New regulatory approach to pensions risks stifling long-term investment, says Allianz GI study
A new risk-based approach to pensions regulation currently under consideration would result in adverse unintended consequences for long-term pension investors, according to a study by Allianz Global Investors.
Using the methodology currently under discussion by European pensions regulators, based largely on the solvency framework for insurance companies, the study by AllianzGI Global Solutions’ risklab models the expected strategic asset allocation of long-term pension investors.
It finds that pension funds would most likely significantly change their investment behaviour in two important respects:
· The size of the liability matching segment of the portfolio would increase at the expense of the growth segment
· The diversification and expected returns of the efficient growth segment of the portfolio would diminish.
Elizabeth Corley, chief executive officer of AllianzGI, says: “We share regulators’ objective to ensure a well-funded and healthy pensions industry in Europe, and understand the desire to establish a level playing field for different long-term investors. Unfortunately, this study shows a number of unintended consequences stemming from the risk-based approach currently under consideration. Indeed, it would seem counterproductive to discourage investment across a properly diversified range of asset classes, which can lead to more stable returns, while also potentially reducing risk.
“The sustainability of pension provision depends on funds being able to make investments that generate an adequate return for their long term liabilities. This will require a more nuanced and differentiated approach to risk factors and associated capital requirements than currently under consideration. By providing transparency on the effects of this model, we hope that this study will provide constructive insight for policy makers working on this important topic.”
The analysis shows that risk-based solvency regulation provides a strong incentive for long-term investors to build further a liability matching portfolio. Furthermore, taking into consideration the different capital charges associated with certain asset classes, few asset classes would be attractive for the remaining “growth” segment of portfolios. These would be cash, long-duration government bonds, emerging market bonds and – in the portfolios promising higher returns – a dominant portion of private equity. Most of these growth portfolios would be composed of only two or three asset classes, with a maximum of four asset classes used simultaneously.
Christian Schmitt, co-head of investment consulting and analytics at AllianzGI and one of the authors of the white paper, says: “The diversification effect was not very high and it decreased with increasing return expectations. The massive and rather unrealistic use of private equity in the portfolios with higher return expectations can be explained by the asset class’ superior return compared to “other equity” investments that all require the same solvency capital. So, in a second step, we limited the exposure to private equity to 2.5 per cent of the overall portfolio. In this scenario, private equity was nearly completely substituted by emerging market equity and to a small degree by developed equity in the portfolios with higher return expectations.”
The study looked at how the picture changed if capital requirements from the base case regulation were tightened in the logic of the regulation i.e. by decomposing risk factors and re-building them according to benchmark compositions in some asset classes eg government bonds, long-duration government bonds, covered bonds, inflation-linked government bonds and emerging market bonds.
“Despite the fact that these five asset classes realistically now required higher capital charges, the basic structure of the ‘growth portfolios’ didn’t change. In addition the solvency capital requirements are higher in all cases, thus potentially leading to a further de-risking of the portfolio,” Schmitt says.
The study found that some of the shortcomings of the risk-based model were addressed by applying an economics-based approach. This approach allows for differentiation between specific investment categories, such as hedge funds, private equity, infrastructure, commodities and emerging market equity, which would otherwise be lumped together as “other equity”. As a consequence, the growth segments of pension portfolios would consist of up to ten asset classes. In addition, the solvency capital requirements would be slightly higher in the low- and mid-return portfolios whereas required capital for the high-return portfolios decreases.
Schmitt says: “Specifications of the required solvency capital have a significant impact on the relative attractiveness of asset classes. Under an economic-based view, which used internal risk models to assess the appropriate market parameters for capital charges and correlations for a more differentiated universe of asset classes, offers a potential way forward. Using this approach, the solvency capital ratio for the optimised portfolios with a lower return expectation was comparably higher. When moving along the efficient frontier with increasing return expectations, the overall capital requirement decreased compared to the base case regulation, providing an incentive for more highly diversified portfolios and also taking the opportunity to set up internal models to assess solvency capital requirements.”
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