Improving investment returns in a risk-averse environment

Continental Europe's pension funds and other institutional investors face a real dilemma, according to new report from Greenwich Associates.

And the big question is: 'How can they improve returns in an environment that increasingly encourages institutions to adopt a conservative stance in their investing?'

"To a great extent, institutional investors in continental Europe find themselves caught between the need to generate additional returns from their investment portfolios and the implementation of IFRS/IAS accounting rules that seem to penalize risk-taking," says Greenwich Associates consultant Berndt Perl.

Greenwich Associates' 2005 report on the European investment management industry reveals that solvency ratios at continental pension funds continued to deteriorate in 2005, exacerbating the need for improved returns on portfolio investments. At the same time, the report presents research suggesting that the demands of new mark-to-market accounting rules are prompting many European funds to put on hold plans to shift their assets from government bonds to equities and other potentially higher-yielding investments.

The new report examines the effect that new accounting regulations are having on other strategic decisions made by continental pension funds, including the question of whether to close traditional final salary plans to new employees.

In addition, the report analyses European institutions' investments in hedge funds and other alternative asset classes, and presents the results of Greenwich Associates' latest research on the compensation levels of European investment professionals.

The Impact of Mark-to-Market

Greenwich Associates' research demonstrates that new international accounting conventions are taking hold among Europe's institutional investors and suggests that these rules will over time gain near universal acceptance across the continent. A quarter of continental European institutions have already adopted the new accounting standards, and another 10 per cent plan to do so in the next 12 months.

"The movement appears inexorable," says Greenwich Associates consultant Chris McNickle. "Mark-to-market accounting is coming."

These accounting conventions are taking hold at precisely a time when the funding positions of European pension funds are being pressured by societal, demographic, and macro-economic pressures that are challenging traditional concepts of retirement funding across the continent. In 2003, the typical European pension fund reported a solvency ratio of 105 per cent. By 2004, that average ratio had dropped to 95 per cent, with some countries and regions reporting even lower ratios.

The classic approach to such a situation for institutions around the world has been to hire investment staff or external managers to outperform investment benchmarks, a strategy commonly known as a "relative return" model. Thanks in large part to the demands of mark-to-market accounting however, many European corporate pension plans have been moving in the opposite direction by adopting "absolute return" strategies.

"With even normal market volatility, a relative return strategy can overwhelm a corporation's income statement and balance sheet in a mark-to-market environment," says Greenwich Associates consultant Markus Ohlig.

The implementation of mark-to-market accounting may also be accelerating the shift from final salary pension plans to defined contribution structures. There is no longer any doubt that the migration from final salary plans to defined contribution structures that has already taken place across the Atlantic - where nearly 100 per cent of large US corporations now offer DC plans - is also well under way in countries in the Nordics and Benelux that have historically relied on defined benefit plans.

Approximately one quarter of Europe's final salary plans have been closed to new employees and companies have begun shifting retirement assets from DB to DC structures. "At present, 55 per cent of Continental pension fund assets are in defined benefit structures, while defined contribution accounts for only 45 per cent of total assets," says Berndt Perl.

"Within 10 years time, executives at these Continental funds expect the share of DC assets to increase to 60 per cent."

European Asset Allocations: Unmet Expectations for Change

Recognising the need to generate higher returns from their investment portfolios, Europe's institutions have been telling Greenwich Associates for the past three years that they plan to reduce their holdings of cash and government bonds, and shift into equities. As a group, they have not followed through. Government bonds, which represented 27 per cent of these institutions' assets at the end of 2002, represented 29 per cent at the end of 2004; cash and short-term investments, which represented 7 per cent in 2002, still represent 7 pert cent of continental institutions' assets, and equities have been flat at 22 per cent for the last year.

The situation is similar in investments such as hedge funds and private equity. Many institutions have been talking quite forcefully about venturing further into these asset classes, but in practice most have continued to dabble. Allocations to hedge funds and private equity have remained flat at about 1 per cent of assets for each of the past three years.

And now that hedge fund returns have fallen off, the proportion of European institutions planning to start using hedge funds has dropped from 19per cent in 2004 to 8per cent in 2005, and the proportion expecting to hire a hedge fund manager has fallen from 23 per cent to 8 per cent. These declines cause Berndt Perl to wonder: "There are a huge number of hedge fund conferences planned all over Europe for the next year, but who knows who is going to attend them?"

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