The driver market
It’s been another tempestuous year for the UK pensions industry. The combination of continued adverse market conditions, a flurry of new government legislation, increasing scheme maturity and the fact that pension fund deficits have hit the front pages of the national press, has made UK plc think long and hard about how it should be managing its pension assets.
Track the history and you can see the big themes of UK pension funds over the last decade: from balanced management/peer group comparison through to indexation/specialisation (core/satellite).
Today’s hot debate though is liability management. The prospect of ‘underfunding’ has quickly focused pension fund minds on the bottom-line.
One knock-on effect of this closer focus on liabilities has been a steady shift by UK schemes from equities to bonds.
A survey earlier this year by JP Morgan Fleming Asset Management found that the average asset allocation mix for DB schemes showed equity allocations down from 67% in 2002 to 62% in 2003 against a corresponding increase in fixed income allocation from 24% to 30%.
On top of the normal fixed-income outlets, corporate bond exposure, particularly overseas, has become part of the norm in many allocations in recent years.
Unsurprisingly, asset managers chasing the money have started to showcase bond capabilities like never before!
However, the underlying scenario is not so clear. Mike Craston, director of institutional business at Edinburgh-based Aegon Asset Management UK, says the number of fixed income RFPs is significantly down on last year.
“What is happening is what you might call “regret risk”. A substantial number of pension funds will no doubt have to shift more into bonds, although there is a debate amongst actuaries about how far this should be. But the reality is that most know they should have made this shift when the FTSE was at 6,000 rather than around 4,000.
“Many are saying they will not make the switch now in the belief that the market will recover because they don’t want to lock in any losses on the equity side.”
This is causing something of a psychological stasis in the UK pensions market. If the FTSE rises to 5000 will trustees sell equities or stick with them? And if they do sell will this just cause the market to rebound?
Three years of market turmoil does not make the decision an easy one for trustees.
Consequently, Jim Owen, co-head of UK institutional business at Credit Suisse Asset Management (CSAM) sees some funds bucking the perceived wisdom of bond buying by diversifying into overseas equities, particularly in Europe, where investors have received a kicker from the strong euro in recent months.
Ian Martin, executive director and head of UK institutional sales at Morgan Stanley Investment Management, is also sceptical on the scale of the switch to bonds: ”In a stock market crash people do the opposite to what they should do!
“There has been greater interest in bonds and the drivers for this are well documented and we saw quite a lot of that in the first part of the year. However, I think pension funds are now reflecting on this a bit and coming up with a more rational response. Bonds have become expensive and some funds realise they might not want to sell equities. Just recently there was a headline about Somerset County Council pushing their equities back up from 70-80% to ‘minimise long-term cost’.”
Nonetheless, Patrick Johns, co-head of institutional business at F&C Management, believes the increasing maturity and continued immunisation of DB plans will progressively lead to an asset split with “more bonds than equities”.
While the bond/equity split discussion rolls on, the more salient debate on benchmarking has come to the fore.
This was perhaps inevitable after three years of underperformance and question marks over pension plan solvency in an industry where the perception of risk had become one of volatility against a somewhat arbitrary yardstick.
UK asset managers argue that the business risk of failure had started to be punished so readily by pension funds (shorter mandates, frequent manager changes) that the benchmark had become less a measure of how managers performed than the driver of what asset managers were seeking to do.
As Martin at Morgan Stanley, notes: “It used to be the case for managers that in recording a 15% loss on a fund against a benchmark that was down by say –20% you could say that you’d done a good job.
“But there have been a lot of constraints put on fund managers regarding the minimising of tracking error because many pension funds were seeking a predictable outcome. The problem is that if you limit managers to a tracking error relative to the index then the manager is perhaps not investing in things he wants to.
“Investors are now looking at this and asking whether it is rational or whether they shouldn’t just have an absolute return target.”
Kanesh Lakhani, head of marketing and consultant relations at State Street Global Advisors, agrees that narrow benchmarking has stripped creativity from asset management: “We have all become slaves to the ‘benchmark’ and the fact that this held up was probably due to the luck of the bear market than any great skill as an industry.”
Lakhani argues that this new paradigm of liability management for UK pension funds should contain an objective to minimise shortfall risk based on an estimate of the true surplus position of the fund.
“There is no point in hiring a lot of specialist managers with low tracking error when they are not matched to the liabilities.
“Pensions funds need to carry out a continuous review of the match between assets and liabilities and the risk of deficit. Such a change won’t happen this year, but there is a need to start thinking on these lines.
One answer, he says could be use of more appropriate bond investments: “If you look at the liabilities of pension funds they are akin to a complex index-linked bond. Once you’ve matched the liabilities you can be a bit more risky with any surplus and fund managers can come up with interesting product ideas.”
The idea that trustees may need to rethink their investment management remits was backed in a survey by Hewitt Bacon & Woodrow (HBW) in June this year. HBW argued that schemes should allow fund managers more ‘freedom’ when picking stocks and that measuring fund manager performance against a traditional market capitalisation index was ‘preventing managers from doing their jobs properly’.
However, Owen at CSAM feels it is a little expedient of asset managers to shift the blame entirely: “Too many asset managers in the past were content to accept mandates they weren’t particularly comfortable and did not inform pension fund trustees of the risk that would be involved for outperformance.”
Whether some active managers made a rod for their own back by not making clients aware enough of the risk/reward equation is a moot point.
Certainly the knock-on effect has been that consultants are closely examining the way funds use their asset managers. At the same time there is an onus on managers to justify their gripes and come forward with new investment approaches.
One such trend has been a move towards tighter portfolios with larger stock bets.
Peter Hunt, marketing director at Fidelity Investments, argues: “There is a need for conviction to return. My view is that more long-term mandates will appear where managers run bigger positions on fewer stocks with lower turnover.”
A notable endeavour in this direction has been the competition run by the Universities Superannuation Scheme (USS) and Hewitt Bacon & Woodrow on duration of manager contracts, value creation and good corporate governance.
Hunt believes one useful change would be the way manager performance is reported: “We think it is unhealthy for a manager to have to go before a trustee board and justify their performance on a quarterly basis, which can be unhelpful and lead to unnecessary turnover in portfolios.
“The USS competition is getting people to focus a bit more on a five year time horizon. I think there is also some evidence at the moment that clients are looking more at issues such as transition costs and thinking more before they change managers.
Nigel Loweth, head of UK institutional sales at AXA Investment Managers, also notes that there is interest in the UK market for what he terms a ‘new balanced’ approach – a ‘balanced’ mix of longer-term specialist mandates that are not peer group benchmarked.
In today’s market conditions, another spotlight has focused on the slew of UK pensions money that headed into passive funds during the last five years. Miles O’Connor, director of UK institutional business at Barclays Global Investors, concedes that this year there were few new pension schemes looking at indexation and that the ‘lucky’ years where balanced managers were ‘blowing-up’ in the UK – partly pre-empting the move to passive, have passed.
He argues though that pension plans are using index funds in different ways such as for strategic asset allocation shifts.
“Clients are asking us to manage the core of their portfolio while managers are changed. So we are seeing a difference in emphasis for indexation. Where we see index flows growing, however, is in DC schemes as the default option for employees.”
While most agree that there has been a shift away from the traditional UK share bias towards a more diversified global equity strategy, the oft mooted move to absolute return strategies such as hedge funds remains as much of a talking shop than ever
Loweth at AXA comments: “I think trustees still don’t fully understand hedge funds and with the onerous duties they already have you can’t really expect them to invest in an unregulated market either.”
However, Peter Ball, head of institutional business at JP Morgan Fleming, says private equity is being seen
as a potential added source of value: “44% of the plans we surveyed invested in private equity, whereas only 8% were invested in hedge funds. The perception is that hedge funds are still high risk.”
Good performance in recent years has also seen a return to favour for property. Owen at CSAM says there has been greater commitment from larger schemes, but adds that this may be a product of rebalancing due to poor equity performance. “In general, I think the bigger schemes may hold about 10% in real estate, but there is some difficulty today in getting access to the best funds.”
It is not just pension funds and asset managers, however that have come increasingly under the spotlight in the last three years. The UK ‘gatekeepers’, the consultants, have also been wrestling with issues such as performance fees and manager recommendation justifications.
Add to the equation the fact that consultants too recognise a need to raise revenue streams in a tough environment and the result has been the ever-blurring boundary between investment advice and implementation - albeit with differing stances on the multi-manager/implemented consulting trend that has worked through to the UK mainstream.
Certainly the need for advice, administration outsourcing and a financially viable specialist investment approach has opened doors for the multi-manager concept amongst small and medium-size UK schemes.
Patrick Disney, managing director at SEI Investments claims the cost/performance ratio is justifying the proposition: “The important thing is that clients are getting net alpha after fees. All our funds are above benchmark and above the CAPS median.
“The value added for trustees also comes through the quicker decision-making process on issues such as manager performance. It helps them focus on the bigger things such as asset allocation decisions.”
Few fund managers dispute that multi-manager is a growth area. And while most seem happy that if they can get on a multi-manager roster they don’t have to pitch for every business opportunity going, some suspect that managers may be switched on a more regular basis. “Whether you can be guaranteed the longevity of contract will certainly be a question going forward,” says Johns at F&C.
Bill Babtie, marketing director at Franklin Templeton Investments, is wary of talking the multi-manager game up too far: “There is a lot of talk on multi-manager, but not a lot of statistics.
“I suspect that they are winning more than they were, but it is still a small share of the market. What matters will be the results that pension funds get after fees and this will be the big test for the multi-managers.”
But as Rufus Warner, chief executive at Société Générale Asset Management (SGAM) in London, suggests, as multi-manager becomes a greater distribution channel it hastens the need for asset managers to decide how far they are manufacturers or distributors of investment product.
Getting the business model right for asset managers will be key. Hunt at Fidelity opines: “There seems to be a consensus today that you either have to be a small boutique and add value for clients in quite an aggressive way or you’re a larger manager in which case you’re cross-selling products that you have within the stable.”
This suggests that the number of managers in the UK market could thin over time; a view shared by Johns at F&C, with a caveat: “I think any financial seller would be reluctant to sell at the moment, but I certainly think we will have fewer managers in the UK. The feeling I get though is that there are probably more sellers than buyers around at the moment.”
SEI’s Disney believes that mid-size asset managers in the UK market will quickly have to decide what they do, particularly as so-called ‘open architecture’ and white-labelling of funds becomes more prevalent on the back of the shift to DC.
Recent SEI research found that 45% of UK companies surveyed had converted their fund to a DC scheme compared with only 17% in the US.
While the rump of UK pension assets will remain DB for some time yet, the number of new DC arrangements coming on stream means that asset managers ignore the long-term prospects of this market at their peril.
The question for managers though is how to make money from the DC business in the early phase.
Says Ball at JPMorgan:“The lesson of Stakeholder was that it is possible to acquire clients, but that this does not always translate into assets!”
Furthermore, DC is developing beyond the level of single account structures to more tailored and well-communicated investment options – an interesting but potentially costly platform for asset managers to covet.
According to JP Morgan, only 20% of DC schemes now have one investment option, with most now running between four and six funds.
And David Butcher at Invesco believes the rapid shift from DB to DC will only be augmented by the UK government pensions Green Paper.
“Fundamentally what I believe it does is to encourage DC by shifting pensions responsibility further on to the individual.”
Additionally, Butcher predicts that employers will increasingly walk away not only from DB, but also from occupational DC schemes on a trust basis: “I believe the model that will be used will be a type of stakeholder plan, or variation on that. Because of that there will be a big increase in the need for employee education and advice and the advice required from employee benefit consultants will reduce.
“Employers will be seeking a one-stop-shop pensions solution where they will outsource everything including the HR function.
“This will be a gradual shift, although I think it could be faster than a lot of people are predicting. DB plans at best have a half-life of 10 years or so in my opinion and of the £800bn of assets in the UK occupational pensions market, probably about £500bn of that will shift over to DC in the coming years.”
Certainly asset managers are well aware of the impact of potential government intervention on their business models, with the issue of soft commissions being just one strand placed under the microscope by the Myners report.
Warner at SGAM, explains that the firm decided it would end soft commissions after finding it difficult to justify to clients: “We struggled to see why clients should pay us a fee because a broker was paying part of our office costs by putting a Reuters screen on our desks.
“But there is a difference between this and the question of research from brokers which we see in a very different light.”
Hunt at Fidelity agrees: “We have a broker segmentation programme and the NAPF is also setting up working models for this.
“In short we think the changes should be led by the market. If the government gets involved it won’t necessarily be optimal and may not achieve the reduction in trading costs they are after. In fact it could lead to less research coverage and higher trading costs for clients.”
The recent government announcement of an insurance net for UK pension plans based on the US Pension Benefit Guaranty Corp, has also met with some surprise.
Ian Martin at Morgan Stanley says he worries that the insurance fund could represent a further ‘tax’ on pension funds that will ‘only help the profligate’.
Nevertheless, it’s not all bad news from the government. Managers agree that the recent relaxation of the MFR requirements should allow pension funds greater freedom in the financing of their commitments.
Not too soon, says Fidelity’s Hunt: “There’s a danger for the UK pensions market that the industry and the government are shuffling around the deckchairs while the Titanic is sinking. There is a huge deficit of £100bn in UK schemes that needs to be filled.
“Initiatives such as the Myners Report and the increasing spotlight on corporate governance are all very worthy, but only if the overall market situation is better.”
For asset managers, their job in ensuring the UK pensions ‘Titanic’ stays afloat during these dark days will involve providing more inventive and attentive products and services to UK pension fund clients.
For the UK asset management industry as a whole, it will be up to investment houses to ensure they have the right model in place if they are to stay the course themselves as the market rapidly evolves.