Defined benefits ainÆt coming back

PrincipalÆs CEO explains what DC will look like, and outlines the firmÆs plans for Asia in 2009.
Governments around the world need to make defined-contribution pension schemes more flexible to help individual investors in times of market crisis, but are not going to support a return to corporate-led defined-benefit systems.

That is the conclusion of Jim Mccaughan, New York-based CEO at Principal Global Investors, who worries that some political pressures to adjust systems such as AmericaÆs 401(k) regime may prove counterproductive. For example, if politicians insist on widening the scope of guaranteed funds, this raises the question of counterparty risk regarding the guarantor; changing tax codes to favour low-risk products could also leave investors underwater in real terms.

ôWe see pressure to tinker with the system, such as allowing it to offer more guaranteed products, but we see no move back to DB,ö he says. ôInstead, more companies will reduce their corporate matching programmes, particularly among the biggest companies. Fortunately most small- and medium-size enterprises are proving resilient.ö

Mccaughan predicts more providers to DC schemes will market target-date return funds (also known as lifecycle funds), which automatically rebalance the portfolio towards a more conservative stance as it approaches a memberÆs retirement year.

The challenge for providers now is to convince members of the benefits of diversification. This year correlations among asset classes have been one, ie, all asset classes have lost value in tandem. This is typical of major crises: the same thing happened during the oil shock of 1974 and the stock market crash of 1987. But over time, diversification does work.

Mccaughan worries that if markets do not recover within the next few months, many investors will abandon equities for cash deposits and stable value allocations, which will prove devastating in the long run against inflation.

ôIndependent financial advice can save people from that,ö he says. So far, members of PrincipalÆs target-date funds have largely sat tight; itÆs in the retail mutual funds market where investors have been selling low.

The US has a huge industry of independent financial advisors, but in Europe and Asia, bancassurance tends to dominate. And right now Asian banks have lost credibility over the sale of structured products linked to things like Lehman Brothers-backed CDOs. The regionÆs insurance companies are not in a position to challenge the banks, and indeed sell most unit-linked product via banks.

ôBanks will continue to dominate Asian distribution but will see more regulation,ö Mccaughan says. ôStructured products have a role, but there needs to be transparency in pricing, particularly in the cost of distribution. This is an opportunity for providers of mutual funds as banks adopt multi-manager platforms and look for trusted brands.ö

Another challenge is to come up with better means of providing income post-retirement. Guaranteed income streams are difficult and expensive for fund managers to hedge, and may not survive as a business, at least in the United States. Variable annuities have grown in popularity in the US, Japan and Korea, but come with a high distribution cost. Instead, Principal favours fixed annuities and yield-oriented investment funds with structured drawdowns. ôThatÆs where 401(k) should go,ö Mccaughan suggests.

He is upbeat about PrincipalÆs business in 2009. The firmÆs Asia-sourced AUM had fallen 21.9% year-on-year in September, a lot less than the fall in regional market values. ôOur AUM has fallen but weÆre diversified,ö Mccaughan says, noting the firm has revenue streams from fixed income and real estate as well as equities. Moreover it has gained new mandates from sovereign wealth funds and big pension funds this year.

In 2009 he expects to increase institutional business as SWFs and others return to global equities, including emerging-market equities, where valuations are very low. The firm is also picking up mandates in specific bits of the fixed-income world that have been unfairly damaged by flights to quality, including high yield and commercial mortgage-backed securities, as well as preferred stock. Businesses such as Hong KongÆs Mandatory Provident Fund flows are stable, and Principal is hopeful its funds JV in China with China Construction Bank will, over time, enjoy growth.

The firm has had to cut costs however. In March of 2007, Mccaughan told AsianInvestor that the firm had set up a team in Singapore to build portfolios of securitised assets sold by regional financial institutions, in order to commingle and split these into tranches that a partner investment bank could sell. The idea was to develop a market in Asia for things like leveraged loans.

Now, Mccaughan says the firm has had to slash teams in structured products, particularly in fixed income and real estate. The MBS origination business was closed in September.

But the firm has also just hired Samir Dev to head sovereign fund relations in Singapore, and is preparing a distribution push for the Middle East, in partnership with JV counterpart CIMB in Malaysia. The firm has also recently acquired a discretionary asset management license in Japan and is looking to build its business development activities there. Mccaughan says the firm will also build an Asia real estate team, given the attractive pricing on offer, although any action must wait until the credit markets are restored.
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