Our world is changing profoundly. As guardians of long-term capital we need to respond now to remain relevant in the future.
As a pension investor PGGM is facing tensions between short and long term objectives. Stakeholders expect us to offer so-called “sustained performance”, also in a volatile market. This is by no means an easy task. Markets are inherently unstable: periods of relative stability are followed by instability. In fact, long periods of stability breed instability, because this is when investors become overly confident, thinking that “this time is different”, and build up risks to unsustainable levels.
The sudden fall in oil prices, persistent deflation worries and fiercely low interest rates in Europe are a source of anxiety in the short term. Markets seem again detached from fundamentals and the real economy. Quantitative easing, strict solvency regulation, and the trend towards building more and more safeguards in the financial system influence our ability to navigate markets and to contribute to the real economy. Trust in the financial sector is still low. As a consequence, we cannot always move in the way and at the speed we would like.
To structure this story it breaks up in three parts:
- The New Normal
- Innovation and Redefining the Long-Term Investor
- Scope for public private partnership
The New Normal
The phrase New Normal was coined in 2009 by Mohamed El-Erian. The new normal was shorthand for a two-speed world recovering from the crisis, in which emerging markets would grow rapidly initially, while developed markets would exhibit slow growth at best, leading to near-zero policy rates.
This crisis has not been kind to us. In 2008 the funding ratio of pension funds in the Netherlands fell off a cliff. Aggressive public sector intervention has since helped double the value of pension assets, but has also done so at the expense of further inflating liabilities discounted at risk free rates.
Regulation is often blamed for pension funds’ inability to recover more quickly. If only we could take more risk, then we would have the flexibility to invest more dynamically in the best asset classes, so the thinking seems to be.
Unfortunately, it is not so simple and I think that, as an industry, we must be humbler. When the Financial Assessment Framework – in Dutch, Financieel Toetsingskader (FTK) – was introduced in January 2007, many pension funds complained that a market-based discount rate for their liabilities forced them to hedge interest rate risk at historically low levels. In retrospect, the introduction of the FTK was a blessing in disguise. It forced pension funds to manage their market risks in ALM space, rather than in an asset-only space, as most of them used to do.
This offered protection during volatile markets in the wake of the global financial crisis and during the EMU crisis. I would argue that microprudential and macroprudential objectives were well aligned at the time, as the widespread hedging of interest rate risk also contributed towards financial stability. The architect of the FTK regulation, the late Dirk Witteveen, deserves credit for his determination to bring discipline to the Netherlands pension industry on the ALM front.
However, today, with near-zero or even negative interest rates, we have reached the point where we need to reconsider the wisdom of widespread hedging interest rate risk. Microprudential and macro policies are now at odds. Continuing with a widespread hedging of interest rate risk at these repressed market levels makes sense only if we believe that interest rates can fall even further, which seems increasingly unlikely.
After all, at some point, it becomes economically more attractive for retail investors to store savings in physical cash or pay down mortgages than to invest in pension schemes that lock in currently low rates for the long term. Hedging would change the investment outlook from “less certainty” to “certainly less”, and lead to a very bad outcome for pension funds and other long-term investors.
Recent PIMCO research argues that the “new normal” has evolved into a “new neutral”. This is a world in which countries converge to trend growth rates below, and sometimes well below, those recorded in the “old normal”. Monetary policy will normalise in some countries, but only at a very slow pace and clearly, normalisation is still a long shot for the euro area. In my view, the process of normalisation may take up to ten years. Moreover, the temptation for the ECB to continue QE longer than announced appears to be substantial given that QE lowers the sense of urgency to reduce the size of indebtedness in the government and household sectors.
This brings me to the next topics of innovation and redefining the long-term investor.
Innovation and Redefining the Long-Term Investor
Pension funds have a fiduciary duty to invest in the best interest of beneficiaries, but the financial crisis has changed the financial sector, including pension fund investors, profoundly. Eight years after the start of the crisis, trust in the sector is still very low. Restoring public trust is essential for our license to operate and a prerequisite for achieving good returns over the long term.
This requires us to look closely at our own business model and risk culture, as well as that of our counterparties in financial markets. Sometimes this entails making difficult choices such as declining deals because of remuneration issues and overhauling our own pay structure to bring it in line with our views on sustainable finance and caps on pay and performance fees.
Increasingly, we include indicators such as long-term behaviour, ethical standards, transparency and systemic importance in judging counterparty risk and brokerage relationships. We have developed new compensation guidelines, which guide our voting on compensation structures for listed companies and have implemented a fee protocol for financial service providers that are our business partners. We look to co-operate with like-minded peers to leverage our influence and change industry practices.
In a joint exercise with our largest client, PFZW, which provides pensions for Netherlands Health Care and Social Sectors, we asked ourselves, “What if we could start investing from scratch?” This question marked the start of a so-called White Sheet of Paper (WSoP) project.
Internal stakeholders, external experts and contrarian thinkers were invited to reflect on ambitions and constraints, and challenge common wisdom. During a process that lasted a year and a half, we addressed topics such as the efficient market hypothesis, the role of benchmarks, and peer group risk. We also discussed more fundamental issues such as our license to operate in a world of lower expected returns, a severe lack of trust in the financial sector, and increasing demands on sustainable development.
The WSoP project resulted in a new investment framework that describes our convictions and investment principles. These form the basis for our conduct and the conduct we demand of others. The resulting investments are focused on efficient achievement of our pension ambition, incorporate sustainability and are intelligible and controllable. Of course, costs play an important role.
Sometimes, we face difficult trade-offs. Realising financial and sustainability goals require innovative investment strategies that will add complexity and costs. The added complexity and costs of certain asset classes require investments in people, systems and changes in governance to ensure strong alignment of interest with Trustees. It also requires clear communication with plan participants on investment objectives, beliefs and governance of the scheme.
The global financial crisis and the problems in the structured finance market have given financial innovation a bad reputation. Former Fed Governor Paul Volcker has famously said that the last useful financial innovation was the ATM. On balance, though, PGGM is very supportive of innovation. Financial innovation has brought huge benefits to investors and to society. Derivatives are crucial to hedge currency and interest rate risks, and sometimes other risks too. We use synthetic securitisation to share risks with banks so they can get capital relief and we can efficiently participate in their portfolio of credit risks. It also allows us to access diversifying risk factors, such as commodity risk. The problems that we have seen in the past were often caused by inadequate use, rather than inadequate design of the products. We must embrace good innovation, while discouraging harmful innovation.
Historically, in the Netherlands, roughly three quarters of total pension savings at retirement has come from investment returns. With the current compression of risk premia this becomes far more difficult to achieve.
One approach to add value is to manage liability risks more dynamically, in particular as large swings in the MTM measures of liabilities occur. How to respond to lofty valuations and time varying risk premia is also an important strategic topic for pension fund Trustees to consider. In recent years, we have therefore made significant improvements in our counterparty and liquidity risk management approaches. We have daily insight in exposures and are able to react quickly when circumstances require so. We have enhanced our scenario analysis capabilities.
The global financial crisis has taught us that the number of truly independent risk factors is limited. We limit our building blocks to rates, equity, commodity and credit risk. To take better advantage of the investable universe we are active in both public and private markets.
For clients we invest in illiquid asset classes like Structured Credit, Insurance, Private Equity, Private Real Estate and Infrastructure. These investments are made for the long term and offer a good degree of control, in particular as we have become a more direct investor through partnerships and co-investments. Furthermore, it gives us the opportunity to add significant value to the real economy, in ways that are also very visible for plan participants in the Netherlands.
For example, last year we participated in a credit risk sharing transaction with Rabobank to support SME lending in Europe. We also provided capital to the spin-out transaction that made the Rabobank Private Equity team independent and established themselves as a new investment firm called Nordian. The transaction involved purchasing the existing portfolio of companies from the sale as well as providing new capital to the Team to make controlling investments in Dutch SMEs. Our lnfrastructure team did several deals that contribute to the development of a more sustainable Dutch energy infrastructure. We are taking part in NOGAT, a gas pipeline network in the North Sea and Ennatuurlijk, a large local heating company which is developing technology to lower energy consumption and diminish greenhouse gases. These are all long term investments with good and stable financial returns as well as societal benefits.
By 2020 our largest client, PFZW, aims to quadruple its impact investments. Four priority areas have been selected: climate change, water scarcity, access to healthcare and food security. We will achieve this via listed and private equity investments, green bonds, and through direct investments in core infrastructure and real estate.
This will lead to a more concentrated portfolio that may be viewed as rather risky by traditional backward-looking measures. It will also increase peer-group risk. However, we believe that traditional measures underestimate future risks of diversified benchmarks that include companies with unsustainable business models. An example that is often mentioned is that of stranded assets, in particular carbon assets.
Returns can sometimes also be enhanced by being smarter, faster or better at the execution. We already participate in joint ventures with construction companies to bundle their technical and our financial expertise. That gives us a better position in bidding for infrastructure projects.
We have also fully internalised the fund management of infrastructure. This contributes to the reduction of total investment costs and enhancement of controllability. The return on our infrastructure investments has improved since these were internalised. In today’s low-yield environment, where costs may erode a relatively large part of gross returns, this makes a significant difference.
The scope for public private partnership
To realise our investment objectives, we need strong and reliable governments. Conversely, governments need us. Currently, there are clear market failures where projects with high social value such as green infrastructure do not get the funding they need, despite ample liquidity in the markets. Public-private partnerships may help to address such failures.
The financing of unproven technologies may be given a boost if governments are willing to finance the construction phase, which is normally the most risky part. Once the construction has been completed and the project enters its operational phase with predictable, long-term cash flows, it becomes more attractive for long-term investors.
In highly-regulated markets, such as energy, governments must be reliable partners for institutional investors and governments need these investors, because the crisis has put big holes in their sheets. And while private finance cannot replace public finance if a country does not have the capacity to repay private financiers, private finance can bring better value for money, if risks are properly shared between public and private sector partners. This argument led to wide acceptance of PPPs in the Netherlands. In addition, as the IMF argued lately, good infrastructure will pay for itself, if it enhances the growth prospects for a country. In such cases, private sector financing may help.
In response to public pressure, PGGM and our clients have indicated a willingness to invest more in the Netherlands, provided investments meet risk/return requirements and can compete with alternatives elsewhere.
Our current allocation to the Netherlands equals approximately ten percent of total AuM. This allocation signals a home bias: the Netherlands’ share in global GDP amounts to only 1 percent. Domestic investments can be particularly attractive if these have a better match with liabilities, which are linked to Dutch inflation.
Responding to calls for action from the government, PGGM and other institutional investors established the Netherlands Investment Institution (NLII). The NLII aims to bridge the gap between the supply and demand for long-term capital, and make investment propositions more attractive, for instance by standardising and bundling them, so that they can benefit from economies of scale. The NLII also hosts a platform in which public and private-sector participants meet on a regular basis to discuss bottlenecks and potential remedies. Market segments that were previously inaccessible may now become attractive investment opportunities.
Unconventional monetary policy has restored market confidence which in turn has stimulated economic recovery. However, the overall picture masks some significant and disturbing distributional effects. Current policies put the burden squarely on savers and long-terms investors, who see their income reduced by low rates, that are likely to stay for the foreseeable future. Financial returns will be low and risks will be high.
In this world, there are no easy solutions. PGGM, together with our clients, tries to address the challenges through innovation and responsible investment.
But we can’t solve these alone. Governments have an important role to play as well. Moreover, they are facing their own financial challenges, where institutional investors may help. So we need each other. I firmly believe that the public and private sector can become partners that feel a joint responsibility to help each other and develop long-term strategies of mutual interest.