Running a UK pension fund should no longer be like risking a hair-raising rollercoaster ride; instead the experience for today’s trustees may be more akin to driving a solid, Scandinavian estate car.
As trustees and advisers learnt lessons from the market crashes of 2000 and 2008, their focus has turned to investment strategies that insulate from the worst of market moves and take schemes on a slower, steady journey to full funding.
At the same time, UK defined benefit (DB) schemes carry significant deficits. Figures from the Pension Protection Fund – the body charged with managing DB pensions of companies that go bust – for February 2013 show a shortfall of £201.5 billion, meaning the need to minimise volatility cannot be at the expense of outperformance.
Rob Gardner, co-chief executive of pension investment consultant Redington, says trustees no longer view risk and return as unrelated elements; instead they are managed in tandem. “Trying to manage risk, while generating sensible outperformance, is a challenge,” says Mr Gardner. “It requires a more sophisticated approach to investment and asset allocation.”
This sophistication manifests in greater diversification across asset classes with UK pension funds abandoning their traditional bias to domestic stock markets and bonds, in favour of encompassing a greater geographical spread and a larger number of investment opportunities.
The UBS Pension Fund Indicators 2012 survey shows DB allocations to UK equities have fallen from 51 per cent in 1999 to 18 per cent in 2011. Meanwhile alternative assets, which include private equity, hedge funds and commodities, increased from 1 per cent to 9 per cent.
Trying to manage risk, while generating sensible outperformance, requires a more sophisticated approach
In January, Hertfordshire County Council awarded LGT Capital Partners £280 million to invest across alternatives, one of the largest mandates of this kind awarded by a local authority.
“Pension funds are thinking less about asset classes in isolation and more about the risk premiums associated with them,” says Mr Gardner. “Some asset classes exhibit more risk than others.”
Except at the largest and most well-resourced pension schemes, trustees cannot be expected to dedicate the requisite time to running an actively managed, adequately diversified fund. As a consequence diversified growth funds (DGFs), which offer trustees a single access point to a range of asset classes run by one investment manager, have won favour over the last five years.
Chris McNickle, global head of institutional business at Fidelity Worldwide Investment, says: “Diversified growth funds are popular because they tend to be well spread across a range of asset classes and try to lean away from asset classes that are expected to do poorly at a moment in time.”
Defined contribution (DC), which is replacing DB as the dominant workplace pension, is also a candidate for DGF investment since individuals are often unable or unwilling to make investment decisions themselves.
Research from consultant Towers Watson in May 2012 showed 92 per cent of FTSE-100 employers offered DGFs in a DC default strategy.
However, more recent research by investment manager Schroders found the majority of assets held by FTSE-100 company DC schemes are in global equities (47 per cent), UK equities (27.5 per cent) and fixed income (10 per cent). The remaining 15.5 per cent is split between cash, property, hedge funds, commodities and other asset classes.
Stephen Bowles, head of DC at Schroders, says: “Many employees of the UK‘s largest employers have no exposure to a wide range of alternative asset classes. The average DC default strategy appears not to have diversified away substantially from pure equity exposure.”
In addition to DGFs, pension investors have the option of risk parity funds. These take the standard idea of diversification but, rather than spreading capital across asset classes, fund managers allocate assets based on their risk relative to each other. However, limiting volatility often means reducing exposure to return-seeking assets, so risk parity funds borrow, or use leverage, to deliver outperformance.
Andrew Dyson, head of global distribution at Affiliated Managers Group, which offers risk parity funds, says: “Even with leverage risk parity, funds are less risky than a traditional portfolio might be. They are catching on and we are starting to see risk parity as an alternative to DGFs.”
In leaner times, when outperformance is scarce, pension funds have started to free fund managers from constraints, allowing them to invest in their best ideas.
These “unconstrained” mandates offer trustees returns over and above traditional index-related funds, and are usually covered by a performance-related fee.
“Many pension funds put unconstrained mandates in their portfolios because they think they achieve better risk-adjusted returns than strategies obligated to stay closer to a benchmark,” Mr McNickle concludes.
