In RiskMonitor, Allianz Global Investors (AllianzGI) together with Investment & Pensions Europe (IPE) magazine surveys European institutional investors’ perceptions of capital market, regulatory and governance risk.

1. (H2 / 2012)
RiskMonitor
#4
Under Pressure
Understand. Act.

2. Investors’ purchases
of sovereign debt
more and more appear
like a donation to the
region’s immediate
stability than a source
of long-term returns
for pension scheme
members.
2

3. Content
3 About the survey
4 Introduction
5 Management summary
6 Financial risks
6 Unyielding governments
7 Decades of pain
11 A Sting in the tail
13 Financial repression
13 This time it’s difficult
15 Look East!
18 Regulatory and governance risks
22 Results at a glance
About the survey
In RiskMonitor, Allianz Global Investors (AllianzGI) together with Investment &
Pensions Europe (IPE) magazine surveys European institutional investors’
perceptions of capital market, regulatory and governance risk. By repeating the
survey on a regular basis, it is possible to gauge institutional investors’ risk
perceptions over time. This fourth survey was conducted from 8 to 26 October
2012 both online and per fax. Altogether, the survey gathered responses from
155 institutional investors with a total of EUR 1,934.5 billion (bn) of assets under
management or assets under advice. The survey targeted institutional investors in
Austria, France, Germany, Italy, the Netherlands, Switzerland, the United Kingdom,
as well as in the Nordic Region (Denmark, Sweden, Finland and Norway). Due to
the size of its sample the survey does not claim to be representative, but it does
carry enough weight to outline the most important trends among institutional
investors in Europe. Allianz Global Investors had agreed to donate EUR 25 for
every completed questionnaire to Allianz Direct Help, an Allianz SE charitable trust
designed to identify and select humanitarian and other aid projects. IPE has
agreed to donate EUR 15 per completed survey to the IPE Scholarship
Programme, a fund whose aim is to give grants to individuals pursuing advanced
study in the area of pensions.
3

4. Introduction It is different today since we are unfortunately not merely
talking about a long-term trend in yield compression and
In my introduction to the previous RiskMonitor, I discussed three financial crises emanated in the new century. Many
the erosion of trust in sovereign debt with regards to investors feel that the market can no longer be trusted. One
hedging costs as measured by a significant increase in CDS of the reasons behind this lack of confidence is that the
spreads. In some instances, these costs have been markedly markets’ ups and downs have not been driven by normal
higher than for some global blue chip companies. Now it supply and demand dynamics, but by what policymakers do
seems like headline-grabbing risks are on the decline and or are believed to do next. Since the financial crisis, the
significant progress has been made in order to contain the U.S. Federal Reserve and the European Central Bank have
eurozone debt crisis. The reason for this lies in the deployed masses of money into the markets in pursuit of
European Central Bank’s willingness to fight the sovereign their goals, creating major market distortions and a
debt crisis in Europe or – as Mario Draghi put it – to do risk-on / risk-off environment, turning much of investors’
“whatever is necessary” to save the euro. Actions and common knowledge upside-down and pushing
money speak louder than words and doubts, so after governments, central banks and regulators in the driver’s
liquidity injections of more than EUR 1,500 bn into the seat of financial markets.
eurozone alone since 20081, it has become clear that no
financial authority is willing to test the abyss just for the Regulation of capital markets and investors will become
purpose of sticking to principles. Unconventional policy more important not only to improve the stability of the
answers are becoming more and more conventional and it global financial system, but also to help governments to
is becoming clearer that Western economies are prepared cope with their debt. In this context, it doesn’t come as a
to inflate their way out of debt thus trying to avoid any surprise that projected regulation on capital requirements
systemic shock. However, the sovereign debt crisis is far favours investments in sovereign bonds. Though not capital
from being over. controls in a strict sense, but because they massively affect
asset allocations of institutional investors and pension
What are the consequences? Yields of investment grade funds in a pro-cyclical way, this is a further facet of financial
sovereigns are at historic lows – often below the respective repression.
GDP growth rates and inflation, leaving investors with
negative real returns. It is no wonder that current interest I am optimistic to see that investors are quite constructive
rate levels have become a serious concern among when it comes to watching out for substitutes to sovereign
RiskMonitor respondents. This phenomenon, known as debt and readying their organizations for a broader variety
financial repression, has reappeared after it was used in the of risks. On the other hand, investors who only focus on
US to reduce public debt from 120 % of GDP in the 1950s to avoiding risks instead of deliberately taking specific risks will
about 35 % in the 1980s. find financial repression a trip of no return.
After this (long) episode, the decade-long “great Sincerely,
moderation” had a sedative effect on long-term investors.
Until the end of the last century, it was rather difficult not to
meet investment targets by simply putting a large chunk of
assets into investment grade sovereigns. Certainly, some
were hungry for higher returns, but the era and the bond James D. Dilworth
markets’ total returns were benign for liability-driven Chief Executive
investors. Those were the days … Allianz Global Investors Europe
1
Source: ECB balance sheet time series, data as of November 2012
4

5. Management summary Respondents do, however, seem cognisant of the danger
and keen to break away from the herd to explore
The good news from this latest issue of RiskMonitor is that alternatives to their own sovereign debt. When asked for
far fewer European institutional investors are worried about government bond substitutes that generate reliable and
the creditworthiness of their sovereign bond issuers. Twelve sufficient yields, answers ranged from covered bonds
months ago, 35 % deemed sovereign debt risk a huge risk to (22.7 %) to infrastructure debt and infrastructure equity
their financial targets for 2012; last month that percentage (13.6 % and 13 % respectively), private equity (10.4 %) and
had dropped to just over 13. Likewise, fewer than 9 % of the commodities (5.8 %).
155 respondents see overall market volatility as a huge risk.
A year ago the percentage was three times bigger. But By far the most popular response was corporate debt. More
investors are far from relaxed on all fronts: since the three than two-thirds of respondents named this class (although
latest surveys the share of respondents deeming tail risks as a few respondents warned of a credit bubble in the next six
a huge risk has remained stable at around 15 %. to twelve months). Emerging markets debt (37 %) and real
estate (31.2 %) were the next second and third most
The bad news is that investors are becoming more popular answers. By country of response, some interesting
preoccupied with the miserable and, in some cases, variations appeared: real estate appealed to more than half
negative yields on sovereign debt. More than 20 % of the the respondents from France and almost half the
respondents view current interest rate levels as a huge risk. respondents from Switzerland; private equity attracted
This is substantially more than every other category that has almost 18 % of the Nordic votes.
been analysed. This perception is even more pronounced in
France, Italy and the German-speaking countries. One in Perhaps the strongest relative surprise was the greater
three respondents named current or falling interest rates as popularity of emerging markets equities (10.4 %) over
the biggest single risk to their financial targets for 2013 developed markets equities (9.7 %). Do the former really
(and even rising interest rates are now a greater worry than promise more reliable yields on an absolute basis, or is it the
sovereign debt risk). case that relatively investors still feel overexposed to the
latter?
Although RiskMonitor concentrates on potential threats
over a one-year period, it appears that investors are It can be fairly surmised that Europe’s institutional investors
increasingly concerned that low yields are here to stay for a have profound confidence in emerging markets from their
long time. When asked which macro topic kept them up at answer to another new question in this edition of
night, one-quarter of respondents answered “financial RiskMonitor on barriers to investing in Asia; fewer than 4 %
repression”.“It is the only way out since massive liquidity believe the Far East suffers from weak fundamentals
has not had any effect,” said the adviser to one Dutch relative to other regions. At the same time, 28 % pinpointed
public-sector pension fund. transparency and difficulty in gathering information as their
biggest obstacle to investing in this region and more than
Central bank intervention has effectively disabled the 20 % worry about liquidity. In spite of these concerns, 58 %
mechanisms of the market. Large rescue packages by the expect to increase their exposure to Asia. Perhaps this is the
U.S. Federal Reserve and the European Central Bank have tell-tale sign of the desire to escape financial repression.
more or less created a binary market. This market is
characterised by strong fluctuations in risk appetite and risk
aversion known as “risk-on / risk-off” (RORO).
The portfolio manager of a German corporate pension trust
added: “Financial repression emphasizes the already
prevalent ‘herd mentality’ among investors, i.e. everybody is
forced to invest in the same assets or asset classes, and is
therefore really dangerous.”
5

6. Financial risks
Financial risks So far, so good. Investors’ confidence in the creditworthiness
of their own states is on the rise. The news gets better. The
sense of danger posed by overall market volatility and a
Unyielding governments sharp drop in the value of equities also seems to have
quelled since the summer. From a low point in the second
The title of the previous RiskMonitor was “Rethinking week of June, the STOXX Europe 600 Index has rebounded
Safety”. In the first half of 2012 investors suggested a to the high range it reached in March. Peripheral stock
variety of assets they defined as safe, from sovereign debt, markets such as Spain’s IBEX 35 and Italy’s FTSE MIB still
quality equities and hard currencies to event-driven hedge show susceptibility to bad news – recall the mid-summer
funds, swaps, renewables and covered bonds.2 As financial falls and recent sell-offs – but even they have shown more
repression takes hold of mature economies, institutional stability in recent months than previous quarters.
investors in Europe are not only having to think even further Yet current interest rates remain a stubbornly big problem
on their definitions of safety, and in particular safe havens, for investors trying to meet their financial targets.
but also seek new means of return. Amalgamating those responses which categorise current
interest rates as a huge risk and those for whom they are a
Much comfort has been taken from the actions of considerable risk, we find this has become almost as
politicians and central bankers in the second half of 2012. common a worry as sovereign debt risk itself (67.1 % of
The declaration by new ECB President, Mario Draghi in early responses versus 68 %3).
September that the Bank would stand behind governments
in the eurozone – effectively as a lender of last resort – has In order to achieve our financial investment targets for
become the most frequently repeated statement within the next 12 months, I see current interest rates …
financial circles. Its power is reflected in the diminution of
sovereign debt risk as a major headache for participants in 100 % 4.4 % 4.5 %
7.1 % 7.4 %
the current RiskMonitor survey. 90 %
28.4 %
80 % 29.4 %
30.9 %
In spring 2012, 21.2 % saw sovereign debt risk as a huge
70 % 45.2 %
threat to reaching their twelve-month financial targets. The
previous autumn the figure had been 35 %. By the end of 60 %
this autumn, just 13.2 % felt the same way. In Germany the 50 %
fall was starker: from more than four in ten respondents to 43.4 % 44.9 %
46.5 %
40 %
less than one in ten in a year.
30 % 41.3 %
In order to achieve our financial investment targets for 20 %
the next 12 months, I see sovereign debt risk … 20.6 %
10 % 19.9 % 19.9 %
6.5 %
100 % 1.9 % 3.6 % 2.2 % 3.9% 0%
H1/2011 H2/2011 H1/2012 H2/2012
90 % 17.9 %
24.1 %
80 % 36.5 %
27.6 % As a huge risk As a considerable risk
As a minor risk Not as a risk
70 %
60 %
43.6 % This shift in anxiety within the world of fixed income from
50 % 52.6 %
creditworthiness to yield is made more starkly when
40 % 55.3 % investors were asked their biggest single financial risk in the
46.8 %
next twelve months. Less than 6 % answered sovereign debt
30 %
risk while over 16 % said current interest rates. This is close
20 % 35.0 % to a transposition of sentiments of six months ago. Note
10 % 21.2 % that falling interest rates also captures more than 16 % of
14.7 % 13.2 %
the vote in this poll. If the two groups concerned most by
0%
H1/2011 H2/2011 H1/2012 H2/2012 rates are put together, they account for almost one-third of
all respondents, far ahead of those worried by overall
As a huge risk As a considerable risk
market volatility or even equity volatility.
As a minor risk Not as a risk
2
AllianzGI RiskMonitor “Rethinking Safety”, June 2012. NB More than 5 % of respondents said there were no safe havens.
3
We aggregate responses of ‘huge risk’ and ‘considerable risk’ as ‘major risk’.
6

7. Financial risks
”Financial repression is a silent way to reduce government
Top 5 financial risks debt. It works much more smoothly than a haircut. And let’s
What is your biggest financial risk in the next not forget that financial repression is politically easier to
12 months? implement than expenditure cuts or tax hikes,” says Stefan
Hofrichter, chief economist of Allianz Global Investors, in
Overall market volatility 20.7 % (–3.2 %)* explaining the appeal of financial repression to
Sharp drop in equity markets 18.1 % (+1.4 %)
democratically-elected governments.
Falling interest rates 16.1 % (+1.6 %)
And this is the sobering thought: the size of the debt for the
Current interest rate levels 16.1 % (+8.1 %) US alone exceeds US$ 16trn. In Europe, for just France,
Rising interest rates 7.1 % (+0.6 %) Germany and the UK the figure exceeds US$ 6trn. Given
the magnitude of these imbalances, it is no wonder that
Reinhart, Reinhart and Rogoff suggest that such debt
*compared to survey H1 / 2012
overhangs last on average 23 years. That is the really bad
news behind responses on interest rates in this current
Decades of pain RiskMonitor. Investors are waking up to the reality that their
fixed income portfolios could be a drag for decades to
What is propelling this rising anxiety about current interest come; that the Great Moderation which gave such a
rates? The obvious cause is that returns on the sovereign favourable tailwind to bond yields seems to be well and
debt of most G10 countries lie somewhere between truly over.
miserable and negative. This alone is enough to hurt those
types of investors constrained by regulation directly or “For the eurozone as a whole, debt-to-GDP ratio is around
indirectly to hold such assets. One UK investment adviser 90 %, substantially above the targeted 60 %. Assuming an
bemoaned the double-whammy on both sides of the annual liquidation effect of 3 % by keeping interest rates
balance sheet. below the ‘fair value’ level, it would take roughly 10 years to
bring the region back to the debt levels that were originally
“The continued low interest rate environment is affecting set at Maastricht as upper limits,” says Hofrichter.
the liability side of the equation which affected the funding
level which puts the pension fund under pressure and For indebted governments, financial repression works best
makes the cost of SWAPS expensive.” when accompanied by sufficient inflation to erode the real
value of the debt. Nothing explains financial repression
We will explore these consequences in due course. better than to consider the real yield on popular
instruments such as the UK 10-year linker. Mid-November,
The more profound cause of worry, however, is that this it was –0.65 %. So bondholders were paying Her Majesty’s
low interest-rate environment could be here to stay for a Treasury for the privilege of lending it money. Of course,
very long time. If the commitment of Mario Draghi to stand inflation-linked liabilities are more explicit for traditional UK
behind eurozone governments is a happy mantra for pension schemes than their peers. In Continental Europe
institutional investors, the wisdom of economists is a customs are different (and equivalent Treasury debt
sobering counterbalance. In their work, the economists instruments fractionally more generous). In the
Carmen Reinhart and Belen Sbrancia show how historically Netherlands inflation-linking of benefits has traditionally
governments faced with huge debts have often passed on been optional, typically dependant on the investment
the pain to their lenders through “financial repression”. returns achieved the year before. In pension plans in other
countries, there is no direct linkage, but individual
In essence, financial repression leaves bondholders and retirement adequacy is hugely determined by real as
savers to pay the bills by dint of miserable nominal yields. opposed to nominal returns. The difference is reflected in
The offload is completed by inflation devaluing those concerns about inflation as a risk to respondents’ twelve-
miserable yields further in terms of ultimate purchasing month financial targets.
power of the lenders.
4
http://www.nber.org/papers/w18015
7

8. Financial risks
In order to achieve our financial investment targets for the “Markets have been driven by sentiment and quickly move
next 12 months, I see inflation … from risk-on to risk-off without regard to fundamentals.
Political announcements have been seen as positive and
100 % then evaporate when they achieve little. This will persist
12.4 %
90 % 22.3 %
17.4 % and shows little sign of improvement as politicians and
80 %
bureaucrats are unable to really manage the problems of
no growth, too much debt and high unemployment” says
70 %
the CIO of a large UK pension scheme.
60 % 54.2 %
45.3 % 53.6 %
50 % For this respondent, the consequence is that market
volatility will persist in a “risk-on / risk-off” environment.
40 %
This in turn suggests that the ‘quality’ of market volatility is
30 % deteriorating, because it has less to do with commercial
20 % 28.8 % 28.8 % fundamentals. If one subscribes to this belief, then it
27.5 %
removes the shine from RiskMonitor conclusions. These are
10 %
1.4 % 4.6 %
that overall market volatility is posing less and less of a risk
3.6 %
0%
to Europe’s institutional investors. A year ago we found
H2/2011 H1/2012 H2/2012
88.7 % of respondents felt overall market volatility was a
As a huge risk As a considerable risk major risk to their twelve-month financial targets. Six
As a minor risk Not as a risk months later the percentage had fallen to 83.7 %. By
November it was down to 74.6 %. The decline is even more
apparent if we focus on those respondents who perceive
One in ten UK respondents views inflation as a huge risk to overall market volatility as a huge risk: 27.9 % one year ago;
their twelve-month targets; this is the highest level of 8.4 % now.
concern ever in the history of RiskMonitor in this category.
While almost 8 % of Dutch respondents also view inflation In order to achieve our financial investment targets for
as a huge risk, unlike in the UK the numbers of Dutch in the the next 12 months, I see overall market volatility …
next category have fallen away. So far fewer Dutch perceive
100 % 1.9 % 1.4 % 1.3 %
inflation as a considerable risk. The three other countries
10.0 %
where inflation risk is indubitably growing are France, 90 % 16.3 %
25.6 % 24.0 %
Germany and Switzerland. Nearly half of all respondents 80 %
from Germany and more than half from France now view
70 %
inflation as a considerable threat to next year’s financial
targets. 60 % 60.8 %
61.5 %
50 %
But the consequences of financial repression are not 66.2 %
40 % 64.7 %
limited to fixed income alone. Clearly the issue is much
30 %
bigger. Reinhart, Reinhart and Rogoff identify 26 debt
overhangs (debt-to-GDP above 90 %) in their historical 20 %
analysis. They claim economic growth slowed by 1.2 % 10 %
27.9 %
22.2 %
during these periods of great indebtedness relative to other 7.7 % 8.4 %
0%
periods. As of end October, US debt to GDP was 102.9 %; H1/2011 H2/2011 H1/2012 H2/2012
UK’s was 82 %; Germany’s was 80 %; France’s was 86 %. So
financial repression spells bad news long-term for most As a huge risk As a considerable risk
As a minor risk Not as a risk
domestically oriented assets and investment strategies. In
the short-term, the major problem with financial repression
– of which quantitative easing has played a major role – is
that it subordinates market fundamentals to political
engineering.
8

9. Financial risks
The same downward trend is evident when investors were The equity-risk premium looks good, as a major Swiss
asked about the single biggest risk to meeting their multi-employer pension fund reminded us:
financial targets. Overall market volatility has always
occupied the top spot in RiskMonitor, but the number of “Fair to cheap valuation should prevent a sharp drop in
mentions has declined with each of the last three editions. equities. Such occurrence would allow us to buy cheaper.”
Before leaving this topic, it is worth reiterating one point
made earlier: overall market volatility might be a lessening In the face of financial repression, dividend-yielding stocks
fear in investors’ minds, but its impact is greater when have a further appeal of providing income more bountifully
accompanying sheepish markets trending sideways. One than government debt. At the end of October, dividend
more quote from a Dutch real estate investment manager yields on the MSCI Europe Index were 3.9 %. German
summarises well: 10-year bonds were yielding 1.43 %.
“Overall volatility will affect all markets and drives We explore further alternatives to government debt in
investors in cash or AAA sovereign bonds, which will hurt Chapter 2. For now let us imagine the imbalance worsens
most markets.” as interest rates fall further. This is a creeping fear among
European institutional investors. Just over 30 % classified
In order to achieve our financial investment targets for falling rates as a major risk in the previous report; by now
the next 12 months, I see a sharp drop in equity markets … the percentage has climbed to over 40. Fears are more
common and accentuated in Germany, Italy and
100 % 2.6 % 2.2 % 4.4 % 2.6 % Switzerland. One reason might be a different book value
90 % 15.9 % accounting of liabilities which in turn implies no interest
22.2 %
80 % 32.9 % 25.5 % rate sensitivity of liabilities. Hence, rising rates in this setup
imply losses.
70 %
60 % In order to achieve our financial investment targets for
50 % 61.6 % the next 12 months, I see falling interest rates …
61.4 %
54.7 %
40 %
54.8 % 100 %
30 % 17.0 %
90 % 23.1 % 22.9 %
20 %
80 %
10 % 20.3 %
15.3 %
9.7 %
13.7 % 70 %
0% 40.7 %
60 % 36.6 %
H1/2011 H2/2011 H1/2012 H2/2012
45.5 %
50 %
As a huge risk As a considerable risk
As a minor risk Not as a risk 40 %
30 % 28.1 %
28.8 %
In previous RiskMonitor surveys, investors have shown 20 % 20.9 %
widespread recognition of the riskiness of equities within
10 %
their total portfolios. This time is no exception as three- 14.1 %
10.4 % 11.8 %
quarters of respondents view a sharp drop in equities as a 0%
H2/2011 H1/2012 H2/2012
major risk to their twelve-month targets. For Germans,
Italians and the Swiss, this is a growing anxiety. For the As a huge risk As a considerable risk
Nordics and Dutch, worry is abating. One reason given for As a minor risk Not as a risk
the overall decline in anxiety is the relative attractiveness of
equities to its major competitor for investor capital: fixed
income.
9

10. Financial risks
We have briefly mentioned the threat perceived by falling A major Nordic wealth manager summed up this problem:
interest rates. When asked in a separate question of their
single biggest fear, this issue garnered more responses in “The short term impact of raising interest rates for
both Germany and the Netherlands than the second and companies with issued guarantees and no hedge will
third options put together. A French multi-employer impact on buffers and the Profit/Loss account more than
pension fund pointed out that falling rates were so many other factors.”
dangerous because they drove up the cost of insuring
liabilities. Several other respondents expressed concern at The Nordics are such well-regarded pioneers of interest and
their lack of full coverage of their liabilities in such an inflation hedges that it comes as a surprise to imagine there
uncertain environment for investing. are institutions lacking such protection. Moreover, the trend
among Nordic pension providers, notably in Sweden and
Yet institutional investors are a heterogeneous bunch. To Denmark, is to persuade their policyholders to forego
misquote Abraham Lincoln, you can’t please all the people guaranteed returns in favour of market returns with some
all the time. So while rising interest rates would evidently optional bonus or minimum return, e. g. 0 %.
take a weight off the minds of those respondents
registering red in the chart above, for a growing minority of But there is a further point underlying this quote: return-
German and Nordic pension providers rising rates present a seeking assets are not currently reliable enough to cover
real problem. increased guarantees. Most Nordic regulators scrutinise
inappropriate risk-taking and do not permit a lax mismatch
In order to achieve our financial investment targets for between liabilities and investments. So we must conclude
the next 12 months, I see rising interest rates … that times are hard and buffers slim even in this well-
organised region for retirement provision; there is little risk
100 % capital left. Finally, it is worth noting that the most worried
90 % 22.5 %
19.7 %
22.4 %
in this category, also for Germany, were mostly company-
80 %
sponsored or local authority schemes rather than insurers.
70 %
38.7 %
60 %
44.9 % 44.1 %
50 %
40 %
30 %
35.0 %
20 % 26.8 % 26.3 %
10 %
5.8 % 6.6 % 7.2 %
0%
H2/2011 H1/2012 H2/2012
As a huge risk As a considerable risk
As a minor risk Not as a risk
10

11. Financial risks
In order to achieve our financial investment targets for
A Sting in the tail
the next 12 months, I see tail risk …
The Financial Crisis taught all investors a lesson or two. We 100 % 4.4 % 2.2 % 3.3 %
are all now familiar with the concept of Black Swans. We 9.3 %
90 %
are all now sceptical of diversification – or to be more
precise, aware of its limitations. In every RiskMonitor, 80 % 33.1 %
43.3 %
33.1 %
diversification has always been the most common response 70 % 41.7 %
from investors as to how they deal with their biggest
60 %
financial risk. So we know that belief holds strong (Note in
the graph below that duration management has crept into 50 %
second place, and fixed income hedging is also on the rise. 40 % 45.6 % 48.3 %
Both answers fit with the concerns about current and 30 %
40.3 %
38.4 %
future interest rates discussed previously). But every
20 %
institution will also remember the frightening correlation
of almost all kinds of asset classes and strategies in 10 % 16.9 % 14.2 % 15.2 %
9.9 %
September 2008. 0%
H1/2011 H2/2011 H1/2012 H2/2012
How do you deal with your biggest financial risk? As a huge risk As a considerable risk
As a minor risk Not as a risk
Diversification 46.3 % (+6.4 %)*
Dynamic asset allocation 18.4 % (–2.7 %)
A Black Swan by nature comes as a surprise and this is well
Duration management 11.8 % (+1.6 %)
observed by the investment manager of a Dutch corporate
Equity hedging 6.6 % (+1.5 %) pension fund:
Fixed income hedging 6.6 % (+3.7 %)
“Some of the major risks [RiskMonitor categorises] are
Target risk portfolio 1.5 % (–2.7 %)
clearly linked, we can imagine a tail risk coming from
Other 8.8 % (+0.8 %) sharp equity markets declines, caused by a deepening of
the sovereign debt crisis.”
*compared to survey H1 / 2012
We are reminded why tail risk is such a worry – it may be a
terrible combination of damaging events that can be
Perhaps the ultimate lesson is that there are more powerful separated mentally in calculations but in reality appear
forces in the world than financial markets; this can be hard simultaneously. In the following chapter, we consider
to remember when you’re living in a bubble. That has not further which issues are nightmarish for Europe’s
been the case for a number of years and is evidenced by institutional investors; and which remedies are available.
the considerable attention respondents consistently give to
tail risk. It has been a huge risk over the past three
RiskMonitor surveys to more or less 15 % of respondents. It
has been a considerable risk to 45 % on average. Since the
summer of 2012, respondents in Germany, the Netherlands
and Switzerland have become particularly concerned –
almost one-quarter of German institutional investors now
hold tail risk as a huge threat to their twelve-month
financial targets. In Switzerland, the number has risen from
none in the first half of the year to one in five.
11

12. Financial risks
In order to achieve our financial investment targets for In order to achieve our financial investment targets for
the next 12 months, I see limited liquidity … the next 12 months, I see deflation …
100 % 100 %
11.7 % 14.7 % 12.3 % 15.3 % 16.7 %
90 % 90 %
31.3 % 32.4 %
80 % 80 %
70 % 70 %
43.8 % 45.5 %
45.6 %
60 % 60 % 53.3 %
59.3 %
50 % 50 %
46.5 %
50.0 %
40 % 40 %
30 % 32.8 % 30 %
35.1 %
36.0 %
20 % 20 % 25.5 %
18.8 % 22.0 %
10 % 10 % 16.9 %
11.7 %
3.5 % 3.7 % 7.1 % 5.8 % 2.0 %
0.7 %
0% 0%
H1/2011 H2/2011 H1/2012 H2/2012 H2/2011 H1/2012 H2/2012
As a huge risk As a considerable risk As a huge risk As a considerable risk
As a minor risk Not as a risk As a minor risk Not as a risk
In order to achieve our financial investment targets for In order to achieve our financial investment targets for
the next 12 months, I see counterparty risk … the next 12 months, I see change in exchange rates …
100 % 4.4 % 3.9 % 100 %
10.9 % 8.0 % 10.9 % 10.2 % 13.1 % 11.8 %
90 % 90 %
80 % 80 %
35.5 %
49.3 %
70 % 54.6 % 70 %
51.9 % 51.1 %
60 % 58.3 % 60 % 54.0 %
61.2 %
50 % 50 %
40 % 40 %
47.1 %
30 % 30 %
43.4 % 34.9 %
35.8 %
20 % 20 % 35.3 %
30.7 %
28.2 %
25.7 %
10 % 10 %
9.4 % 6.6 %
2.6 % 2.9 % 1.9 % 2.9 % 2.2 % 1.3 %
0% 0%
H1/2011 H2/2011 H1/2012 H2/2012 H1/2011 H2/2011 H1/2012 H2/2012
As a huge risk As a considerable risk As a huge risk As a considerable risk
As a minor risk Not as a risk As a minor risk Not as a risk
12

13. Financial repression
Financial repression government bonds to generate reliable and sufficient
yields. The overwhelming answer was corporate debt,
appealing to more than two-thirds of the universe of
This time it’s difficult respondents [in the chart on the next page percentages are
exclusive of each other as respondents could each give up
We began the preceding chapter by discussing the to three answers]. In France, corporate bonds attracted 85 %
re-evaluation or redefinition of safe havens. Fears on the of respondents. This did not stop one Paris-based insurer
creditworthiness of European member states may have warning of the dangers of a wholesale shift from govvies to
abated, but investors’ purchases of sovereign debt more credit:
and more appear like a donation to the region’s immediate
stability than a source of long-term returns for pension “The low level of safe haven bond yields is fuelling a credit
scheme members. Although RiskMonitor concentrates on a bubble. Not a risk in the short-term (and Solvency 2 will
12-month outlook, there is a sense in this edition that compress spreads further), but a significant one in the next
respondents are acknowledging the dawn of a much longer 6 to 12 months.”
period of financial repression. In fact, one-quarter of
respondents named this as the macro issue keeping them There is another consequence of the rising prices of
up at night, far more than the much discussed “fiscal cliff” corporate paper that is already manifesting itself as a
in the U.S. or a slowing of China’s growth. short-term risk. The companies that back occupational
pension schemes are required by international accounting
It should be quickly added, as the picture below illustrates, standards to measure those liabilities using the discount
that the eurozone debt crisis troubles more than twice as rate of a corporate bond swap curve. When the prices of
many respondents. But the two problems surely go the related corporate bonds rise and spreads decrease as
hand-in-hand. Investors may rightly fear that between an much as they have in 2012, then liabilities, on paper at
angry electorate and political sensitivities on the least, look bigger. Swaps can take care of such changes
international level, they may be a far easier target for but few institutions are that well-matched, not least
Treasuries seeking to creep out of indebtedness. because it sacrifices any opportunity to increase buffers.
Towers Watson calculates that corporate pension liabilities
The question then becomes which route to take away from for DAX 30 companies rose EUR 22 bn to EUR 281 bn in the
what once were safe havens but increasingly resemble first half of this year alone due to the rising price of
costly dead ends. We asked investors for substitutes for corporate and government debt.
Which macro topic keeps you awake at night?
54.6 %
25.0 % Eurozone
10.5 % Financial
5.9 % U.S. “fiscal cliff” repression debt crisis
Slowing of China’s
growth momentum
13

14. Financial repression
Where do you find a substitute for government bonds in order to generate reliable and sufficient yields?*
Traditional asset classes Alternatives
Corporate bonds 68.8 % Real estate 31.2 %
Emerging market bonds 37.0 % Infrastructure debt 13.6 %
Covered bonds 22.7 % Infrastructure equity 13.0 %
Emerging market equity 10.4 % Private equity 10.4 %
Developed market equity 9.7 % Hedge funds 5.8 %
Multi asset 7.8 % Commodities 5.8 %
0% 10 % 20 % 30 % 40 % 50 % 60 % 70 % 0% 10 % 20 % 30 % 40 % 50 % 60 % 70 %
* up to three answers possible
We began this edition of RiskMonitor by referring back to Respondents from the Nordic region exhibit perhaps the
the debate on ‘safe assets’ from the previous edition. We most adventurous nature: for one in six investors, both
continue that debate here by looking at substitutes for emerging markets equities and private equity were
government debt. The grim joke is that a risk-free return deemed reliable substitutes for government debt. Another
has become a return-free risk. And yet the asset class choice worth noting is the high interest from France in
sectors of highly-rated debt and publicly-quoted equities, infrastructure debt. This attracted twice as many responses
preferably denominated in a hard currency, have remained from France than the universe average of 14 %. From the
the traditional bedrock of investors’ portfolios, not least for UK, 24 % of respondents registered an interest, although
reasons of liquidity. To these strata, quality real estate can this comes as less of a surprise as the National Association
be added. of Pension Funds there has liaised with the government to
create a platform for infrastructure investment by UK
But this edition of RiskMonitor suggests that the tectonic pension plans.
plates are shifting. It says something about the state of the
world that more than one-third of investors feel emerging Real estate was third most popular as a category, but
market bonds are a reliable and sufficient substitute for second favourite among Swiss investors, attracting almost
G10 government debt. Emerging market countries now half the voters there. Finally, the fact that fewer than 10 % of
hold close to 70 % of global reserves, versus around 30 % in respondents ticked the box for developed market equity is
the mid-1990s. The average yield for Asian EM debt, for noteworthy. At the end of June, 80 % of dividend-paying
example, is higher than median G7 debt – the HSBC Asian shares in the S&P 500 were yielding more than Treasuries.
Local Bond Index registered a 6.1 % total return in US dollars But then, as with emerging market debt, Europe’s
for 2012 to the end of September. We must add institutional investors already seem happier putting their
immediately, however, that investors are not talking about money further afield: emerging market equities are more
entire substitution. As one German life insurer notes: popular than developed equity as reliable substitutes to
government bonds for yield generation. But as a concluding
“These choices are obviously not surrogates for govvie note of caution on the relative current attraction of
bonds – we invest in covered bonds more to compensate.” emerging market equities: current average dividend yields
in Asia of 3.1 % are lower than those in Europe.5
Nevertheless, the fact that 56 % of Dutch institutional
investors, 55 % of Austrian investors and almost 48 % of their
German peers feel comfortable using emerging market
debt for secure returns is remarkable. Perhaps it is no
coincidence that in both of the bigger countries, falling
interest rates are named as the biggest risks to financial
targets over the next twelve months.
5
Source: Datastream; MSCI Asia ex Japan, MSCI Europe as of
31 October 2012
14

15. Financial repression
Look East! for about 50 % of global output by 2050 and China will likely
have surpassed the U.S. as the world’s largest economic
The strong showing of both emerging market debt and power in 20206. In 2012, Asia holds more than 60 % of the
equity in the poll is explored further in this edition of world's currency reserves and its local currency bond
RiskMonitor. We surveyed European institutional investors’ market has more than doubled since 2005, now accounting
allocation and appetite for assets in Asia. Allocations and for 8 % of the global outstanding debt7. Thus, the majority of
exposures are not exclusive, i. e. respondents could vote for respondents are content to buy the Asian story.
more than one. Two-thirds of respondents have exposure
to Asian equities. Regionally by response, the Swiss top the One Dutch public-sector fund claimed:
league with 85 %, followed by the Nordics with 75 %. Almost
36 % of the entire universe of respondents has exposure to “Asian equity = Asian bonds + International corporate
Asian debt. Germany was notable here for its widespread equity in return, but with lower risk and better correlation.”
interest: nearly 48 % of respondents have exposure. The
Dutch came in second at 44 %. Not everyone, however, is happy looking East. Another asset
manager owned by a Dutch pension fund said:
Nearly one-third of the total universe acknowledged
indirect exposure via large corporates doing significant “Changes in the legal system are necessary to make this
business in the region. Only 15 % of respondents claim to region more popular. The risk-return profile is getting too
have no allocation to Asia directly or indirectly. From France, high; often this is visible via foreign currency movements.”
the percentage was almost 29; from Germany, the
percentage was almost 24. From the UK, on the other hand, It is worth noting that while almost three in five
fewer than 7 % of respondents claimed to have no respondents said they would invest more in Asia, the
exposure. reverse was true in the Netherlands where 58 % said they
would not. Only the Nordics were more hawkish, with
Looking to the future, almost three in five expect to raise almost 94 % declaring their allocation to Asia could only
their exposure. Given the strong fundamentals of the reduce from the present situation. Given the overall big
region, this may come as little surprise. In 2010, for appetite for investments in Asia across all of Europe, it is
example, Asian exports to the US were close to US$ 400 bn worth to look at what have been the peculiar obstacles thus
while imports from the US just US$ 158 bn. According to far to investing in the Far East.
estimates by the Asian Development Bank, Asia will account
Appetite for assets in Asia is strong – regardless of existing exposure to the region
58 % 36 % 66 %
Switzerland
UK
Nordics
Italy
Germany
France
Austria
Netherlands
100 % 80 % 60 % 40 % 20 % 0% 20 % 40 % 60 % 80 % 100 %
further investments in Asia planned exposure Asian bonds exposure to Asian equities
European average European average European average
6
Source: Datastream; Allianz Global Investors Capital Market Analysis
7
Source: Datastream as at March 2012; AsianBondsOnline
15

16. Financial repression
Fewer than one in twenty respondents have concerns but now Malaysia and Thailand rank in the world’s top
about the economic fundamentals in Asia. More than 28 %, 20 countries for doing business. This is according to the
on the other hand, bemoaned the lack of transparency and International Finance Corporation and the World Bank’s
difficulties in gathering information. The Dutch office of measure of government rules and regulations on business.9
one global investment consultancy tartly replied that
indirect investing in Asia was okay, but direct investing did One in five respondents said exposure to Asia was bound by
not work. Many commentators contrasted the quantity and investment limits. The answer was more than one in four in
quality of commercial information available with that in Germany, whence one investment adviser made a clear
Europe. plea to rethink such bounds:
“Market characteristics are not sufficiently developed for “We believe that the limits should be increased because of
the requirements of European standards,” said one Dutch the rising exposure of EM and because of the positive trend
real estate manager. for many of the EM currencies.”
The CIO of a UK Corporate Pension Fund added that Asia is It is worth remembering that over the past five years, many
“less well known to the investment team and the trustees. Asian currencies have appreciated against the euro, British
More time needs to be spent understanding the risks and pound and US dollar. The Malaysian Ringgit has increased
how different asset classes operate. And there is less more than 22 % against the euro, for example. More
transparency around these markets.” significantly, the appreciation is expected to continue.
Research by Allianz Global Investors suggests that major
Fundamental issues, such as the free float of quoted Asian currencies, with the exception of the Indonesian
companies, remain. The Philippines’ stock exchange, for Rupiah, will appreciate in the coming decade by an average
example, hopes to instigate a minimum 10 % free float by of 1 % annualised, with the Renminbi notably faster at 2.4 %
the end of 2012. On a sharper note, Transparency annualised10.
International’s Bribe Payer’s Index 2011 has just three Asian
countries in the top half of countries surveyed (one of While Malaysia, Cambodia, Korea, Singapore, Taiwan and
which was Japan) while six were in the bottom half, Vietnam were all specifically mentioned by respondents as
including China, where perceptions of corruption in the target destinations, the most popular countries were the
private sector are second only to Russia8. On the other hand, most populous. Of those that stated a preference, 17 % said
not just reliable centres such as Singapore and Hong Kong, India; 24 % said China.
What is the biggest obstacle for moving investments to Far East?
30 % 28.1 %
25 %
21.6 %
20 % 19.4 %
16.6 % Difficult
15 % Market information
characteristics gathering/
Limits set by
10 % (e.g. liquidity, transparency
7.9 % own investment
Risk considerations market depth,
guidelines
volatility)
5% 3.6 %
Regulatory hurdles
Weak fundamental
0%
outlook compared
with other regions
8
Bribe Payers Index 2011, Transparency International
9
“Doing Business 2013” IFC and World Bank
10
Allianz Global Investors “The Case for Emerging Market Currencies in the
Long Run”
16

17. Financial repression
It should be noted that another 24 % also made it clear that
they are looking for broad country diversification.
There is a similar story when looking at asset class. While
7 % of respondents stated infrastructure and just over 10 %
are looking to real estate – direct and indirect; there is more
of a mix when discussing the major asset classes. Hence,
equities attracted 55 % of respondents and bonds 41 %, but
in many cases the same institutions are looking for broad
exposure via both asset classes.
17

18. Regulatory and governance risks
Regulatory and regulators to maintain open minds on what constitutes safe
assets in order to avoid pro-cyclical regulation. Earlier this
governance risks year, a Rotterdam Court overturned the Dutch regulator’s
demand on an industry-wide pension fund to greatly
reduce its exposure to gold.
Both regulatory and governance risks generally are not on Interestingly, the Netherlands was third most worried
the rise for Europe’s institutional investors. Even stricter country about stricter regulation. A national reform
regulation, regularly the biggest risk in this category, has package introduced this autumn included a new discount
ticked down over the second half of 2012. rate, the Ultimate Forward Rate (UFR), for liabilities with
a duration of longer than 20 years. One Dutch fiduciary
In order to achieve our financial investment targets over manager, which labelled stricter regulation a huge risk,
the next 12 months, I see stricter regulation … disclosed that it had had to unwind some long-term
interest rate swaps for clients in response to UFR’s
100 % introduction. Although in Germany, 47.6 % of respondents
90 % 23.2 %
17.8 %
23.5 %
17.3 % classified stricter regulations as a considerable risk, no one
80 %
here deemed it to be huge.
70 %
In order to achieve our financial investment targets over
60 % 47.4 % 39.0 %
47.3 % the next 12 months, I see limited own risk management
50 %
47.7 %
capabilities...
40 % 100 %
30 % 90 % 21.1 %
25.5 %
30.0 % 30.4 %
31.6 % 28.0 %
20 % 23.2 %
31.1 % 80 %
10 % 70 %
5.8 % 5.9 % 7.3 %
3.7 %
0% 60 %
H1/2011 H2/2011 H1/2012 H2/2012
50 % 57.2 %
47.1 % 54.7 %
As a huge risk As a considerable risk 56.7 %
40 %
As a minor risk Not as a risk
30 %
Drilling down to country level, however, reveals some 20 %
interesting trends. Swiss and Nordic institutions seem more 10 %
20.3 % 17.5 % 20.4 %
12.7 %
preoccupied than other regions by stricter regulations. They 0.7 % 2.2 % 2.2 % 1.3 %
0%
represent a major risk to twelve-month financial targets H1/2011 H2/2011 H1/2012 H2/2012
for a significant minority in these two places – 42.8 % in
Switzerland and 40.3 % in the Nordic region. As a huge risk As a considerable risk
As a minor risk Not as a risk
The corporate pension fund of one Swiss multinational
made the following observation: We find differences again between the general and
country-level results on the topic of in-house capabilities
“'Stricter regulations' are fine as long as this also means to monitor and manage risk. In general, this risk has fallen
that responsibility is shifted over to the regulators.” slightly over one year, but gently risen over the past six
months, notwithstanding the higher efforts and resources
This sentiment will no doubt find sympathy in other institutional investors planned to commit to this area11.
countries where the regulators of pension providers are So, no strong change of directions; and indeed one in five
– by accident or design – taking much greater interest in respondents currently say their own risk management
institutions’ activities. James Dilworth, CEO of Allianz Global capabilities pose no threat at all to twelve-month financial
Investors Europe, made a plea in the previous edition for targets. On the country level, however, other trends
11
More than 54 % of the respondents said that in 2012, they planned to
spend more in order to deal with governance and regulatory risk than
in the previous year. Only 3% said they would spend less. Cf. RiskMonitor
“Rethinking Safety“.
18

19. Regulatory and governance risks
manifest themselves. In Germany, for example, the issue
Which of is your biggest governance and regulatory
is growing, albeit at a low level. When the opinions of
German institutions were first canvassed four editions ago, risk in the next 12 months?
46 % declared that in-house risk management was no cause
Stricter regulation 32.7 % (–5.1 %)*
for concern. To now, that percentage has dwindled to 14 %.
Having said this, German-based respondents are still not Limited own risk 25.3 % (+6.0 %)
management capabilities
greatly perturbed. The sense that internal processes must
Rising reporting requirements 17.3 % (+11.6 %)
be improved is strongest in neighbouring Switzerland,
where one-third of respondents reckon their own risk Organisational complexity 10.0 % (–3.3 %)
management capabilities pose a considerable risk.
Pressure from sponsor 8.0 % (–4.6 %)
In order to achieve our financial investment targets over Other 2.7 % (+0.5 %)
the next 12 months, I see rising reporting requirements …
Pressure from trustees 2.0 % (–3.2 %)
100 %
Heterogeneity of investment 2.0 % (–1.0 %)
90 % 24.3 %
set-ups cross-border
32.0 % 33.8 % 34.3 %
80 %
*compared to survey H1 / 2012
70 %
60 %
50 % 54.6 %
While stricter regulation remains the prime concern, it
47.7 %
51.1 %
44.5 % has lost as many votes as own-capability limits gained. But
40 %
the fastest riser has been rising reporting requirements,
30 % attracting nearly 12 % more respondents. Other issues such
20 % as organisational complexity and pressure from sponsors
18.3 % 19.0 % 17.8 % also make a significant showing.
10 % 15.1 %
2.0 % 2.2 % 3.3 %
0%
We have undertaken additional analysis of respondents’
H1/2011 H2/2011 H1/2012 H2/2012
remedies for dealing with these biggest risks. The most
As a huge risk As a considerable risk popular response is to improve in-house capabilities:
As a minor risk Not as a risk we find one-fifth of the respondents raising existing
comprehension of risk or recruiting new staff. A similar
Fears over rising reporting requirements are found share of respondents has or is updating their processes and
in similar places as fears over stricter regulation: The systems – this answer applies to the issue of organisational
Netherlands, Nordics and Switzerland are the only countries complexity, as much as limitations of capability and rising
or region where rising reporting requirements are deemed reporting requirements.
a huge risk (albeit by a small minority). In Italy, by contrast,
either regulators must be resting their pens or the country’s One Dutch pension fund said of organisational complexity:
pension providers are extremely well managed. Here,
rising reporting requirements represent a negligible risk “It concerns internal organisation and has directly nothing
to all respondents. The UK is almost as confident: 93 % of to do with the asset management. I cannot change
respondents registered similar sentiments. anything, so I observe, adapt and integrate the new
structures into my working environment.”
These first three issues score highest when we asked
respondents for their biggest single risk from regulation or Noteworthy is that both these remedies are more
governance. popular than increased outsourcing. The one exception
here regards fiduciary management. Nearly one in ten
respondents said that they had or would adopt fiduciary
management to cope with the twin burdens of regulation
and governance.
Two other kinds of activity are communicated by the rest
of the responses. The first is lobbying, notably in response
19

20. Regulatory and governance risks
to stricter regulations. More than one in ten respondents
said that they lobbied authorities to have their voice
heard. But the final action was even more popular and
especially relevant to pressure from sponsors and trustees:
communication.
“We share information with the sponsor and advisor and
have fruitful discussions in order to prevent the sponsor
feeling not in control,” said the asset manager of one Dutch
corporate pension fund.
A UK peer saw a more direct but equally valid reason for
communicating: “to manage expectations”.
But we conclude on a most relevant summary of how
pension fund management ought to be, from the
Norwegian subsidiary of a multinational giant:
“Reduced risk on investments, more complex risk
monitoring.”
There seems no more fitting way to end a survey of the
habits, fears and aspirations of Europe’s institutional
investors regarding risk.
20

21. Regulatory and governance risks
In order to achieve our financial investment targets for In order to achieve our financial investment targets for
the next 12 months, I see heterogeneity of cross-border the next 12 months, I see pressure from trustees …
set-up …
100 % 100 %
90 % 90 %
34.3 %
80 % 43.3 % 45.1 % 36.7 % 80 % 46.1 % 42.0 %
70 % 55.9 % 70 % 61.0 %
60 % 60 %
50 % 50 %
44.4 %
40 % 40 %
42.7 %
48.0 % 43.6 % 55.3 % 41.7 %
30 % 30 %
37.1 %
28.7 %
20 % 20 %
19.4 %
10 % 10.5 %
10 % 11.3 % 15.3 %
8.9 %
7.0 % 8.7 % 7.3 %
0.8 % 0.7 % 1.5 % 1.9 % 0.9 %
0% 0%
H1/2011 H2/2011 H1/2012 H2/2012 H1/2011 H2/2011 H1/2012 H2/2012
As a huge risk As a considerable risk As a huge risk As a considerable risk
As a minor risk Not as a risk As a minor risk Not as a risk
In order to achieve our financial investment targets for In order to achieve our financial investment targets for
the next 12 months, I see organisational complexity … the next 12 months, I see pressure from sponsor …
100 % 100 %
90 % 90 %
32.4 %
37.8 % 23 % 37.3 %
80 % 39.1 % 39.9 % 80 %
46.7 %
57.1 %
70 % 70 %
60 % 60 %
50 % 50 %
41.5 % 57,2 % 47.6 %
42.5 %
40 % 43.5 % 40 %
49.0 % 34.2 %
30 % 30 % 30.1 %
20 % 20 %
20.0 % 17,1 % 18.1 % 15.8 % 16.4 %
10 % 15.2 % 10 % 10.5 %
10.6 %
1.3 % 1.4 % 0.7 % 2,6 % 2.3 % 1.9 % 3.3 % 3.7 %
0% 0%
H1/2011 H2/2011 H1/2012 H2/2012 H1/2011 H2/2011 H1/2012 H2/2012
As a huge risk As a considerable risk As a huge risk As a considerable risk
As a minor risk Not as a risk As a minor risk Not as a risk
21