In the second in a series of articles on a new report, Amin Rajan argues that asset allocation is more about mindsets than models, as pension funds move from calendar time to real time

Back in April, two-thirds of the defined benefit (DB) plans across Europe had funding levels below 100%, according to a new study launched in IPE November*. Though under pressure now, when the markets recover funding pressures will ease, but not disappear. But without fresh thinking, says our new study, pension funds will continue to stumble from one crisis to crisis as old certainties no longer hold true. 

In this article, we will turn the spotlight on the key problems, starting with the single biggest source of returns: asset allocation. Hindsight tells us that it is no longer about not putting all the eggs in one basket: it is a high wire act between long-term goals and short-term opportunism.

“The crises that we will experience in the future will probably show increased volatility. Remarks like ‘it’s a 10-sigma event’ will resonate regularly in the press in the period to 2020. Systemic risks are increasing relative to idiosyncratic risks, promoting a move away from active management,” says Alfred Slager, adviser at PGGM Investments and researcher at Tilburg University in the Netherlands.


At the end of this turbulent decade, three lessons will have become clear. First, correlation between asset classes is asymmetrical - low in the upturn, high in the downturn. Second, risk return characteristics of asset classes are hard to ascertain except over very long periods. Meanwhile, volatility is inevitable due to too many ‘fat tail’ events. Third, risk models are more a therapy than anything useful. While the past may be our best guide to the future, it is still a pretty bad one.

So, successful diversification is as much about timing as it is about the choice of asset classes; as much about tactics as strategies.

In this decade, these plans diversified their proverbial 40/60 bond/equity portfolios in pursuit of high returns. Their asset managers duly responded. Some used swaps and other tools to immunise the unrewarded risks. Some diversified into different asset classes in the long only, alternatives or ‘exotic’ spaces.

However, for most pension funds, diversification came at a time when their peak returns were history. It was like putting chips on every table in a casino. 

Its success rests on understanding the intricate interplay between different asset classes at the most granular level. “2008 shows us that adding new [absolute return] strategies to the portfolio is not diversification. Risk premia are accumulated slowly over long periods but quickly lost in short ones,” warns Slager.

To start with, those who diversified outside their traditional long only funds did so because they either believed the uncorrelated returns story from their asset managers or they were enticed by the prospect of the much publicised ‘prime mover’ advantage, which has turned the Yale and Harvard endowment funds into world class icons.

Managers’ rear-view mirror approach based on sophisticated models has proved as robust as a row of sand castles. Active management has just been a ‘noise’ in the risk-return context, except where managers have had an eye for things to come.

“Well-performing pension funds have a clear view on market movements, where they add value, and what organisation is needed to achieve this,” continues Slager. There is no substitute for judgement.

Accordingly, the bar has been raised on the quality of advice that pension funds need from their professional advisers - be they in-house experts, pension consultants, or asset managers. They are all climbing new learning curves - some steeper than others.

Neither past performance nor simple heuristics help much with asset allocation and manager selection. “Even so, diversification has to be a cornerstone of any plan. The elements of a modern pension policy are: a degree of liability matching, a degree of cash collateral, a growth portfolio and dynamic switching,” says Alan Brown, group CIO at Schroders Investment Management. But he is also quick to emphasise the need to raise the governance budget. “Failure to do so in a world of dynamic asset management greatly raises the likelihood that funds will sell low and buy high at great cost.”

Hence, pension funds need to focus on two areas. The first is board composition, decision making and investment expertise. Currently, vested interests are over-represented and outside experts under-represented. It is time for a better balance so as to ensure that key decisions are driven by strong investment beliefs rather than herd instincts. Governance is the alpha behind alpha. The full-time executives also need to have the skills that enable them to operate in real time.  The second area of action is the relationship with service providers: they must use pension consultants as thinking partners, not hand holders; they must use asset managers as strategic partners not product pushers.

Pension consultants also need to focus on their core competency, on forward-looking personal convictions, not models that are backward looking. Their recommendations on asset allocation and manager selection need to be driven by high-conviction logic rather than past performance. Their relationship with pension funds is also key: consultants need to be trusted independent advisers, not gatekeepers who create deep blue sea between asset managers and their end clients. Consultants and asset managers should talk more in the future.

Across Europe, the most successful advisers on asset allocation are usually those that understand, anticipate and articulate their clients’ needs in ways that clients themselves do not. For them, asset allocation is more an art than a science; an art that relies on an unusual degree of common sense. Intangibles - like professional rapport, the breadth and depth of understanding of clients’ challenges, and deep insights into market dynamics - differentiate the outstanding from the mediocre.

Case study of a UK private sector pension fund

“Our problems started back in the 1990s, when equity markets were raging and we were overweight with an 80% allocation. We were led to believe that equity risk premium will always remain hefty enough to take care of all our future liabilities. At the time, this seemed credible because our funding ratio had raced up to 119%. Our plan sponsor was even advised to have a ‘pension holiday’ for three years. Then, disaster struck when the markets crashed in 2000. Funding levels went into free fall, hitting an all-time low of 67% in 2002. In response, we were advised to do a number of new things.

“We switched to government bonds and started immunising the inflation and interest rate risks via swaps. We got into bonds when everybody else was doing it. Also, the equity component of our portfolio was deliberately halved at a time when markets were especially jittery due to the war in Iraq. We switched 10% of our portfolio to real estate and private equity. In the meantime, the near 50% recovery in the equity markets since the war passed us by like a ship in the night. Since 2003, our total portfolio had averaged 2.5% returns (net of charges) until the current crisis. The timing of our radical switch as well as its rationale was wrong; as was the faith in the alternatives.”

Professor Amin Rajan is CEO of CREATE-Research.

*Available free from and papers