Pensions World

Pension schemes are eschewing equities in their bid to mitigate risk. Allison Plager reports

Against a background of austerity measures in the UK, the bail out by the Euro-zone of Greece in April 2010, the explosion of the BP rig in the Gulf of Mexico and the snow in December having a detrimental effect on everyone’s Christmas shopping, the FTSE 100 reached 5,899.94 by the end of the year. It had reached 6,000 around Christmas before slipping back, but experts are wondering if it will crack the potentially record breaking 7,000 point by the end of 2011.

It seems that, despite everything, the finance world is clawing its way back up, with the FTSE 100 reaching 6,056 at close of play on 8 April. How, though, does pension scheme investment measure up?

According to Towers Watson’s global pension assets study published on 7 February, global pension assets grew by more than 10% in 2010. “The global financial crisis is still with us”, says Carl Hess of Towers Watson, but “while nervousness about the volatility of markets and extreme events is just below the surface, there is broad acceptance that this is the new normal and that investors will need investment strategies that are more flexible and adaptable than they have been in the past.”

Certainly managing risk is all important for pension scheme trustees and, says Mercer’s Crispin Lace, “this means bigger allocations to government bonds”. The National Association of Pension Funds’ (NAPF) latest annual survey, carried out in late 2010, certainly underlines this conclusion. It shows a distinct conservatism in the investment choices made by pension schemes as they move away from equities into gilts and other asset classes. The overall share of investment in UK index linked gilts rose from 7.9% in 2009 to 12.3% in 2010, while pension schemes’ investment in equities fell by a quarter between 2005 and 2010. According to the NAPF “this underlines the need for the government to increase its issuance of long-dated gilts”.

A good year?

Did pension schemes have a successful time in 2010? BNY Mellon Asset Servicing (BNY MAS) estimated results for the year show that the average UK pension scheme achieved an estimated weighted average return of 12.5% for the year ending 31 December 2010. This is an estimated real return of 7.8% when measured against the Retail Prices Index (RPI) for 2010 and an estimated return of 10.5% when measured against the average weekly earnings index (AWEI). It is the second year in succession that UK pension schemes have delivered a positive return.

Over the three-year period to 31 December 2010, schemes achieved an estimated average return of 3.6% a year, outperforming the RPI by 1% and the AWEI by 1.7%. Likewise, over longer periods BNY MAS estimate that schemes managed an estimated weighted average return of 5.2% a year over five years and 4.5% a year over ten years, also outperforming the RPI and AWEI.

The analysis shows that equity and fixed income returns were positive over 2010 for all the key sectors, with the strongest returns coming from Pacific ex Japan equities returning 23.4% and emerging markets equities 22.6%. The return for UK equities was 14.5%. UK bonds posted 7.2% and overseas bonds posted a 9.9% return, while the estimated property return was 9.6%.

Commenting on the estimated results, Alan Wilcock of BNY Mellon says “2010 was another positive year for UK pension fund asset performance.

“These results would have helped to offset increasing liabilities driven by falling bond yields.”

Hello bonds

As already mentioned, pension scheme trustees have become more risk averse over the past decade and have increased their investment in bonds at the expense of equities. The BNY Mellon estimated analysis confirms this, as in the past ten years the asset allocation of bonds has risen from 15.8% to 28.9% with index linked also increasing from 5.2% to 13.5%. The emerging markets sector continues to rise, reaching 3.2% at the end of September 2010 – in September 2000 the percentage held in that sector was 0.8%. In considerable contrast, the UK equities percentage has fallen from 51.2% to 23.7% over the same period.

Rather oddly, this is not entirely borne out by research carried out by Towers Watson recently. The number of equity mandates awarded by the firm’s clients worldwide in 2010 increased by over 30% from 2009, while the number of hedge fund mandates grew by 50%. At the same time the number of bond mandates fell by 30%, with US and Euro bonds showing the most significant fall in demand from the previous year. Private markets attracted significantly more interest from investors in 2010 than in 2009, with the number of mandates growing by 73%, led by renewed interest in direct real estate and distressed debt.

However, Towers Watson’s Craig Baker notes that emerging markets are growing in popularity, saying “while global mandates continue to dominate, there was a significant increase in emerging market equity mandates”. Similarly, Mercer’s Crispin Lace says that trustees are aware that the level of returns from developed markets may not be as high as it was in the past, so they are looking at new opportunities in, for example, the emerging markets. However, they are not restricting themselves to equities in these markets; he cites interest in other areas such as equity debt and infrastructure.

The Towers Watson research finds renewed interest in hedge funds, with demand for fund of hedge fund mandates rising back to 2008 levels and mandates for direct hedge funds accounting for 60% of all hedge fund searches.

Mr Baker adds “a noteworthy development of the year area was the interest in distressed debt which was the second most popular mandate, after direct real estate, in the private markets area”.

Similarly, BlackRock’s Mark Johnson says there has been a resurgence of interest from trustees in diversification, especially in alternatives such as UK and global property, real estate debt, hedge funds and private equity.

Balanced management is not dead

This is the 20th investment managers’ survey carried out by Pensions World. Anyone who has followed the history of this feature will not have failed to notice that it has, over the past few years, shrunk in terms of numbers of managers taking part, as can be seen in Table 1. This can be ascribed in part to mergers of firms and reticence on the part of some to divulge figures, but most significantly to the diminution of the number of managers offering segregated balanced pension funds. Not that balanced management is dead – it is still available, just in a new guise of “multi-asset”.

Whether or not there is still a place for balanced management is a vexed question (Table 2). As James Thorneley of Aberdeen Asset Management says, “the balanced investment management industry has undergone a number of changes, not least in nomenclature” in the past ten years or so. Investment managers have during this time adapted to pension scheme trustees’ changing investment needs, but he adds that “while there is still an element of work in progress for some balanced investment offerings to bring them into line with trustees’ requirements, balanced still has a major role to play in pension funds’ investment”.

Balanced products tended to invest in equities, bonds and property, usually following peer group benchmarks, with modest outperformance targets. Most now agree that, with the benefit of hindsight, this was far from perfect. As Mr Thorneley says, “most managers were essentially being asked to deliver ‘beta’, with commensurately low stock specific risk and asset allocations close to peer group average. It was little wonder that much of the criticism centred on the industry’s willingness to collect an active fee for what often turned out to be a quasi-passive product and that peer group indexing ultimately impacted on managers’ propensity for creative thinking.”

Recently, the term “multi-asset” has become the replacement industry jargon for “balanced”. This combines different asset classes, including private equity and hedge funds, allowing more flexible investment to cope with a volatile environment. Of particular note, says Mr Thorneley “is the significant flow of new multi-asset investment products currently being developed by the industry to meet the demand of smaller pension schemes in this area”.

Mercer’s Crispin Lace confirms that “the idea of a pooled multi-asset fund is not new: it is a new evolution of the old balanced product, but with many more asset classes”. The benefit is that such funds give smaller funds looking to allocate to multi-asset classes the opportunity to do so.

So it would seem that balanced management continues to play a vital role for many pensions schemes, especially smaller ones, as they can offer access to asset classes including alternatives, allowing schemes to include investment types that would otherwise be unavailable to them, and often have absolute return based targets that more closely match a scheme’s liabilities.

Standard Life’s Robert McKillop says: “Having a specialist asset manager structure in place has provided investors with both manager and asset allocation diversification. However, most of these asset classes became highly correlated during the downturn, significantly impacting expected diversification benefits.

“Therefore, we are seeing a trend to absolute return investing.Effective absolute return strategies rest on robust and repeatable investment processes, combining dynamic allocations to traditional assets, such as equities, bonds, property and treasuries, with more advanced sources of market returns accessed using derivatives.

“This results in a fund that actively maintains a highly diversified array of positions, offering the possibility of positive performance, regardless of individual market conditions.”

Pooled funds

BNY MAS’s quarterly CAPS survey shows that pooled balanced funds ended 2010 on a positive note with a return of 6.8% in the fourth quarter.

This resulted in a median return for the full year of 13.8%. The results were also positive over three and five years, with returns of 3.1% and 5.4% a year respectively.

Over 12 months, UK equity achieved 15.2% which also outperformed its index which returned 14.5%. For the three year period to 31 December 2010, UK equity posted a positive return with 1.4% a year, matching the FTSE All Share Index. The five and ten year periods were also positive with annual returns of 5.1% and 3.7% respectively, again matching their indices’ returns.

Global equity produced a return of 15.8% for the year against its index of 16.7%. The three, five and ten year returns achieved 2.6%, 5.7% and 3.7% a year respectively.

Within the balanced pooled fund universe, the most notable change was the increase in weightings in UK equities which, by the end of the fourth quarter, had risen to 38.2% from 36.9% in the third quarter.

With regard to asset allocation trends over the last decade, the BNY Mellon statistics show that in the final quarter of 2000, weighting in UK equities stood at 53.3%. Given the current 38.2% weighting, this equals a reduction of 15.1% from the start of the decade.

Commenting on the results, BNY MAS’s Alan Wilcock said there had been a “strong recovery in UK mid-cap and small-cap companies, in terms of share prices” over the past year. He added that, although large caps have “not been as strong, they still posted double digit returns”.

The figures in Table 3 reflect BNY MAS’s findings, with Aberdeen and Aviva achieving 16.30% and 16.45% respectively for the year. The results for the period 2006 to 2010, which take into account the disastrous results for 2008, are not so impressive. Schroders, for example, hit 7.37% and Standard Life 4.16%.

More aware

Pension scheme trustees have had to immerse themselves in investment issues over the last few years and are considerably more knowledgeable than they used to be. Mr Lace says there is a “huge improvement in trustees’ investment knowledge”, adding that they are “much more proactive in this area and realise the importance of making timely decisions”. Trustees have to be focused on ensuring that the scheme’s liabilities are met and, to do this, must be well informed and keep as up to date as possible with the investment options open to them.

As BlackRock’s Mark Johnson says “trustees are managing and anticipating risk more astutely than in the past. They and the sponsoring employer see the scheme on a journey which may end in an insured solution. The more buoyant equity market in 2010 and pick up in yield has helped improve funding levels. As a consequence we have seen greater interest in liability matching and how to mitigate interest rate and inflation sensitivity.”

Returns over the past two years have been positive, but we all know that past performance is no guide to the future. Trustees’ current aversion to risk is understandable.