Transcript Financial crisis – what is next?

Global challenges for the pension industry:
The financial crisis and ageing
Oecon Conference 2009
Århus 26 September 2009
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
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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
3
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…
4
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….
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Have the equity markets turned?
6
… or is it just another bear market rally?
Source: Global Financial Data and Bridgewater
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The Great Depression vs. today…
Source: Global Financial Data and Bridgewater
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Is the economic recovery strong and sustainable?
9
Unemployment is still rising rapidly
10
This is not an ordinary recession

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
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Medium term outlook still mostly scary
Deleveraging will continue for years
Renewed pressure on banks?
Huge challenges as regards monetary and fiscal ”exit strategies”
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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?
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Investment regimes
Seven Coherent Investment Regimes in the Last Hundred Years
Investment
Regime
Dividend Yield
Change
Investor
Mindset
Approx Time
Span
The WW I Decade
Pessimistic
10 years
5% → 7%
- 5%
Roaring Twenties
Optimistic
10 years
7% → 4%
+ 12%
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%
Pessimistic
9 years-to-date
1% → 3%
- 9%
Dirty Thirties/ Fateful Forties
Post-Bubble Blues
*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%.
Realized
ERP*
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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?
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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!
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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
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ATP Key Numbers
2008
Members
Retirees
Contributors
(DKK mill.)
Contributions
Benefits
Balance
(DKK)
Investment costs/member
Administrative cost/member
4.611.100
829.200
3.089.400
7.210
7.652
677.544
32
40
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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
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Investment risk – never too much, never too little…
Expected growth in
bonus potential
Risk tolerance
Red light risk
OK
Minimum risk
portfolio
Red light risk
excessive
Investment
portfolio
Risk of losing
bonus potential
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Effective diversification protects you during a bumpy ride
Investment portfolio
Equities
35%
Rates
20%
Credit
10%
Inflation
25%
Commodities
10%
 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
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Diversification is a free lunch
Accumulated return in excess of absolute return target
90%
40% equity 60% bonds
80%
70%
Risk equivalent diversified
portfolio (8.75% vol)
Sharpe ratio = 0,67
60%
50%
40%
Sharpe ratio = 0,38
30%
20%
10%
0%
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
5- 86- 87- 88- 89- 90- 91- 92- 93- 94- 95- 96- 97- 98- 99- 00- 01- 02- 03- 04- 05- 06- 07- 08- 09-10%
8
19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20
-20%
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Falling interest rates – a problem for unhedged pension funds
Procent
18
10-årig tysk statsobligation
16
10-årig amerikansk statsobligation
14
12
10
8
6
4
2
20
08
20
06
20
04
20
02
20
00
19
98
19
96
19
94
19
92
19
90
19
88
19
86
19
84
19
82
19
80
0
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Diversification and hedging improves the odds
Bonusdegree
450%
400%
Hedged liabilities & diversified portfolio
Hedged liabilities & 60% bonds, 40% equities
350%
Unhedged liabilities & 60% bonds, 40% equities
300%
250%
200%
150%
100%
50%
0%
1989-1
1991-1
1993-1
1995-1
1997-1
1999-1
2001-1
2003-1
2005-1
2007-1
2009-1
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Are all swans white? Risk models failed to predict large losses
Daily returns on European equities since 1 January 2006
Sandsynlighed
Probability
25%
Sandsynlighed
0,7%
Events that statistically should happen once
each 1,500 year and 450,000 year
Actual returns
0,6%
20%
0,5%
0,4%
0,3%
15%
0,2%
0,1%
0,0%
-8,7
-8,2
-7,6
-7,0
-6,5
-5,9
-5,3
-4,8
-4,2
-3,6
Daglige afkast, pct.
Model predictions
10%
5%
0%
-8,7
-7,6
-6,5
-5,3
-4,2
-3,1
1,5
0,3
-0,8
pct.
afkast,
Daglige
Daily
returns,
percent
-1,9
2,6
3,7
4,9
6,0
7,1
8,3
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Protect yourself against “Black Swan” events
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
Profit/Loss ($)
80
60
Normal portfolio
40
Hedged portfolio
20
0
-60%
-20
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
-40
-60
-80
%-change in financial markets
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Investment returns 2008 (after tax)
Return on ATP's Investment Portfolio, 2008
DKK bn
70
16,7%
60
50
40
30
20
10
0
-10
-3,2%
-20
-30
Rates
Credit
Equity
Inflation
Commodity
Investment
Return on total
portfolio before investment assets
funding
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What’s next?
 The Pension nightmare
 A prolonged period with:
 Muted growth
 Low equity returns
 Increasing inflation?
 New regulatory framework
 Are we prepared?
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