The story of the British Coal Staff Superannuation Scheme (BCSSS) is part of the story of the UK’s nationalised coal mining. The fund was created in 1947 as the industry came into public ownership to look after the staff including senior underground personnel, and became a closed fund in 1994, as the remaining pits themselves were sold off after nearly 50 years of public ownership.
“At the time of privatisation of coal, the scheme had 100,000 members and assets that peaked in 2000 at £13.4bn (E19.6bn),” says David Morgan, chief executive of the Sheffield-based Coal Pension Trustees Services, which manages this fund and the Mineworkers’ Pension Scheme.
Ten years on the BCSSS still is formidably sized with assets of around £10bn currently and 68,000 pensioners and further 25,000 with deferred pensions. “There are no active members, so it is a very mature scheme indeed,” he points out. “The fund will reduce from hereon in, unless there are very pleasant surprises on the investment side.”
The fund has no sponsoring employer to support it, not even in a formal sense with the scheduled demise of British Coal as a legal entity later this month. “But in the event of a shortfall, the government guarantees the scheme.”
That guarantee puts a very different complexion on the amount of risk the trustees are able to take. “It means we can have an asset allocation that invests very heavily in equities.” The strategic allocation is 70% equity, 10% real estate, 5% private equity, with just 15% in bonds. “Such a level of bonds would be unthinkable without this support,” he says.
“Our approach to asset allocation is discussed openly with government on a regular basis. So that the guarantor – the plan sponsor in effect – agrees with this. The government appoints half the trustee board, one of these being a Department of Trade & Industry official. But he is scrupulous to ensure he behaves like a trustee.”
A different approach is taken on the fund’s investment sub-committee, where a DTI representative is present, though not as an actual member, but with the role of speaking for the guarantor. “Part of his role is to get agreement not just from the DTI, but from the other areas of government interested in the scheme, such as the Treasury,” Morgan points out.
The biggest portion of the fund is the guaranteed section, which has to meet the benefits built up before privatisation in 1994, plus price inflation since then. “While the government protects these, they did not do so without exacting a price for it.”
The price that was set in 1994, and the deal the trustees at the time accepted after negotiation was that half of any surplus would accrue for the government. “This was a leap of faith in 1994.” But as it turned out with the favourable returns a substantial guarantor’s fund was built up on the basis of the surplus, which is to be paid to the government over a 10-year period. “With three good valuation results behind us, the payments from the guarantors’ fund have been running at £216m per annum.”
Inevitably, there has been discussion that this was too high a price to pay, with even some mounting a court action, since withdrawn. Morgan takes a robust view of the choice: “In 1994, the choice was simple, either we ran without a guarantor in which case we would have had a bond-based strategy or we took the guarantee and invested in equities with their expected outperformance, which did indeed materialise in the 1990s.”
Another sub-fund in the scheme is the investment reserve, which comprises British Coal’s pre-privatisation surpluses that it had not used by 1994. “These will eventually be paid to the DTI, in the meantime they represent a very useful buffer for poor market conditions. In particular, this will be very much needed in the valuation being undertaken at the moment, which is expected to reveal a deficit.”
Morgan adds: “Overall, I think members recognise that the decision to take the guarantee was the right one, as was the consequent allocation strategy. But without the guarantee we would never have generated the surpluses which are benefiting the government to the tune of £216m plus a year – with an equal value gain for members, paid over a longer period.”
In view of all of the discussions to the proposed insurance protection fund, he stresses that this payment is in no way a ‘risk price’, it is just a formula applied to whatever the surplus happens to be.
“Of course, if the fund is in deficit, as is expected, there will be no payments into the guarantee fund, so in one sense, the guarantee then becomes free,” he adds. Other consequences of having a government guarantee is that the fund is free of the minimum funding requirements and other investment requirements. “But that does not mean we are not scrutinised. We are put through comparable hoops by the trustees and by the Government Actuary,” he says. The scheme’s trustees are made up of four independent members appointed by the DTI and four elected pensioner representatives.
“The key thing about the guarantee is that members are certain to receive their benefits and because of the good investment returns, we have been able to provide 20% more by way of additional pension.” Whether these can be maintained at current levels, Morgan says, depends on the current valuation being undertaken. He warns that it may not be possible to maintain this additional pension at its current level. If so, there would not be a monetary adjustment. “The guarantee provides that any change is made over time by allowing inflation to reduce the value of the benefits, so the current level of pensions would stay static in money terms.”
On the investment front the fund has had some exciting times last year in changing the manager structure. “Before privatisation, the scheme’s assets were managed by an in-house investment manager and as a subsidiary of British Coal it was sold off in 1996. “Goldman Sachs bought the right to manage 80% the assets for six years,” he points out. Despite Goldman’s good performance over the period, the trustees decided on a more diversified manager structure. This was achieved using Watson Wyatt’s core satellite concept. “This reduced the overall risk expected in the portfolio and increased the expected return; it also reduced the single manager event risk, with the range of new managers.”
Everything else was left virtually unchanged, including the strategic asset allocation. “We will be undertaking a new allocation strategy, using not just the existing ALM tools, but also looking at more modern techniques and taking due account of cashflow matching.” But at the end of the day, Morgan acknowledges that it is the government’s guarantee that will be the biggest determinant of the eventual strategy.
With a fund of this size, Morgan emphasises the need to pay attention to the detail as well as the headlines. “So we have focused on our transaction costs, for example.” While the trustees spend significant time on structure and running of the fund, they have also delegated some aspects of monitoring to Coal PensionTrustees. “We are responsible for supervising the stocklending programme, the commission recapture programme, working with managers on transaction costs, as well as corporate governance. And we report annually on what has been achieved.” He adds that the commission recapture was well worth undertaking – “it is the only area where I have found that the streets of London were paved with gold! It’s all part of making the scheme’s assets work that bit harder.”
With the adoption of the core satellite structure, a new investment risk committee was established. “This meets monthly and monitors the amount of risk being taken by the managers and their style footprint to ensure they are delivering the type of investment process expected by the scheme.”
Using the Barra analysis and the style footprint, he feels some questions do need to be asked of managers, even after a short time. “It lets them know we are watching them closely. But it does ensure they are taking the appropriate amount of risk – not too high and perhaps more importantly not too low.”
The managers are each set a performance target over a rolling three year period and a risk level measured historically over a rolling three years as the actual standard deviation of the returns. “Managers are skilled at using predicted tracking error in markets with variable volatility and we watch this as a guide to where the historical tracking error is likely to lie.” The new structure was created using the fund’s investment consultants Watson Wyatt’s Sigma alpha modeling techniques, firstly creating a hypothetical structure that then had to be populated with the managers. “Here we worked again with the consultants to create short lists of managers. The decisions were informed by a balanced scorecard and the views from Watsons.” Past performance was a relatively minor factor - almost like a “hygiene factor” in the final decision, he adds. There were between two and four short listed managers for each category.
BGI won a passive mandate amounting to 33% of total portfolio, mostly equities but including a passive bond mandate. The fund retained its 10% SAA to real estate and 5% to private equity. In the reshuffle, one fund manager was dropped, Edinburgh Fund Managers.
All the equity mandates were awarded on global benchmarks, some on a global cap basis and some on customised regional weights, he points out, except for one UK medium and small cap mandate. “There were three low risk core equity mandates, two going to Goldman Sachs on a fundamental research and a quant basis, and one to BGI on a quant basis. Goldmans also kept a fixed interest low risk mandate.” Four satellite managers were appointed with higher levels of targeted risk, Schroders remaining as small and medium cap UK equities managers with an increased allocation to 4%, with new mandates at 6% each going to Nordea AM for global growth, Alliance Bernstein for global value and at 2.8% to First State for emerging markets. “Then separately, we allocated £36m to the Hermes European Focus Fund and £50m to their UK Focus Fund, principally in the cause of good governance.”
Specialist transition managers were used to put the structure in place, whose performance was measured on an implementation shortfall basis, but details of the managers are not disclosed. The global custodian used is JP Morgan Investor Services.
The strategic asset allocation was given a slight tilt with UK proportion being slightly reduced and overseas increased. “The scheme has a 65% currency hedge and that has certainly helped cash flow this year.” No active currency or tactical asset allocation overlay programmes are in place currently, as the former overlays run by Goldmans have been discontinued under the new structure. “But our global mandates allow managers to take some tactical views of the markets.”
With the equity prices below their peak and strong property performance, real estate is running at 13% of assets, above the strategic 10% weighting. The portfolio is managed by LaSalle IM. “In the main this is in UK directly held properties, with some involvement in indirect pools in Europe,” he says. The fund has been a private equity investor since the 1970s, he points out. The portfolio has become almost entirely large cap as the related private equity firm CINVen invests in large buy-outs. “Our aim is to diversify from this and include some early stage venture capital, in the US and Europe as well as UK. This means using managers in addition to CINVen, which still remains our largest private equity manager.”
The private equity portfolio should return at least 5% pa over that obtained from large caps and over the years the class has earned its keep. “PE is not as illiquid as people imagine. You may not be ale to sell it easily but, in reality, the bulk of money takes three years to invest and most of the draw down is over by six or seven years. So it’s much shorter than the 10 or 12 years of a private equity limited partnership.”
Hedge funds just have not made it to the action agenda yet because of the pressures of other aspects. “But there is no implicit reason why our trustees cannot ever invest in some types of hedge funds.”
As with many things in pensions fund investment, Morgan adds: “You can never say never!”