Global challenges for the pension industry: The financial crisis and ageing

Oecon Conference 2009Århus 26 September 2009

2

The big picture

The great debt bubble has burst The financial crisis has morphed into the deepest economic

crisis in living memory Governments have acted globally to save the banking system Pension fund reserves have nosedived and many pension funds

are technically insolvent Necessary to reconsider investment strategy and risk

management in this new environment

3

What happened pre-crisis?

”Pax Americana” and globalisation Peace dividend and falling goods prices

”Greed, governance, and Greenspan” Deregulation

procyclical regulation risk based solvency requirements IFRS

4

What went wrong?

Low measured volatility on investments made risk-adjusted returns look attractive

Investors thus accepted higher gearing despite falling risk premia…

… and focussed too little on tail risks and liquidity Eventually, it turned out that measured risk was far less

than actual risk, and everybody wanted out at the same time…

5

One year after Lehman Brothers: Is the worst over?

Financial markets are showing signs of healing ”Green shoots” have blossomed in the economy over the

summer – impressive recovery in Asia Armageddon seems to have been avoided But we are in uncharted territory….

6

Have the equity markets turned?

7

… or is it just another bear market rally?

Source: Global Financial Data and Bridgewater

8

The Great Depression vs. today…

Source: Global Financial Data and Bridgewater

9

Is the economic recovery strong and sustainable?

OECD leading indicator, 6m ann. change, %

OECD area USA Euroland Japan

78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

-20

-18

-16

-14

-12

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

14

16

-20

-18

-16

-14

-12

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

14

16

10

Unemployment is still rising rapidly

USA - Official and augmented unemployment rate, %

Official Augmented (RHS)

Source: Reuters EcoWin

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

6,75

7,75

8,75

9,75

10,75

11,75

12,75

13,75

14,75

15,75

16,75

3

4

5

6

7

8

9

10

11

12

13

11

This is not an ordinary recession

Medium term outlook still mostly scary Deleveraging will continue for years Renewed pressure on banks? Huge challenges as regards monetary and fiscal ”exit strategies”

12

The aftershock will last for many years

The Great Depression shaped investor behaviour and regulation for many decades

The current crisis will also be felt for a long time Muted growth – China in the driver’s seat Re-regulation instead of deregulation Balance sheet reductions instead of gearing The financial sector will become boring again – less CDO, CMBS,..

… Risk appetite?

13

Investment regimes

 Investment

Regime

 Investor Mindset

 Approx Time

Span

 Dividend YieldChange

 Realized

ERP*

The WW I Decade Pessimistic 10 years 5% → 7% - 5%

Roaring Twenties Optimistic 10 years 7% → 4% + 12%

Dirty Thirties/ Fateful Forties Pessimistic 20 years 4% → 7% 0%

Pax Americana I Optimistic 20 years 7% → 3% + 8%

Scary Seventies Pessimistic 10 years 3% → 6% - 3%

Pax Americana II Optimistic 20 years 6% → 1% + 9%

Post-Bubble Blues Pessimistic 9 years-to-date 1% → 3% - 9%

Seven Coherent Investment Regimes in the Last Hundred Years

*Stock returns come from Triumph of the Optimists by Dimson, Marsh, Staunton. Bond returns are based on a hypothetical CPI-linked bond with a real yield of 2.5%.

14

The regulatory environment will change

New regulation must deal with the lessons of the crisis Liquidity is not given The breakdown of risk models The lack of alignment of interest

We will approach a ”Solvency II world” Potential problems – pro-cyclical investor behaviour?

15

The financial crisis – another problem for pension funds

Three major challenges Ageing Financial crisis New regulation

Pension funds desperately need higher returns But they must also reduce risk in order to protect their

decimated reserves A true dilemma!

16

Ageing puts pension systems under pressure

Percent 60+ Millions 60+Increase

(%)2005 2050 2005 2050

Germany 25 37 21 27 32

Japan 26 44 34 45 32

Russia 17 32 25 35 42

USA 17 27 50 108 116

China 11 31 144 438 204

India 8 20 85 335 294

Source: United Nations World Population Prospects: The 2006 Revision

17

ATP Key Numbers

2008

Members 4.611.100

Retirees 829.200

Contributors 3.089.400

(DKK mill.)

Contributions 7.210

Benefits 7.652

Balance 677.544

(DKK)

Investment costs/member 32

Administrative cost/member 40

18

ATP’s approach – an overview

Highest possible real value of future pensions Protect ATP’s solvency

Avoid large losses in order to protect your reserves

Diversify aggressively A portfolio that does well – rain or shine

Avoid risks that you are not paid to bear Many pension funds do the equivalent of crossing a heavily

trafficked motorway by foot: They don’t hedge their pension liabilities

Have ”Black Swan” events and other tail risks in mind

19

Investment risk – never too much, never too little…

Investment portfolio

Red light risk OK

Red light risk excessive

Expected growth in bonus potential

Risk of losing bonus potential

Minimum risk portfolio

Risk tolerance

20

Effective diversification protects you during a bumpy ride

Equities don’t dominate – each of the five risk classes contributes substantially to portfolio risk

Portfolio expected to do well in a fluctuating economic environment

Mitigates the risk of large losses Higher risk-adjusted return than more concentrated portfolios

Investment portfolio

Equities35%

Rates20%

Credit10%

Inflation25%

Commodities10%

Investment portfolio

Equities35%

Rates20%

Credit10%

Inflation25%

Commodities10%

21

Diversification is a free lunch

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1985

-1

1986

-1

1987

-1

1988

-1

1989

-1

1990

-1

1991

-1

1992

-1

1993

-1

1994

-1

1995

-1

1996

-1

1997

-1

1998

-1

1999

-1

2000

-1

2001

-1

2002

-1

2003

-1

2004

-1

2005

-1

2006

-1

2007

-1

2008

-1

2009

-1

40% equity 60% bonds

Risk equivalent diversifiedportfolio (8.75% vol)

Accumulated return in excess of absolute return target

Sharpe ratio = 0,67

Sharpe ratio = 0,38

22

Falling interest rates – a problem for unhedged pension funds

0

2

4

6

8

10

12

14

16

18

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

Procent

10-årig tysk statsobligation

10-årig amerikansk statsobligation

23

Diversification and hedging improves the odds

0%

50%

100%

150%

200%

250%

300%

350%

400%

450%

1989-1 1991-1 1993-1 1995-1 1997-1 1999-1 2001-1 2003-1 2005-1 2007-1 2009-1

Bonusdegree

Hedged liabilities & diversified portfolio

Hedged liabilities & 60% bonds, 40% equities

Unhedged liabilities & 60% bonds, 40% equities

24

Are all swans white? Risk models failed to predict large losses

0%

5%

10%

15%

20%

25%

-8,7 -7,6 -6,5 -5,3 -4,2 -3,1 -1,9 -0,8 0,3 1,5 2,6 3,7 4,9 6,0 7,1 8,3Daglige afkast, pct.

Sandsynlighed

Actual returns

Model predictions0,0%

0,1%

0,2%

0,3%

0,4%

0,5%

0,6%

0,7%

-8,7 -8,2 -7,6 -7,0 -6,5 -5,9 -5,3 -4,8 -4,2 -3,6

Daglige afkast, pct.

Sandsynlighed

Events that statistically should happen once each 1,500 year and 450,000 year

Daily returns on European equities since 1 January 2006Probability

Daily returns, percent

25

Protect yourself against “Black Swan” events

-80

-60

-40

-20

0

20

40

60

80

-60% -50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50% 60%

%-change in financial markets

Profit/Loss ($)

Normal portfolio

Hedged portfolio

Large losses may reduce your risk budget and curtail your ability to generate high future returns.

We use option strategies in, e.g., equity and oil markets

26

Investment returns 2008 (after tax)

Return on ATP's Investment Portfolio, 2008

-30

-20

-10

0

10

20

30

40

50

60

70

Rates Credit Equity Inflation Commodity Investmentportfolio before

funding

Return on totalinvestment assets

DKK bn

-3,2%

16,7%

27

What’s next?

The Pension nightmare A prolonged period with:

Muted growth Low equity returns Increasing inflation?

New regulatory framework Are we prepared?