Pension Funds Letter 5 - Building the long-term alignment

After several decades driven by short-termism, we have observed since the Global Financial Crisis the rising of a “long-term awareness”, the perception that we are facing long-term challenges and that long-term investment needs are expending.

The world can today observe some preliminary impacts of long-term materialising challenges on the society and the planet, such as climate changes or demography dynamics, having investors rethink the valuation of stock prices to include long-term trends not yet captured by financial markets. In addition, while life expectancy is increasing all over the world, the investment horizons are expanding and liability duration is increasing. Individuals have to accumulate savings for a very long-term period for their retirement (35-40 years); even retirees still have potentially a period of 20 years to preserve their capital.

Due to their very long-term liabilities, asset owners such as Pension Funds can fully benefit from long-term investing.  Not only will they be able to capture the long-term premia, should it be factor/multi-factor risk premia through a cycle or the illiquidity premia embedded in real and alternative assets, but they will also be in a position to avoid the negative impacts related to short-term investments, notably transaction costs. If asset allocators already integrate long-term considerations in their investment decision process, the whole investment model and value-chain have been developed in a way that is entrenched in short-term considerations: metrics for the measurement of value creation or portfolio risks, return profile guidelines, fees schemes, bonus systems... Long-term investment cannot be implemented with the same approach. A new framework needs to be defined for long-term perspectives to be properly taken into consideration.

Long-term horizon has to be properly integrated into the portfolio allocation. However, long-term-investment-only is not the proper answer either. Long-term investment should rather be seen as a journey across “time allocation” and “time diversification”: the portfolio is split into several buckets by investment horizon (“time allocation” between short-, medium- and long-term horizons) and the asset allocator can mix these buckets (“time diversification”), as combining horizons is a source of diversification which should not be neglected. When addressing long-term investing, Pension Funds need as a prerequisite to set the objectives of their asset allocation, at both strategic and tactical levels. When doing so, it is particularly interesting to point out that we encounter different practices in the pension funds industry, depending on specific pension plans’ size and model.

Long-term investment is also a matter of regulation and how regulators may encourage this trend. However, regulators remain ambiguous as some post-crisis regulations still tend to favor short-term behaviors, as highlighted in a recent empirical analysis of regulatory changes affecting defined benefit (DB) pension schemes in the US, Canada and the Netherlands.

Last but not least, there is a premium to be captured from a long horizon investing mindset according to the Willis Towers Watson’s Thinking Ahead Institute. This premium is evaluated at between 0.5% and 1.5% per annum, depending on the size and the governance of the asset owner. The enhanced performance would stem from active ownership, capturing systematic mispricing, liquidity premia and thematic investing.