By Sameer Sharma
More than a decade of low bond yields, high public debt supported by relatively loose monetary policies pursued by global central banks have created many challenges for pension funds in Europe and in North America when it comes to managing funding gaps. Pension funds receive monthly contributions and need to invest the net surpluses between outflows and inflows and generate returns which lead to a positive funding ratio over time. Pension funds typically have long term investment horizons, typically 20 years. Historically, pension funds have had a large share of their investment portfolios invested in government bonds including Treasury inflation protected bonds and corporate bonds. Prior to 2008, pension funds had large fixed income allocations and a moderately sized domestic and international equities portfolio.
When bond yields started to fall however, the present value of liabilities shot up. A long period of low bond yields typically means low expected returns on fixed income over the investment horizon of a pension fund. As bond yields declined over the past decade, the negative correlation and associated portfolio diversification benefits, which came from investing in bonds and equities, also became more unstable. Pension funds attempted to seek bond-like returns which offered them some inflation protection and some capital appreciation as well via real estate investments, be it public real estate investment trusts or even the less liquid private real estate market.
Given that earnings yields of equities were on aggregate higher than long term government bond yields, allocations to equities increased over time. This also included larger allocations to emerging market equities.
There were, however, limits from a risk budgeting standpoint to a continuous increase in equities allocation especially after the great financial crisis of 2008. Equity markets were subject to significant drawdowns which needed to be carefully managed. This over time pushed pension funds to allocate a larger share of their portfolios to other alternative asset classes such as commodities, private equity and private credit. In essence, the traditional fixed income equities allocation evolved towards a factor based asset allocation framework which involved higher equity risk, including both emerging market and growth equities risk and illiquidity risk via a greater share of investments in private markets.
Pension funds exposed to various risks
Today, pension funds are exposed to various risks, from economic growth risks, inflation risks, credit risks, foreign currency risks and illiquidity risks. These are risks that must be dynamically managed throughout various market regimes. This has essentially meant that pension funds have ramped up the quality and sophistication of their investment and risk management teams and processes.
Today, the typical US private pension fund allocates around 35% of its portfolio into private markets, 46% into developed market equities and emerging market equities while the rest of the allocation is split between fixed income and some commodities. From a risk return standpoint, such an allocation has a similar risk budget to a traditional 70% equities and 30% fixed income portfolio, but unlike the latter, such a portfolio design is able to generate absolute returns of 7% per year over a 20-year period. Of course, the level of expertise that is required and the dynamism that is needed to manage such a complex multi-factor, multi-asset and multi-strategy portfolio is significant.
These days, pension funds are becoming increasingly ESG aware, and their equities allocations are beginning to reflect this. Governance risks and political risks in a geopolitically more volatile world need to be taken into account as well. The governance processes at pension funds, and this is increasingly including Asian pension funds as well, are very sophisticated, and accountability is key.
The local equity market is not very liquid, and there are very few investment opportunities.
All the people who work in the pension funds are investment professionals or actuaries. Even after all of this, generating absolute returns of 7% a year on average over the investment horizon is not an easy task. Pension funds in Europe struggle to achieve 5% absolute returns while their liabilities are higher. In order to meet or to minimize the risk of having a significant funding gap, they need to rely more heavily on what is known as alpha.
Alpha essentially is a measure of manager skills. If your strategic asset allocation framework is expected to generate returns of 5%, and you need to achieve returns of 7%, then you better make sure that your managers are able to generate a 2% alpha over time. They need to generate alpha leads to manager selection. You need to find the right managers.
Pension funds that are unable to adapt and modernize their investment management processes including their alpha generation capabilities, which also includes best-in-class risk and management practices, tend to go down under or will do so in the not too distant future.
Relatively backward investment approaches
When it comes to Mauritius, whether we look at the National Pension Fund, the National Savings Fund or private pension plans, their investment approaches remain relatively backward. The asset allocation framework that is used in Mauritius is very old school and relies heavily on both local fixed income in an underdeveloped and fragmented domestic bond market and on local equities which have liquidity challenges on top of a small list of viable investment opportunities. While private pension funds have increased foreign allocations which at least benefit from greater opportunities outside of Mauritius on top of the benefits which a weaker rupee tends to bring to the fore, the asset allocation frameworks of public pension funds have remained archaic at best. The investment committees and the skills set available do not tend to reflect what is required to compete in global markets.
Private pension funds may have moderately more diversified portfolios (which would even include real estate investments) when compared to their public pension fund counterparts, but the lack of a sophisticated asset allocation framework and skills mean that both will struggle to maintain positive funding ratios over time. While the earnings yield of a select list of local stocks is expected to remain higher than the 10-year government bond yield, the local equity market is not very liquid. There are also very few investment opportunities. The private equity market in Mauritius has not already been developed, and even the venture capital industry does not really exist, certainly not in the quantum that is needed for pension funds to invest in there.
Unlike their international counterparts, the Mauritian pension fund industry and the local asset management industry in general lack the required skills in order to effectively manage portfolio risk and take advantage of dislocations found in various asset classes across different market regimes. Diversifying into alternative asset classes, for example, requires a certain skill set, and managing a multi-asset, multi-strategy and multi-factor portfolio requires a certain degree of dynamism and a comfort level with the use of derivative overlays which the industry obviously does not have in Mauritius.
The Contribution Sociale will not be able to fund expected pension outlays as the population ages.
Yet the problems of meeting funding gaps in a low yield environment where inflation is well above nominal yields is still the same. In this period of deleveraging in Mauritius, we should expect yields to remain below inflation or very close to inflation for an extended period of time across the yield curve.
Unless managers in Mauritius are able to have a sea change in the way they design assets allocation frameworks and then manage these portfolios in a more dynamic way, the next best thing to do will be to reduce pay-outs especially for new entrants. There will also be a need to increase contributions in these defined contribution plans so that people can retire and earn a decent income relative to their cost of living when they get older.
On the public side, the problem is actually even worse. This is because the Contribution Sociale will not be able to fund expected pension outlays in the coming decades as the population ages. Unless this tax is increased significantly in the coming years, which will have political limits obviously, the remnants of the National Pension Fund will be gradually cannibalized. The expected drain after 5 years on national pension fund assets, for example, has a significant impact on the ability to maintain a long term investment horizon and hence the available investment opportunities for the National Pension Fund.
In many ways, we need a more dynamic and modernized National Pension Fund portfolio with a longer investment horizon, but that is not what we are going to get. We are going to get something that must be more liquid, and it will need to have a shorter investment horizon because the liquidity needs to fund pension outlays from the government will increase over time.
In layman terms, Mauritius and the Mauritians who will retire two decades from now in particular are going to have an unpleasant surprise. We are indeed living with a ticking time bomb that no one has addressed so far.