Part 3: How does Philips Pensioenfonds determine its investment mix?
Investment mix is based on the future pension payments
This is the third and final part of our series on investments. In the first part, we explained that without investments it is impossible to accrue an affordable pension. In the second part, we described the asset classes in which Philips Pensioenfonds invests. We saw that risk and return go hand in hand: a safe investment in government bonds yields a lower return than a more high-risk investment in equities. In this final article about investments, we explain how Philips Pensioenfonds determines its investment mix. Philips Pensioenfonds has an obligation to pay out pensions, now and in the future. Our ambition is to increase those pensions every year with inflation, to ensure that your pension retains its purchasing power in the long term. This ambition is the starting point of the Pension Fund’s investment policy. We use what is commonly known as an ‘ALM analysis’ to identify the investment mix that best suits our ambition. ALM is short for Asset Liability Management. The ‘assets’ are the investments; the ‘liabilities’ are the current and future pension payments. Such an analysis helps to determine why 27.5% of our assets should be invested in equities, for example, and not 25% or 40%, given the above mentioned inflation ambition.
Uncertainties require economic future scenarios analysis
As a rule, Philips Pensioenfonds determines its investment mix based on a time horizon of generally 15 years.
However, as it is difficult to predict with accuracy what the world will be like 15 years from now, our investment policy must make allowances for some uncertainties. We do this by using multiple different economic scenarios: positive scenarios, but also, negative scenarios. Using as many different economic scenarios as possible gives us the best insights into the assets that Philips Pensioenfonds holds. A typical ALM analysis covers an astonishing approximate of 2,000 different economic scenarios. This allows us to determine how our invested assets will behave over the next 15 years in both good and poor economic conditions. It also shows us which improvements we can make by adjusting our investment mix.
An investment mix that carries more risk will yield higher returns in positive scenarios...
For example, a positive economic scenario might show that equities will yield an average annual return of 5% over the next 15 years, and that interest rates will rise to 3%.
ALM scenarios also allow for inflation, which will rise slowly in positive scenarios. All these factors will make it easier for Philips Pensioenfonds to achieve its ambition. Philips Pensioenfonds can subsequently run simulations to determine what the value of its investment portfolio will be in 15 years’ time if a particular investment mix is used, and whether that value will be enough to pay and index its future pensions. If these simulations show that the future assets will not be enough to pay the pensions and raise them through indexation, a relatively larger portion will need to be invested in more high-risk investments such as equities and real estate, which generate higher returns.
…but is more likely to yield losses in more negative scenarios
However, an investment portfolio that yields relatively higher returns automatically carries a higher risk. This is particularly important in negative economic future scenarios.
Although an investment mix with more risk will yield higher returns in positive scenarios, in scenarios where the economic growth is poor, the assets invested in that mix will lose value more quickly than assets invested in a relatively safer mix.
ALM analyses are used to find the right balance between risk and return
We use ALM analyses to identify the investment mix that strikes the best balance between the level of returns that we want our investments to yield and the degree of risk that we are willing to take.
As explained above, Philips Pensioenfonds seeks to raise its pensions every year by the same rate as inflation. To achieve this, our investments need to yield returns. This means taking risks. However, those risks should not be too high: too much risk can make it unacceptably probable that we will be unable to index our pensions, or might even be forced to reduce them, if the economy experiences a downturn. Therefore, Philips Pensioenfonds continually monitors its investments to make sure that they are not exposed to too much risk. In this manner, we hope to identify the investment mix that will help Philips Pensioenfonds to achieve its ambition over a 15-year period.