> Pension Funds Insider> More of the same won't do for UK pension fund asset allocation
A recent document sent by consultant PwC to its clients has questioned the accepted 'wisdom' that gilts are the best matching asset for UK pension liabilities.
Writing in the Financial Times ('Plunging gilt yield sends pension schemes in search for alternatives', 5 August 2012), Gill Wadsworth points out that the latest round of quantitative easing (QE) resulted in ten-year gilts falling to record lows of 1.4%. With UK pension fund deficits standing at 267bn (Pension Protection Fund, June 2012), these poor gilt yields "may drive trustees to consider more derivative-based strategies that free up capital and promise the opportunity to deliver extra return."
She goes on to observe that gilt repos – where investors sell gilts with an agreement to repurchase them at a future date – and swaps are "growing in popularity as a more efficient way to match liabilities while also acting as a deficit repair strategy."
Pension fund trustee responsibilities
This is just one example of the challenges facing pension fund trustees in a rapidly changing investment landscape. Engagement in the markets, along with the risks and opportunities associated with the responsibility of trusteeship has never been so important. The following extract from Schroders' 'Best practice for pension fund investment' (October 2010, but the principles still stand) is a useful reminder of the responsibilities.
"The ultimate aim of pension scheme investing is to pay the scheme's liabilities. Schemes should therefore look to manage their investments accordingly. This is commonly referred to as "liability driven investment" (LDI). In practice this can mean:
1. Adopting an overall liability based benchmark (e.g. outperform the liability discount rate by x%) rather than, say, a peer group benchmark.2. Focus on managing funding level risk rather than just asset risk. This may mean, for example, tailoring a scheme's bond portfolio so that it matches the nature of the liabilities, even if in isolation such a portfolio would be more volatile than a poorly matched one.3. Schemes should look to only take investment risk when they expect to be rewarded for doing so. An example of a rewarded risk is equity risk. Unrewarded risks include interest rate risk and inflation risk in the liabilities not hedged by the assets.4. Schemes should look to diversify their assets where possible. However to be successful diversification strategies should be "dynamic", reacting to changes in the economic environment.5. Pension schemes are very long-term investors. They should therefore look to exploit this by investing in assets with time based premiums such as the illiquidity premium (i.e. receiving a premium for locking up capital for a period of time).6. As long-term investors pension schemes should avoid focusing on short term performance excessively. Excessive short-termism destroys value by the cost of excessive trading and by draining a scheme's governance budget.7. As investors with large amounts of available capital, pension funds with significant governance budgets may be able to exploit an "early adopter" advantage when moving into new markets that other investors cannot."
Annual return demands
A separate article by FundFire's Tom Stabile ('Pension funds need to rethink their targets', 5 August 2012) provides a useful comparator with US public pension funds in the light a National Association of State Retirement Administrators report that 45 out of 126 large US pensions have reduced their investment return assumptions since 2008. Commenting on the balance between short-term performance and long-term objectives, he says that pension funds could adopt two core rates, "one looking at big funding inputs and macroeconomic assumptions, establishing what they need to run soundly for decades; and another framed around possible returns, given the current market." He adds: "Divorcing the two could tie politics and policy fights to long-range rates, without tainting a sober market call on the present."
What these two very different observations point to is that pension fund trustees need to be more demanding of their consultants and not be content with doing what has always been done in the fond hope that the long term will smooth out all the bumps. The funding deficits are simply too big.
First published 8 August 2012
09 August 2012
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