Our head-to-head discussion with two prominent pension schemes in the UK reveals problems with investment benchmarks that came to light in the financial crisis. It also indicates that there is a desire for passive solutions that is not being satisfied by investment managers' product offerings. These, along with other issues considered here, set the scene for forward planning in the pensions industry. Chaired by Nick Fitzpatrick (part1)
Mike Weston (Head of Investments, DMGT Pensions), Geoff Reader (Head of Pensions & Treasury, Bedford Borough Council)
Funds Europe: Is the answer to the problem of pension funding as simple as just seeing equity markets rise?
Geoff Reader, Bedford Borough Council: I wish it were that straightforward. The key is liabilities: if these move the right way the funding position will improve quicker than that provided by equity markets rising.
Mike Weston, DMGT Pensions: It’s about both equity and bond yields. How much would equity markets have to rise or how much would yields have to fall to return us to full funding? What combination would get us to the same place? Managing liabilities is important too, whether that’s de-risking or adjusting the benefits structure.
Funds Europe: How has the past year’s equity performance affected you?
Reader: We have a smaller allocation than most local authorities to equities. Against our long-term benchmark, performance has been helpful, so last year was positive.
Weston: We have just over 40% allocated to equities, so the rise has undoubtedly helped. Our deficit to last year has narrowed, but if you compare it to the last actuarial review in 2007, it’s still bigger.
Funds Europe: Over the past decade, UK pensions are known to have increased their allocation to alternatives at the expense of equities. Is this the case with your funds?
Reader: We’re currently about 50% in equities; we’ve gone into alternatives.
Weston: We have not been reducing equities; the current weightings were set by our 2007 actuarial review and have not strategically altered since then. It is likely to change though as we are currently in the midst of our latest actuarial review. Once the trustees and sponsor decide on an acceptable funding schedule and risk tolerance then the asset allocation strategy will evolve to meet that.
Reader: That’s one of the key things, understanding the risk parameters that trustees want to take.
Funds Europe: How can trustees manage risk and return objectives, especially managing long-term risks and short-term opportunties?
Reader: First, you have to recognise that pension funds are a long-term investor and markets react in the short term. Key to this is to consider a long-term benchmark, which has flexibility around various weightings, and then to try to increase flexibility through the use of a sub-group. This comprises trustees and advisors who can make reactive decisions around the benchmark should the market conditions need those adjustments. That’s how we try to bring those two positions together to give us that short-term flexibility in the long-term context.
Weston: For us, there are two or three facets to this. Once we’ve defined a long-term trajectory for the scheme – be that around solvency, funding or cash flows – if short-term market movements take us above our desired trajectory then that gives us the opportunity to remove risk. Approaching this from the asset side, we have been thinking about how you might implement a medium-term tactical asset allocation process around an 18-month to three-year timescale. If markets look seriously mis-valued, is there a way of generating return for the schemes?
We have to recognise that if you’re hiring, or firing, a manager it takes time and has costs associated with it so we are not thinking about trading in and out of markets on a short-term basis. But the most important thing is to get the longer term framework in place first.
Funds Europe: Is the frequency of trustee meetings a problem in terms of making the most of opportunities out there in the markets?
Weston: If the anomaly in the markets isn’t long enough to get through a trustee decision-making cycle, it’s probably not something we would seek to act on. We don’t want to be tactically asset allocating on a short-term basis. The structure we have in place makes it easy to talk to the members of our investment committee, and the trustees have delegated decision-making to the investment committee so the logistics of making a decision are not difficult.
Reader: And the same with issues for our sub-group; we can seize the opportunities that occur outside the committee framework.
Funds Europe: How useful are investment managers to pension schemes when it comes to strategic problem solving; specifically what are your thoughts on liability-driven investment? Is this something best left to the pension fund consultant?
Reader: I don’t think anybody has a particularly good track record. I’m cynical towards investment managers because I think they just come up with ideas to make money and charge higher fees.
Weston: Having been an asset manager for 20 years before I moved over to this side of the fence, you might be surprised, but I agree with Geoff. I would say investment managers are modestly useful. Generally, it feels as though asset managers come up with products that they then push to clients rather than them responding to clients’ new product requests. Over the last decade I think the most notable new developments have been the array of passive products with lower fees. If we look at how to generate good returns, paying lower fees certainly helps.
Funds Europe: Are exchange traded funds within this new array of these products?
Weston: Yes. They’re a passive product when they replicate equity or bond indices. That’s straightforward. But when you move into more esoteric areas you have to be careful. I’m sure we’ve all seen the performance numbers from some commodity ETFs [exchange traded funds] where the spot commodity prices have gone up significantly but the ETF is struggling to make a positive return simply because of the way the product is constructed.
Funds Europe: So the passive product universe is significant then. If the fees are fairer, this is presumably to do with failure of active management?
Reader: It’s to do with the disappointment over active managers.
Weston: Active management is a zero-sum game. Some active managers will outperform and others underperform, and when you layer on active management fees, that tends to skew the distribution even more. There are some great active managers out there but it’s not easy to pick them.
Reader: I think Towers Watson are saying that they are starting to lean towards funds having greater passivity, to reduce costs and get better results.
Weston: I’ve heard that, too. One argument is based on the governance budgets of schemes. How much governance resource do you have to look at investment managers? In areas such as developed market equities, where the markets are reasonably efficient, why spend this governance budget when you can have a low-cost passive product? Why not use the limited time of investment committees to look at other areas where it’s more difficult to be passive?
Funds Europe: Are these attitudes towards passive management a result of the crisis or do they pre-date the financial crisis?
Reader: For us, they pre-date the crisis. Although I think it’s a really pertinent question, because if you’ve got an active manager who has outperformed an equity market by four or five points, on the face of it that’s fantastic, but the benchmark’s down 30%, so in absolute terms you’re down 25%. That’s not great from the perspective of the asset’s absolute position. It doesn’t argue positively for passive management either, but what it does is encourage concentration on absolute performance.
Funds Europe: On the subject of liability management, are fiduciary management services an option?
Reader: In a local government context that’s just not relevant.
Weston: We have looked at it and decided not to pursue it. There is a governance appetite to manage our investments. We’d prefer to be running them ourselves rather than outsourcing.
Funds Europe: And what about liability-driven investment? Is this one of the better products in the market?
Reader: In the local government context I think it’s got a very shallow importance because it just doesn’t meet where I think we are at the moment. Our funding levels aren’t brilliant and we don’t want to tie up assets.
Funds Europe: I see. So, it is the kind of strategy you put in place then when your funding levels are good?
Reader: That’s where I perceive that it would have more value for a fund like ours.
Weston: We haven’t adopted it. I think it’s a good concept but you have to be aware of the limitations. If you were perfectly liability matched and then, like last year, the government changed the rules on RPI [retail price index] and CPI [consumer price index] indexation, suddenly you’re not perfectly matched anymore. You’ve sold all your return-seeking assets and you just have matching assets. So what do you do? You either have to go to the members and reduce the benefits, or you go back to the sponsor and demand more contributions to make up the gap. It’s not easy to be consistently perfectly liability matched.
The way we’re thinking about it is to try and be liability cash-flow matched. If we know what our forecast liability cash flows are then we can look at our asset portfolio and ask ourselves what positive cash flows should be generated? What cash flows do we have to pay the pensions? That’s a more interesting approach for us.
Reader: Are you currently cash positive?
Weston: We’re reasonably balanced at the moment, but we will become cash negative in the next couple of years and our peak outflows are going to around 2040.
Funds Europe: Do pension funds find it useful, or even unavoidable, to access certain asset classes with pooled funds rather than segregated mandates, and how significant is the compromise on tailor-made mandates if these are employed?
Reader: As a local government pension scheme we are big users of pooled funds. There are two main reasons, one of which is that our investment regulations are structured so they are potentially ambiguous. Lawyers find it easier to sign off on pooled investment structures. The second is again to do with regulations: because we’re a public sector sheme you have to follow European procurement rules, and they are hideous. But if you put it in pooled groups, you’re not buying a service, you’re buying a product and, therefore, you shorten the process by about six months, and so again there are specific reasons that have pushed schemes down that route aggressively.
There was a survey by the Chartered Institute of Public Finance and Accountancy that identified a number of funds that have used pooled funds. I think there’s a growing number of local government pension schemes which recognise this ambiguity, in terms of speed of investing.
Weston: We don’t particularly favour either option over the other. As we have increasingly looked at specialist managers, the individual mandates have got smaller and the instances of managers asking us to use a pooled
vehicle rather than a segregated portfolio have gone up. Our view in the active management piece of the portfolio is that most value is going to be added by choosing the right manager rather than specifying a particular structure for an investment. So, if we’ve gone down the route of choosing the right manager and the manager comes back and says, “Well, actually you can access me through a pooled vehicle but not a segregated account,” I would say, “Fine.” So it’s not really an issue.
We’d prefer to have a good manager than a segregated account. Our preference would be a pooled vehicle with our number one choice manager rather than a segregated vehicle with our second choice manager.
End of part 1. Read part two in next week's newsletter.
©2011 funds europe