A series of regulatory changes aimed at shoring up the €48.5 billion ($65 billion) Irish defined benefit sector likely will result in sweeping portfolio restructurings across the industry.
The Pensions Board, Ireland's regulator of occupational pensions, will publish a set of new guidelines for defined benefit plans by the end of the year. Although details have not been announced, sources familiar with the new framework said it is likely to include a three-pronged approach to investment risk management: a restoration of required funding standards that are likely to become stricter over time; new requirements for risk reserves linked to a fund's level of investment risks; and the potential introduction of sovereign annuities to help funds better manage liabilities.
“One of the central themes coming out of the new regulations will be for pension schemes to reduce risk,” said Michael Dempsey, Dublin-based principal and head of Mercer LLC's investment management business of Europe, Middle East and Africa. “There has been a lot of (market and regulatory) uncertainty, which has meant that pension schemes have not done what they should be doing. … I think it's good that there will be more clarity.”
The Pensions Board estimated 70% of Irish pension funds are underfunded, “and in many cases the deficit is substantial,” according to information provided by the board.
Brendan Kennedy, CEO of the board, said earlier this year in a speech: “The greatest single issue faced by Irish schemes is investment risk and the failure to recognize this risk and to manage it.”
Ireland's pension funds historically have had one of the highest average allocations to equities among European nations, resulting in a more dramatic drop in asset — and funding — levels when volatility rocked global markets in 2008-‘09 and again earlier this year. According to an asset allocation trends survey conducted annually by Mercer, the average equity allocation among Irish pension funds reached a high of 67% of assets in 2008 before paring to 59% at the end of 2010, mostly as a result of increases in the average bond allocation.
Mark McNulty, managing director and head of institutional and intermediary clients for Ireland at State Street Global Advisors in Dublin, said his firm is working with as many as 100 pension clients to explore asset allocation options ahead of the expected regulatory requirements. Some have begun implementing ways to reduce risk, including a shift into core European bonds from growth assets such as equities. In addition, some are moving from investing in an aggregate basket of euro-denominated bonds to a strategy that's dominated by securities issued by Germany, France and the Netherlands. (In October, SSgA introduced two new euro-denominated core bond strategies targeting Ireland's pension funds.)
Pension fund executives are also putting in place “more tailored structures that balance risk and reward for each pension scheme,” said Gordon Kearney, senior portfolio manager in the multiasset-c class solutions team at SSgA, Dublin. “The reduced equity allocations are partly due to the fact that (pension funds) are maturing anyway, so it's appropriate to hold less risk. Secondly, there will be more of an incentive to hold bonds under the (new) funding standards.”
Among those that have already begun to shift to bonds from equities is the €2.65 billion eircom Ltd. Superannuation Funds, Dublin.
“A lot of funds would like to reduce risk, but the problem is that many are still in deficit while the liabilities march on and on,” said Jim Foley, group pensions director at the eircom fund. “You can't reduce risk if you haven't gotten the liabilities side in order.”
In an effort to eliminate a €435 million deficit, the company closed its defined benefit plan to new members in 2009. Among other measures company officials took was an innovative agreement with employees to freeze their pensionable pay (the salary off of which their benefit is based) until 2013 and subsequently cap the growth rate to allow for “actuary certainty over the rate of benefit increases built into the (liabilities) assumptions,” Mr. Foley said.
After controlling the liabilities, trustees decided to substantially reduce risk by shifting into bonds from equities between March and May of this year. The liability-matching portfolio, comprising mostly bonds, grew to 59% of total assets from 29%, while the return-seeking portfolio — which is predominantly equities — decreased to 41% from 71%.
“Rather than taking nice and gentle steps over time to reduce risk, we decided on a much quicker pace,” Mr. Foley said. “If you're trying to achieve a required level of yield in order to take risk off the table, why just take a little bit off if the objective is much bigger?”
For the nine months ended Sept. 30, 2011, the fund returned 1.1%, and is “back to being well squared in terms of assets and liabilities,” Mr. Foley said. Over the next 10 years, fund executives are aiming to shift another 10 percentage points to bonds from equities.
More pension funds are expected to follow suit once clearer guidelines are established, said Jerry Moriarty, director of policy at the Irish Association of Pension Funds, Dublin, an industry organization representing DB and defined contribution funds with e63.5 billion in assets.
“Generally, most trustees have considered reducing risk” in the investment portfolios, Mr. Moriarty said. “But there has been so much uncertainty, leading people not to make any decisions at all.”
In 2010, Irish pension regulators temporarily suspended funding requirements following the 2008-‘09 recession to allow pension funds more time to recover, sources said. However, according to Mr. Kennedy of The Pensions Board, many of Ireland's pension funds have shown “no noticeable reduction” of their equity exposures, more than three years since the markets crashed.
“The unavoidable conclusion is that, in very many cases, trustees have not faced up to the issues,” Mr. Kennedy said in the speech earlier this year.
Under the new guidelines yet to be announced, trustees of funds that are in deficit likely will be required to submit a recovery plan at the earliest by July 2012, according to sources. Fund executives likely will have until 2022 to comply with the new funding standards, which will become increasingly stricter, according to information released by The Pensions Board.
In a statement issued on Oct. 28, Mr. Kennedy said: “Trustees must recognize the contribution rate, the investment policy and, where relevant, changes to the benefits structure.”
Another related proposal centers on the required capital reserves that likely will fluctuate according to the level of investment risks, sources said. One option being considered would require pension funds to hold a buffer to cover a 20% decline in the value of the equity portfolio, a 1% decrease in bond yields and a 0.5% inflation outlook. The risk reserve is “a significant concern” for Irish defined benefit funds, Mercers' Mr. Dempsey said. Depending on the investment portfolio, the reserve could add as much as 10% to existing funding requirements, according to estimates by The Pensions Board.
Pension funds are likely to need a higher risk reserve to buffer against higher equity allocations, therefore, the new rules will encourage “a move into core European bonds — the higher-rated sovereign bonds — that, in some respect, are more about being defensive rather than performance seeking,” said Martin Haugh, partner at consultant Lane Clark & Peacock LLP based in Dublin.
At Mercer, Mr. Dempsey already is seeing clients take initials steps to move out of equities. Since introducing a dynamic derisking solutions program earlier this year, Mercer has attracted new accounts totaling $1.5 billion. “When funding levels increase, (assets) are automatically moved quickly and efficiently toward bonds,” Mr. Dempsey added. “It's a very structured and systematic way of moving out of equities.”
A separate government proposal would counter the effects of rising pension liabilities through the introduction of sovereign annuities. The annuity products would be sold by insurers and may be linked to longer-dated Irish government bonds with maturities of more than 10 years or a broader basket of euro-denominated government bonds. Purchasing these sovereign annuities would likely reduce pension liabilities because they are higher-yielding than German bunds, which currently dominate most Irish pension funds' government bond portfolios, Mr. Haugh and other consultants said.
“Obviously (pension executives) would be taking more risk when they do that, so they have to balance the need to reduce funding requirements with the additional risk,” Mr. Dempsey added. ”While there's uncertainty surrounding the eurozone, I don't think there will be any significant moves in that direction. But in the longer term, (sovereign annuities) might provide pension schemes with another route to explore.”
