UK Pension Funds have historically been run on a defined benefit (DB) basis, whereby either the company or a combination of the company and employee put money into an investment fund. When the employee retires the benefits he receive will be based on a combination of his salary and the number of years that he has worked.
A number of factors have converged over recent years to challenge the traditional ways of administering and financing these funds.
The population is ageing as the post war baby boom generation approaches retirement. The speed of this ageing has been exacerbated as the result of dramatic increase in longevity.
The new accounting regulation, FRS17, brings any change in the value of the pension fund assets into the company accounts, bringing about a much closer link between the fiscal well-being of the company, it’s pension scheme and it’s shareholders. The resulting problems of managing the balance sheet are not appealing to the finance director.
The extent to which these factors combined to contribute to a retreat from final salary pension schemes is open to conjecture (and much debate in the UK pensions press). However, the last 18 months has seen a substantial number of organisations make the decision to close their defined benefit (DB) schemes to new members. In place of the DB scheme companies are offering defined contribution (DC) schemes – moving the investment risk from companies to members. The amount of the pension provision is then directly related to the amount saved, the performance of the individual’s pot of money and the cost of annuities at retirement. This is resulting in an increase in the maturity of the average UK DB pension fund.
However, a number of high profile funds have asserted their commitment to keeping their DB schemes open to all members. Indeed, at least one large scheme has actually reopened a previously closed scheme to new members. Schemes that form part of the Local Government Pension Scheme are not permitted to close, and because of recent inclusion of part time workers, are actually becoming as a group, less mature.
So whilst the average maturity increases, the range is likely to widen.
The average maturity ratio of UK pension schemes is almost 60%. The maturity ratio is defined as the ratio of non active liabilities to total liabilities which means that currently only 40% of the average pension fund’s liability is in respect of members who are still working and making contributions. The remainder of the liability is in respect of members who are either drawing on the fund or have deferred pensions.
In earlier periods when funds were growing with positive cash flow, most were content to set a peer group benchmark. With increasing maturity many funds, acting on the advice of an investment consultant, have moved to customised, fund specific benchmarks.
Given this change in benchmark setting the level of maturity should have a major impact on the way the fund is invested. If it is assumed that the best match for pensioner/deferred liabilities is bonds and the best match for current member liabilities is equities the average fund should be invested 60%/40% bond/equity. At the end of September 2002, despite depressed equity markets the average fund split was closer to 33%/67%.
Obviously many funds are choosing an asset allocation that is not in line with their liability profile.
The range of approaches taken can be seen in graph 1 which shows the exposure to real assets ie, equities and property across a large sample of funds with a wide variety of maturity. The reason for a high equity biased approach can be understood by looking at the following projections of value growth based on based on 100 years of data from the Barclay equity/gilt study in graph 2.
It can be seen that an equity orientation has a substantially increased upside potential over the longer term whilst the downside remains broadly in line with a more conservative bond strategy. The excess return from equities has kept the scheme affordable.
Differences in investment strategy will arise from such factors as the sponsoring companies appetite for risk – this can vary depending on the fiscal stability of the sponsoring company, the size of the pension fund in relation to the sponsoring company and constraints brought about due to FRS17. Other reasons for variations may be down to factors such as which consultant is being used or even trustee inertia.
As well as maturity when looking at the benchmark set, funding level must be brought into the equation. The funding level will have an impact on investment strategy – a poorly funded pension scheme is likely to have less appetite for equities than its overfunded peer.
WM has brought these factors together within our maturity universe analysis. WM Maturity Universes facilitate the comparison of funds that are broadly similar in terms of maturity and funding. These two factors, although not exclusive, are of central importance in determining a fund’s strategic asset allocation.
All funds fall into one of nine groups split as shown in graph 2. Within each group various levels of analyses can be undertaken. The bond/equity split of the benchmark set by the fund can be compared with the split of the benchmarks of other funds in the group. This allows the owner to see whether the fund is relatively aggressively or conservatively invested. Within this the fund can look at the split within equities and bonds to see how this differs from its peers.
A more in depth analysis can be undertaken to look at the liability profile of each of the funds within the group. The analysis then goes on to look at the asset/liability mismatch of the fund relative to those of the other funds across the group and the potential risk/benefits that this could bring about.
Graph 3 shows where a demonstration fund sits in terms of its asset liability mismatch. It is plotted against the most extreme strategies adopted by other funds within the same maturity and funding constraints. The graph demonstrates the additional risk taken on together with the potential added value in terms of outperformance.
Such analysis provides a valuable context for asset allocation decision making – where previously funds made decisions within a vacuum brought about by their ‘unique’ profile there is now a group of similar funds with similar maturity and funding constraints with whom to compare current and potential decisions.
Much as consultants stress the uniqueness of their client’s requirements, in essence they are all trying to do broadly the same thing – provide cost-effective pensions for scheme members. For funds with similar funding and maturity profiles it is only human nature to compare their own solutions with those of their peers.
Karen Thrumble is executive director at WM Company in Edinburgh
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