Perspective - Summer 2009

Dealing with the
New Investment Landscape

Changes for institutional investors and strategies going forward

A discussion between five Watson Wyatt Investment Consulting global leaders

AS THE GLOBAL uncertainty continues, institutional investors are struggling to understand and evaluate the new environment they find themselves in. Five Watson Wyatt investment leaders recently sat down to discuss how the world has changed in the last year for institutional investors and investment strategies going forward.

Q. How have investors' attitudes to risk changed as the crisis has evolved?

Roger Urwin: Funds have found it difficult to adapt their strategies to these new conditions. This is unsurprising, as the current situation is unprecedented. Most funds have moved in one of two directions: some have rebalanced back to their original asset mix, which has been quite painful because it involved selling secure assets to buy more risky assets as those risky assets have depreciated. On the other hand, some funds have been more prepared to let their asset mix drift away from their benchmarks.

We have suggested that rebalancing is not ideal for the new conditions confronting us, and instead of rebalancing, funds should adopt a lower allocation to the return-seeking equity side of the portfolio. In the current condition, funds need to adapt their risk profile – rebalancing back to the original equity target would mean balancing back to a much riskier profile.

Also, many funds are still trying to come to terms with what's happened and many are expecting markets to rebound relatively quickly and relatively completely. We do not believe that is likely given the outlook facing us. Our view is that this is a fundamental change in investment markets, and that while much of that change has already taken place, a lot more is still to come.

Carl Hess: Clearly, everyone's poorer than they were, and as Roger [Urwin] points out, risk appetites could have easily changed. Additionally, the ability to take risk may have changed – simply, funds are dealing with financially weaker sponsors and required contributions have increased relatively quickly. So taking a fresh reassessment of how much risk is appropriate for the fund and the entire enterprise will be an initial imperative.

Right now, credit remains attractive relative to equity. But that will change over time. The difficulty is to be opportunistic – to do that, funds are going to have to be prepared to act much more quickly than they might be accustomed to. And unless the proper infrastructure is in place, this may be tricky.

Paul Trickett: We've seen more inaction than action – which is not good or bad per se, depending upon why the inaction arises. If there's inaction as a result of a consistent strategy, that's fine, but if there's inaction because of not knowing what to do or how to start, that's not so good.

Some funds have the structure and capability in place to think about their investment strategy in a variety of different ways – they may then decide to act or not to act, but at least they're doing it in a thoughtful fashion. I agree with Roger [Urwin] that there are others who think that the world is going to return to 2006 levels, not taking any action and simply waiting for that reversion. And that's probably not wise.

Naomi Denning: It's a common perception that Asia is somewhat protected, and in the very first round of the crisis there was a feeling among Asian funds that this was all happening elsewhere. But there is now recognition that there is no escape.

One of the major differences in Asia relative to the U.S. and Europe is that there is less of a Defined Benefit (DB) exposure in the corporate arena. The two big pockets are Japan, which is primarily DB and Hong Kong, which has a fair portion of DB. For the rest of the region, Defined Contribution (DC) members are suffering more than the corporations. Also, many of the DB arrangements in Asia are lump-sum plans that pay out on termination – so this has not been as large a hit to the balance sheet.

These factors have contributed to the slower response. But now that it has started to impact behavior, these behaviors are not dissimilar to what has been described in Europe and the US – people first sat back and watched, not necessarily knowing how to react. Now, many are starting to refocus their understanding of risk both from their perspective and from the market's perspective, and reconsider their strategy decisions.

Q. How has the downturn affected the strategy of liability hedging?

Hess: Over the last couple of years, the liability hedge has actually fared extremely well. This is mainly because interest rates have fallen – and in particular, if investors implemented it through the recent swaps market, they will have had some unexpected gains. However, this type of windfall gain cannot be consistent going forward. Looking forward, we can expect implementation to get trickier and the focus on basis risk to increase.

Trickett: It has been almost exactly the same in Europe, where liability-driven investing has had a longer run. While it has worked well enough in the recent past, it will probably be done in a different way going forward. The strategies that have been typically used in the last few years were impractical over the past 9-12 months, because the cost of putting them in place has become very expensive.

Denning: The liability hedging trend has not really taken off in Asia-Pacific, and the reason links back to the comments I made earlier about the limited DB exposure. There has been debate about this in Japan, but not really in other markets like Hong Kong. This is partly because, as mentioned earlier, the pension deficit problem is not as big a worry to the typical finance director as it does not necessarily have a large impact on their balance sheet. Consequently, they don't have as much governance to deal with it, which is understandable.

Q. What are the implications for DC plans?

Graeme Miller: The situation in Australia is similar to what Naomi [Denning] has described to be the case in the rest of Asia. As the majority of pension plans in Australia are DC, the burden of the dislocation has fallen on the shoulders of members – on employees rather than employers. And while I don't think that is an optimal outcome, obviously from the perspective of an employer's balance sheet, it does eliminate one problem.

In Australia, members of DC "super funds" by and large, have had their confidence severely knocked – and it will be quite some time before they embrace DC as an effective savings tool. Having said that, I think that the Australian industry has done quite well in educating its members to expect periods of poor performance. But of course these current negative returns will be more substantial and last for much longer than expected – and the reaction of members will be the real test of the system.

Hess: One thing we're seeing in the US right now in terms of DC plans is employers saying that they're not going to contribute to DC funds, and suspending the match. There's a real possibility that we could kind of see the exit of employers from retirement altogether – a rather dramatic redraw of the employer's role in any sort of retirement planning.

Urwin: In UK pension funds, around 90 percent of the money is run on lifecycle lines where exposure to equities has been quite light in the last five years before retirement. So in the UK, DC has actually done quite well for its close-to-retirement membership. In the US, DC has done a bit less well. Australia's done relatively poorly.

In my view, the defense against very difficult markets is in different forms of designs, such as lifecycle strategies, and not responses from a tactical point of view, which are just not plausibly going to accomplish anything. That is, it's just not realistic for there to be a lot of DC investors who suddenly know that the market's about to go down and do something about it in concert.

Q. What are the investment governance implications?

Denning: In Asia-Pacific, there is still a lot appetite for absolute return. But I think what people will be demanding is more transparency with regard to how those returns are being achieved.

So it is partly a governance issue – funds do need to have the governance to secure some of the more complex returns they are seeking, otherwise they should be simplifying their game. Already, we are seeing some funds retreat, saying "we're not up to this"– and we are also seeing a little bit more of a move to passive management.

Trickett: I agree – going forward, there will be a recognition that if you've got low governance, you need to do simple things, do them well and do them cheaply. If you've got high governance, you can do more complicated things as there are still benefits in using more complex options.

Urwin: The governance of institutional funds has historically been a weakness – funds have been set up with a governance structure that has had much more regard to representation of member interests, as opposed to investment competency. And as a result, funds haven't been able to grow their decision-making capacity at a rate commensurate with the demand of our increasingly complex investment system.

This "governance gap", as we call it, seems to have grown wider in the past two years. So in that context, institutional funds can either remain what I call bystanders, or can start to take on a more flexible and adaptive role in managing their future. And innovation in governance is getting more air-time. And I'm hopeful that stronger governance layers will start to emerge in all parts of the world.

Q. What will be the long-term legacy of this crisis, and how are firms looking forward?

Denning: The long-term legacy will probably be a better appreciation of risk. I think members have been tested in their understanding of the extremes of risk, but I hope that they carry the current lessons learned with them, because we are generally not good students of history.

Hess: I think at least one takeaway should be a willingness to fund. I mean, to a certain extent all this risk was taken on because many pension plan sponsors didn't want to pay for the obligations that they were promising. And a bit of better balance between funding and investment policies would serve many, many institutions much better than what they've done today.

Trickett: I'd agree with Naomi [Denning] on risk. The only other thing I'd say is that perhaps less confidence about covenant (which we define as the willingness and ability of the sponsor to finance the pension promise) might be a good idea going forward. Everybody assumes theirs is strong and everybody else's is weak.

Miller: From my perspective, I would add that clients should remain focused on the things that are really going to matter in their investment portfolios – primarily their asset allocation decisions. There's an awful lot going around out there, and it's very easy to get distracted by interesting but less important issues.

Urwin: I'd like to answer your question with ten different things, but for now I'll agree that risk is the number one area. The other aspect to this is governance, which is crucial to include in discussions going forward – the investment world can no longer see investment committees as driven by titans, using up a lot of time and resources but not always adding the kind of value that is expected.