Pension managers in Asia need to be more aggressive in taking on risk if they are to plug their funding gaps, says Reinhold Hafner, chief investment officer of the global solutions division at Allianz Global Investors.
“If your funding only covers 70% of your liability obligations – which we estimate to be the case in a number of countries globally – you need to ensure your assets generate a higher return than your liability return,” he says Hafner. “Otherwise, you won’t improve the funding level.”
One example is Japan’s Government Pension Investment Fund (GPIF), the world’s largest pension fund with $1.2 trillion in assets. Some analysts have predicted that it could run out of money in less than 25 years, due to its heavy target allocation to Japan government bonds (they account for about 60% of its portfolio) and under-investment in higher-yielding assets such as alternatives and public equities.
GPIF reportedly has target allocations of 12% each in domestic and foreign equities. It has, however, been increasing its exposure to overseas assets in the past year or so, including emerging market investments, with a view to tackling its underfunding issues.
Hafner says pensions should consider using risk overlay rather than merely traditional liability-driven investing (LDI), particularly given the current low-interest-rate environment, with 10-year US treasuries yielding 2.79% and Japan government bonds 0.64%.
LDI calls for plan sponsors to make investment decisions that seek to match assets with liabilities. Many pension fund sponsors construct portfolios comprising long-term bonds and inflation swaps to reduce the impact of interest rate changes on retirement scheme liabilities.
But Hafner argues that this traditional approach – often dubbed ‘immunising’ pension liabilities – merely serves to “lock in losses”, falling short of improving the funding gap faced by many pension funds.
That’s where risk overlay comes in, he notes. It combines investing in risky, illiquid investments – such as private equity and infrastructure assets – with using derivatives to hedge risks that cannot be diversified away in bear markets through asset allocation.
In bull markets, risk overlay requires dynamically changing the weight of asset classes to capture as much upside as possible by using derivatives. The approach can improve a plan sponsor’s ability to take on more risk where there is potential for reward, says Hafner.
“Risk management is not only about trying to limit the downside risk; it is also about taking on more risk in situations where risk is rewarded,” he notes. He advises using listed derivatives – simple contracts such as index futures or options.
Hafner heads up the investment and risk advisory unit, Risklab, in Allianz GI’s 90-strong global solutions team. There are two specialists from the team in Asia – one in Japan and one in Hong Kong – helping sovereign wealth funds, pension and endowment funds to implement risk overlay in their portfolios.
The global solutions executive in Hong Kong also covers the pension market Australia, where the team has relationships with some of the institutional managers for the $1.7 trillion superannuation sector.
Hafner says his team is having “concrete” discussions with a couple of potential clients in Japan.
The Japanese government would appear to be thinking along similar lines to Hafner. A panel was set up in December 2012 aiming to completely overhaul the goals, management and governance of its public pension funds. It has made recommendations designed to make the funds’ stewardship of more than ¥200 trillion ($2 trillion) of assets more active, more diversified and more focused on generating higher returns.