The shape of things to come

Trustees, scheme managers, consultants and fund managers have much to focus on for the pensions year ahead, as will pension scheme members.

What with the Pensions Act 2008, the review of the Institutions for Occupational Retirement Provision (IORP) directive and implications for pensions and government plans for state pension benefits, legislative considerations will be to the fore.
When it comes to investment, trustees also have much to engage them as they monitor how their funds are performing and ensure their professional advisers and practitioners are meeting their brief.

Punter Southall principal Jane Beverley explains why the review of the IORP directive could be one of the main challenges in 2008.

She says: “While pensions were excluded from the scope of the Solvency II directive for insurance companies, there remains a concern that a solvency regime may still be introduced via the IORP directive and this could have a significant detrimental effect on pension provision across the EU.”

When it comes to regulation closer to home Beverley adds the other key development will be the Pensions Act 2008, which will give shape to the personal accounts scheme.

She says: “While the broad outlines of personal accounts are now clear, there are a number of key issues that need to be resolved – not least the exemption criteria for existing schemes, including group personal pensions.

“The Pensions Act will also contain any areas on which the government plans to legislate following the deregulatory review – however, it looks increasingly unlikely that there will be any substantial changes to the existing rules for defined benefit schemes.”

As a big-picture question, the arrival of personal accounts is something agitating Baring Asset Management’s UK head of institutional Richard Graham.

Graham says: “The government needs to understand that the Citizens Pension will not work with the current system of means tested pensions credit.

“Quite simply the way the system works at the moment is you are much better off not saving anything and falling back on means tested pensions credit than saving a little bit and fussing about a personal accounts pension.

“The object of personal accounts is that they will help people who are not very well off save and prepare for retirement, but it is incompatible in my view with the existing means-tested pensions credit system.

“The government needs to think hard about how they are going to change that system and they need to start it now by winding down the means-tested pensions credit so that by the time personal accounts arrive in 2012, means-tested pensions credit has disappeared and the basic pension the government provides has been significantly increased so you have much fewer people on the poverty line.

“If they try and do it in one jump it will be absolute chaos.”

Meanwhile there will be obvious focus on the investment strategy of pension funds.

Funds will continue assessing themselves and their advisers, both formally and informally, to improve effective decision making, according to Henderson’s director of institutional business Arno Kitts.

He says: “The NAPF review of UK Institutional Investment Six Years On (Review of Myners Principles) will focus attention on this.”

As regards risk management, Kitts says funds will continue to look at investment strategy in a more holistic and integrated way, as function of covenant, funding, governance, assets, and resources.

He says: “The LDI buzzword will be challenged if not replaced by covenant driven investment.”

Graham agrees with Kitts on the importance of pension fund managers focusing on what advisers are telling them and has a message to pension funds, and in particular their consultants, as regards to the asset classes they are incorporating into their investment model.

Graham says: “Consultants need to think more carefully about whether their current model recommends lots of specialist managers in specialist asset classes, which are going to be, and already are proving, more volatile than consultants predicted and trustees expected.

“For medium-sized pension schemes and certainly for smaller ones, there may well be lots of value to be had in multi-asset targeted return portfolios, focusing on an objective and risk budget which trustees can agree on. The manager can then get on with the difficult business of forecasting returns, choosing asset classes and anticipating things that are going on in the market, which causes them to adapt to the portfolio tactically.”

“It is no good having a fixed view on specialist alternatives. You need to have a fluid view that recognises that they can add value in certain markets and conditions and then you have to have someone with the expertise and capability of deciding when that moment is. Asset allocation is an asset manager’s skill and that is not something consultants give enough recognition to.”

When it comes to property as an asset class Goodman Property Investors’ deputy managing director Andrew Smith, not surprisingly, has a different view, although he concedes we may have seen the best of commercial property returns in the UK for a while.

Smith says: “The focus for most institutional investors is commercial property which has a good run of extremely strong performance for several years and really the last three calendar years returns have been around the 18-19pc mark in the UK consistently year on year.

“It is a very unusual thing to have such a sustained period of outperformance but the reason behind that is a lot of institutional investors felt commercial property as an asset class was under-priced relative to other investment markets.

“There has been a wall of money chasing property from a large number of institutional buyers both UK and international and only a limited amount of stock to invest in and that is what has driven this strong performance.”

But Smith agrees now such a confluence of factors is unsustainable and over the last few months there has been a shift in investor confidence and a feeling parts of the market have overheated.

The quite severe correction in values in the commercial market is despite the fact the market is driven by two factors: what investors are doing and what property occupiers, i.e. those paying rent and providing income streams to pension funds, are doing.

Smith says: “We have this unusual distinction between the sharp fall off in returns and investor confidence which is undermining capital values but at the same time we are still seeing a healthy letting market. We are seeing rental growth across all sectors and in many cases the letting activity is busier than it has been for some time.”

While the market has therefore seen a reversal in returns from 18-19pc last year to a minus 2pc forecast for the year ahead, the reasons for that decline are still not logically relative to what is happening in the wider economy.
There are chinks of light in the overall attraction of property as an asset class.

As Smith points out: “It has very useful diversification attributes compared with much more volatile equities and bonds and it has this very healthy income stream which is a stable part of the performance which appeals to long-term investors and pension funds in particular for liability matching.”

It is this long-term view and how well property sits within that, which will keep pension funds interested in property Smith predicts.

He says: “With the values correction in place, which we feel will happen quickly, there is evidence there are buyers there willing to come into the market again but not until they feel prices have bottomed out.

“So unless something else happens to upset the continued growth of the economy there is a reasonable likelihood, with more buyers around in the middle of next year, prices will stabilise and then we are back into a more normal and balanced market.

“You will not get the unsustainable high returns but a realistic prospect of real long-term returns of about 5pc on top of inflation, which is what pension funds generally are looking for.”

Looking beyond the UK there has also been a shift for pension funds to diversify property holdings overseas mainly into continental Europe, Smith adds. Although a slowdown in returns is anticipated next year he says there is going to be more of a shift to a more balanced view including the UK at more attractive pricing in a pan European portfolio but also diversifying beyond Europe.

Smith says: “ Pension funds will be thinking about global property opportunities and the way they will do that is investing indirectly in funds rather than owning bricks and mortar which smaller funds were often not able to do anyway.”

The movement away from the UK is not just one evident in the property sector. According to T Rowe Price’s UK and Ireland regional head Stephen Millar on the equity side we will see the UK and non-UK split becoming less apparent as the move out of UK equities and the adoption of global equity mandates continues.

Millar says: “The wider opportunity set means there are great opportunities to generate alpha on a more consistent basis by having a global opportunity set rather than a domestic one.

“Investors will become more comfortable in allowing their managers to adopt more unconstrained approaches, but that will be subject to clients being comfortable that their managers have the skills with which to use that wider investment framework.”

For clients the starting point will be their liabilities and where their assets are and what they need to meet their liabilities on a long-term basis, Millar says. That in turn will mean they do have to look at whether they are doing enough with regard to the equity components of their assets, and if not enough to identify what they need to do and who they need to do it.

Millar says: “The number of unconstrained global mandates has increased substantially over 2007. We very much expect that to continue as clients are more aware of those managers with the investment skill and those without.”

So 2008 will see more diversification of asset classes within pension fund portfolios. Investment strategies will still encompass LDI type needs, risk mitigation and the drive for potential higher returns but the move to alternatives to equities and bonds and mandates for managers to use their discretion to achieve those ends will increase.

ABN AMRO Asset Management’s Deborah Harris says there has been much more interest in an absolute returns type mandate in 2007.

She says: “We are starting to see more demand for the type of products that look to outperform cash rather than any particular bonds or equity benchmark.

“More schemes are moving towards putting a liability match in place alongside something that can give a return in excess of cash, which is effectively the growth asset part that compliments the LDI section. And we are seeing a shift away from UK equity exposure.

“We are seeing a lot of demand for dynamic asset allocation, which looks to generate returns similar to equities but with a risk level much closer aligned to a bond type of portfolio.”

Harris says there is also a demand for alternatives, such as fund of hedge funds, currency, global tactical asset allocation etc, and she agrees there is more focus on global or European property.

At route clearly of any investment strategy has to be the pension fund trustee among whom Harris says there is a greater awareness of risk but that they are trying to broaden out the number of asset classes they can access at the overall portfolio level.

Harris adds: “The risk can often remain the same and enhance the return potential or even bring the risk down a little and keep the same return potential. This is where dynamic asset allocation funds demand comes from. It gives the opportunity to move between these asset classes, for example to access property at the right moment if that is what the manager thinks appropriate without the trustees needing to have that level of decision making.”

There is a continuing trend towards co-operation between pension fund consultants and the asset management industry to help clients meet their objectives so that ongoing dialogue will continue.

As for trustees, they need to keep a beady eye on their investment manager and make sure they are doing what they said they are going to do, according to Graham.

He says: “It is going to be a difficult year – there are plenty of things, credit, mortgage backed securities, hedge funds, quite a few cash funds which have hit all sorts of icebergs and rocks no one knew were around, so this is a good year to have a look at whether investment managers have sailed through this reasonably intact and with some positive returns.

“Next year will be more of the same. If the markets trend down sharply over the next few months there might be some interesting opportunities later in 2008 but I do not think it is going to be an easy run.

“Know your expectations, ask the difficult questions, batten down the hatches and review whether you need a slightly more dynamic approach to asset allocation recognising that we are in volatile times.”