By using asset liability modelling studies, trustees have recognised over the years that the characteristics of their pension fund liabilities are akin to those of fixed interest and index-linked bonds. They have determined their investment policy by assessing the risk and return benefits of investing in other types of assets, primarily equities, relative to holding the bonds that would best match their liabilities, and then determining how much of this risk they want to take.
The catalyst for change is, of course, that equity markets declined over the first three years of the decade and interest rates have continued to fall (albeit more modestly than in the late 1990s). This led to the emergence of significant funding deficits and has led to greater attention being focused on less traditional asset classes, manager skill (alpha) and liability-led investment.
Teeing off
The starting point for establishing a liability-led investment policy is to identify the future cashflows in respect of the pension fund’s liabilities over its remaining lifetime. The liability benchmark is the portfolio of assets that best matches those cashflows, or at least their characteristics. This will generally be defined as a combination of fixed interest and index-linked assets and include both government bonds and swaps.
The end point for some schemes is eliminating or minimising risk (for example Boots, at least until recently). Most trustees, however, wish to retain some risk in order to address any deficit or reduce the reported funding cost. For these trustees the identification of the least-risk position acts as a benchmark against which to measure risk.
It is at this point that many investment management firms have identified a new opportunity. Managers are seeking to sell services that add value to this least-risk position, rather than trustees seeking to add value by taking strategic asset allocation decisions and then asking the investment firms to manage money relative to this strategic asset allocation. This situation represents an opportunity for many investment managers to reach a position where they are managing all of a pension scheme’s assets.
The type of service offered by managers varies considerably. At the basic level, managers are offering traditional bond products, seeking to create added value of perhaps up to 1 per cent a year relative to the liability benchmark rather than a traditional bond index. In addition to investing in traditional government and corporate bonds they will use the swaps market to obtain the duration and fixed/index linked exposure. To date, it is this type of product that has attracted most interest.
Many managers have gone further, providing a service that seeks to add a higher amount of alpha through various strategies. Typically this involves investing in a variety of the firm’s products (equities, bonds, currency, asset allocation funds and other hedge fund strategies) capturing an array of alpha sources. The market exposure inherent in each product is then swapped back into the desired liability matching portfolio. Managers are increasingly offering such products. Implementation costs, transparency of best-execution and capacity constraints are likely to be key issues to address.
Finally, some managers are combining sources of active management with market exposure. This kind of approach is often referred to as “new balanced” and it contains a number of drawbacks that were a feature of old balanced. Not least is the assumption that the manager possesses investment skills in a wide variety of markets (a criticism that can also be levied against any manager using multiple in-house products as the sole source of outperformance). This type of product has had limited success in the pension fund market so far.
It is not yet clear how the marketplace in such products will develop. There is undoubtedly a role for fund managers in assisting pension schemes wishing to construct matched portfolios. Perhaps the most obvious extension is for the pension funds which have a high bond content strategy but wish to seek additional alpha from active bond management.
Some of the more adventurous strategies are attracting assets, but there will inevitably be disappointments in performance terms. Identifying whether the underperformance is the result of poor implementation, a lack of alpha or just a short-term experience will be also a challenge for all. For these types of product to gain traction managers need to give clients the option to choose external sources of alpha and then provide the means by which the alpha sources are ported back to the desired benchmark. We will encourage providers of such products to follow this route.
Andrew Barber, European Partner, Mercer Investment Consulting
