There was a time when British university lecturers carried around bundles of individual life assurance policies accumulated throughout their careers as part of their retirement arrangements. By the mid-1970s, the folly of this approach had become apparent, leading to the establishment of the Universities Superannuation Scheme. It is now the third largest fund in the country with assets of £19bn (e30bn).
“This started to be run actively and internally from 1981 onwards, as prior to that it had all been externally managed,” explains Peter Moon, the fund’s chief investment officer. Though small initially, with the transfer in of assets from life policies, it had a very strong cash flow of £500m annually. This persists today and is a major determinant of its approach to investment. “We took the policies as transfers for prior service and we still have some £200m in policies with the Equitable Life, for example.”
Internal management of the fund continued until 1992, when it was decided to put a proportion with outside managers: 25% into an index fund and 25-30% actively managed. “Our structure at the moment is still pretty similar, with 25% still managed externally and 25% still in an index fund we now run internally, and the rest actively managed in-house.” In addition, there is a £1.6bn property portfolio.
“We are a pretty immature fund really, with a positive cash flow expected for the next 40 years. Currently this is £800m each year and growing,” says Moon. Of the 180,000 members, of whom over 90,000 or so are active members, 34,000 are pensioners and 46,000 are deferreds. “Active members are growing at over 5% per annum, but our pensioner numbers are now growing at a slightly faster rate.” The original focus on academic staff has been broadened, and now it takes in other university staff and affiliated bodies, including for example research units, where these are university-related. “The addition of the new universities should increase membership significantly over time.” The fund reckons it has about 75% of university lecturers and looks after nearly 300 institutions’ schemes. “We are an industry-wide scheme for the sector, with a uniform structure on the benefits side. It provides half of final salary after 40 years’ service.” The benefit level is under discussion, but much will depend on the outcome of the actuarial valuation later this year and what employers and employees are prepared to do.
The fund is run by a board, which is the equivalent of trustees, made up of representatives of universities. “We probably have the brightest trustee board going,” says Moon, adding that this does not mean that they always get everything right. The board of directors is the trustee board and the investment committee is one of a number reporting to it - advised by an external investment consultant William M Mercer. “Every five years, we have a full review, where we start with a blank sheet of paper. The reasons for the external management, as compared with internal, were that the trustees did not want all their eggs in one basket and that it would add diversification.”
The fund has not yet felt the need to undertake any asset liability modelling because of its cash flow position. “There did not seem to be any circumstances where we would be forced sellers of any asset class. So from that point of view, we have the freedom to determine what we would like to invest in. We believe that equities will be better-performing over the longer term, and we feel that equities best meet the liabilities of the fund,” he says, adding: “That may sound a bit old-fashioned now.”
The fund has always had an equity bias, but this was “institutionalised” three years ago. “We separated the index fund which used to be incorporated in the asset profiles and asset allocations of both the internal and external managers, when they had a ‘notional’ proportion of that fund allocated to them. This is now entirely invested in UK equities.” So combined with the four balanced managers - the internal team, Schroders, Capital International and Baillie Gifford – the total portfolio has an automatic equity tilt, of some 12% in UK equities, over and above what an average WM50 fund would have. The index portfolio is run with the help of HSBC.
The major structural changes undertaken in 1992 originally decided on a balanced manager structure. This was reviewed again in 1998, when there was a long discussion about going specialist. “But as the performance was substantially above average and despite all the pitfalls of the balanced structure, the trustees decided they would continue to run with it.” However, manager PDFM was then dropped in favour of Capital International.
In 1998, the fund took another move that many would consider reactionary, away from an index benchmark (though combined with peer group). “Some of the managers were uncomfortable with this and moved on to a straight peer group benchmark to beat the fortieth percentile of the WM50 benchmark over a rolling five-year period.” On the property side a customised benchmark is used based on the 100 top portfolios of the IPD database, which is to be beaten by 0.5% pa over a rolling five-year period.
“We are comfortable with the WM peer benchmark, but we are aware that it is a shifting benchmark, as we can see retrospectively, and the components are changing all the time. We are in fact quite different from the average fund in the 50,” says Moon. “But we have told our managers that we do not expect them to try and replicate the benchmark. Their remit is to beat the benchmark – it is there as a measure, but not something we want them to be close to!”
Moon is adamant that there are no brownie points for managers hugging the benchmark. “If there was a benchmark that said ‘Do as well as you can’, that is the one I would like to adopt.” He agrees that this is approaching an absolute return focus, but adds: “We all are driven by benchmarks and I know we cannot adopt that with markets moving relatively. What we are saying is that it is a benchmark, it is a line in the sand, we want you to go out and choose the best asset classes available. Volatility does not worry us particularly, provided over the five-year period you add the return. We are much happier with that than low volatility and lower returns. It is the freedom that our cash flow gives us.”
Currently, the actively managed portfolios in UK equity exposure range between 47 and 49% for the four managers, about the same as for the average fund in the WM50 universe. But including the index portfolio drives the UK equity content to 63%, giving a tilt or a skew to the portfolio. Apart from overseas equities at 23%, which matches WM, most other asset breakdowns are well below, UK bonds are 3% (14%), index-linked 2% (10%), cash 3% (4%), but overseas bonds in the fund are 6% compared with 3% for WM average.
Moon agrees that having over 80% in equities would seem extreme to some, but as he is there not to match but meet liabilities, and to provide an excess return as well, the strategy should work over time.
The internal and external managers all have the same benchmark and the performance information is shared among them. “To have everyone know how the other is doing is part of the system.” In practice, different managers perform better than others for a period and then come off the boil. “And we do get very different approaches by the managers. No matter how much we say don’t hug the benchmark, some of them are concerned about it and the retrospective nature of a peer group benchmark.” Two could be described as cautious and two as adventurous in terms of their interpretation of the benchmark, he adds. “Over a 10-year period, all of the three managers have shown quite similar performance. For the external managers asset allocation tends to converge but, over the shorter term, performance diverges.”
But, generally, he says: “We do not see much change in style of managers over time. They are either value- or growth-oriented and can’t change their spots that easily.”
He would like to see a situation where the managers would, say, invest in areas where they expect to do well, even if other managers are not doing so. “Yes, there is a commercial risk, that you would end up away from the benchmark, but we want that to be a long way in the background. They do find it difficult to perform against such a benchmark.”
The internal team tends to be more equity-oriented than the externals – at present, it has 50% UK equities, 36% overseas equities, 10% overseas and no domestic bonds and 4% cash. “We are growth-focused, but the aim is to find assets that will outperform the average long term – through dividend and capital growth, which is why we are equity– and overseas-focused.”
There are asset allocation parameters for the team, set every six months with a two-year horizon, but the group has monthly meetings where tactical shifts are examined. “We are stockpickers at that level - but it is hard to separate companies from their economic environment.” There was a time when stock selection was contributing steadily to performance while asset allocation has been less positive. “Allocation was then highly positive to 1999, but has slipped into negative territory since then and will probably be neutral for 2001.”
“We do have difficulties measuring risk in a fund of this type - we are not paying risk-adjusted pensions and we need the returns to pay them.”
Overall performance has been positive, though in the past couple of years it has suffered from the heavy equity tilt. “We believe that that is a price worth paying for the long-term outperformance we expect from equities. In fact, we have become more bullish about equities and have started to put more money in during the second and third quarters of 2001. But we see the current scenario as being good for both bonds and equities.” But the fund is not looking for anything spectacular by way of equity returns, perhaps between 5% and 10% – about 5% above inflation.
The fund is to the forefront in terms of socially responsible and sustainable investment (SRSI) and engagement. “We put an adviser on the payroll in August 2000 and have boosted the team since to three to look at the social aspects, the environmental aspects and corporate governance aspects.” The aim is to promote an engagement process on sustainable investment.
Moon says that the fund did look at a screening methodology, but could not see how it would be implemented. “We could not see how it would work, it would definitely reduce the ability of the fund to perform its fiduciary responsibilities. This is why we have not got involved in this regard. Engagement is the way forward for us, even if it is more expensive to implement than screening.
“So we are talking to companies, trying to encourage them to take the right approach, because we genuinely believe the company that is well governed and does ‘the right thing’ will do better over the longer term. So there will be some reflection given in the valuation of the company due to that. We are taking it very seriously, by actually devoting resources to it, but we have only to get a number of investment decisions right and it will have paid for itself. It is money well spent.”
He reckons that the level of resources already allocated is going to be very beneficial to the portfolio. “We also know we will never be able to devote enough resources to it, so alliances with other funds and other groups are important.” The external managers, which USS has been talking to about the approach, are listening and taking it on board. “Some are more enthusiastic than others, but they are all now aware of the role SRSI will play. We like to think that the resources we have in place will make a difference.” But Moon warns that, with a payback period that could be 10 years or more, there are no guarantees of the outcome.

The property portfolio accounts for nearly 10% of the fund’s assets and has to earn its keep, Moon maintains. “We are looking for an equity-type return. In the past five years this has done quite nicely, but longer term has not been so good. So the fund has tended to be underweight in property, though now we are overweight.”
The outlook, he reckons, is much the same as for equities for the next few years. “Over the past few years, it has been a most useful counter-cyclical investment, which is why we are overweight, but that will decline over time.” The portfolio of properties is entirely in the UK now, as in the past any ventures overseas were not rewarded by the returns expected. “Our view is that intensive management of the portfolio is the way forward. That is very difficult to do overseas.” The fund is using special purpose vehicles where possible to maximise the opportunities, he adds. A three-person team handles all the property investment, with the management run through Jones Lang, which also acts as surveyor and produces investment proposals - “though we are open to proposals from any source”. The portfolio is made up of a number of “cornerstone properties” on a core-holding basis. Others are held and worked on with a view to selling them on.

On the alternatives side, Moon says that they have looked at private equity, commodities and hedge funds. “These are being kept under constant review, but as yet we have not invested in these areas. Private equity would fit in with our philosophy quite well, but we have not been convinced that we would get the returns we want. Also, we have been unimpressed by the charging structure in PE,” he says. “There is an enormous amount of money out there chasing not a huge amount of investment opportunities. Time is on our side and we keep looking. At some point, I am convinced we will get involved.”
Hedge funds pose a problem for USS on the transparency side and research is now showing that these funds don’t perform any better than more standard investments, he says. “But, again, we keep it under review, but they are not of interest on the grounds of diversification, so it’s a question of returns.”
Securities lending is undertaken through the fund’s two global custodians, JP Morgan and Deutsche Bank. “It adds some income, but we cannot allow it interfere with the investment process here. It has to be seamless, so that the fund mangers here do not even realise we are doing it - that’s most important, even if it is more expensive to ensure this.” It is a tidy earner rather than a substantial revenue flow, providing some millions in revenue to the fund in any year. “But we certainly would not do it if we thought the risks were significant!”
Currency overlay is another area that Moon regards as interesting, but not yet adopted. “We do trade currencies forward and look to ensure that the currency weightings in the portfolio reflect our preferences on currencies. But we end up doing some lumpy deals from time to time, as our views change.” Derivatives are also used, not for speculative purposes, but for “efficient running of the portfolio”, such as asset allocation shifts.
The Myners review, with its new best practice code for UK pension funds, will have an impact, Moon acknowledges. The fund’s benchmarks will be reviewed, the fund will check that the levels of expertise of trustees and others are appropriate, and the minimum funding requirement changes are likely to have some impact once it is known what these are. “My feeling is that the government will become more interventionist - Myners is voluntary so long as you do what it says! There is pressure to invest in private equity. SRSI is another such area.”
“Pension funds need to be aware that the wind direction is changing a bit,” he warns. For his colleagues in corporately sponsored schemes he points to FRS17. “It puts an extra degree of responsibility on trustees, where the corporate sponsor says we cannot have a particular asset allocation because of its impact on corporate profitability. This puts the trustees in an invidious position if they believe the allocation is better for the members. It adds another pressure to move to defined contribution. It does mean that trustees have to stand up to corporate boards if that is the right thing to do. They are then in an extremely difficult position if they are managers and workers of that company.”