Most people in our industry recognise that while pension schemes have become more demanding of investment strategies and implementation, most schemes remain in deficit and are becoming more mature. Accounting rules mean these deficits are much more visible with the result that pension provision has become a topic for national debate.
Trustees are looking again at how they meet the promises made to members by running the investment strategy in closer alignment with the liabilities of the fund. More asset classes are being reviewed and it is fair to say that the overall sophistication of trustees has risen through training and possibly with the participation of more senior company management with a finance background.
However, one has to question whether the existing situation assists trustees in their duties to members. For some time, we have expressed concerns that current processes do not begin with explicit investment objectives and therefore give trustees little context for their investment decisions. Furthermore, at present the majority of fund managers are not incentivised under current fee structures to improve the financial health of the fund over the long term.
It does seem that measuring performance by specific benchmarks - against which managers take an overweight, neutral or underweight stance - may be changing. In our experience, clients are now seeking a more active approach and are looking to make their assets and the managers of those assets work harder. Trustees can still monitor performance, but on their own terms not necessarily relative to a market index.
These changes are important as they mark the realisation that investment risk should be measured versus the liabilities and not by tracking error to an index. For trustees, this means that the risk of being different from one’s peers is now not regarded as important as the risk of actually losing money.
Equity has been dominant over recent times but this is now changing. However, more importantly, the nature of equity investment has changed. Schemes have reduced their weighting in the UK as clients embrace the greater opportunity set of global equities and an increase in the active risk of those equities.
Some of the equity reduction has been into bonds as trustees attempt to reduce overall scheme risk and some has been into alternatives such as property, infrastructure, commodities and hedge funds as trustees try to reduce strategy risk and diversify sources of alpha.
A framework designed to set investment objectives relative to a scheme’s liabilities is central to our advice to our investment clients. In our view, the rise of the scheme-specific benchmark has meant that most schemes do take account of the liabilities when setting investment strategy.
The problem is that while asset-liability modelling means that liabilities are considered when choosing a particular asset allocation benchmark, beyond this point the liabilities are often ‘forgotten’ and the strategy is implemented with traditional mandates and no regard to real (liability-based) risks, the relative merits of market, manager risk and returns.
As the bond weighting has risen the way the bonds are managed has come under greater scrutiny. Trustees are looking at better ways of matching scheme liabilities through duration or cashflow matching, which in turn demands a detailed understanding of liabilities and greater interaction with the fund manager.
So if trustees are keen to make their investments work harder as demonstrated by an increase in higher performance mandates and genuinely active management, it raises the questions what does this mean for the fund management industry and how can the industry respond?
The response is dependent on the brief and below we consider a range of different mandates. What might the future look like?
Multi-asset briefs: Multi-asset briefs are attractive in principle. Why not have one manager take a comprehensive investment view across different asset classes and give him/her the opportunity to deliver performance in a more dynamic way? Trustees can ask the fund manager to deliver the objective, for example liabilities plus 2%, and make themresponsible for the asset allocation and implementation required to deliver or exceed this return.
To be successful the right timescales are critical and this requires a fundamental shift in the periods used to review performance by trustees and their advisers. And that requires confidence. There is also a rise in ‘new balanced’ types of mandates where a fund manager may be given full discretion over the assets and is given an RPI-plus or gilt-plus type performance target. The main problem is that few managers have been able to demonstrate significant value in all areas or in asset allocation, and historically many have been unwilling to take on these decisions for pension schemes. The market is responding to the challenge, with both new entrants and established players offering products, but there remain few really credible candidates.
Equity investment: In our experience, trustees are now seeking a more active approach across the board, but particularly in the case of equities. Once risk is measured relative to liabilities rather than an index it is apparent that ‘best ideas’ or unconstrained approaches are no more risky than passive (or closet passive) management but offer the potential for real added value.
A traditional equity manager’s portfolio has often invested large amounts in companies that best reduce the risk of underperforming their index benchmark rather than in companies that they actually believe will outperform. We believe that investment decisions should be based on risk and return considerations and manager skill, not an arbitrary index. Holding an underweight position suggests low conviction and logic would suggest the investor should either be engaging with the company’s management or reviewing investment in that company.
Trustees are beginning to realise that higher tracking error does not necessarily equate to higher risk and that the risk of losing money is more important than tracking error. Over the last two years, 40 Hewitt clients representing pension fund assets totalling around £20bn (e29.4bn) have allocated a portion of their total assets to equity-based approaches without traditional benchmark constraints.
By freeing up managers to manage, trustees are asking them to put their investment skills to the test and increasing numbers of institutions are rising admirably to the challenge. The talent drain into hedge fund management seen in the mid- to late-1990s is subsiding and possibly even reversing as even the larger houses catch on to what trustees really want.
Bond mandates: Bond investment has become dominated by liability driven investment (LDI), buzzwords covering everything from rough duration matching to cash flow matching strategies. Typically, the fund manager’s benchmark is very closely linked to the scheme’s liabilities and if the manager is beating his target, the scheme is getting healthier.
Under an LDI approach bonds are invested with regard to the scheme’s liabilities (rather than the characteristics of a particular bond index) and this requires a detailed understanding of liabilities, greater client interaction with the fund manager and, usually, the use of swap contracts. This raises a number of challenges but, in general, the fund management community has been tremendously enthusiastic about the concept and have invested heavily in systems and personnel in the expectation of receiving new LDI mandates.
For example, some fund managers are now set up to receive liability data from the actuary, analyse the cashflow profile, interest rate and inflation sensitivity and construct a portfolio of bonds to either match or exceed the return on the liabilities.
Alternatives: Investing in alternatives is attractive on diversification grounds because of the potential for meaningful returns which are lowly correlated with existing equity ‘return’ assets. It does, however, pose a number of challenges and, to date, liquidity issues, perceived or real lack of transparency, costs and the (understandable) fear of the new have acted to slow more significant investment.
It seems clear that many of these developments involve a mix of higher costs, greater complexity and less liquidity, not to mention heavier involvement from trustees, less well tried and tested ideas and the risk of doing something ‘different’. This is only credible if real progress is made in improving funding levels and security.
There is no magic investment bullet but with an open mind and the ability to be flexible do we need one?
Dean Wetton is a research specialist at Hewitt Associates