Achmea IM: Illiquid investments under the Wtp
This interview was originally written in Dutch. This is an English translation.
Illiquid investments offer attractive returns and diversification benefits for pension funds, but they also present challenges. Jeroen Roskam and Reinout van Tuyll of Achmea Investment Management answer some crucial questions about this type of investment under the new pension system.
By Daan Nijssen
How attractive are illiquid investments under the Dutch Future Pensions Act (Wtp)?
Reinout van Tuyll: 'Under the Wtp, adding illiquid investments remains a good way to improve the risk profile of the portfolio. They offer diversification to an investment portfolio and are associated with attractive returns and low volatility. The transition to a new pension scheme does not change these characteristics.
Figure 1 shows how the investment universe is classified within our organization according to the primary source of risk. We distinguish between three portfolio roles: Inflation & Diversification, Return, and Security & Matching. Private equity is classified under Return, mortgages fall under Security & Matching, and real estate and infrastructure offer Inflation & Diversification.
Within the Financial Assessment Framework (FTK), the benefits and costs of illiquid investments are shared collectively via the funding ratio. Under the Wtp, the link between the investment portfolio and the participant's assets is more explicit than within the FTK. This means that although illiquid investments are still a valuable addition to an investment portfolio, the advantages and disadvantages become more explicit.
Jeroen Roskam: 'In addition, illiquid investments offer the opportunity to invest in projects or companies that have a positive social impact, such as sustainable energy projects. This ties in well with the ambition of many pension funds to not only achieve financial returns, but also to create social value.'
What are the main challenges for illiquid investments within the new pension schemes?
Jeroen Roskam: 'The main challenges are stale pricing and costs. In addition, allocation effects may arise which, given the illiquid nature of these investments, cannot be adjusted. As is currently the case within the FTK, this requires a sound portfolio plan. The valuation of illiquid investments is available with a delay, which means that it does not reflect all recent market developments. This is referred to as stale pricing. Trading at delayed prices can have an impact on individual pension capital. This is particularly relevant in the event of major market movements that coincide with large changes, such as transfers or (collective) value transfers. The longer the delay in valuation, the greater the potential impact.
Relatively speaking, it is young people who bear the brunt of the burden and who benefit most from the rewards of illiquid investments.
In the event of a market shock, and depending on the delay, a price that becomes available with a delay for categories such as private equity and infrastructure may historically be 15% to 20% lower than the price that was available at the time the change was processed or the portfolio was adjusted.
There are also challenges relating to costs. Illiquid investments often involve higher management costs. These are expected to be offset by higher returns and/or better diversification and potential social impact.
Pension funds must carefully weigh up whether the potential benefits of illiquid investments outweigh these additional costs. It is wise to review the existing frameworks for costs and instrument choices. If the current costs of a category are considered (too) high, a pension fund may consider other forms of implementation. For example, an investment in a broadly diversified open-ended fund may entail lower costs than a combination of investments in specialized closed-end funds.'
What does the addition of illiquid investments mean for different age cohorts?
Van Tuyll: 'Illiquid investments have a positive effect on the risk-return profile of an investment portfolio. This in turn has a positive effect on the expected pension for both younger and older participants. Illiquid investments such as real estate and infrastructure offer exposure to the risk source inflation. These categories make the portfolio less vulnerable in a scenario with higher-than-expected inflation.'
Roskam: 'Illiquid investments such as mortgages and private equity play a role as return enhancers within the protection portfolio and the return portfolio. The majority of illiquid investments will form part of the return portfolio. Young people receive the highest implicit (SPR) or explicit (FPR) allocation to the return portfolio. Relatively speaking, it is therefore the younger participants who bear the greatest burden and who benefit most from the rewards of illiquid investments.
Pension funds would be wise to provide insight into the effects on their own portfolios at cohort level.
How can pension funds deal with the delayed valuation?
Roskam: 'The most obvious solution is to use the last known price as the basis for transactions and movements. This means that the delay in valuation is de facto 'simply' accepted. In addition, they can encourage external managers to provide faster and more frequent valuations. Using their own estimates of the price of illiquid investments is complex and entails new and undesirable risks for pension funds.
In addition, pension funds can work out with their administrators how to implement significant (collective) value transfers, specifically at times of market volatility. This translates into the establishment of a set of rules.
Pension funds should also consider the risks involved in transfers and possibly define in advance whether situations may arise that require retroactive changes at participant level and what options are available in such cases.'
Van Tuyll: 'Pension funds would be wise to reassess the investment cases and portfolio plans for illiquid asset classes, with an emphasis on the valuation frequency. Continuously settling price adjustments retrospectively is impossible under the Wtp.'
In the US, illiquid real estate investments are valued daily through partnerships with valuation management companies.
What developments are there in the market to make valuations available more quickly?
Roskam: 'A survey of illiquid managers shows that funds with mainly Dutch clients are shifting from quarterly to monthly valuations. These are mainly Dutch real estate and mortgage funds. Private equity and infrastructure funds are usually internationally oriented. This is not an issue there.
Dutch real estate managers are also investigating whether more frequent valuations and appraisals are feasible. Monthly valuations seem possible. In the short term, this can be achieved by incorporating monthly changes (sales results, dividends, entries, and exits) into the valuation. In the long term, automated valuations (automated value modeling), similar to what is already happening in the United States, are also being considered.
More frequent external valuations (e.g., monthly) seem impractical, both in terms of valuation capacity and costs. In the US, illiquid real estate investments are valued daily through partnerships with so-called valuation management companies. This trend could spread to other asset classes and also become applicable to European or Dutch investors.'
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SUMMARY Under the Wtp, illiquid investments remain a good way to improve the risk profile of the portfolio and create social value. The delayed valuation of illiquid investments has an impact on participants' capital. This has a particular impact in the event of large changes in combination with market shocks. Pension funds can review the investment cases and enter into discussions with their external asset managers in order to achieve faster and more frequent valuations. |