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Risk Managed Equities: The funding dilemma

With its desire to de-risk and its growing deficit, the Strathclyde Pension Fund is one of many ideal candidates for the risk-managed equities experiment. Martin Steward reports on its plans

While they would startle many institutional investors in Continental Europe – and indeed many corporate pension fund sponsors in the UK – high equity allocations are a pretty common feature of most of Great Britain’s local authority pension funds. Even among its peers, however, the Strathclyde Pension Fund’s 64% allocation (73% if you count private equity) is fairly aggressive.

Local authority funds have just about the strongest employer covenants available, of course, enabling them to take a bit more risk. But the fact that they are backed by governments and their taxpayers also informs their mission to minimise the cost of benefit provision – again pushing them towards a preference for equity risk to maximise long-term returns. All of this is very different from the priority of the typical corporate pension fund sponsor, which is to remove the obligation from a balance sheet or at least minimising the volatility of the value of that obligation: in both cases, de-risking towards a bonds-focused buyout portfolio is the result.

But there is one important way in which the profile of these schemes is changing: they have tended to have a younger membership than corporate schemes in the past, but are now fast catching up. Strathclyde’s active and deferred members now average about 50 years of age and rising. Hitherto the fund has been cash flow-positive, but that is likely to reverse this year or next.

“Like most public-sector funds we are maturing quite quickly as the public sector reduces its payroll, typically by offering early retirement,” explains head of pensions Richard McIndoe  “That’s having quite a big impact and will feed through to our investment strategy at some point. Our equity benchmark has been up at these levels since we started setting our own benchmark back in 1998, but we have set down a marker that that won’t continue forever.”

As well as the changing liability profile of the fund, the ongoing project to diversify assets – which began a decade ago with a shift out of a predominately UK equity exposure to a more globalised portfolio – is also spurring a re-think of the equity-heavy benchmark.

Indeed, the equity part of the portfolio has been through a bit of a shake-up with the latest strategy review, which was implemented in July 2012. Global unconstrained mandates, themselves implemented as part of a strategy review five years ago, had disappointed, leading to the termination of AllianceBernstein, Edinburgh Partners and Invesco. Nonetheless, Strathclyde is sticking by the unconstrained concept itself, appointing Veritas Asset Management and Oldfield Partners instead. Similarly, an EAFE mandate held by Capital International to balance the signficant US tilt in the fund’s passive portfolio also disappointed, but has been replaced by another EAFE strategy managed by Baillie ­Gifford. Smaller companies remain with JPMorgan Asset Management and the Gartmore team that now works at Henderson Global Investors; and global passive equities remain with Legal & General Investment Management.

But despite this activity around manager appointments, the scheme is in no hurry to shake up the asset allocation itself. That is because it faces the same dilemma as just about every other pension fund investor across Europe: collapsing bond yields have destroyed its funding level and made a rotation from (relatively cheap) equities into (horrendously expensive) fixed income undesirable.

At the last actuarial valuation, which reported in March 2011, the fund boasted a healthy-looking 97% funding level. But even this was based on “prudent” actuarial assumptions that equities would outperform bonds over the long-term. Using a pure bond-yield discount rate, the funding level dropped to 77%. Fast forward to today, and even the more generous estimated actuarial funding level lies at about 80%.

“We are quite a way from full funding and we’d like to make that ground back up before we decide to start selling equities down,” says McIndoe.

Given this dilemma, many pension funds have sought ways to hang on to their equity allocations that make them look more like bonds, in terms of lowering their volatility (if the problem is primarily one of balance sheet maintenance) or maximizing dividend income (if the problem is primarily one of cash flows) or both.

The fact that Strathclyde’s principal problem will eventually concern cash flows is reflected in its decision to think more actively about how it manages dividends from its equity portfolio, although this is not a matter of urgency.

“A lot of us in the public sector funds are mulling over how to get more income from our equities, without yet having done anything about it,” says McIndoe. “The maturation of the fund is a slow-burning story: even if we become cash flow negative this year we still have about three-times dividend cover without really trying to optimise those dividends. We are still mulling that one over.”

The Strathclyde fund also shifted a good deal of its equity allocation to passive some years ago. Today Legal & General Asset Management run almost 43% of the equity portfolio tracking market cap-weighted benchmarks. McIndoe says that the fund has certainly discussed minimum variance and other ‘smart beta’ alternative weighting methodologies with both its consultant, Hymans Robertson, and asset managers.

“We’re not particularly interested in quantitative minimum variance, however, partly because one of the managers we parted company with, Invesco, was running a quant portfolio that didn’t really work out for us,” he says. “Minimum variance is structured differently from what Invesco were doing for us, but nonetheless is soured us a bit on quant.”

Nonetheless, Strathclyde is about to tender a mandate for an equity portfolio with the same composition as the MSCI World index, but a different weighting methodology. The tender, for up to 5% of the equity portfolio, is being designed to remain relatively open-minded about which weighting methodology that might be, but McIndoe says it is likely to be clear that the fund favours fundamental or valuation metrics over low-volatility or low-beta metrics. Importantly, this is not just because Strathclyde has turned against quants, but also because the allocation will come out of its current, core passive portfolio.

“Our view is that fundamental indexation is a genuine variant on passive, whereas most of the other alternative-weighting schemes, including minimum variance, are really quant-active,” McIndoe explains. 

That view agrees pretty closely with the view of the pioneers of fundamental indexation, Research Affiliates, and it implies an important message to those asset managers that are attempting to market ‘smart beta’ solutions to Europe’s pension funds, that they need to consider carefully whether their product should be pitched as a variant on the core, passive portfolio or rather as simply another systematic, quantitative active satellite strategy. The answer to that question may define the nature and size of the opportunity set among institutional investors that, like Strathclyde, find themselves on a mission to de-risk their portfolios, but with a desire to maintain long-term exposure to the equity risk premium.

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