Back to basics
The pensions funding crisis has put asset allocation under sharper scrutiny than ever. If the fundamental investment mix is right, experts say, then many of the problems the schemes are facing will be resolved. But while there is general agreement that funds must diversify, the nature of the split between asset classes varies widely from one European country to another.
Asset allocation has come into the spotlight for many pension funds, according to Ken Willis, investment partner at consultancy Lane Clark & Peacock in London. It is the growing desire of trustees and sponsors to diversify their pension funds’ investment arrangements and lower the volatility of their funding positions, he says, that has focused attention on asset allocation.
“Typically pension funds are looking to increase the range of asset classes in which they invest,” he says.
“Whereas previously pensions investment was made up predominantly of equities and bonds with perhaps a modest allocation to property, increasingly, pension funds are reducing their allocation to these traditional assets in favour of alternative assets such as fund of hedge funds, private equity, infrastructure and active currency,” he says.
Despite differences between countries, increased diversification of investments will be a common theme in Europe, Willis predicts.
“Different European countries have different types of pension funds, differing regulation and differing approaches to funding,” he says.
These differences already lead to very different allocations, he says, ranging from the historically heavy reliance on equities in the UK and Ireland, to the well-diversified allocations in Switzerland - which are due to the ranges imposed by regulations - through to the significant allocations to bonds in France and the Netherlands, which are also driven by legislation.
“It is likely, however, that the increase in focus on risk and in available products from investment managers - due to Ucits III - will lead to greater diversification in other countries in Europe,” he says.
Asset allocation data collected by the European Federation for Retirement Provision shows that between 2004 and 2005, pension funds have made little change to the way they divide their money between different asset classes.
“This means that the pension funds and asset managers are strictly following the investment strategy that they approved or implemented,” says Jos Verlinden, director of Belgian consultancy M&P Consult. However, he questions whether this is a good strategy, since, in a rising market equities are sold and replaced with fixed income, and a falling market leads to extra purchases in order to keep to the agreed asset allocation.
“What is certainly a trend is that pension funds are looking for less volatility,” he says. To this end, they have increased their investments in real estate - direct or indirect - and are also considering derivatives, he says. Increasingly, supervisory authorities in Europe accept pension fund use of derivatives, particularly where the aim is to protect the portfolio, says Verlinden.
However only the larger pension funds or companies are likely to use derivatives, he says, where the fund has one or more full-time manager. Other pension funds which are managed by finance managers on a part-time basis are less likely to include the instruments in their strategy, he says.
In Switzerland and Germany, at least, says Pictet Asset Management’s Udo von Werne, there is far more talk that action over the perceived benefits of diversifying into alternative asset classes. Von Werne is head of business development for continental Europe, including Switzerland, but excluding the UK and Scandinavia.
“There’s a lot of talk about it, and particularly about hedge funds and private equity, but very little has been allocated,” he says. The levels of new pension fund investment once expected in these asset classes has never really materialised, he says.
Derick Bader of Pictet Asset Management, who is responsible for institutional marketing in France and French-speaking countries, says that though most pension funds do seem to have marginal exposure to alternatives, it is not sizeable.
At this point, the reason for having these holdings seems to be to more about helping the funds learn about alternatives rather than actually spreading their portfolio risk, he says. Real estate holdings, however, are more substantial and this asset class is much more fundamental to pension fund asset allocation, though holdings are still largely domestic, says von Werne.
But Paul Bourdon, head of the European Pensions Solutions Group at Credit Suisse, says pension funds in the Netherlands and Scandinavia have been diversifying into private equity, hedge funds and commodities for a while now. “It is definitely there now,” he says.
“There’s a lot more visibility in the marketplace in terms of pension funds actually doing this,” he says. In its fundamental review of investment strategy last years, the London Pension Fund Authority, led by Chief Executive Peter Scales, included active currency management, and two new £190m (€283m) ‘target return’ mandates, partly to provide a counterweight to its more traditional equity mandates.
And, says Bourdon, Hermes Pensions Management which manages the BT pension fund, has said it is increasing its allocation to hedge funds.
But Willis says that even though the risk/return arguments of diversifying a portfolio are clear, some recent high profile hedge fund losses have made trustees a bit hesitant to go for alternative asset classes instead of the traditional classes.
Overall, pension funds in Europe have not changed the way they allocate assets in any dramatic way over the last few years, says von Werne. “Core-satellite is still dominant,” he says. Consultants are urging pension fund clients to do more risk budgeting and take more active risk,
Pension funds in French-speaking regions of Europe are taking their asset allocation in the same direction as the German-speaking regions, says Bader; they are including far more indexed products in their portfolios.
SRI is also becoming a more widely accepted style of investment strategy, says von Werne.
“We still strongly advise a really diversified asset allocation, which has to be stress-tested,” says Andrea Canavesio of consultancy MangustaRisk in Rome, “but each sub-class has to be diversified as well”, he says. Though a lot has been said about diversifying between the asset classes, many funds do not diversify within the classes sufficiently, he says, and many have a real home bias.
There are signs that some pension funds are starting to examine asset allocation more frequently than they traditionally have. But rather than wanting to change asset allocation more frequently, pension funds are looking at ways of making more tactical changes, says Canavesio.
Because the basis of setting up a strategy is to make sure that there is consistency in approach over the longer-term horizon, says Verlinden, a strategic asset allocation will definitely be decided upon for a longer period. This will be for between three and five years.
“There may be intermediate tactical deviations, depending on the market circumstances, but a strategic allocation, which will be decided upon after long reflection process will not be amended overnight,” he says.
However, Bourdon says there is now a lot more depth required in strategic asset allocation reviews. Pension funds are likely to start looking at their strategic asset allocation more often in future, he predicts, whether or not they actually change it.
Strategic asset allocation is the key for pension funds, says Bourdon. “People are focusing more on the factors that affect the returns,” he says; if they get asset allocation right, then some of the other issues they are grappling with will fall into place. In its recent pension fund asset allocation survey, Mercer Investment Consulting forecast that among UK pension funds, there would be significant further increase in the use of alternatives, especially hedge funds, active currency management and tactical asset allocation, with less growth in private equity.
One in 10 funds, it predicted, would consider introducing some form of liability benchmarked strategy; this would be split equally between those funds implementing a passively managed swap strategy - either an overlay strategy or to replace traditional bond mandates - and those putting actively managed liability benchmarked strategies (‘LDI plus’).
In continental Europe and Ireland, Mercer said investment in hedge funds, active currency management and TAA were all likely to expected to increase significantly in the next year.
National Pensions Reserve Fund
In its initial investment strategy in 2001, Ireland’s National Pensions Reserve Fund had a simple 80% allocation to equities and a 20% allocation to bonds.
But after looking at prospective new asset classes more recently - with a view to diversifying the fund’s investment base - it decided to allocate 18% to alternative asset classes - property, private equity and commodities.
“We also decided to increase the fund’s small cap equity allocation from 2% to 4% and to make a 2% allocation to emerging markets equities,” says the National Treasury Management Agency’s John Corrigan, director of the National Pensions Reserve Fund Unit.
Target strategic asset allocation for the €17.6bn NPRF for the end of 2009 now stands at 69% quoted equity, 18% alternatives and 13% financial assets (bonds).
“Transition from a portfolio fully invested in quoted assets to a more diversified portfolio including substantially less liquid assets, such as property and private equity, will take time,” says Corrigan. This is why the fund plans to reach its target allocations in phases by the end of 2009.
The review was aimed at improving long-term returns without substantially altering the risk profile. Corrigan points out that the fund has no drawdowns until 2025, and receives an annual contribution from the Irish government equivalent to 1% of GNP, which is €1,446m in 2006.
“The fund’s long-term investment horizon and its strong cash flow mean it is ideally positioned to exploit the additional return and diversification benefits available from holding less liquid assets such as private equity and property,” he says.
Implementation is the biggest challenge within the asset allocation strategy, he says. The targets for property and private equity are likely to involve around €2bn in each asset class by the end of 2009. “Building up high quality diversified portfolios of this size requires considerable investment in terms of management time and resources,” he says.
Though at the beginning, the NTMA used an external consultant to help with the NPRF’s asset allocation, it has now built up its own internal team, and can carry out the work itself.
“We use an asset allocation model with independent inputs from a number of market sources,” says Corrigan. “We also look at the allocations of a number of international peer funds to sanity check the model’s results.”
The strategic asset allocation of the €2.3bn Norsk Hydro corporate pension fund is reviewed annually, says finance director Runar Gulhaugen. This 12-month gap between reviews is fixed, but the fund does make some tactical adjustments to asset allocation in between the yearly reviews, he says.
Though there have been no real changes in the way the pension fund does decides on asset allocation, there is more to take into consideration than there was before. “We include more factors,” says Gulhaugen, “and the regulations change all the time.”
“We try to look at it from different angles, and do more analysis,” he says. “We have alternative investments and we try to spread our active portfolio over more and more asset classes… but we try to keep the broader asset classes,” he says. Currently, the fund has 35% of its portfolio in equities, between 6 and 7% in alternatives, 20% in real estate and the remainder in fixed income investments.
“We have tried to take that into account all the time; we have seen the regulations changing and we take that into account, but we haven’t really changed our view (over the last seven years),” says Gulhaugen.
At Sweden’s third buffer fund, the SEK196bn (€21.6bn) Tredje AP-fonden, AP3, the mix between real estate, equity and fixed income has been relatively unchanged over the last four years, says spokeswoman Christina Kusoffsky Hillesöy.
But within this overall framework, there have been some alterations. The proportion between regions and segments within equities has changed, as has the proportion between nominal fixed income and index-linked bonds as well as durations, she says.
Within equities, the allocation has swung geographically towards Asia and away from Europe. Within bonds, allocations to European index-linked bonds and Asian nominal bonds have increased at the expense of Swedish nominal bonds, according to information from AP3.
At the end of June, AP3’s portfolio was split 54.5% equity, 43% fixed income and 2.1% real estate and forestry land. Striving to achieve high returns in what is a low-yield environment is the main challenge of asset allocation for the fund, says Kusoffsky Hillesöy.
The buffer fund carries out a thorough analysis of the strategic portfolio every year, she says. “However the strategic portfolio is analysed on a regular basis,” she adds.