s’.Investment is about deferring consumption. There are many different reasons for deferringconsumption, but by far the most important now is the deferral of income from the period whilean individual is working to their retirement. This used not to be the case, at least in publicsecurities’ markets. In the heyday of nineteenth century capitalism, the majority of investorswere rich men intent on getting richer – not thinking about their retirement, and insuranceand provident companies investing small contributions from policyholders to provide for life’sdisasters – death, injury, ﬁre – but not generally retirement. Few women in this period wereeconomically active (in the sense of having paid jobs), and men were expected to work until60 or 65.The fundamental changes in the economic and social structure of western societies in thelate twentieth century have changed that – families no longer expect to look after their elderly relatives, life expectancy in the developed countries has been extended markedly andaverage retirement age has, if anything, gone down. See Box 1.2. It is not untypical for a
4
Currency Overlay
worker to retire in their mid to late ﬁfties and live to their early eighties. This requires 25years of income – income that governments are either unwilling, or now increasingly unable,to provide. Providing this income is the principal concern of the investment managementindustry.Box 1.2
Life expectancy
Life expectancy in developed countries has been increasing almost continuously for twocenturies. However, the pattern of mortality has also changed, and this has a signiﬁcantimpact on the need and scale of retirement provision. Taking the UK as an example, thestriking thing about the change in mortality patterns is the collapse in early death rates.In the nineteenth and early twentieth centuries, people died at every age group – mainlythrough infectious diseases and what would be regarded now as avoidable causes – accidents,childbirth, etc.In the late twentieth and early twenty-ﬁrst centuries, death is almost exclusively thepreserve of the elderly. This means that the population is becoming increasingly elderly,and the ratio of working years to retirement years has collapsed. In 1841, only 30% ofmales born reached 65; in 2000, 83% reached 65. Life expectancy for those lucky enoughto reach 65 has changed less markedly. In 1841, the life expectancy of a 65-year-old manwas 76 years; in 2000, 81 years.This effect can be seen graphically in male life expectancy at ages 0, 45 and 65:Male life expectancy90.0
Life expectancy
80.070.060.0at 6550.0
at 45at birth
40.030.01841*
1870*
1900*
1930*
1960**
1990***
2020p
Year
Source : UK Government Actuary's Department.
The female experience is very similar: just a few years longer at every age. So both thecontinuous rise in the solid line, and the recent rise in the dotted and dashed lines, aremaking the provision of retirement income so much more difﬁcult and material.These changing social and economic trends mean that the majority of investment is bypension funds. While there is a large sector which is explicitly labelled ‘pension funds’, thereare also mutual funds and insurance company investments which, even if not labelled so, arealso largely for the purpose of securing individual income in retirement.Pensions are divisible into two key types – deﬁned beneﬁt and deﬁned contribution.
Introduction
5
1.1.3 Deﬁned beneﬁt pensionsDeﬁned beneﬁt (DB) pensions are just that. They are a promise by an employer, or a government, to pay a deﬁned amount of annual pension between a retirement date and death. TheBox 1.3
Deﬁned beneﬁt pensions
The key characteristic of deﬁned beneﬁt (DB) pensions is that the pension they deliver isnot affected by any factors except the number of years of pensionable employment and theemployees’ ﬁnal (or, more rarely, average) salary. DB pensions are typically expressed inthe form ‘1/60 of ﬁnal salary for each year of pensionable employment’. In the UK, but notthe US, they are now required to be index-linked (0–5% p.a. limits) after retirement. Theyare typically offered to men and women on the same terms, although the expected cost to theemployer is higher for women than for men because of the higher life expectancy for women.The cost of DB pensions is highly sensitive to real investment returns, salary increases andlongevity. If the cost of providing a DB pension were outsourced to a third-party providerlike an insurance company, then it would be possible to calculate from ﬁnancial economicsthe annual cost to the employer that the insurance company would have to charge. I assumehere that the insurance company is prepared to take mortality (annuity) risk (which isdiversiﬁed), but not investment risk (which is systematic), and that the contract is pricedat cost. The graph below shows the annual pension cost compared to employee age on thefollowing assumptions: UK pension; investment only in I/L gilts; 2.5% real returns for I/L;I/L pension (no cap or ﬂoor); UK average mortality; annual salary increase 3% p.a. higherthan inﬂation; continuous employment with one employer for 40 years; retirement at 60;1/60th accrual. Later years are so much more expensive to the employer because of theuprating of accrued rights with salary increases. And just to be clear, this graph means thatthe annual cost to the employer of a male aged 59 is 60% of his salary!Risk-free cost of DB pension by age(% of annual salary)70%
60%
MalesFemales
50%
40%
30%
20%
10%
0%20
25
30
35
40
45
50
55
60
On these assumptions, the average cost per year to the employer is 26% p.a. for males, and30% p.a. for females.
6
Currency Overlay
deﬁned amount may go up (in the UK it routinely increases with inﬂation for example), but itwill never go down. The level of pension is not dependent on the performance of any underlyingassets guaranteeing the pension – only on the rules of the pension. This is the distinguishingfeature from deﬁned contribution pension schemes.1.1.4 Deﬁned contribution pensionsDeﬁned contribution (DC) pension schemes are not really pension schemes. They are basicallymutual funds or unit trusts with a beneﬁcial tax-wrapper. The ‘tax-wrapper’ is usually thatgovernments will allow income tax relief on investment into a DC scheme, and allow the incomeand capital gains to roll up inside the fund tax-free.3 By way of compensation, governmentsusually tax all of the subsequent capital value as income when it is received by the pensioner,which will usually be by way of annuity receipts.DC pension schemes allow individuals to build their own ‘pot’ of assets, often with contributions also coming from their employer. Most jurisdictions require retiring DC members tobuy an annuity with much or all of this ‘pot’. An annuity is a promise from a provider (usuallyan insurance company) to pay a ﬁxed annual amount from the date of purchase until the annuitant’s death. Payments from an annuity are, in effect, a pension. Annuities are priced by themarket, which is run by insurance companies. They pool the mortality risk they are taking, andthen replicate the payments required by holding bonds. If bonds are expensive (i.e. bond yieldsare low), then annuities will be expensive (i.e. a ﬁxed outlay will buy less annual pension).The DC investor therefore runs two very signiﬁcant ﬁnancial risks: (1) the risk of poorperformance of his investments up to the point at which he retires, and (2) the risk that annuitieswill be expensive, thereby reducing his pension.1.1.5 Investors in a currency overlay contextThe remainder of this book will deal with the issue of currency exposure and institutionalinvestors. The currency exposure at the centre of this question is that embedded in the ownershipof securities outside an investor’s home country, and denominated in a foreign currency. Asa practical matter, most of the currency overlay mandates awarded in the period 1985–2002have been to manage the currency exposure of international equity portfolios. In addition, mostof the investors awarding such contracts have been DB pension funds. This has come aboutbecause the majority of cross-border portfolio investment is experienced by DB schemes’equity portfolios.Table 1.1 shows rough estimates of the scale of global asset classes. It is very difﬁcult to makesensible estimates of total cross-border asset holdings, hence my choice to show estimates forDB cross-border holdings alone (which are better documented). Sufﬁce it to say at this stagethat international equities are the largest creator of identiﬁable currency risk, and DB pensionfunds are the largest of the investor types experiencing currency exposure.
3In the UK, the notorious 1997 withdrawal of ACT relief for pension fund holders of UK equities was a partial withdrawal of thistax-free status. The position with regard to bonds is now anomalous – bond interest cost is fully tax-relievable for UK corporates, andnot taxable in the hands of pension funds.
IntroductionTable 1.1 Estimates of global asset ownership ($ bn)Total worldmarket cap
Of which ownedby DB funds
Of which DBcross-border
DB%total
Crossborder% DB
EquitiesBonds
23 80018 000
52003466
1126125
22%19%
22%4%
Total
41 800
8666
1251
Sources: Lehman Bros; MSCI; Record Currency Management, December 2002.
7
2The Problem2.1 ASSET AND LIABILITY VALUATIONS, VOLATILITYAND SOLVENCY2.1.1 Funded pension schemesPension funds as distinct ﬁnancial entities are a post-war phenomenon. They emerged in scalein the 1950s in the US and UK, and they largely invested in domestic, mainly government,bonds. Domestic bonds were regarded as a safe investment, and trustees, in many jurisdictionshedged around with legal limitations, had neither the expertise nor the incentive to invest inany other instruments.The idea of establishing trustees in a statutory framework to oversee the investment of aseparate fund was gradually enshrined in legislation in the US,1 UK, Australia, Canada, Netherlands and Switzerland, as well as several smaller economies. Notably, the major economies ofcontinental Europe, Germany, France and Italy, did not adopt this model, and to a great extenthave not done so to this day. Japan is a special case, with substantial funded schemes, but notin the standard employer-sponsored model.Pension funds were only established because the sponsoring employer had made a pensionspromise to its staff. Generally speaking, these promises consisted of the employee ‘earning’ aproportion of his ﬁnal salary for each year of employment. A typical pension scheme mightoffer 1/60 or 1/80 of the ﬁnal salary as pension for each year’s service. In the US this remainsa promise which is not linked to inﬂation after retirement; in the UK deﬁned beneﬁt pensionsare now required to be given limited price indexation – in effect linked to retail prices witha 5% p.a. cap and 0% p.a. ﬂoor. Governments and regulatory authorities were rightly waryof allowing companies to take on long-tail ﬁnancial obligations to employees (who are alsovoters!) without putting in place some mechanism to ensure that these promises were fulﬁlled.Hence the pension fund, legally distinct from the company, and able to survive the insolvencyof the company without danger of attack by the liquidator.Clearly, the desirable aim for the security of pensioners and future pensioners is to ensurethat in the event of the insolvency of the sponsoring company, the assets in the pension fundare sufﬁcient to pay all the outstanding promises in full. This opens the door to an area ofsigniﬁcant controversy. I feel that in order to fully explore the concept of investment risk in apension fund, I need to lay out some elements of that controversy.2.1.2 Asset valuationsIn the modern world of electronic communication, real-time market price screens and large andliquid securities’ markets, it might seem that the question of establishing how much the assetsof the pension fund are worth was a relatively trivial one. Why not look up the price of all the1Michael Clowes, editor for many years of the premier pension trade journal (Pensions & Investments) in the US, has written adetailed post-war history of US pension funds. Clowes, M. J., The Money Flood, John Wiley & Sons; ISBN 0-471-38483-6.
10
Currency Overlay
constituent stocks, and sum the consequent value of each holding over the whole portfolio?While there might remain some question over the pricing of unquoted securities and of property,nevertheless the realisable value would be established with a narrow margin. This procedurehas now been adopted in many, but not all, of the major funded pension jurisdictions. Evenin those where market valuation is now the standard, this change has in many cases happenedwithin the last 10 years.What can possibly have been the alternative basis? The answer to this is dependent onthe jurisdiction, and the practices of the profession responsible for pension fund valuation –actuaries.In the UK and the US, until fairly recently, many pension fund asset valuations were madeon the basis of ‘discounted cash ﬂow’. Discounted cash ﬂow valuation ignores market values ofotherwise perfectly marketable securities, and instead values them on the basis of a valuationmodel. As this applies to equities, the model runs something like this:
r Step 1r Step 2r Step 3r Step 4
Establish the current dividend yield of the security or indexProject the dividend out into the future using a dividend growth assumptionCalculate the stream of dividend cash ﬂows arising from these assumptionsDiscount the stream of cash ﬂows to a present value (PV) at an arbitrary discount
rate
r Step 5
Call this PV the valuation of the assets
There are numerous objections to this valuation methodology, not least that the valuation sodevised will not be the asset sale value. Other objections include the arbitrary nature of thedividend growth assumptions and the discount rate, neither of which can be readily determinedby reference to a market. Indeed, it could be argued that the only possible reference to themarket would be to derive an implied dividend growth rate and equity dividend discount ratefrom the market’s valuation of the security – which then makes the whole exercise plainlycircular.Discounted cash ﬂow valuations have all but been replaced by market valuations in pension fund valuations (see Table 2.1), so the discussion may seem a little academic. However,the culture that created actuarial valuations for assets lives on in the valuation of liabilities.Table 2.1 shows that the market value valuation methodology, while the largest category of assetvaluation, is by no means the only methodology. ‘Smoothed value’ (taking only a proportionTable 2.1 Asset valuation method relative frequency in North AmericaUS
Number of responsesAsset valuation groupFair market valueDiscounted cash ﬂowBook valueSmoothed valueOther (including combinationof methods)
Canada
Small plans
Large plans
Small plans
Large plans
5799
3168
274
311
65.3%0.0%27.8%6.9%0.1%
48.6%0.1%13.9%36.4%1.0%
90.5%0.0%1.1%8.0%0.4%
47.3%0.3%4.5%42.1%5.8%
Source: Survey of Asset Valuation Methods for Deﬁned Beneﬁt Pension Plans, Society of Actuaries, 1999.
The Problem
11
of the asset value changes each year) and ‘book value’ (essentially cost) are also remarkablywidespread.It is worth noting that ‘During the period from 1988 through 1996, plan assets were “markedto market” sparingly in the U.S. (a low of 0.3% of all plans in 1989 to a high of 2.6% of all plansin 1996) and very rarely in Canada’ (SOA 1999 Survey). So the change to market valuationhas come very recently and very rapidly. The reader will notice ‘book value’ as a valuationalternative, which is essentially asset purchase cost (or possibly market valuation if less).Since most assets will have been long-held, book value will not acknowledge any volatility invaluation brought about either by equity market ﬂuctuations, or by currency ﬂuctuations.2.1.3 Liability valuationsLiabilities do not on the face of it fall as neatly as assets into market-based valuations. DBpension funds’ liabilities to future cash outﬂows are not certain. They are subject to a numberof uncertainties, including:
r Mortality (currently on an unfavourable trend)r Pensions-in-payment inﬂation (depending on the pensions promise)r Salary inﬂation prior to retirementr Early leavers (a favourable risk to the fund)r Early retirement (variable effect)These factors combine to make the calculation of future cash ﬂows an educated guess, or arange of values with probabilities assigned, rather than an exact value. However, all of theseuncertainties can be estimated with more or less precision, and the estimates are unlikely tochange rapidly (mortality), or can be hedged (inﬂation). One key uncertain variable is left tobring these future cash ﬂows back to today’s values – a discount rate.2.1.4 Liabilities’ discount rateThe value, and the underlying calculative principles, of the discount rate are by no means asettled question, and indeed at the time of writing have been raised right to the top of the politicalagenda in the UK, and to a lesser extent in the US and elsewhere. What is so contentious?There has been a considerable history around the subject of liabilities’ valuation. Theposition in most of the developed economies with funded pension sectors is that liabilities arevalued in two or three different ways depending on context. In the US, funds are required byERISA2 to undergo a regular solvency examination to determine whether they meet minimumsolvency requirements. This was the context of the asset valuation results shown in Table 2.1.The valuation of liabilities is similarly varied, with no pension funds reporting their liabilitiesdiscounted at the risk-free discount rate. In addition, companies are required to report theirnet liabilities and pension expense under the US accounting standard FAS87. However, thisallows for smoothing of asset valuations, as well as a choice of three key variables for theliability valuation – salary inﬂation, ‘expected rate of return’ and the discount rate.In FAS87 parlance, the discount rate is commonly applied to pensions in payment, and to alesser extent future pensions at the shorter end of the maturity spectrum. The ‘expected rate ofreturn’ is the discount rate applied to longer maturity liabilities. The nomenclature is revealing:2
The US Employee Retirement Income Security Act 1974.
12
Currency Overlay
liabilities do not have an expected rate of return; assets do. Why should the returns of a fund’sassets affect the calculation of the PV of the liabilities?Box 2.1
Discounting
A pension fund has obligations to pay its pensioners out into the distant future. How doesthe fund value this liability in today’s money? This is important if only because it gives aguide as to how much it needs in assets valued today to cover the liabilities. Assume for themoment that a pension fund owes a level £10m per year from today to 2050, after which ithas no further obligation. (Pension liabilities do not have this level payment characteristic –it is for illustration only.)We can calculate a PV of this liability using a risk-free rate (say 4% p.a.) – the rate ofreturn from investing in government bonds of the appropriate maturity. We can also valueit at higher discount rates, representing a ‘hope’ that the assets in the fund (on the otherside of the balance sheet) will yield a return yield than or equal to the higher assumed rate.We can show the huge impact of changing the discount rate in the following table:Discount rate
PV (£m)
% risk-free PV
4% (risk-free)5%6%7%8%9%10%
222191167147132119109
100%86%75%66%59%54%49%
The answer, I believe, lies in the realpolitik of the actuaries’ profession. Proﬁt-maximisingcompanies wish to minimise their payments to their pension funds, commensurate with thefunds remaining solvent. As they increased their holdings of equities in the 1950s and 1960s,the superior returns of equities meant that each year the discount rate used for the valuationof their funds’ liabilities looked over-conservative. If their assets went up, on average, fasterthan their liabilities, then was there not a case for adjusting the discount rate of the liabilitiesto more closely match the returns achieved in the investment portfolio?The pressure from companies on their actuaries, and then from actuaries to governmentregulators (via their position on working groups, etc.) began to enshrine in law the idea thata risk-free rate for the liabilities’ discount rate was a luxury they neither needed nor couldafford. In its place was put a series of discount rates, each applying to different types ofliability (pensions in payment, active staff members, deferred pensioners (ex staff), roughlyreﬂecting the maturity of the liability and its ‘certainty’. ‘Uncertain’ liabilities, particularlythose of young active staff members, could be discounted at ‘assumed equity’ returns (in 2000,these were about 9% p.a. in the UK, versus a risk-free rate of about 5.5%).What has escaped most governments (despite a regular trickle of underfunded pensionschemes in bankrupt companies) is that enshrining ‘long-term’ rates of return in the liabilitydiscount rates ensures that there is a strong likelihood that the primary purpose of pensionfunds – to secure promise payments to pensioners – will fail. The turn of the twentieth to thetwenty-ﬁrst century has seen interest rates (and inﬂation) across major industrialised countriesfall to 40-year lows. This has not only created well-publicised problems for insurers like
The Problem
13
Equitable Life in the UK (who promised (high) Guaranteed Annuity Rates to some of its savers),but has also made the equity return assumption for the liability discount rate increasinglyuntenable.2.1.5 FRS17A new accounting standard, introduced in the UK in 2001 and originally coming fully intoforce in 2003 (but now delayed until 2005 to mesh with the move to international accountingstandards), requires UK companies to put the assets of their pension fund less pension liabilitieson the parent balance sheet (in the interim, in the notes). Not only is this the ﬁrst time thatUK companies have had to do this, but they are required to value assets at realisable marketvalue on the balance sheet date, and liabilities at a discount rate equal to the AA corporatebond rate prevailing on the balance sheet date. There is no ‘smoothing’ and no ‘assumed rateof return’. This standard has almost always shown that pension funds reporting in 2001 and2002 are in deﬁcit, and sometimes by very large absolute and relative amounts. Bizarrely, thenew standard, which goes some way in allowing the owners of companies to know what theirnet pension obligations are, is under attack from an unholy alliance of unions, business leadersand politicians. The unions want the standard postponed or abolished because they fear the badnews it brings will prompt the company to abandon ﬁnal salary pension schemes; businessmenwant it postponed or abolished because it introduces an ‘uncontrollable’ element of volatilityonto their balance sheets, and they can’t afford to eliminate the volatility by investing in bonds;and politicians of all hues want it postponed or abolished because they fear it will lead to theclosure of ﬁnal salary pension schemes, which will not only be unpopular amongst a signiﬁcantproportion of the electorate, but will also put more pressure on the state and the taxpayers tofund retirement.Those in favour are a small group of informed accountants and actuaries, who are attemptingto provide ﬁnancial transparency and objectivity to the users of company accounts – the equityholders. Ironically, pension funds form a signiﬁcant proportion of equity holders, and theyhave remained mute in this role. This group will most likely win the battle – the Equitable Lifedebacle in the UK, and Enron in the US, very different in both cause and result, will ensurethat the call for transparency is going to be politically irresistible.2.1.6 IAS19The UK and other EU members are committed to adopting international accounting standardsby 2005, and the US will wish to move to closer harmony with these if at all possible. US andinternational standards currently allow smoothing and non-market liability discount rates –the outcome of the next few years’ debate will determine whether the new UK principles willprevail at international level.2.1.7 Summary on assets and liabilitiesThe result of the changing valuation culture is to make pension funds more sensitive to therisks they are running with their investments. Generally speaking, for DB pension funds, thisrisk is principally in holding assets other than bonds. Bonds are a low-risk investment becausethey are increasingly forming the basis of the liability calculation (and are the only instrumentcapable of securing future pension liabilities with a high degree of certainty).
14
Currency Overlay
By far the largest category of non-bond assets is equities. For several investing countries, thenext largest is currencies, since several (smaller) countries have large allocations to internationalequities. This is followed (in decreasing importance) by property, private equity, hedge fundsand other, ad hoc, assets. The latter are less important sources of risk simply because they aresmaller average allocations.I will devote the remainder of this chapter to examining the role of currencies and theconsequent investment risk that they create. At the end of the chapter I will also look brieﬂyat cross-border investment by entities other than pension funds.
2.2 HISTORY OF PENSION FUND CROSS-BORDERPORTFOLIO INVESTINGThe countries with the two largest funded pension sectors are the US and the UK. Both havedifferent histories of international investing2.2.1 USUntil 1980, the entire US pension sector had less than $1bn invested outside the US (or about1% of the roughly $390bn 1980 total in pension assets). In that year, several pension funds4adopted new asset allocations, driven by the desire to diversify and the ascendancy of the newquantitative modelling of risk, and the amount invested abroad quintupled to $5bn, or morethan 1% of total assets. This heralded a trend which continued throughout the 1980s and muchof the 1990s. By 2000, the US deﬁned beneﬁt pension sector had about $7000bn in total assets,of which about $800bn, or about 11%, was invested outside the US. US pension funds, with11% in total of international assets, are low in the international league table of internationaldiversiﬁcation by percentage, but by far the largest in absolute value. By far the majority ofthe international assets that the US holds are equities, and it is equity portfolios, as we shallsee, that form the basis for the growth of the currency overlay sector.2.2.2 UKThe growth of the UK funded pension sector paralleled that of the US. But the UK’s experiencein international investing is very different, and can be divided ﬁrmly into two halves – pre-1979and post-1979. Why 1979?Before October 1979, the UK maintained exchange controls. These had been introducedat the beginning of the Second World War as part of the panoply of measures put in placethen to create, in effect, a command or ‘planned’ economy. Even though most of the legacy ofregulation and control was scrapped by the middle of the 1950s, one overarching regulationremained – exchange controls.Exchange controls required that UK residents apply to the Bank of England for permissionto acquire foreign currency. Permission would be given for speciﬁed purposes, including theimportation of necessary foreign commodities and goods, and £50 per year (raised to £200 inthe 1970s) for each individual for the purposes of foreign travel. However, permission wouldnot be given for the purchase of overseas assets. Here the Bank of England was faced with adifﬁculty – at the imposition of exchange controls, there was a considerable pool of Britishcapital invested abroad. The government decided that this could stay, but that when a UKinvestor wished to repatriate his investment, he could sell his foreign currency to another UKinvestor who wished to invest abroad.
The Problem
15
This created an arbitrary, but largely ﬁxed, pool of overseas capital which had to be competed for by UK investors. It was called the ‘dollar’ pool, and it traded at a premium to thenormal exchange rate. The premium varied according to supply and demand, and was called,unsurprisingly, the ‘dollar pool premium’. This strange corner of the ﬁnancial world had onemajor effect on UK pension funds – they could not as a group increase their holdings ofinternational assets, every individual increase was matched with a compensating decrease ininternational holdings elsewhere. Then, in 1979, in the ﬁrst months of the new Conservativeadministration under Mrs Thatcher, exchange controls were summarily and totally abolished.The dollar pool (and premium) disappeared (incidentally causing a one-off loss for those fundsalready invested abroad), and from that point UK funds could invest abroad unhindered.Figure 2.1 shows the proportion of assets invested overseas by UK funds in the 20 years toend-2001. It includes equities and bonds, but overseas equities are the dominant asset class.At the end of 2001, UK pension assets were about £800bn; this puts international assets heldby UK funds at about £220bn.31.0%
Overseas as % of total assets
26.0%
21.0%
16.0%
11.0%
6.0%
81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01
Source : WM Company.
Figure 2.1 Overseas asset allocation 1981–2001 (UK pension universe weighted average)
Table 2.2 is a very rough ‘guesstimate’ based on asset values at the end of 2002, for theextent of international asset allocation. It has been compiled by the author from a range ofdiverse and sometimes incomplete sources, so it should be relied upon only as a general guide,not a source of deﬁnitive values. It should be noted that for the three years