embraced liability-driven investing (LDI), although implementation has been hampered by the low interest rate environment.

Implementation of LDI in the insurance-regulated pension funds has been even more limited. “Insurance-regulated investors are looking at LDI approaches but more for the future than the present,” says ING’s Morjan. “They can use forwards and derivatives, but it’s a highly regulated sector so the exposures are limited in terms of how much you can put into your books.”

Carl-Heinrich Kehr, principal at Mercer, says he has a couple of clients working through the LDI process at the moment. Others would not adopt an explicit LDI approach in the same way as the UK funds would, he explains, because insurance-regulated investors don’t have market prices reflected in the balance sheet.

Interestingly, with all the focus on de-risking, there’s little appetite for pension-risk transfers. Given the nature of Solvency II, insurer-related solutions are deemed just too expensive (and as noted earlier, some of the deficits on these funds are sizeable).

“Buyouts and buy-ins usually occur only when there are substantial changes in an organisation,” says Mercer’s Kehr. “Investors who do want to consider a different platform for their pensioners compared with their active members are more likely to do so for tax efficiency reasons than for buyouts.”

Longevity risk products are also not yet broadly accepted. “The reason mentioned most often is that market participants believe there is no independently assured mortality data available for making this type of bet fair,” explains Aon Hewitt’s Thurnes.

Employers who are keen to remove the liabilities from their balance sheet can do so using an informal trust arrangement, he adds. “Companies started doing it 20 years ago; many more have done them in the past 10 years. Most large companies in the DAX index do it, for example.”

What we are seeing the start of, however, is an emerging defined contribution (DC) class. DC in its traditional format doesn’t exist in Germany—the legislation isn’t there to support it—but savings plans that look similar to a 401(k) are becoming more popular.

Employers often set them up to allow for additional contributions, and they usually follow a lifecycle approach, meaning the investment strategies are similar to those on DB plans.

“The trend from DB to DC was already there, but it has become more urgent, as it has in the Netherlands. The guarantees being handed out have become too expensive,” says Fidelity’s Mössle. “We’d call it an emerging DC market in Germany. The assets are between €40 billion and €50 billion, depending on how you define DC.”

These cash balance plans are unlikely to develop into DC plans as the UK or Denmark would recognise them, though, according to ING’s Morjan, that’s politically motivated, as “politicians are trying to make pensions as safe as possible for the employee”. 

This sector might warrant a closer look soon, however, as defined benefits might well be regulated out of existence. 

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Newsmakers

Revolution

From aiCIO Europe's December issue: How investment outsourcing needs to change—or unravel. Elizabeth Pfeuti reports.

To view this article in digital magazine format, click here. 

“Consultants outsourcing is an accident waiting to happen—it’s a very dangerous model.”

These are not the words of an asset manager trying to win over a new client. They were uttered by one of the most prominent figures in European fiduciary management—who is also the CIO of a pension fund—and they go some way to explain the problem the industry faces if it is to reach its much-hyped potential.

Patrick Groenendijk, CIO of the Dutch transport workers’ pension fund Vervoer and the man to whom these words belong, has more experience than most in these matters. In early 2010, after becoming one of the first to embrace investment outsourcing, the €14 billion fund heaved Goldman Sachs Asset Management (GSAM) out of a fiduciary management contract. Vervoer did not dump the idea completely, however: it brought in Robeco to take over the role.

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“I think outsourcing is a great idea,” says Groenendijk—but only on certain grounds. His experience with GSAM was one of a problem with the tactics of a specific player, rather than hating the game. And he has more worries for the -evolution of the market.

His main concern is consultants’ lack of experience in the field—observing is only part of the job, he says. You can watch Roger Federer play tennis for 20 years, but it’s fair to say you won’t pick up a racquet and immediately be able to play like him.

He also has a concern about conflicts of interest more widely—consultants are not the only ones who can trip up the system.

Vervoer’s assets are slotted into investment mandates by Robeco, which itself runs money but is not allowed to allocate to its own funds. “This means that if we miss out on stellar performance as Robeco is the best European high-yield manager—which it is by the way—then so be it,” he says. It keeps them honest.

There is still too much muddy water for some, however.

“How can you be acting in one client’s interest when you have to release information to all your clients at the same time?” says Stefan Dunatov, CIO of the Coal Pension Trustees Investment. “This assumes that all clients’ interests are identical, which can’t be right.”

Dunatov oversees one of the UK’s largest pension asset pools, a similar post to Groenendijk’s, but their views are diametrically opposed. And to build a business of any size, the outsourcing industry in the UK will have to reach out and convince these non-believing investors of their worth.

“There’s a great interest in larger mandates and tenders from providers, but it’s not really what we see happening,” says KPMG’s Head of Manager Research Alex Koriath. “We’re seeing these funds separating out the advisory and investment management to more specialist firms to implement a certain part of the portfolio—it’s looking less likely that fiduciary managers will see a way in to this end of the scale. There needs to be change for this to reverse.”

Groenendijk believes that in the Netherlands, where asset managers are the predominant providers of this service, the sector has moved on and learnt from its initial mistakes.

“Investors can now take a modular approach to fiduciary management,” he says. “If, for example, they want a risk management module from BlackRock, they can go and just take that. It used to be all or nothing, but things have now changed.”

And the proof may be already visible in the numbers. In the Netherlands, most fiduciary management mandates are run by asset managers—and it seems to be working. Even in 2011, MN Services, a provider of a range of outsourced solutions, published data showing Dutch pension funds had committed more than €790 billion to the approach.

In the UK, which has similar assets under management to the Dutch system, the number is just £58 billion—less than 10% of the Netherlands’ total—according to figures from KPMG.

In order to really crack the market, there are mountains to scale. Since 2007, outsourced assets in the UK experienced an uptick of 34%, KPMG’s figures show. But despite this increase, the exposure the industry gets, and arguably the marketing budget, less than 3% of the UK’s pension pots are managed in this way.

There are plenty of asset managers offering outsourcing arrangements in the UK, but the allocations remain stubbornly low. Therefore, looking beyond the battle lines drawn between fund houses and consultants, there are issues that both sides must address in order to gain any ground at all.

For one, there is a serious lack of standardisation across the industry. Far from just confusing investors with a range of names (implemented consulting, fiduciary management, outsourcing), the products that lie behind the labels are an eclectic range of different approaches and delegation levels.

“The market is growing rapidly,” says Koriath. “As this market matures, it will have to become more transparent and there will have to be more standardisation.” The array of products on offer ranges from basic advice on investment navigation all the way through to taking over the map, wheel, and accelerator—and it depends on who you ask, and how much they ask to be paid, as to where you fit in on the scale.

Within this mishmash of approaches lies another problem: Can a provider offer a fund bespoke solutions if it has lumped its assets in with countless others?

“Some concerns trustees have centre on how the money is run and reported, for example, from an environmental, social, and governance [ESG] perspective. BT trustees are no exception,” says Sunil Krishnan, head of market strategy at the British Telecom Pension Scheme Management (BTPS). “Therefore, it suits them to have tailored investing and reporting so there is no nasty aftertaste when they have to ask a certain manager: ‘Can we change our investment approach to X?’ If the idea makes investment sense, there is no compromise needed. If I was a fiduciary manager, I’d want to concentrate on how closely I can replicate that.”

BTPS offers a similar model to the one targeted by many outsourcing providers—but to just one client: the biggest pension fund in the UK.

Koriath also believes there are problems brewing here. “If you go to someone and say: ‘I want ESG, or this type of investment only’, it will cause huge problems for many of these fiduciary managers. Many of their models are based on model portfolios, which are then scaled and implemented in different ways for each client, but most are based on a basic model portfolio,” he says.

“By name, it’s supposed to be a tailored solution, but there may well be limits. You have to realise them at the point of selection, rather than engage someone and then spring the news on them that you need all these specialisms.”

One of the most important issues is how to measure a fiduciary manager’s activity, and as of yet, partially due to the lack of standardisation in the sector, no one has satisfactorily achieved this.

“How do you keep the checks and balances of fiduciary responsibility?” demands Koriath. “How do you keep grasp of how well things are going? Do you rely on the reporting from the fiduciary manager that tells you they are doing a good job? Do you ask a custodian? How do you verify the reporting and do independent checks? That is a question.”

Members of KMPG’s investment consulting practice appointed themselves as key gamekeepers of this space in 2009 with the creation of a new department. They have been brought on board by several UK pension funds to oversee how their fiduciary manager is doing, hence the production of an annual survey. In the Netherlands, Ortec Finance carries out a similar job as there are also muddy waters across the North Sea.

“Metrics for assessing success would, ideally, be quantitative in order to ensure objectivity,” says Ralph Frank, an independent solution provider who previously worked at Anglo-Dutch fiduciary manager Cardano, and suggests a range of quantitative methods. These could include solvency ratios for those promising improved funding and asset class achievements for those just selecting managers. “Metrics would help assess success objectively. Different providers would also be more easily compared using relevant reference points.”

Krishnan at BTPS says there are soft and hard measurements of success. “The value for money has to be clear, and costs have to be transparent.” 

Cardano is the only provider operating in the UK to offer year-by-year figures on its clients’ solvency. But without competition the numbers, although applauded, are pretty meaningless in a wider context. Providers will soon run out of excuses as to why they cannot provide firm figures—and claiming that each client and their service is different may soon turn out to be a curse.

KPMG has decided that a balanced scorecard is the best option. “You need to see the overall performance against a funding level with a high-level objective that everyone needs to approve,” Koriath says. “But then you have to dig a little deeper and look at how this result came about. Is it just risk being taken? What kind of market risk? And how did they add value? Were they successful in asset allocation or selecting managers that really deliver alpha? Did they change how they hedged the liability profile? Or the LDI strategy?”

And then there’s the qualitative angle—how the fiduciary manager works with the internal team and trustee board. The list goes on and on.

Groenendijk at Vervoer has two basic metrics for measuring how well his outsourced provider is doing. “I look at how well the managers they chose have performed after fees to measure their selection success,” he says. And for the general fit of the relationship and if they are fulfilling the mandate? “We go on how satisfied we are. It is completely subjective. We look at the working relationship we have and assess that.”

This working relationship is what might be the undoing of the whole industry if it is not managed properly. “People who outsource their investments need to realise that it’s not just a way of getting rid of a pension fund problem,” says Groenendijk. “It can never become someone else’s problem—and the regulator needs to know that you still understand all that is going on.”

To illustrate, Groenendijk’s team has grown from two to seven since appointing a fiduciary manager. The team beefed up risk controls and other functions they had never needed before just to better oversee the new processes being brought in to their investment strategy.

“Fiduciary management won’t cut down the time you spend on your investments, or the time budget you have allocated to them,” says Koriath. “You just spend the time differently, and usually more closely with a fiduciary manager, getting to understand what they do to add value for you. In most cases, strategies are more complex than the investor might have had previously.”

Understanding liquidity profiles, risk premia, and volatility may be outside a pension fund’s previous remit, and some might be disappointed to find they have to spend more time on investments rather than less. Was this the fault of providers failing to let their potential clients know what they were in for?

“I don’t know whether consultants and asset managers really knew what it meant in terms of how the working relationship would develop,” says Koriath. But it is certain that they are going to have to inform them in future. So if the providers iron out all of these issues, will they end up with the golden goose—the really large pension funds across Europe?

“Fiduciary management is an abrogation of responsibility,” says Dunatov. “By exercising their authority to use a fiduciary, they are giving away their authority. If you don’t know what you’re meant to be doing, how can you measure what someone else is doing for you?”

It might be a tougher climb than they think. 

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