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Entry strategy crucial to success of Pensions Reserve Fund Back  
In a paper given to the Dublin Economic Workshop in Kenmare, John Corrigan, a Director at the NTMA, set out how the new Pension Reserve Fund could be launched, how investment managers could be chosen and how to match its liabilities. He introduced the subject by looking at strategic asset allocation approaches such as efficient frontier analysis and went on to analyse how risk return trade-offs could be addressed within the context of the broad investment mandate for the Pensions Reserve Fund and the overseeing Commission, included in the Bill being brought through the Oireachtas presently. The following are edited extracts from his paper.
Notwithstanding the long-run superiority of equities over bonds, for pension funds the long-run tends to be a series of short-runs, as represented by the annual performance statistics. The market entry strategy for the Fund, which on its establishment will consist solely of cash, will obviously be of vital importance. If risk is redefined as the downside risk (or, statistically speaking, semi-variance) the key question in looking at the efficient frontier is how big a loss can one tolerate in one year out of six (one standard deviation).

In terms of entry strategy a not unreasonable concern would be that the outlier one-in-six event would occur in the first year of the Fund’s existence. In a presentation earlier this year to a seminar on the new Reserve Fund organised by the Irish Association of Pension Funds I suggested that possible entry strategies might be as follows:

(i) fully invest the Fund as soon as possible after its establishment;
(ii) invest the Fund on the basis of an ‘averaging in’ approach over say 12/18 months;
(iii) fully invest the Fund as at (i) above but insure some of the downside risk by, for example, by buying put options which could be partly financed by selling call options; and
(iv) some combination of (ii) and (iii).

Fully investing the Fund on its establishment would intuitively expose it to unacceptable market risk. An averaging-in approach clearly reduces the Fund’s market risk by spreading investment over time. Depending on market volatility the options approach could be expensive and indeed may not provide any more cost-effective risk reduction than the simple averaging-in approach. As the chart shows, market timing can be problematic leading to the conclusion that the simple approach may well be the best.

The conclusion to be drawn is that in trying to avoid the ‘worst’ days to invest, you may miss the ‘best’ days, which could reduce the portfolio’s return.

Active - passive combination
Passive management means holding securities in proportion to their weighting in the benchmark so that the risk and return of the portfolio very nearly match the risk and return of the benchmark. Active management seeks to outperform the investment benchmark by active asset allocation, security selection, sector rotation and other potential sources of valued-added, each of these decisions is likely to result in the risk and return of the actual portfolio deviating from the benchmark.

There is evidence that top-quartile managers add value but that their persistence of performance (i.e. their ability to continue to outperform) is weak in certain asset classes, notably those involving more efficient markets, such as US large capitalisation stocks. There is considerable merit in the idea of the Fund having a core passive portfolio combined with active specialist portfolios in those asset classes where there is a reasonable degree of confidence that managers who consistently outperform can be identified.

Manager selection process
The manager selection process should, of course, be subject to transparent competition. In seeking to identify good active managers the Fund should be looking for those managers with an externally verified high Information Ratio, (compliant with the Global Investment Performance Standards) indicating that they are able to generate more value-added for each unit of active risk or tracking error (the standard deviation of a manager’s return relative to the benchmark).

Managers should have a clearly articulated investment process which can be expected consistently to deliver alpha within clearly defined performance targets and risk parameters. They should also have stable and properly incentivised investment teams, sound IT systems and databases and a clear sense of corporate governance.

An active investment manager’s demonstrated ability to operate within prescribed risk parameters will be essential if there is to be effective management and control of the Fund’s active risk across the different asset classes and at the total Fund level through a formalised risk budgeting process, most likely operated by the NTMA on behalf of the Pensions Reserve Commission.

The prudent man/expert should also look at the liability side. This should involve not looking just at their size and structure as currently constituted but also looking ahead by analysing the dynamics of those liabilities. For example: are the liabilities growing; if so, are they growing in line with inflation? So how big are the pension bills to be addressed by the National Pensions Reserve Fund? The cost of Social Welfare pensions in 1999 was 3.4 per cent of GNP which is projected to rise to 5.7 per cent in 2026, 6.9 per cent in 2036 and 10 per cent in 2056. By contrast the Public Service pensions bill was 1.3 per cent of GNP in 1999 and will rise to 2.4 per cent by 2026 and stay at around that level. So the key part is the rapid growth in outlay to the Government from Social Welfare pensions in the years after 2026 - hence the 25 years commitment to injecting money before it can be drawn down.

There are, of course important differences between the liability streams of the Pensions Reserve Fund and those in private sector pension funds, notably the solvency/discontinuance actuarial tests for defined benefit schemes which the latter must meet every 31/2 years and which it would not be appropriate to apply to the Pensions Reserve Fund.

It will be important to see whether the investment performance has been sufficient to keep up with the growth in liabilities or not - and to understand the reasons for falling behind or gaining ground.

The decision to set up the Fund in the first place should be reinforced by establishing sensible review processes, but in the short term these should not impact on the main objective of maximising investment returns.

Long term perspective
The Pensions Reserve Fund is going to be a very big Fund: The Minister for Finance said that, assuming a conservative equity risk premium of 1 per cent, by 2025 the value of the Fund would be equivalent to some 42 per cent of GNP. The Fund needs to be looked at from a long-term perspective: short-term rigidities, which do not allow the Prudent Man’s common sense to prevail, will undermine the successful management of the Fund. A long-term perspective with a heavy equity bias, combined with proper risk management systems, clear strategic asset allocation and manager selection processes, as well as sensible monitoring and review arrangements, will ensure that the Fund will meet its statutory investment policy objective.

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