Kees Koedijk, at P&I's 5th annual Global Pension Symposium, addressed strategic transitions in investment governance in European pensions, macro economic and institutional pension changes.
2. 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
4. … 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
5. Increase in old-age dependency ratio in the EU countries
constant factor for years to come
55
50
45
40
35
30 EU15
25 EU25
20 EU10
15
2005 2010 2015 2020 2025 2030 2035 2040 2045 2050
Old-age dependency ratio: 65+ age group as a share of 15-64 age group
Source: Eurostat
6. The change in old-age dependency ratio and the situation in 2050
is spread unevenly throughout the European Union
70
ES
IT
65
Elderly dependency ratio 2050, %
BG
60
EL PT
DE SI
55 CZ
AT
RO PL SK
50
BE HU
FR
UK FI
45 LT IE
LV
EE CY
SE MT
40 DK
NL
LU
35
30
30 50 70 90 110 130 150 170 190 210
Percentual change of elderly dependency ratio 2004-2050, %
EU-25 average Source: Eurostat
7. Public pension expenditure as a share of GDP set to rise further
between 2004 and 2050
14
13
12
11
% of GDP
10
EU15
9
EU10
8
7
6
5
4
2004 2010 2015 2020 2025 2030 2035 2040 2045 2050
Source:EPC/AWG-calculations 2006
8. Countries deal with pensions in different ways
Third pillar:
private pension
Second pillar:
collectively
organized pension
First pillar: public
pension
9. Size of pension liabilities overshadows government debt
600
500
400
300
Implicit public debt related
to future costs of aging, %
200 GDP
100 Offical public debt, % GDP
0
10. 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 a case study in organizational
change
• Assessment
11. 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
12. Macro economic transition
• Separate implicit pension claims from explicit government
Create claims
Private
Pensions • European division:
Netherlands, Sweden, UK, Norway, Denmark have capital
based systems, Southern Countries PAYGO
• Link retirement age to longevity
Embed • More or less implemeted in European countries
Longevity
• Question: how to stimulate labour participation for older workers
• Shift from DB to (Collective) DC
Absorb
financial • European employers: stability and
shocks predictability pension contributions
key
13. Organizational transition
Principal
Agent issues
Complexity Shifting
financial investment
industry paradigms
New
investment
frameworks
14. Organizational transition – Complexity financial industry
Principal Agent
Financial sector is highly innovative issues
• However, most innovations have been Complexity Shi ing
financial investment
supply based; industry paradigms
• focus on diversfiying balance and income
of financial institutions New
investment
frameworks
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
15. Organizational transition – Principal agent issues
• Increasing awareness: principal (pension Principal Agent
issues
fund board) not always the same agenda
Complexity Shi ing
as the asset manager (agent) financial
industry
investment
paradigms
• New, more assertive role of pension funds New
investment
underway frameworks
Risk diversification Inefficiencies
Risk premiums Focus
Active
Pension fund management Asset manager
Responsible Impact
Investments Teams and staff
Risk man.
Goals
Koedijk and Slager (2006, 2008)
16. Organizational transition – Shifting investment paradigms
• Challenges up ahead; aging on asset pricing Principal Agent
issues
(cf. Working paper Elod Takats, Bank of International
Setttlements) Complexity Shi ing
financial investment
industry paradigms
• “Disinvesting”, retiring generation increases
in importance relative to “investing”, working New
investment
generation frameworks
• 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
17. 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 a case study in organizational
change
• Assessment
18. 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?
19. 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
20. 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
21. 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
22. 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
23. Strategic management rationale
Best practice funds: “WHY” Muddling through: “HOW”
1. Clear framework based on investment 1. Implicit dependance on financial
beliefs to guide investment choices structuring to deliver the expected
results
2. Disciplined investment process to
counter/minimize behavioral biases 2. Leaning on external advice, following
the herd – what are my peers doing?
3. Management of the investment
process as a tightly knit supply 3. Poorly developed managerial
chain, instead of assembling parts framework to assess which strategies
after delivery will (not) work, how, and under what
circumstances they help achieving add
4. Clear understanding and organization
value to the fund’s goals
of needed skills and resources for the
required governance level
Authors: Ellis, Ambachtsheer, Rajan, Koedijk and Slager
24. 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
25. Investment beliefs
Financial markets beliefs Investment process beliefs
•Risk premium •Impact, focus on management decisions
•Risk diversification •Risk management
•(In)efficiencies in financial markets, •Investment management style
asset pricing •Costs
•Horizon
Organizational beliefs Sustainability and Governance
•Teams, role of investment managers •Role Sustainability and corporate
•Out vs. insourcing governance in asset pricing
•Experience •Role in investment process
•Implementatiion / execution
26. Focus on a number of beliefs
To be published
in the Anthology
Project, AP2
Fonden
27. Best practice investment process
Investment Belief Theory Investment Strategy Organization
•Observes behavior in •Theoretical basis behind •Describes how the •Organization to successfully
the financial the investment belief. investment belief can be exploit the investment strategy.
marketplace •What is it about that practically put to use. •Links the exploitation of the
•Frames why the mechanism investment beliefs to
organization deals •Is it a structural, performance measures.
with this in a repeatable phenomenon
sophisticated way.
Belief: Investors Theory: Stocks that have Investment strategy: Organization:
overreact had bad news •Buy (sell short) stocks •Trading strategy with short
announcements will be after bad (good) term horizon.
under priced relative to earnings •Good versus bad news
stocks that have good announcements. announcements have to be
news announcement. •Alternatively, buy (sell identified.
short) stocks after big
stock price declines
(increases).
28. 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
29. 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
30. 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 a case study in organizational
change
• Assessment
31. 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
32. 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.
c.koedijk@tilburguniversity.edu
