Although the subject of Liability Driven Investing now almost seems like old hat, very few funds have actually changed the way they set their investment objectives. A number of commentators have been raising some very interesting questions about whether the majority of pension funds really understand the risks to which their schemes are exposed.
I get the distinct impression that all too few really understand how to set and then spend a risk budget. With so many pension funds in deficit it is important that trustees realise just how they can set meaningful risk and return objectives.
Kerrin Rosenberg of Hewitt Associates is one of the leading advocates of change in this area. He is currently trying to persuade pension funds to create a proper risk budget then choose an asset allocation and manager structure which can be best be expected to deliver the desired investment risk and return objectives.

Gartmore Investment Management are also doing some interesting work in this space and Jamie Lewin their Senior Market Economist whilst looking at the UK Pension Funding Crisis is asking what funds have learnt? One of his conclusions is that too many fund managers have been (and still are) shooting at the wrong target on behalf of their clients. He argues that pension schemes each face a unique set of objectives and constraints and that one size does not fit all. He strongly believes that schemes should set their risk budget with reference to their liabilities, not meaningless market indices.
Interestingly, Kerrin Rosenberg has some very interesting graphs which show that tracking error relative to an equity benchmark is pretty much irrelevant when it comes to considering tracking error relative to a Liability Driven Investment benchmark. However you potentially should get better performance from a High performance or Unconstrained equity mandate than from a tightly constrained or indexed portfolio without incurring any additional real risk. And yet for so long we have been led to believe that tracking error had to be measured against an index benchmark to be relevant.

So where should funds start? Vincent de Martel, Director, Liability-Driven Solutions at AXA Investment Managers strongly believes that funds need to de-risk. He would like the design of all pension fund investment portfolios to be much more closely related to their liabilities and that this should take into account changes in market conditions.
In other words, it is not good enough for a fund just to move from equities into bonds. Duration mismatching can cause significant changes to solvency levels. If you don’t get the bond duration right relatively small changes in long term interest rates can significantly increase deficits, although admittedly in good times you get better surpluses!. However these days can many pension funds really afford to take such risks.

In the view of Kerrin Rosenberg, in the UK, it is now the potential for Sponsor insolvency that is the biggest risk to trustees. Therefore the fundamental focus should be on a scheme’s discontinuance funding position. The reason for this is that the main risk to trustees is their being unable to pay the benefits that have been promised by the scheme. With recent changes in legislation, this can only happen if you have a bankrupt sponsoring employer and insufficient scheme assets.
This is a decision for trustees that cannot easily be delegated or ignored but should form the basis from which other risk calculations can be taken. I am sure it will not come easily but funds do need to work out the maximum risks they could stand and the minimum rates of return they need to achieve. A range of investment strategies can then be considered.
However trustees can not ignore their sponsor’s perspective. Although at the end of the day it is the trustees who must make the final decision – this can not be delegated to sponsors, advisers, or even investment managers. This implies considerable education.

Deciding a risk budget is however only the first step. Trustees then have to decide how they spend the risk budget? At this stage they could give whole problem to an asset manager. However, I would guess that once trustees have gone through the trouble to work out their risk appetite most will then be keen to follow it through by setting a full asset allocation, manager structure and even style. My guess is that this is where the fun starts, as the answer will usually be found to be more than just bond investment.
Of course, bonds will figure very largely in such portfolios but there should be room for equities. Most funds will also search for more alpha, more swaps, more hedge funds and other alternative investments such as private equity, commodities and property. It really looks a far from boring future.

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