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 (part 2)
Mike Weston (Head of Investments, DMGT Pensions), Geoff Reader (Head of Pensions & Treasury, Bedford Borough Council)
Funds Europe: What have been the strengths and weaknesses of investment in (a) real estate, (b) hedge funds, and (c) private equity?
Reader: I think it depends on the different asset classes that you look at because we’ve had real estate holdings ever since I’ve been involved in the fund, which is over a decade.
The one thing we did discover during the financial crisis was that we’ve actually given them a benchmark that we perhaps wouldn’t have done because it was encouraging them to take leverage, and of course leverage in a down market was not the place to be.
That is one of the hidden beauties of investing: setting the benchmark is an absolutely huge decision, rarely do you give it the appropriate level of analysis [or] stress testing.
Funds Europe: Can we speak more about the benchmark issue, and how you see that evolving? To begin with, what was this benchmark and how did it force managers to take more leverage?
Reader: We were using the IPD All Property Index, whereas we were actually investing in balanced and specialist funds. One of the problems was, when we invested, it was at such a stage [that] I don’t think an index existed that was fully relevant to our investing, and the only way to make the fund meet that benchmark index was to encourage investing in various funds that had higher fields of leverage than we would have otherwise been comfortable with. We had some great results on the way up and we didn’t question it until we got to the end.
Funds Europe: Do we feel that benchmarks need to be revised in terms of how they apply to pension funds? And would this be across asset classes and sectors?
Reader: It’s something we’re certainly conscious of. One of the areas that we want to do some investigation into is of fundamental indexes in the equity space rather than just purely around market capitalisation. We suspect that the risk we’re running by just having all the assets in one index is something that we should find a way of mitigating.
Weston: It’s one of those issues you have to devote time and attention to. We all know that investment managers are going to use their benchmark to drive their activity; they’re focused on the benchmark, so if we give them the wrong benchmark they’ll do the wrong thing. Simple. So the way we look at it is there has to be a benchmark for the total scheme, which is actuarially derived.
We know what we have to deliver to meet our liabilities, so that’s not open to question. It’s the line in the sand. The key for us is to translate that total-return benchmark into a series of coherent and consistent benchmarks for each of the individual managers, and that’s not always that straightforward to do.
It’s a matter of recognising that managers will manage to the benchmark they are given. If you set an IPD benchmark for a
property manager, that’s what they’ll manage to, regardless of what your liabilities are at the scheme level. We have to bear in mind that we need a coherent framework of benchmarks.
One of the earliest things I had to do at DMGT was to look at all the individual benchmarks. The scheme had been through quite a significant restructuring in the two or three years prior to my arrival and it was difficult using the benchmarks that existed to get a sensible picture of what was going on.
We had to put some time and effort into making sure we had something sensible to measure both the total scheme against and each of the individual managers, and to highlight the impact of asset allocation and manager choices.
Funds Europe: Could benchmarks be out of line with the liabilities?
Reader: They could be, but they also have hidden risks that you weren’t familiar with.
Another one we came across was concerning one of our alternative portfolios because we were doing it on a collateralised basis; we obviously pay cash in and so needed a benchmark, which was the market standard three months Libid [London Interbank Bid Rate]. This seemed a perfectly reasonable thing to do and all parties agreed to it. However, when three months Libid went haywire, there was no direct investment for the benchmark, which led to the manager taking more credit risk to try and meet it. This was not where we really expected or had thought about them investing, and so when the credit risk proved to be realised in terms of performance, we suddenly started saying, “Hang on, we’re getting tracking error on this return, it’s not through the asset class, it’s how we’re dealing with cash.” We just didn’t realise that that was a risk we were running using a standard market rate.
Funds Europe: Considering hedge funds and private equity then, what are your experiences of these asset classes?
Reader: It tends to be how you set it up within your pension fund and what you’re expecting it to do. The building block would be constructed, hopefully, to a specification that you set. The hedge funds that we have are very specialist and we’ve got some reporting requirements. One of the things is, it’s not quite as transparent as the traditional equity market, you cannot, at the end of the day, exactly see how it was going, you were always sort of one step behind. The big weakness with hedge funds is that they continue to find investors prepared to pay high fees. I think that it is absolutely amazing that the 2-and-20 fee structure still exists.
Weston: We’ve got exposure to real estate, hedge funds and private equity. Slightly different to Geoff, we’ve got a 10% allocation to property and have a specific property investment committee harnessing expertise from within our sponsor and we manage
the investments ourselves. All our property is in the UK. We have a property adviser, but essentially we make all the decisions on which properties we’re going to buy and sell. The day-to-day management is contracted out. The portfolio has performed extremely well against an IPD benchmark over many years. Property is also a great class because it’s inflation-linked and it’s a real asset.
For hedge funds, we use a fund of funds manager. The trustees took the view that there was not enough resource internally to run a direct programme.
Private equity is slightly different. The scheme has invested in private equity for quite a long time, again building on expertise from within our sponsor. We run the programme with the assistance of an investment consultant. It is a semi-fiduciary type of arrangement. We retain the ultimate decision-making about particular managers, but our adviser goes out and finds interesting managers, looks at the portfolio in its entirety, and makes recommendations about direction and assets. We don’t accept everything they say, but if we weren’t happy with most of the recommendations we wouldn’t keep them on as the adviser. Considering the subject of fees, costs, transparency, illiquidity, they’re all issues that we have to be aware of. The idiosyncratic risk of hedge funds is quite apparent given the SEC investigations at the moment – the SEC sweep of US hedge funds through the back end of last year.
The industry has seen a couple of hedge funds decide to give money back to investors because although there’s no evidence that the funds were implicated in any way, the fact that they’re being investigated and the fact that the investigation is ongoing means that fund of funds clients were just taking their money away, so they suddenly became non-efficient, so they give money back. So it’s a pretty volatile area. It’s a confidence issue at the moment. If clients have no confidence in them or are worried, why bother staying around just to see what the result is?
Funds Europe: We were recently in Stockholm where they are starting to see a trend away from funding towards seeding hedge funds. One institution we saw is doing a number of funds that are providing seed capital to hedge funds and this was being substantially backed by institutional investors. So the appetite is coming back for hedge funds, but for clean investments, for clean strategies, new start-ups without any heritage. There was take-up, but it was limited, but now that there is a track record of a year, there’s been more interest from institutions.
Weston: I think there is a gap in the market because the big funds of funds have tended not to invest in start-up hedge funds. So if somebody’s effectively prepared to move a bit up the risk spectrum and say, “This is a new start-up, OK, we know the individuals etcetera, but there’s no separate track record.” I think it’s a bit like venture capital at the higher risk end of the private equity spectrum.
Funds Europe: So what would you say are the ongoing challenges for pension funds on the investment front?
Weston: There are a number of issues that we have to think about and deal with as the scheme evolves. One is how we’re going to actually manage the scheme. Is it going to be solvency driven? Is it going to be driven by cash flow? Is it going to be driven by considerations of minimising volatility? These decisions really come down to where the risk tolerance of the trustees and the sponsor. What are they most concerned about? Are they most concerned about full funding? Are they most concerned about cash flow contributions or the timescale of achieving full funding? We need to find these sensitivities.
Once we’ve done that, we can think about how the investment strategy can deliver the goals. We have to weigh up things like the practical management of the assets. Do we outsource or insource? We manage property internally, we do asset allocation thinking
and sensitivity checking and asset liability monitoring. How much more should we do? Do we go down the route of Barclays and set up an independent regulated fund management company within the pension fund? Organisationally, how do we go forward? These are big challenges.
Then we have to consider the asset objectives. Are we after relative or absolute returns? What’s the right balance in the portfolio? Active or passive? Real assets or derivative assets? Where should we be on all these spectra?
For example, should we sell off our equities, have index features as our equity exposure and redeploy the cash into other assets? The more derivative assets you have the easier it can be to change asset allocations quickly and facilitate some of the more esoteric strategies that are now available. But for trustees, thinking about not having real assets but having a portfolio made up of derivatives is a big psychological shift. That will be an interesting challenge going forward.
I think it’s a huge psychological leap. I can see some of the benefits of having more flexibility in terms of how you run an investment strategy but on the other side of it, if you get a Lehman’s [2008 collapse] and everything blows up, how do you really calculate the risk? How do you give trustees comfort? We’ve got a portfolio of 40 buildings; they can go out and look at them. They know they’re there, they’re real; it doesn’t matter if Lehman’s blows up they’re still there. If you have a portfolio of derivative assets, it is completely different.
Funds Europe: There is the issue of whether trustees understand how these instruments are used.
Weston: This will be a major educational task and I think that balancing the returns that will be derived from doing that is ultimately a risk on its own. The key question is if we’re going to generate more return, is it really only because behind all the strategies we’re taking on more risk? It will be key going forward to ensure that we expand the comfort zone of the trustees so that we can look at more advanced strategies without trying to take them outside of this zone.
Funds Europe: Where have these products been pushed from: consultants for investment managers?
Reader: This sort of stuff is coming from the big asset management houses, and probably those asset management houses that are linked with investment banks because they’re used to selling options strategies to the asset management houses.
The pensions advisory departments in the investment banks pick up on this and go, “Why don’t we try and sell that to pension funds? It makes a lot of sense.” Sure it makes paper sense; you can just see how it works, and some of it is whether they’re happy being invested in commodities funds when you’re effectively rolling futures contracts all the time. So why don’t we do something similar on the equity markets? Great, intellectually fantastic; practically, you don’t see there are some more issues around it.
Weston: There are lots of hidden risks that you need to understand. We believe in a ‘conservation of risk’ principle: You can move risk around but you can’t get rid of it. You might remove one risk but you’ve taken on another risk, and in this sense you might remove the risk of the equity market going down, but you’ve taken on a whole chunk of counterparty risk.
Reader: The area I was going to suggest was to do with regulatory change because in the last year it has been immense. The industry thought we had to worry about RPI as the inflation ratio – and now it’s CPI. Investment management houses are slowly recognising that this means they have new challenges, and I wonder what else is up the Chancellor’s sleeve.
Funds Europe: That was a change that obviously came along without any thought for what it might mean for the pension funds.
Reader: Well, I think there was thought, and the thought was about how they funded them.
Funds Europe: Has it had the opposite effect?
Reader: No, it’s had the right effect. We were talking about liability management and worrying about inflation hedging; well, if you’ve been trying to hedge RPI and you’ve now got to hedge CPI, the instruments aren’t there to do it so you’re finding that you have
to come up with a solution rather than pure investment.
Weston: I think it would be remiss not to mention longevity. I think that’s a challenge going forward. We’ve seen a number of deals in the marketplace that seem to remove longevity risk. I do worry that something in the longevity space is going to blow up.
Reader: The counterparty risks?
Weston: Possibly. As with any new market, it can appear to be a great solution but then something goes wrong and we all have to take a big deep breath, step back and look at it again. We haven’t done anything yet to explicitly remove longevity risk. We’ve done a lot of work on potential structures but want to make sure that there aren’t any unintended consequences that might crop up further down the road.
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