The regulatory drive following the 2008 financial crisis was intended to make the financial system more stable. But instead of helping institutional investors like pension funds put their money to work for long-term gain for their stakeholders, it has effected a cycle of derisking that is leading to potentially destabilising procyclical behaviour. Ian Goldin, Director of the Oxford Martin School and Professor of Globalisation and Development at the University of Oxford and Ashok Gupta the Chair of the PLSA Defined Benefits Taskforce, look at the example of the UK and discuss how this cycle can be overcome.
Overcoming failures in long-term savings and investment: The lessons of the UKIan Goldin, Director of the Oxford Martin School and Professor of Globalisation and Development at the University of Oxford
Ashok Gupta, Chair of the PLSA Defined Benefits Taskforce
Has the flood of financial regulation made investors’ money safer? Enhanced oversight sought to make financial markets more stable and provide frameworks for long-term investors – like insurance companies and pension funds – to generate returns consistent with their liabilities. But when we contributed to a 2014 discussion paper by the Bank of England, we found that the recent regulatory drive, combined with and industry practices, helped destabilise UK markets and undermined these investors’ ability to meet their mandates. 
In many respects, current insurance regulation, including the European Union-wide Solvency II Directive, has benefited the industry. But it also has serious shortcomings in its treatment of long-term investment risk. As a result of this structural failing, life insurance companies struggle to provide investment certainty to consumers or guarantee returns to investors.
“Volatility is the most widely used measure of risk. But the primary risk for long-term investors is a permanent loss in the value of their investments.”
Likewise, in response to a variety of regulatory, valuation and accounting changes, the £1.1 trillion UK defined benefit (DB) private pensions sector has been going through a process of investment de-risking over the past 15 years or so. Consequently, private pension funds have reduced their holdings of equities, largely in favour of fixed-income instruments.
As insurers and pension funds are now taking on less investment risk, the former will provide lower returns and the latter will struggle to meet their liabilities without increased sponsor support. But this trend also has more profound economic consequences.
First, these investors are now providing little capital for investment in industry and infrastructure. They cannot, therefore, make a material contribution to stimulating economic growth. Logically, individuals saving for their retirement should invest in building businesses and infrastructure whose profits will fund their post-work lifestyles. This long-term investment agenda is also consistent with the needs of industry and government objectives. Private pensions should, therefore, act as a powerful engine of growth to the economy. But, unlike their state-owned local authority peers, which are not subject to mark-to-market based regulation and accounting, private DB pension funds have limited ability to support long-term projects.
Second, the current approach to pensions’ management will continue to act as a significant drag on the UK economy for at least the next two decades. Plan sponsors have had to dig deeper into their pockets to honour their pension promises, rather than invest in their businesses or return cash to shareholders. So-called pension buy-outs, where the employer sells the liabilities to an insurer, have become big business. But this cannot be a solution. The Pensions Regulator estimates that the cost of full DB buyout at £550 billion over 20 years. This cost is unaffordable. If such a bailout did occur, it would represent a massive intergenerational transfer of wealth to baby boomers from their children.
Happily, investors are waking up to the situation. Financial services players have started to group together to advocate management practices and stewardship policies that support long-term investing. But despite laudable attempts by organisations like the Focusing Capital on the Long Term (FCLT) initiative sponsored by the Canada Pension Plan Investment Board, the country’s largest pension fund, and consulting firm McKinsey & Company, asset owners feel frustrated and powerless to influence the underlying causes of the problem.
The challenge for insurance is that efforts to implement Solvency II (following other major reforms) has resulted in regulatory fatigue. Few in the insurance or financial services industry, and indeed regulators, governments or the European Commission, have an appetite for more regulatory change.
DB pension funds’ actions are constrained by the pressure of accounting and regulatory requirements combined with current governance structures. As it stands, an inherently long-term system has been converted into one operating short term.
The causes behind system dysfunctionality
We have identified four aspects of the system that appear to be failing.
An inappropriate approach to risk and de-risking
Volatility is the most widely used measure of risk. But the primary risk for pension funds and other long-term investors is not volatility, rather a permanent loss in the value of their investments. These two risks are fundamentally different, and the inappropriate focus on volatility undermines the ability of pension funds to invest in assets that deliver long-term returns.
For example, long-term investors should be able to enter equity markets at low valuations, even if volatility is high. Yet this is when mark-to-market principles make it hard for them to hold or buy equities, as a period of higher volatility is supposedly risky. In fact, the reverse is often true. Long-term investors may actually face the greatest risk of losing money if they buy equities when market values are high and volatility is low.
By encouraging pension funds to hold fewer risk assets like equities, mark-to-market accounting reduces investment income, particularly in periods of low interest rates. This practice thus crystallises deficits and requires sponsors to make capital contributions to their funds. Whilst investment risk may be reduced, sponsor dependency has increased and with it covenant risk. On the whole, it is debatable whether this process has resulted in any net reduction in a fund’s risk.
An inappropriate focus on deficits
The ultimate aim of pension funds is to pay liabilities when they fall due. Currently, we measure their ability to do so by quantifying deficits. But deficits fluctuate depending on market valuations. In the 18 months to December 2015, total DB pension funds’ deficits swung from approximately £77 billion to £367 billion in January 2015 and then to £222 billion, according to the PPF 7800 Index published by the Pensions Protection Fund. Yet amid all this apparent flux, little has changed in the ability of pension funds to meet their 20-to-30 year liabilities.
Ultimately, we should view pension funds as being in the business of climatology, not meteorology. The focus on deficits could undermine long-term investment strategies by encouraging them to avoid volatile assets, which could bring long-term returns.
“As pension funds have limited liquidity needs they can exploit illiquid, longer-term investment strategies.”
A failure to exploit pension funds’ illiquidity in their investment strategies
As pension funds have limited liquidity needs they can exploit illiquid, longer-term investment strategies. Illiquid markets are often inefficient and can have major information asymmetries that skilled managers can exploit over the long term.
CPPIB is the most notable example of an asset owner adopting this strategy. The fund allocates more than half of its assets in alternatives, principally to illiquid investments. It generates significant real long-term investment returns as a result. The fund reported 8.0% net nominal and 5.8% real returns annualised over the 10 years to December 2015. CPPIB’s performance contrasts starkly with Government Pension Fund Global, Norway’s $850 billion sovereign wealth fund. The fund allocates over 95% of its asset to liquid, listed assets. It has only produced an annualised real return of 3.35% over the same period, according to its 2015 performance and risk report.
The incentives that encourage pension and life insurance funds to de-risk have caused long-term investment to crowd into bond markets and further depress yields. The idea that favouring liquid assets is a low-risk or even risk-free strategy for long-term investors is, therefore, one with which few pensioners are likely to agree as they see dwindling returns.
Short terms and herding embedded in investment practices
Long-term investors often rely on a small group of investment consultants who adopt similar asset allocation strategies. These approaches tend to have short-term investment horizons and index-relative performance benchmarks inconsistent with pension funds’ and insurance companies’ long-term investment horizons.
By using a small group of advisors, long-term investors may display herding behaviour. This can cause short-term booms or busts in asset prices, exacerbating volatility and further reducing the funds’ ability to invest for the long term.
What can be done?
One option is to concentrate on corporate governance and other reforms that the finance industry can undertake itself. This tactic may bypass the intractable difficulties associated with international regulatory reform.
This is the approach taken by the Focusing Capital on the Long Term initiative. FCLT aims to develop and share best practice among investors, such as moving away from daily investment measurement and quarterly financial reporting. This is a welcome development that stands to make major progress particularly in jurisdictions such as Canada where the regulatory environment is not governed by Solvency II.
Another option is for regulators to agree to exempt certain actors from current frameworks. But this solution raises major questions of moral hazard. It also brings the danger that the rules may be interpreted differently at times of crisis or by new officials. The sudden inclusion of a group of previously exempt asset managers into regulatory regimes could be destabilising.
A third option is to make the case for reform of the written and unwritten rules. In our view this is necessary as the current regulations are often counterproductive for all concerned. These options are by no means exhaustive and in practice should be pursued simultaneously.
The aim of our article has been to highlight the need for reform. The regulatory and operating environment for long-term investment has improved. But the task is not done. We must undertake further analysis to ensure long-term investors can put their money to work for the long-term benefit of society.
 Pro cyclicality and structural trends in asset allocation by insurance companies and pension funds: A Discussion Paper by the Bank of England and the Procyclicality Working Group – July 2014
The authors were Deputy Chairs of the Bank of England Procyclicality Working Group. They write in their personal capacity.