Plan sponsors, too, are recognising the impact of equity market volatility on their pension costs and balance sheets.
Trustees are investing more in bonds and less in equities, reducing investment risk as schemes become more mature. Sensible, yes, but investment returns must exceed bond returns if deficits are to be eliminated within a reasonable period of time. How can we square this circle?
Equity markets have outperformed bonds in almost every 20-year period in the last century. It is plausible that the same will be seen over the next 20 years. Trustees continue to invest in equities for just this reason, but returns from strategic equity investments over short periods are unpredictable.
As March 2000 to March 2003 showed, bad luck happens. Mature pension schemes have short time horizons: focusing on the short term and protecting against deteriorating solvency levels is key. Employer insolvency may arise with little notice. Members’ benefits may have to be secured, at a time of someone else’s choosing, by the scheme’s assets and by partial cover from the new Pension Protection Fund.
Picking shares is different: over a three-year period a good investment manager should deliver “alpha”, or returns ahead of the market. But how can trustees access manager skill without the strategic exposure to equity markets?
Economists may expect equities to outperform bonds by 3 per cent a year on average over long periods, but annual volatility of equity returns may still be 15 per cent a year. Over a three-year period there is a reasonable likelihood of equities significantly underperforming bonds. Market risk is poorly rewarded: approximately 1 per cent of return for every 5 per cent of risk.
An active equity manager may target performance of 2 per cent a year above the market return, typically with expected volatility of 3 to 5 per cent a year. If market risk can be eliminated, this is a much more attractive trade-off. Even after investment management fees, we should expect at least 1 per cent of return for every 3 per cent of risk.
Shift from risk
Trustees have historically favoured market risk: with two-thirds invested in equities and an active manager aiming to outperform by 1 per cent a year after fees, three-quarters of the investment risk is attributable to the strategic allocation to equities.
Some trustees are shifting the balance away from the roller-coaster of market exposure, using equity market futures and interest rate swaps. We could call this “bonds plus” investing, as it aims to provide a steady return in excess of the return on bonds.
The idea is simple: invest in assets where active managers are most likely to outperform and where a futures market exists for hedging (almost) all market exposure; sell index futures to give up the market return; buy interest rate swaps to obtain the return on bonds, so that the investment return becomes “bonds plus alpha”.
The result is radically different: investments are chosen according to the perceived level of opportunity for alpha. Strategic allocations to equities or other non-matching assets are not required, though some reduced exposure may be maintained. Similar target returns relative to bonds may be maintained whilst volatility of returns is reduced.
Search for alternatives
The quest for alpha and the need for diversification may lead trustees to invest in a much wider range of assets than before. Some alternative asset classes offer excellent opportunities. Currency markets may be inefficient due to the large number of participants who do not seek to maximise profits on trading (such as you and I when travelling abroad).
Diversified exposure to hedge funds may, with appropriate selection and monitoring, be well placed to provide returns above cash. Tactical asset allocation may also add value, if positions for and against a wide range of markets and currencies can be implemented efficiently.
Each additional approach increases the complexity of the arrangement and adds to the burden of monitoring, but each uncorrelated source of alpha raises the likelihood of the overall performance target being met with consistency from year to year.
Just as equity markets may disappoint even over long periods, so an investment manager may fail to deliver the expected outperformance. The net result will be overall performance below that of bonds, leading to lower levels of solvency.
For many trustees, the use of futures, swaps and, perhaps, alternative asset classes would require significant further analysis and education. The approach, its costs and benefits, its strengths and weaknesses, must be clearly understood by those with responsibility for investing on behalf of scheme members. And yet this has been achieved by some and is being considered by many. A growing number of investment managers are well-placed to assist trustees and to make “bonds plus” investing accessible to pension schemes of all sizes.
Lessons to consider before adopting a “bonds plus” approach include: understanding the loss of potential “upside”; knowing tht the scheme will not participate if or when equity markets produce spectacular returns; quantifying the performance drag due to fees and the costs of managing and transacting derivative portfolios; knowing that diversification is key; and using a range of investment managers or different teams with uncorrelated performance to provide protection against those that disappoint.
Steven White is a partner at Lane Clark & Peacock LLP
