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Institutional Investment - July 01, 2014

There are still too few pension funds putting risk management at the heart of their investment strategy - an interview with Cynthia Sweeney Barnes, Sophie Debehogne and Thomas Heckel

In this month's interview, we speak to Cynthia Sweeney Barnes, Head of EMEA & Global Segments; Sophie Debehogne, Investment Specialist Customised & Fiduciary Solutions within the Multi Asset Solutions team; and Thomas Heckel, Head of Financial Engineering with BNP Paribas Investment Partners, about the EDHEC-Risk Institute publication, "Dynamic Liability-Driven Investing Strategies: The Emergence of a New Investment Paradigm for Pension Funds?" produced as part of the BNP Paribas Investment Partners research chair, the risk management approaches of pension funds, and BNP Paribas Investment Partners' approach to institutional markets in Europe.

Sophie Debehogne, Thomas Heckel, Cynthia Sweeney Barnes

A survey of European pension funds and sponsor companies entitled "Dynamic Liability-Driven Investing Strategies: The Emergence of a New Investment Paradigm for Pension Funds?" was released earlier this year as part of the BNP Paribas Investment Partners research chair at EDHEC-Risk Institute. The first section provides a summary of all the work done to date as part of the research chair and the second section provides a picture of current industry practices. What is your reaction to each of these sections?

Sophie Debehogne, Thomas Heckel: The first section is a good summary of the key findings of the four previous research articles. It explains the rationale behind the optimal strategies that EDHEC drives as well as the different factors affecting those strategies. It clearly highlights the benefit of using a theoretical framework to understand the mechanisms driving funding ratio developments and the best way to control them, even though this framework is by necessity simplified compared to our day-to-day actions in the real world.

The key messages for investment practitioners are as follows.

  • From an asset and liability management perspective, it is better to split a pension fund portfolio into two parts: a liability hedging portfolio (LHP) that is designed to hedge liabilities, and a performance seeking portfolio (PSP) that is designed to capture upside potential.
  • In the presence of a short-term funding ratio constraint, implementing an extra dynamic mechanism to protect the funding ratio floor adds value to a liability-driven investment (LDI) strategy.
  • As the risk premia of asset classes held in the PSP tend to mean revert over time, two competing forces (one pro-cyclical from the floor protection and one anti-cyclical from the asset risk premia mean reversion) drive the dynamic allocation between PSP and LHP.
  • Dynamic LDI strategies help to reduce conflicts of interest between the various pension fund stakeholders.

The second section details the main findings of the extensive survey conducted by EDHEC-Risk Institute in Q4 2013. The survey assesses the views of 104 pension funds and sponsor companies (the large majority of which are European pension funds) about dynamic LDI strategies and their current and projected use of such strategies.

EDHEC-Risk Institute conducted this survey in order to assess the rate of adoption of optimal solutions derived from their theoretical framework. Doing so is important as reality is much more complex than any theoretical framework and research should have practical implications for investors – and not just be done for its own sake.

Do you agree that progress remains to be made in the area of appropriate risk management for pension funds?

Sophie Debehogne, Thomas Heckel: Yes, there are still too few pension funds putting risk management at the heart of their investment strategy. It came out in the survey that too many pension funds are more concerned with stand-alone performance than holistic risk management, which explains why they implement dynamic strategies more for fundamental or tactical reasons than to manage risk or protect their funding ratio.

For instance, most respondents do not translate their short-term constraints, such as a minimum funding requirement imposed by regulation, into the protection of a floor. From a risk management point of view, to do so would make a lot of sense as it would avoid a large underfunding in adverse market conditions.

We think that the situation is likely to improve rapidly as a consequence of the low-return environment. In fact, long-term investors such as pension funds now face a dilemma. On one hand, they need to take on risk to meet their future obligations to their pension members, reduce the future contributions of their sponsors and cover potential risks (such as longevity risk). But on the other, they have to comply with short-term constraints dictated by their regulators, new accounting norms, and even their own internal investment policy. Better risk management through the implementation of systematic dynamic strategies will be the only way to reconcile their short- and long-term objectives. We clearly see from our contacts in the industry that interest in such strategies is growing.

Is it true to say that too many pension funds remain asset-only rather than truly ALM funds and do not take sufficient account of the impact of their liabilities in their asset allocation policy or risk management?

Sophie Debehogne, Thomas Heckel: Yes, it’s true that too many pension funds are still managing their assets against a traditional benchmark instead of a liability-based benchmark. There are two main reasons for this. First, in some countries, the concept of LDI is relatively new and trustees may see the move to LDI as a risk that takes them out of their comfort zone. Second, in other countries where pension funds may better understand the LDI concept; there could be reluctance to embrace LDI due to the current yield environment. Some believe that adopting a LDI strategy in this environment could lock pension funds into very low rates, while if they keep their existing duration mismatch (derived from an asset-only approach) they could benefit from an increase in interest rates and improve their funding ratio. But we disagree with this argument. We believe that a portfolio should be split into two parts – a liability-hedging portfolio and a performance-seeking portfolio – in any interest rate environment to ensure better risk management, while the level of the interest rate hedge should be adapted to the market backdrop. For example, in the case of a strong conviction that interest rates would rise, the interest rate hedging percentage could be reduced.

It’s our role as an asset manager to educate investors about the potential negative implications of not adopting an LDI approach. This is especially the case for corporate pension plans, as underfunding could affect the sponsor’s balance sheet and have an important effect on its credit rating and dividend policy.

BNP Paribas Investment Partners has recently strengthened its institutional business line in the UK. Is this part of a pan-European drive or is there a specific focus on the UK?

Cynthia Sweeney Barnes: BNP Paribas Investment Partners is strengthening its institutional business line throughout Europe and North America. Since the UK is one of the largest institutional markets, we are putting more focus here. Furthermore, some of our capabilities, such as fiduciary management, are more suited to some markets than others. We are making a significant push in fiduciary management: we already have a substantial base of LDI assets in the Netherlands, and are looking to grow our fiduciary management business in the UK and Germany.

What particular strengths do you think BNP Paribas Investment Partners provides to its institutional clients?

Cynthia Sweeney Barnes: BNP Paribas Investment Partners offers several strengths for its institutional clients. Our approach is based on engaging with participants in the markets in which we operate, committing resources to developing our relationships with our institutional clients, and achieving top-class results for them by pursuing excellence in everything we do.

Our local on-the-ground expertise in markets around the world is an important advantage as it enables us to engage in terms of our ability to understand not only local investment opportunities, but also the local regulatory backdrop against which we serve our clients.

We commit resources to developing our client relationships into true long-term partnerships. We have developed several of our market-leading investment capabilities, such as our liability-driven investment and risk overlay capabilities, as a direct result of working closely alongside our clients and listening to their needs.

Lastly, we aim to achieve top-class results for our clients by promoting a culture of investment excellence. The members of our investment teams have an average of 15 years of experience and we have a long-term incentive scheme to retain our most talented investment professionals and attract new talent. Our investment teams offer an attractive combination of experience, size, and capacity. Several of our strategies are in the asset management “sweet spot”, with assets under management that are large enough to exploit economies of scale but small enough to enable us to nimbly capitalise on opportunities as they arise.

About Cynthia Sweeney Barnes, Sophie Debehogne and Thomas Heckel

Cynthia Sweeney Barnes is Head of EMEA & Global Segments with BNP Paribas Investment Partners. Cynthia has over 25 years’ experience in the asset management industry most recently as a Managing Director in the Institutional business line at HSBC Global Asset Management where she was responsible for Sovereign & Supranational clients globally. She joined HSBC in 2001 to head up the Global Liquidity Funds product line management and business development in the UK and EMEA and during this period she was also a member of the ExCo of HSBC Asset Management (Europe) Ltd. Cynthia stated her career with Putnam Investments in the USA before coming to London with the US insurer, Aetna, where she held a variety of roles ranging from Manager of US Mutual Fund Sales to Director of Wholesale Sales & Service with Aetna International (UK). In 1996 she joined Chase Asset Management, subsequently JPMorgan Asset Management, as Vice-President with responsibility for wholesale and institutional sales in Western and Southern Europe. Cynthia was educated in the USA, France and the UK and holds an M.B.A. from The University of Oxford and a B.Sc. from Boston University.

Sophie Debehogne is Investment Specialist Customised & Fiduciary Solutions within the Multi Asset Solutions team at BNP Paribas Investment Partners. Sophie has 18 years of experience in asset management having begun her career in 1996 when she joined the asset management department of Générale de Banque as financial analyst. She moved in the Equity portfolio management team in 1997 for 8 years where she was managing the Technology and Telecom sector funds. In 2004, she became investment specialist for asset allocation solutions before moving in 2007 in the Corporate strategy team of Fortis Investments. After the merger with BNP Paribas and Fortis, Sophie joined the Multi Asset Solution team of BNP Paribas Investment partners to promote Customized and Fiduciary solutions to institutional clients. Sophie Debehogne studied at the Solvay Business School and is a Financial Engineer.

Thomas Heckel is Head of Financial Engineering with BNP Paribas Investment Partners. Thomas has been Head of Financial Engineering at BNPP IP since 2014. He was Head of Financial Engineering for Solutions for BNPP IP between 2007 and 2013. He started his career in 1999, and conducted applied research in economics and short term forecasting at both INSEE (French official statistical office) and Banque de France (national central bank) until 2007. Thomas holds a PhD in Economics and Econometrics, 2006, ENSAE (Engineering School), Paris, 1999, Ecole des Mines (Engineering School), Paris, 1996.