Choosing the right path

As pension funds around the world to take investment decisions, amid levels of unprecedented uncertainty, the advice of investment consultants becomes more important than ever.

Redington Partners co-founder Robert Gardner put it this way: “I like to use the analogy of the Rubik’s cube, with each different colour representing a different concern for both trustees and sponsors. All of these concerns are interconnected and interdependent, and all must be considered holistically.” 

Firstly, he noted, trustees need to review their investment strategies. This review must take three specific points into account: the state of the employer covenant, and its likely state in months and years to come; current market conditions, which can render a strategy practicable or unrealistic; and finally, the trustees’ own roles with the scheme – their relationship with the sponsor, and their ability to meet and make decisions. 

Gardner also identified the sponsor company’s covenant as a major source of concern for pension funds, pointing to examples of companies such as Woolworths, Nortel and Lehman Brothers. These are clear cases of how important the covenant is to the scheme (and its members) and highlight the importance of focusing on shorter term horizons as well as the long term funding target.

Risk tolerance and funding levels, which are inextricably linked to sponsor covenant and investment strategy, are issues that Gardner noted will no doubt be at the centre of discussions at the annual valuations, the results of which are typically published at the end of the first quarter.

In addition, Gardner said pension schemes would be addressing their fund managers’ performances, as in 2008 many funds experienced a sharp divergence from their performance benchmarks.

Hewitt’s Global Investment Practice principal Zuhair Mohammed commented: “In the overall scheme of things we think that manager selection is important but not the most important thing for a pension scheme. If you look over a three to five year period, even though some managers underperformed in 2008 most ‘buy rated’ managers are adding value.”

Mohammed agreed plummeting funding levels represented a major issue for schemes, following negative investment returns for all but the most nimble pension plans. 

Loss of equity

Referring to equity related losses above 30%, Mercer European director of consulting Nick Sykes explained: “Trustees know that equities can fluctuate in such a way. They have done it before and they will do it again in the future. On the other hand, areas like hedge funds, which are down between 15% to 20%, came more as a surprise. Among the bad news some were more surprising and upsetting than others.”

In particular, Sykes pointed out losses incurred in cash funds came as a real shock for pension funds. He said: “The problem in this case was that there are two types of cash funds. Some, which we could call pure cash funds, are very much focused on security and liquidity. Others, the enhanced cash funds which took extra credit and liquidity risk in seeking extra returns, did not manage to stay at par value.”

bfinance director, business development Sam Gervaise-Jones emphasised the biggest challenge for pension funds was the impact of the crisis on the values of pension assets and liabilities.

However, he added: “This period has prompted a lot of pension funds to start to look at not only whether their portfolio is set up the way they want it to be, but also whether or not the managers they have in place are the ones to lead them through the recovery.

“As with any crisis, there is a move to greater pressure on the governance side, i.e. how they [pension funds] are making decisions, what information they are using and which advisers they are using.”

Other opportunities

Against such a backdrop of uncertainty and looming economic recession, are there any investment opportunities pension funds should consider?

Cardano head of solutions Ralph Frank pointed out that, ultimately, pension funds need not try to gain massive returns, but should rather deliberately target what returns they need to achieve, based on their obligations and objectives. In this way, they can select the most appropriate opportunities in the market. Consequently, he said: “We advise trustees to carefully evaluate how much risk they can take in order to achieve their objectives.”

In terms of specific asset classes to consider and agreeing with Frank, Hewitt’s Mohammed pointed at the current attractiveness of the credit environment: “There are fantastic opportunities in the investment grade space through to the high yield, included convertibles. If you can secure some yield in excess of what you need in terms of returns for your funding plan, why should you not do it?” For larger pension schemes Mohammed added “there are some excellent ‘off-market’ opportunities across a range of asset classes for those with liquidity”.

Put it in different terms, many players in the industry are debating whether credit is actually the new equity. Gardner explained: “Historically people have invested in equities because they believed that, over a long time [a 10-year horizon], equities have shown the highest annualised returns. Typically that has equated to a return premium over government bonds of 3% to 4%. 

“Today, credit offers a similar type of return over government bonds, i.e. a 320 to 350 basis points credit spread over government bonds.”

Indeed, the question now faced by pension funds who are reviewing their strategic asset allocation comes down to whether, for the same company, they should hold its equity or its bonds, given historically high level of returns on credit. Gardner concluded that, on a fundamental basis, credit had a better downside risk profile than equity; however, credit does show considerable technical as well equity-like market risk. He quoted the example of banks: following government bailouts, banks’ equity value has dropped considerably, but senior paper has been guaranteed. 

As for opportunities in the equity space, Mercer’s Sykes believed the issue had to be approached in terms of a risk budgeting exercise aimed at determining the changes to the risk profile with respect to the previous year.

He explained: “If it [the risk profile] is unchanged, there is an argument in saying the fund should rebalance back towards its long term strategy of, for example, 60% equities and 40% bonds. Others would be more cautious in terms of risk budgeting and therefore be inclined to be overweight in bonds, even government bonds.”

The alternative option

A special place is deserved by alternative asset classes, given the increasing importance they have achieved in pension funds portfolios over the last years. Also given the bad press hedge funds have received coupled with the massive slowdown in the private equity activity caused by the lack of available credit.

Gervaise-Jones commented: “Undoubtedly, the Madoff situation has created some credibility issues for the hedge fund industry. However, when pension schemes are looking at the investment options available to them, if your equity allocation is down between 40% and 50%, then you would rather be with your hedge fund manager down 20%. Clearly there are issues around selecting hedge fund managers, but several pension funds still consider this asset class as a valuable opportunity.” 

In the same vein, Gardner also commented pension funds that have been invested in hedge funds for the last five years have actually seen this asset class deliver good returns, despite the performance of 2008. “The concern,” he added, “is the degree of transparency and the level of liquidity within that asset class - understanding the liquidity profile is important. The third problem with that asset class is the headwind of high fees and, in some cases; these fees were paid for simple market beta.”

Watson Wyatt head of European investment consulting Paul Trickett pointed out there are pension funds in the market prepared to have confidence in the asset class despite the some poor recent results and the Madoff scandal. Yet, he warned: “These kinds of investments are not for everybody, but with access to the right skilled managers they certainly can represent long-term successful strategies.”

On the private equity front, a sharp decline in the value of (listed) equities portfolios has often made private equity allocations become overweight against the scheme’s allocation benchmark, where this exists.  This, in turn, may have an impact on potential considerations relating to the rebalancing of the overall scheme’s portfolio. Cardano’s Frank commented: “On the question of the overweight to private equity, pension funds should not think in terms of hard/static allocations, but rather consider the forward looking risk and return expectations for future investments.  Cutting exposure to existing investments should take into account the cost and likelihood of exiting those investments. 

“It may well make sense to allocate further capital to private equity at the current point in time, given the opportunities coming up for fresh capital.  It should be borne in mind that capital committed in the near term will likely be drawn down over time.  Manager selection continues to be important in this regard as ideally managers should deploy capital when opportunities arise rather than seeking to invest commitments quickly, as was often the case in 2006 and 2007.”

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• Topics
• Investment
• Risk Management
• Mercer
• Hewitt Associates
• Watson Wyatt