As we head for the third straight year of falling equity markets with pension fund surpluses no longer the norm, we are all too painfully aware of the importance of aligning pension strategies with their ultimate objective. Pension assets need to be invested with reference to pension obligations (ultimate cashflows) not with the aim of following the peer group or outperforming a generic balanced market index.
Typically, a trustee in conjunction with an actuary or consultant sets a fund’s risk tolerance and the long-term policy mix appropriate for its liabilities. On the assets side, this process generally employs equilibrium asset return, risk and behaviour assumptions and may not necessarily reflect prevailing market conditions and a fund’s specific circumstances.
The double-digit returns achieved from equities over the last couple of decades and the assumption that this will continue into the future has arguably led to the industry’s focus on pension assets and a corresponding appetite for the equity asset class. Over the last century, the historical outperformance of equities relative to bonds of between 4 – 6% has served funds well up until two years ago. The prevalence of growing surpluses and contributions holidays is witness to this. The growing deficits of the last two years, however, are indicative that funds’ liabilities need to come to the fore.
A liability-driven process
Formal definitions of a liability driven benchmark vary; the concept can mean different things to different funds. The overriding theme is that it is fund specific, has an agreed target return and a clear articulation of a fund’s specific risk.
The first step towards a liability driven benchmark is to understand and define the role of liabilities in setting a pension fund’s strategy. Typically, liabilities are defined as a capitalised sum. This is not particularly useful for setting a pension fund’s investment mix as it does not reflect the exact magnitude and timing of the obligations to be met. In articulating pension fund strategies, there can be too much focus on accounting standards (FRS17, FAS87) and discontinuance measures rather than meeting the accrued or ongoing pensions promise. Ultimately, a fund’s assets must meet the actual physical pension cash-flow payments when they are due. Understanding a fund’s liabilities in conjunction with its pensions promise, its trust deed, its trustees’ risk tolerance and its sponsor’s contributions policy, are all valuable inputs when formulating its investment strategy.
A good starting point of any investment strategy setting process is to define and articulate a fund’s investment objectives. We suggest that investment objectives should quantify real return and risk targets and include a specific time horizon. They are best set with a view to controlling the cost to the sponsor. Risk can be considered with respect to stability (volatility in contributions), security (minimum acceptable market value of assets, diversification and permissible investments) and liquidity (income requirements).
From an investment perspective, once liabilities and contribution policies are understood, an ongoing fund simply needs to meet future cash flows efficiently and allow for wage inflation and future service. On this basis, a strategic asset allocation can then be set.
First, we start at the minimum investment risk position. This can be seen as an anchor in setting a liability driven benchmark and it represents the closest match between assets and liabilities. Dependent on maturity and the nature of the trust deed, and provided a fund’s assets are viewed as collateral against accrued liabilities, this position is often 100% weighted to fixed income.
In other situations, such as when a fund’s assets are viewed as collateral against projected pension obligations rather than simply the accrued liabilities, other assets will also be included in the minimum investment risk position. There is a significant risk that the accrued obligations for these more diversified asset mixes that are designed to protect against wage inflation cannot be fully paid from existing assets. This is unavoidable.
Any movement away from the minimum investment risk position is only beneficial if it adds incremental return. Nonetheless, heavily weighting a fund’s assets to fixed income is not an option for many funds because implementation is simply too expensive. Higher investment return assumptions help reduce future pensions contributions.
In moving away from the minimum investment risk position pension fund, decision makers would benefit most by considering a full range of investment opportunities. In this way individual fund’s asset allocations would reflect their fund’s characteristics and not the average allocation of their peers.
To achieve their return targets, we suggest funds move away from the minimum investment risk position to a liability driven benchmark. This can be achieved by employing one of a number of different disciplined processes. One approach involves considering real asset class return expectations and volatilities and then allocating a risk budget (notional units of risk) to several primary active asset allocation decisions (equities versus bonds, active versus passive, mainstream versus alternatives). In adopting such an approach, risk units can be best distributed across these active asset allocation decisions commensurate with the level of confidence in their ultimate success.
This procedure would lead a fund to be invested across a diversified range of asset classes that best represents its liabilities and return targets as captured in its investment objectives.
The next step in the process is to tie the liability driven benchmark strategic asset mix to the configuration of the fund’s investment manager structure. Communicating the process to a fund’s investment managers enables them to provide feedback and identify when, due to developments in investment markets, their mandate benchmarks are misaligned with a fund’s overall investment objectives. Further return enhancement can be achieved if the monitoring occurs on an ongoing basis. This process contrasts with the more common approach where a manager structure is set around an asset allocation without referring back to objectives and risks.
A liability-driven benchmark is an effective way to establish and question what risks are being taken by a pension fund at any time. A clear, concise and transparent asset allocation strategy can be used to derive benchmarks that help protect a fund against its commitments by focusing on the appropriate asset mix for an agreed set of investment objectives that allow for changing market conditions.
As we enter a potentially protracted period of single digit investment market returns, pension funds are realising that, as far as their liabilities and contribution policies are concerned, asset allocation matters. Outperforming a generic market index or one’s peers is less important.
Contributed by GMO Asset Allocation in London