Helen Morrissey talks to Eugene O'Callaghan and Adrian O'Donovan of the National Pension Reserve Fund about their objectives for the fund as well as their role in recapitalising Irish banks during the financial crisis
Helen Morrissey: Tell me about the National Pensions Reserve Fund (NPRF) – what was it set up to achieve?
O’Callaghan/O’Donovan: The National Pension Reserve Fund was set up in 2001 to partially meet the costs of public service and social welfare pensions from 2025 onwards. However, what happened in the early part of last year was that the Ministry of Finance decided to utilise €7bn of the fund to recapitalise Irish banks. In March 2009 €3.5bn was invested in Bank of Ireland and in May the same amount was invested in Allied Irish Banks. These investments remain part of the fund and any income on them will accrue to the fund.
As a result of this investment we have split the fund into two separate portfolios. We have the discretionary portfolio which was worth €15.3bn by the end of 2009 and then we have what we call the directed portfolio which is invested in the banks at the discretion of the Minister and the fund’s statutory investment policy is not applied to this part of the fund. However, there is no change in the date of first drawdown from the fund – 2025 – and our overall investment objectives for the NPRF have not changed.
We also need to take the issue of inflation on board. In the medium term we could find ourselves either in a high or low inflationary environment
Helen Morrissey: How does your investment in the Irish banks work and how long do you expect it to last?
O’Callaghan/O’Donovan: There are two separate points to consider here. The fund has invested in preference shares of these banks and these can be paid back at the bank’s discretion. However, it is in the banks’ interest to pay these back in less than five years because they will have to pay a premium if they choose to buy them at a later time. The banks may find they need to raise further capital in future and they have a variety of ways of doing this. They could look to raise capital privately or through asset sales or else they may need further capital from the state. If capital was needed from the state the Minister can direct us to make further investment, underwrite an issue or else convert our preference shares into ordinary equities.
Helen Morrissey: I believe you are currently carrying out an asset allocation review on the fund – how is it going?
O’Callaghan/O’Donovan: Our current investment strategy covers the period to end 2009 and we are currently conducting our scheduled review of this strategy. The review is ongoing and I wouldn’t like to speculate too much on its outcome prior to a final decision by the Commission. However, one lesson from the financial crisis is the need to consider the extent to which the Fund is truly diversified. While the Fund has investments across a number of asset classes such as quoted equities, property and commodities which have different economic drivers and tend to perform differently in different economic environments, what we saw during the crisis was a flight to safety with investors eschewing all risk assets as they sought safety in government bonds. Up to now we have managed the Fund by focusing on long-term risk and accepting the volatility that accompanies such risk. There may be a need in future to give more emphasis to diversification in all market conditions and to make an allocation to absolute return products which target a specific return in all market conditions.
So while the asset allocation review is still ongoing and as yet we can’t confirm any firm decisions we are looking at the possibility of whether there is a role for an absolute return allocation.
Another point worth noting is that since the start of the credit crisis we chose to underweight our equity allocation and we have profited from this and other tactical asset allocation decisions we have taken in the past. However, there could be room for a more formalised role for dynamic asset allocation going forward whenever prices move to extreme levels or volatility rises to levels with which we are not comfortable.
We have also tendered publicly for a consultant to help us with a fund of hedge funds allocation. It is essential to research the market before making any decision on an absolute return fund allocation and, because of this, we are running this tender in parallel with the finalisation of the strategy.
Helen Morrissey: The government unveiled plans to launch a career average scheme for new public sector employees in the December 2009 budget. How much will this affect the NPRF given your role in meeting the cost of public sector pensions?
O’Callaghan/O’Donovan: You need to think of the NPRF as a defined contribution fund to part meet the increased cost of future social welfare and public service pensions as the population ages. If the government was to introduce a career average scheme then this would reduce overall pension costs but the role of the NPRF would not change.
Helen Morrissey: What do you see as being the key investment trends that are emerging?
O’Callaghan/O’Donovan: As regards to investment trends we have to think about the possibilities of what may happen as there is still so much uncertainty.
Over the past year or so we have seen an unprecedented amount of government intervention and this stimulus will need to be withdrawn at some point. We need to think about the possible effects that this could have on the real economy and on the asset classes in which we invest. We also need to take the issue of inflation on board. In the medium term we could find ourselves either in a high or low inflationary environment. We need to think about how we should be positioned in these different scenarios if we are to remain flexible and adaptable for the future.
Helen Morrissey: Infrastructure is often cited as a good hedge for inflation. Is this an area you are interested in investing in?
O’Callaghan/O’Donovan: Infrastructure does have characteristics that we find attractive. We have always had a small allocation to this asset class but we have not yet made any investments. However, I would see us looking to do more in this area over time as infrastructure provides a good hedge for inflation as well as providing stable long term income.
Helen Morrissey: What about ESG issues? The NPRF has always shown a real commitment in this area so how do you propose to continue?
O’Callaghan/O’Donovan: You are right we have always been pretty active in this area and we take our commitment to environmental, social and governance issues seriously. For instance, we were a founder signatory of the United Nations Principles for Responsible Investment (UNPRI) in 2006. We have sought to be a responsible owner and actively vote our public equities. We also have an ongoing engagement process with companies we invest in - via Hermes EOS. In 2009 we also excluded a number of cluster munitions manufacturers from our portfolio due to Ireland signing the convention on cluster munitions.
We would hope to increase our ESG activities across the portfolio – in particular the integration of ESG factors into investment analysis.
Investment
Irish pension funds have historically invested in domestic equities and while they are currently enjoying something of a bounce it comes off the back of stunning losses in 2008. As a result there is a need for pension schemes to further diversify their portfolios.
“The key lesson learned is that risk is something tangible that can seriously damage your funding level – it is more than just a number on a page,” said KBC Asset Management’s head of consultant relationships, David Hogarty. “We are out talking to clients and I’ve noticed the discussions we are having are changing. For a long time there was real inertia regarding asset allocation but now I see people are looking at different asset classes.”
Pioneer’s global head of institutional, Paul Price agreed with the need for further diversification but warns that progress will be slow as “people do seem to like their equities but that the market really needs some fresh thinking.”
He continued: “One thing I feel we should push for is to get funds to think about investing in areas such as infrastructure,” he said. “I think it could be a really good thing as pensions need to have access to secure long term yields. The Irish government has been trying to encourage investment in electrical and renewable energy infrastructure but the industry has been slow to adapt – I think they are reluctant to take the risk but really it should take up no more than 10% of a pension fund’s assets.”
However, Hogarty believes that progress is being made in terms of education and that trustees are starting to embrace more alternative investments.
“There has been a significant increase in scheme exposure to alternatives. It just takes time and education. Trustees used to get very uncomfortable with any discussion of alternatives but now they are less so. They don’t want huge volatility - they want consistency.”
However, the Irish pensions market is small and it can be difficult for schemes to gain access to certain asset classes or managers.
“This is a very valid point,” said KBC’s Hogarty. “The cost of research and understanding is high and this is where a bundled approach can bring real advantages. If pension funds could work together then that would be great as there would be no reason why they could not use their increased bargaining power to negotiate better deals.”
Price agreed saying that he believed the best way forward is to get schemes working together on their investment strategies.
“The question of how to collectivise the pension industry is an area the smart investment managers will look to facilitate going forward,” he said. “The co-investor culture could become more prevalent with funds being able to take advantage of the increased liquidity.
The key lesson is that we need to be more differentiated in our pension scheme assets. The reality is looking at the power pension funds can wield by working together.”
Eugene O’Callaghan is head of investment manager programme at the National Pension Reserve Fund
Adrian O’Donovan is secretary to the National Pension Reserve Fund
