Longevity Increases Are Leading to ALM Shift

(September 24, 2013) — Gains in longevity are forcing pension funds to consider increasing their exposures to equities, according to research from Axa Investment Management (Axa IM).

The latest longevity assumptions have shown that half of all children born today in highly developed countries could well live for more than 100 years.

That means that for every new day we live, we gain an additional five and a half hours of life expectancy at the end of our lives.

The rapid life expectancy rise, combined with baby boomers approaching retirement and a low-yield environment has forced a rethink when it comes to asset liability management (ALM) strategy, Axa IM said.

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“In order to pay additional annuities in the short term, pension funds need to invest in higher return assets such as equities or real estate,” the report said.

“With increased pressure on the short term horizon of their liability and a chase for yield that delivers in the longer term, pension schemes are caught in a duration mismatch which keeps widening as the new demographic, post baby-boom, is getting closer.”

Tilting the balance towards equities would hopefully compensate for depressed bond yields, a tactic which the report said was already being employed by some major fund managers, which were shifting their retail communications targeting new retirees and workers about to retire.

“At the level of institutional investors, this unconventional approach is being adopted as well. It is striking to note that CalPERS, a major US pension fund whose client base is vastly exposed to population ageing, has not tilted its exposure to bonds as might have been expected,” the report continued.

“The change in its clients’ life expectancy outlook and the age pyramid implies that the liability profile is extending. CalPERS data show that the overall allocation has experienced a slight decrease in fixed income exposure, while exposure to traditional equities has lost some ground, but mainly to the benefit of private equity and other alternative investments rather than to bonds.”

The rise in life expectancy has also seen a shift away from domestic bias, most notably in Japan, where longevity assumptions are at their highest.

In Japan, the hunt for yields has taken the form of international diversification in order to benefit from higher overseas returns.

The recent decision by the Japanese public pension fund (GPIF)–which manages around US$ 1.1 trillion of assets–to diversify its allocation toward overseas securities evidence of this, the report said.

“The Japanese experience shows that, in the context of depressed real yields (in local currency), the home bias of pension funds is likely to be re-assessed and to generate a search for higher return overseas.”

The full report can be read here.

(September 24, 2013) — US pension funds seeking a bulk annuity purchase should hold bonds, commercial mortgages, and asset-backed securities to secure asset-in-kind buyout deals, according to research from Penbridge Advisors.

Traditionally, US pension risk transfers with insurance companies have been transacted using only cash generated by the plans liquidating their assets.

In the UK however, the use of assets-in-kind—where assets are transferred to the insurer/s as part of the buyout deal—has been prolific.

The scale of the GM and Verizon deals in 2012 led to the need to allow asset-in-kind transactions too, and now other US insurers are becoming comfortable with accepting assets instead of cash.

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That need has forced more insurers to consider what assets they would accept in future asset-in-kind transactions, leading Penbridge Advisors to survey insurers to see what their favoured assets are.

All of the insurers the consultancy asked said they would accept treasury bonds, investment-grade corporate bonds, high yield bonds, private placement bonds, commercial mortgages, and asset-backed securities in an assets-in-kind buyout transaction.

Most would also accept real estate, preferred stock, and private equities, the research found. In some cases, hedge funds, unit-linked funds, and derivatives were also acceptable.

However, the report was quick to warn that even if a certain asset class was approved, the specific asset may not be suitable, as insurers need to manage duration as well as credit and exposure limits within the entirety of their investment portfolio.

“Most carriers said that they would in fact need to evaluate specific assets within each asset class for suitability; and they generally agreed that duration, credit quality, issuer credit limits, and their view of the issuer would all be relevant in that regard,” the report said.

“But, should certain assets be unsuitable for the buyout business, several insurers said they would consider using them to support another line of business.”

Valuation

The trickiest aspect of using assets-in-kind is arguably working out an agreed value for the assets. Penbridge Advisors’ report showed a variety of acceptable ways for insurers to agree on price: the insurer sets the valuation alone, a mutual agreement between both parties, or using third-party valuation.

One company even suggested selecting different methods for different asset classes, with those more heavily traded using publicly available pricing sources.

“Clearly, it may be quite a challenge to manage negotiations with several insurers at once on different valuation methods,” the report said.

“On the other hand, if a plan sponsor decides to ‘lay down the law’ in terms of what valuation method must be used, they may lose participation from some insurers in the bidding process.

“Beginning discussions with insurers well in advance will allow time to negotiate terms, to establish an agreeable valuation methodology (including the use of an independent third party where needed), and to enable review of the plan’s asset portfolio by the insurers.”

The full report can be read here.