The new importance of bond yields for UK schemes' solvency underlines the re-thinking of liability-driven investing, bond mandates and the need for tactical decision making, finds Martin Steward
As AA corporate yields fall to civilized levels again while asset portfolios continue to creak under the rubble of last year's equity market crash, UK pension scheme deficits yawn ever wider. The FTSE100's deficit went from £25bn to £70bn between January and July this year, while the Pension Protection Fund's index of 7,400 UK defined benefit schemes reported a slump from a £13bn surplus in June 2008 to a £200bn deficit.
That is a shock for an industry that has supposedly spent the last 10 years ‘de-risking'. The fact is that even many of the larger and more sophisticated schemes really only tinkered at the margins, loathe to bear the potential opportunity cost of seriously trimming 50-60% equities exposure. Then there is the long tail of smaller schemes that have been 70% (or more) in equities for a generation, for no better reason than that it is what they have always done. It's looking a bit late to de-risk in earnest now: the holes are so big that taking huge punts seems like the only way to get back to full funding - if there was any way your sponsor would allow you to do such a thing - and the idea of selling risk assets in their troughs is not appealing. De-risking is either dead, or severely disrupted.
"The credit crunch has finally forced people seriously to ask: ‘What is the right investment strategy for a final salary pension scheme?'" says Robert Gardner of pension risk consultant Redington Partners. "‘And is there actually a tension between the idea of de-risking and the ultimate goal?'"
The vanguard has for some years been attempting to square the circle with swaps-based liability-driven investing (LDI). Immunise inflation and interest rate risk synthetically and you only have to fund collateral movements - freeing up most of your assets for better-diversified, risk-adjusted deficit-zapping. "LDI has delivered," argues Michael O' Brien, head of distribution EMEA with Barclays Global Investors (BGI). "If you look at the dispersion of returns across pension funds over the last couple of years, the major differentiation has been whether or not they had an LDI hedge in place. On the assets side they have generally started to look pretty similar."
They have, and interestingly, there have been conspicuously low levels of credit. "People focus on the liability-matching properties of bonds at the exclusion of all else," notes Paul Price, global head of institutional business for Pioneer Investments, "so no-one was seriously using the intermediate, spread-based products." Until now, of course. With yields skyrocketing last autumn, they have promised better risk-adjusted returns than equities, and pension consultants spent the entire spring urging their clients to fill their boots.
But the way this has happened is intriguing. It has enabled the continuation of traditional de-risking (money moving out of equities but into corporate bonds instead of gilts), but also a new move within bond portfolios from gilts to credit, as the downside price risk on government debt begins to look bigger than that on corporates. Indeed, as LIBOR volatility and negative swap spreads played havoc with the LDI equation, there have been even more telling shifts: "Some smaller pension fund clients which committed to start swaps-based LDI with us before the crisis decided instead to go into cash bonds," notes Louise Kay, head of UK institutional business development, Standard Life Investments, "and most of that is going to go into corporate bonds now."
Is credit a return-seeking or a matching asset? The answer, potentially, is both. "If you can link a global portfolio of highly-rated corporate bonds, yielding 2% over risk-free, into your own liabilities that's an opportunity that's opened up," enthuses Hugh Cutler, head of distribution with Legal & General Investment Management. "Now is a great time to combine that with working towards putting inflation hedging into place."
That gets kudos from Gardner at Redington Partners as a "smarter" approach to corporates that takes account of the new growth-plus-matching context for credit. He details other ways in which institutional asset managers need to refashion credit portfolios for this opportunity: longer duration is a must, so managing passively or actively around the indices that tend to float around the five to six-year mark does not help; that in turn forces one to go global - and particularly to the US; and to emphasise robust long-term credit analysis rather than the relative-value trading that sees traditional corporate bond funds posting 70-80% turnover per annum. "In this new world pensions schemes need their bond managers to be more like goalkeepers than strikers," he says. "The mandates we're looking for we call ‘buy-and-maintain' - lots of stock-by-stock homework focused on long-term ability to pay the coupons."
Standard Life's Kay agrees, having seen several clients asking for customised benchmarks and awarding briefs, not to outperform an index, but to avoid downgrades or defaults. "They are thinking about credit in a much more bespoke way," she observes. "We are being asked to do a whole range of things like that which we've never been asked to do before."
If credit is yoking together the matching and return-seeking portfolios, it fits a growing trend to manage - or at least conceptualise - all forms of pensions risk in a dynamic, solvency-based structure. Within the context of the sponsor covenant, the actuarial account of technical provisions (which makes static assumptions about real returns) have to interact with the deficit-funding investment decisions, which in turn have an impact on liability-hedging decisions (if the growth portfolio is contributing huge amounts of risk, it can drown out the efficacy of scrupulously accurate swaps overlays. And, vice versa, the more accurate swaps-based hedging becomes, the greater the contribution of risk from the growth portfolio).
"LDI is evolving into a multi-asset solution, because it has to recognise the risk from all assets, not just deal only with hedging out inflation and interest rate risk, in the context of the overall solvency position," explains Joe Moody, head of LDI at State Street Global Advisors. "You need to have a good feel as to how your matching and growth portfolios interact, and a dynamic framework to monitor the different component parts of risk and switch from one risk to another when they are working in my favour or against me. Whilst funding ratios were rising into early 2008, the overall level of risk was largely maintained as the focus was on relative value between different assets, rather than on having a plan that could be communicated to an asset manager - a trigger to shift risk exposures when funding ratios hit a certain threshold."
At BGI they call this "journey-management". O'Brien says: "If your solvency level goes from 70% to 85% thanks to some phenomenal kicker in your return assets, guess what, your tolerance for risk will change. You need to have a rules-based decision framework so that trustees don't have to come together every six months and make a subjective call on the next step. We're doing a lot of work on that."
Given that the growth portfolio that needs to be managed so intimately against the hedging portfolio in this overall funding context is likely to become more and more diversified and complex, isn't all of this further argument for the implemented-consulting or fiduciary-management structure? "At the smaller end where schemes are closed to accruals and new entrants and liabilities have been crystalised, I can see fiduciary-management styles along the lines of Cardano's model becoming very popular," says Hamish Wilson, founding partner of the eponymous independent pensions consultancy.
Both Moody and Cutler disagree to some extent, emphasising the rules-based, systematic element of the tactical risk management as a means to effective delegation. "The sponsor and trustee board, with support from advisers, provide the framework, management of which is simply delegated to an asset manager," says Moody. "There are clear lines of responsibility there. The only trouble with the current consulting model is that it's not clear who has responsibility and accountability when some action needs to be taken - so you introduce a big time lag as a discussion happens about who is going to do what and when."
One could argue that this is more semantic than substantive, but the key point comes through that it is the framework and process that is important, not the organisational structure that implements it. And there are several different organisational structures that could serve, each creating roles for different asset-management (or banking) models and each suited to different UK pension scheme governance models - of which there are a bewildering variety. Fiduciary management is one; but it will be joined by more ‘standby' mandates that can be funded at short notice when larger, better-resourced schemes are ready to make tactical switches; and more multi-asset absolute return mandates.
If any asset management model is under threat, it is the one that merely delivers the return stream of an asset class with no concessions to the liability-matching needs of the fiduciaries who are being asked to buy it.