UK pension funds are aware of some risks more than others. A recent Hewitt survey of 52 large UK corporate pension schemes with assets under management of more than £1bn (€1.47bn) found that 70% of pension funds’ assets were return-seeking, for example in equities. As a result, many are reliant on longer-term equity returns for their regulator-required recovery plans, despite some schemes’ need to manage short-term risks, including volatility, through diversification and hedging.

Vanessa James, investment director at the London Pensions Fund Authority (LPFA) pension fund, attributes the £3.6bn fund’s performance in 2006 to an overweight position in equities. The fund has 13% in domestic equities, 44% in overseas equities, 17% in UK fixed income, 6% in property and 4% in private equity

The LPFA delivered a 7% return in 2006 - “well in excess of the benchmark”, she points out. “Our overweight position in equities did well for us. It was a good year for investment markets - for equities, though not for bonds. Bonds performed poorly.”

Public-sector pension schemes are required to conduct periodic strategic reviews every three years, which makes a volte-face unlikely. In any cases, James says she wouldn’t favour major changes in the strategy.

“We undertake a statutory actuarial valuation and base our strategic asset allocation on the valuation,” she says. “It’s working well. The thing about being a pension fund is that you won’t necessarily go into cash with a bear market coming. You don’t become a forced seller, which allows a high weighting in equities. The volatility of equities comes with the territory. A 50-year horizon means you don’t have to risk calling the top of the market and pulling out too early.”

As James sees it, the imminent challenge for the fund is not to mitigate its equity investments but to ensure they’re responsible. “We want to stamp ethical investment (SRI) on the portfolio,” she says. “We’re already long-term investors. We may become more responsible investors.”

The fund has so far pursued a policy of engaging companies it invests in rather than screening. “It isn’t just about investing in ethical [screening] funds. Everyone agrees that tobacco is unethical so investing in BAT wouldn’t be acceptable. But what do you do about Tesco selling cigarettes or the transport companies that carry them?”

When it tendered a mandate for global real estate, for instance, the fund required information from bidders about their attitude to carbon emissions and environmental real estate.

SRI, James adds, “is something local authorities have always been interested in. We want to develop it. You have to look constantly at new opportunities and new ways of doing things - within the emphasis on doing things in a responsible way.”

An extended bull market has created something close to consensus and persuading UK pension funds to reduce their equity allocations would take some doing.

“I can’t envisage it but something would have to change dramatically for me to change my mind,” says James. “You’d need a very different global economic scenario for me to be convinced that bonds, for instance, would be a better investment.”

Strathclyde local authority pension fund likewise plans to stick with equities, which returned 16.4% in 2006. The bulk of the return came from European equities (19.6%), with negative returns from Japanese equities (-10.4%). “The Pacific worked better than Japan, largely because of currency,” says Richard McIndoe, head of pensions at the scheme.

The scheme returned 11.8% in 2006. “Most things worked,” he says. “It wasn’t universally rosy but most worked.”

Unlike the LPFA, Strathclyde has not ruled out an increasing its allocation to bonds. “Bond yields have been unnaturally low for a period,” he says. “We expect a sustained improvement.” But the scheme’s long-term strategy is to invest 75% in equities. The current allocation is 70% - 40% in the UK and 30% overseas.

McIndoe says: “2006 was a good year. We won’t change in 2007. But we’ve done what most funds have done - been selective. It’s a challenge to work out what you want to be exposed to and what you don’t. Something will blow up. [The US fall-out after] sub-prime will have an impact. It will bring something down and we’ll keep an eye out.”

Kevin Wesbroom, an actuary at Hewitt, suggests that refusing to reconsider equities could eventually play out badly for pension funds because they take on more risk.

“They don’t change strategy when things are going well and they end up like the Grand Old Duke of York [a character in a UK nursery rhyme who marches 10,000 soldiers up and down a hill]. When funding levels are at 95-100%, it’s a good time to lock in. You can set up appropriate measurement mechanisms or you can call the market on a day-by-day basis.

“It’s a question of taking risk in a smarter way. Some have thought it out in terms of how much risk they want to take but it’s also a question of fashion.”

Wesbroom argues that return seeking can blunt UK pension funds’ focus on long-term liabilities.

“You need to be clear about what you’re trying to do. It’s a fundamental problem with UK pension funds. They need to be long-term investors because they have liabilities. If you have liabilities, you behave like bonds. If you’re investing in anything that isn’t bonds, you’re taking on risk.

“If you ask some people in the US, they see bonds as effectively the end of capitalism. It’s an almost religious zeal about not investing in bonds. It’ll change as accounting standards move to bonds but there’s a failure to measure liabilities appropriately.”

Powys County Council pension fund culled its 10% allocation to overseas bonds, citing poor returns from foreign bond markets. At the same time, it increased its allocation to overseas equities to 13.9% from 8.9%. The move follows a liability study that resulted in a switch from a 50:50 split between return seeking and liability matching to 60:40. The fund’s asset allocation now stands at 20% UK equities, 25% overseas equities, 10% UK fixed interest gilts, 10% sterling non-gilts, 20% index-linked gilts, 10% property and 5% private equity.

“If you ignore your liabilities, there’s a lot of stuff you can do,” says Wesbroom. You get pension funds deciding to risk 50% [of their portfolio] looking not at equities but at whatever moves - hedge funds, private equity, commodities. They haven’t come up with lottery tickets to invest in yet but they will.”

Return seeking is in many cases a response to a continuing need to plug deficits.

The Hewitt survey found that 40% of schemes had in place contingent assets in case of the sponsor’s financial failure. Many of those surveyed were reliant for contingent assets on parent company guarantees, which focus on the parent, don’t tie up assets and don’t directly cost the pension fund.

Both the BT and Pearson pension funds have seen recent cash injections aimed at plugging significant deficits. Investment performance - combined with a £520m cash injection - helped the BT fund, which has liabilities of £28.75bn, lift an end-2006 deficit of £300m to £1bn surplus. Combined sponsor cash injections in recent years have totalled £800m. British Airways also plugged part of its deficit with a £560m one-off cash payment designed to round off an £800m payment deal to reduce its deficit from £2.1bn to £1bn.

To date, Scottish funds have not faced the same pressure their English and Welsh counterparts have done to deal with flexibility in retirement age, banded employee contributions (with future cost-sharing mechanisms) and changes in the accrual rate.

But for Strathclyde, a Scottish fund, it’s a matter of time. “Regulation is becoming more and more of an issue,” says McIndoe. “In particular, Scottish local government schemes - including ours - are under review. The rules are being rewritten. The rules in England and Wales have already been rewritten so we can expect similar changes.”

Yet pressure to plug deficit gaps risks overfunding, according to Aon senior consultant Marcus Hurd. He claims there is a danger that trustees will “overdo the aggressive approach”, resulting in overfunding pension schemes.

“Traditionally, trustees have not been professionals,” he says. “Now they’re increasingly aware of their obligations. They’re taking a more robust stance on funding and they’re prepared to negotiate. I’d encourage partnership between the company and the trustees. I’m not keen on the adversarial approach.”

Such an approach, he says, can lead to companies that want to fund their pension funds properly wanting to overfund them rather than opting for contingent assets that leave cash on call.

“By taking an aggressive stance, trustees could end up forcing too much cash into them so that the scheme ties up the company’s cash for a long time.

“They’re on the right track - but it takes careful handling.”