In an article in the January edition of IPE I made the observation that a large number of pension funds had long since delegated responsibility for the investment process to consultancies, yet still retained responsibility for pension payment obligations. Research had also indicated that, far from providing bespoke solutions for pension funds, the consultancies generally developed similar investment strategies for pension fund clients irrespective of liability structure or funding status.
I strongly encouraged pension funds to take responsibility for their investment process and develop a conceptual, and workable, investment framework supported by a vibrant in-house investment capability which, of course, will require a long-term commitment from trustees. This need for change is critical in an industry environment of high and sustained funding deficits and increasing focus on the compliance directives of regulatory authorities.
This has also taken on even more resonance as the structure of pension fund portfolios has evolved over recent years. Where the traditional asset classes of listed equities, bonds and cash had historically made up the investment universe, it is the exposure to private equity, hedge funds and other structured products, including liability-driven investment strategies, which now generates significant interest and excitement.
Ultimately, the success of my recommendation will be measured by the number of funds heeding the advice and making the required commitment, in contrast to those that steadfastly maintain the status quo.
But many pension funds have limited opportunity to control either side of the funding deficit equation. On the liabilities side, taking the UK as an example, while there is acceleration in private sector pension funds closing defined benefit schemes, UK regulations require that public sector funds maintain their defined benefit status.
Also, most public sector employers are not able to make large and sustainable contribution increases, resulting in a limited positive impact to asset growth. All this means funds must rely on substantially increasing investment returns. But they now face their biggest challenge: how will these higher investment returns be achieved?
The options would seem to involve:
l placing even greater reliance on consultancies;
l retention of the traditional investment strategy and asset classes; or
l investing in a sophisticated portfolio of new assets classes, investment products or strategies.
As noted earlier, a growing reliance on consultancies has not produced the required outcome and is not consistent with my recommendation that pension funds take greater responsibility for their investment strategy. All of which means pension funds are having to actively choose between retaining the traditional asset classes (the old) and adopting a sophisticated portfolio (the new) to achieve the higher investment returns required (although I feel most pension funds will eventually hold a combination of both strategies).
Traditional investment strategies have generally been constructed from a limited investment universe, which provided an ideal environment for a thorough analysis by pension funds of the range of investment opportunities. In addition, these asset classes generate income, have distinct capital growth/preservation characteristics and offer the potential of positive diversification benefits across the economic cycle.
Also, trustees are able to develop a strong understanding of how
these asset classes behave under changing market conditions, supporting effective decision-making and risk management. This is an important consideration for trustees, with compliance high on the agenda. As an investment operation it is straightforward and cost-effective to manage, so the primary skills required by pension fund trustees are determining how much to invest in each asset class and which managers to employ.
Nonetheless, pension funds must consider whether this approach will generate the investment return required to reduce the funding deficit based on a long-term outlook for investment markets, irrespective of the positive compliance aspects and ease of operation. Unless thorough analysis supports a high level of certainty I believe pension funds must, at the very least, actively consider expanding their investment universe to incorporate the new assets classes, investment products or strategies, cognisant of the risk and compliance issues that trustees would face.
However, in many cases pension funds may still retain the existing investment strategy irrespective of the long-term investment outlook without considering the new assets classes, investment products or strategies available. One reason may be that the majority of pension fund managers’ investment experience has come from the broader pension fund environment generally across the traditional asset classes, with few having experienced life on the asset management side of the fence.
If pension funds elect to go down the path of expanding their investment universe a range of issues must be considered, and the basis for allocating an increasing component of the portfolio to these sophisticated solutions must be continuously reviewed by trustees. And until the expanded investment universe receives the same rigorous analysis applied to traditional investment strategies these solutions should not be included.
The primary reason for such analysis is that investment banks and other providers of these asset classes, products and strategies have introduced an exceptionally high level of sophistication, creating what I describe as a ‘knowledge gap’. That is, there is an increasing mismatch between their level of sophistication and how well they are understood by pension funds. On the other hand, investment banks and other providers have the staff, technology and profit motive to develop increasingly sophisticated solutions.
The difficulty with these sophisticated solutions is that most are unfamiliar to trustees, with investment processes that are difficult to understand, lack full transparency and have high fees. Yet most information available to pension funds has been primarily designed as marketing tools by the investment banks and other providers and does not appear to have any minimum criteria as to objectivity and educational content. As a result, it reinforces the notion that the range of potential outcomes of these asset classes, products and strategies are positive and known.
Another dilemma confronts those pension funds seeking recognition as active and responsible investors. Exposure to such products and strategies creates separation of ownership of the corporate governance decision and it is entirely feasible, even likely, that investment managers will apply policies inconsistent with those of the pension fund.
Whichever approach is selected there is certainly need for pension funds to focus on improving the in-house investment skill set and adopting a non-consensus approach to their investment strategy. But is it feasible, or even reasonable, to expect pension funds will overcome this ‘knowledge gap’ by developing an in-house investment capability? Or is the gap too great to overcome without the intervention of regulatory authorities placing constraints on what is allowed in the investment universe? This is a scenario that the regulatory authorities and pension funds must confront in the short-term.
It would require increasing the size of investment departments and employing the necessary resources to enable thorough analysis and informed judgement on the expanded investment universe. But even if it were possible to employ the best and brightest, such sophisticated asset classes, products and strategies generally have outcomes that not even the best of analysts is able to forecast or conventionally model and at the fund level it becomes problematic to put in place a workable risk budgeting process.
I believe that many of these issues are not yet fully considered or understood by the majority of pension fund trustees who, persuaded by the need for sophisticated solutions, and their apparent ease of implementation, forego the rigorous analysis that was the cornerstone of implementing traditional portfolios.
The preceding discussion does not seek to make any grand pronouncements as to the preferred approach for pension funds to achieve higher investment returns. But I hope it raises awareness of the issues confronting pension funds in an investment environment that is becoming more dynamic and complex.
Nonetheless, and irrespective of the approach taken, there is a requirement for pension funds to develop a workable conceptual investment framework and create a vibrant in-house investment capability to manage the ‘knowledge gap’ between the sophistication of new asset classes, products and strategies and how well they are understood by pension funds.
Sophisticated portfolios offer a range of opportunities not available within traditional investment strategies. Yet, the ability of pension funds to analyse these thoroughly is limited. While pension funds are increasingly attracted to these sophisticated solutions to solve their funding dilemma, the traditional portfolio continues to offer trustees the comfort of a more straightforward investment process and compliance regime.
Paul Kessel is an investment manager at London Pension Fund Authority