Professional Pensions’ roundtable discusses how pension scheme asset allocation is changing due to the pandemic
Mohamed Fazal, Co-head of ALM and investment strategy, Redington
Fazal joined Redington in 2012. His focus is on making sure the firm delivers the best advice and investment solutions, based on sound analysis of its clients' individual circumstances
Tony Filbin, Independent trustee
Filbin joined Legal & General in 1979 and held a number of senior roles, including managing director of workplace savings. He left the firm in 2014, taking up a number of pension trustee positions and non-executive director roles
Marcus Hurd, partner and managing director, ndapt
Hurd is a professional and sole trustee and also provides non-executive director services for organisations with pension challenges
Claire Lincoln, EMEA head of sales, World Gold Council
Lincoln joined the World Gold Council in 2020. Prior to this, she spent more than 13 years working in front office sales roles within firms including Bloomberg, Credit Suisse and Bank of New York Mellon
Graham Jung, trustee director, Ross Trustees
Jung joined Ross Trustees in 2021 and has more than 20 years' senior experience in roles that include KPMG, Goldman Sachs, Henderson Global Investors and BlackRock. He has worked with DB and DC schemes of all sizes
Danielle Markham, senior investment consultant, Barnett Waddingham
Markham advises UK schemes on a wide range of investment issues, including asset strategy, risk reduction and manager selection. She leads the company's research on LDI and is a member of its investment consulting research board
John Reade, chief market strategist, World Gold Council
Reade joined the World Gold Council in 2017 and has more than 30 years' experience in gold, working in mines, investment banks and hedge funds. He leads WGC's research team and is a member of its executive committee
Angela Winchester, trustee director, 20-20 Trustees
Winchester joined 20-20 in April 2021. She has over 20 years' experience in areas such as investment management, business transformation and change management
How is asset allocation for pension schemes changing due to the pandemic?
Mohamed Fazal: Asset allocations are ultimately a function of client objectives, preferences and expectations of return and risk. While it has been a tumultuous year, if we look today at where our risk and return assumptions are, they aren't all that different to where they were a year ago. Credit spreads are low, equity market valuations seem high, but we've been here before.
Among clients, there has been an increased focus on covenant risk. They are keen to get to their long term objectives quicker and to take advantage of strong funding positions by derisking when it's affordable to avoid potential losses from sponsors going out of business.
The other main area of change is a much greater appreciation of the potential market impact and risk of non-financial macroeconomic events. As a result, climate risk and ESG have moved up the agenda for most of our clients. A lot of this has been supported by regulatory change, but clients are more concerned about the impact of risks that might not originate in financial markets. How these risks translate to pension schemes and investors more generally is how the pandemic has shifted the dial.
Angela Winchester: We have been in a period of suspended animation for the last 15 months, but there will come a point where there will be a lot of insolvencies. There have been very few in the past year because everyone has been propped up by government money. When that starts to trickle away, the economy is going to look very different. It's difficult at this point to make decisions because there is a lot to still come out of this pandemic.
Marcus Hurd: That point on sponsor covenant is important. We are going to see a wholesale shift in the number of insolvencies. From an investment perspective that's a bit of a nightmare, because if you're heavily invested in a risky strategy and your sponsor disappears, you're going to find yourself in the Pension Protection Fund. There is guidance available on how to invest in a risk-controlled way if you have a weak sponsor - and I would argue pretty much all sponsors are weak now, but we've not taken it too literally because we know the support is there.
Tony Filbin: Most defined benefit (DB) schemes are on a journey to buyout in some way, and many are disinvesting because their cash needs are greater than their income. The conversation I have is more about liability-driven investing (LDI) or, if there's a valuation coming up, about the impact of investment decisions.
In defined contribution (DC) there's a lot of emphasis on default funds. We've been talking about the Task Force on Climate-related Financial Disclosures (TCFD) recommendations and other regulatory things. These tend to dominate the conversation and we leave the expert [investment] stuff to people like Mohamed and Danielle.
We do an annual member analysis that points to average size, holdings, and contributions, and this informs changes to asset allocation. We have a discussion with our asset managers and make those decisions, but we're not making them on a day-to-day basis.
Angela Winchester: Although we're talking about the change due to Covid, there has been a gradual shift in the last ten years, and the pandemic has perhaps just further contributed to the shift. If you look away from that pure equity/bond split, the bucket of ‘other' has increased significantly, driven primarily by LDI strategies for DB funds.
I've also seen a rise in private markets allocations. This is a challenge for pension funds that are traditionally low risk, but some schemes and funds are dipping a toe in the sector. ESG, thematic and impact investing could also drive some changes when you consider infrastructure projects and development of new low-carbon technologies are often funded outside of the mainstream asset classes.
Are changes we are experiencing now part of that shift towards alternatives, or is something fundamentally changing in asset allocation?
Danielle Markham: People are much more accepting of the fact that they need to focus on their end objectives. The risks within the scheme need to be aligned with that. They're not trying to get every last ounce of return out of the portfolio; it needs to be well-managed and well-diversified to achieve that endgame.
The pandemic has thrown a spotlight on the risks that need to be managed. We are seeing a lot of action to de-risk and to avoid the sleepless nights trustees had back in March last year. It's not a case of having a strategic allocation that's going to be in place forever - schemes need to be able to act when it's affordable and look for opportunities to get back on track to meet their objectives.
Is increasing volatility in portfolios a concern?
Danielle Markham: It comes back to diversification, and not just by asset class but by drivers of return, to ensure volatility is manageable. There are different ways that you can do that, like moving towards private and illiquid assets to access that illiquidity and complexity premium.
In the past, only larger DB schemes have had the governance budget for this, but we've seen it expand across all schemes. Considering the full spectrum of investments is being forced on smaller schemes because of the need to control volatility and risk.
Angela Winchester: It feels like every asset class has its challenges. Pension funds, particularly DB, have been less inclined to take risk because they have obligations to fulfil, and must ensure that they get the correct balance to fund their liabilities, but certainly for DC schemes, and outside of the default fund space, there is an opportunity to be more open to exploring different asset classes, but it comes down to managing risk and doing the right thing for the members, and to a certain extent this may depend on the demographics of the scheme membership.
Graham Jung: Volatility is not what's going to carry us out here, it's downside - risk of loss. There is not enough focus on downside risk.
What worries me is there will be some investments that will just not be here in a few years' time. I get my clients to think about whether they are holding something that could suddenly or over time become structurally worth less than it is now.
Should we focus more on protecting yield rather than finding it?
Mohamed Fazal: If there's a specific reason for your risk appetite or time horizon changing, for example because of significant uncertainly about your sponsor covenant, I can understand why people might focus more on protecting their current position. It's also tempting to think that, with rates as low as they are, we need to hunt for new assets and chase yields by for example, allocating more to illiquids. Sometimes keeping things simple and being conventional is what works best. Over the past ten years, being long US equities would have served you well in a historically low interest rate environment.
Tony Filbin: One of the things that we agonise over is that we pay a premium to have a diversified portfolio, but sometimes we'd have been better off without it. We've got private equity and infrastructure in our target date funds, but ultimately members are paying more for that diversification. As trustees, we buy into diversification theory, but does it serve our members as we want it to? The jury is still out on that.
John Reade: The return smoothing you can get from some private assets, in particular private equity, looks good in historical terms, but are you getting enough for locking your money up? Will those smooth returns prove to be as good going forward? Or are we about to see the denouement in private equity that we've seen in hedge funds over the past decade?
Volatility isn't necessarily the enemy. I am keeping an eye on crypto-currencies as investors often have questions about Bitcoin and whether it could potentially replace gold. Firstly, it is important to point out they are two very different assets that do different jobs in a portfolio. Bitcoin is the most volatile asset out there, and one that has delivered well. Its Sharpe ratio isn't that terrible either.
What worries me more however is correlation, which people misunderstand sometimes. Correlations can look good historically, implying useful diversification, but often you find correlations increase to one just at the time you really need that diversification.
What have been the key diversifiers for the portfolios you advise on?
Graham Jung: The diversification I've seen is within asset classes. It's not just about investment grade bonds or global equity. As a trustee, I pay an asset manager to put those together, make the calls, and trade. Volatility is great if you've got the ability to trade as it gives you buying opportunities. I'm not so happy to sit back and watch somebody put money in a bull market and then charge big fees.
Mohamed Fazal: In last year's drawdown there weren't many places to hide but if we look at last year as a whole, most growth assets actually performed pretty well. In that context, you might argue diversifiers were assets that didn't perform as strongly as things like equities.
For example, quantitative systematic hedge funds had performed poorly over the past couple of years but so far this year have had a fantastic start. The challenge with diversifiers is, when the going gets tough and they underperform the general market, you've got to have the ability to hold on to them so they can come good in the future.
John Reade: Gold is one of the classic diversifiers. There was nowhere to hide early last year for a week or so, and gold fell too. It didn't fall for very long, it didn't fall that far, but it did go down. When people are rushing for dollars and de-leveraging, everything goes, particularly the most liquid stuff. Nothing is a perfect diversifier and that is one of the lessons from last year.
There is a consensus that inflation will increase in the short term, but what are your expectations over the next three to five years?
Danielle Markham: The data we see is showing some short-term inflation pressure. Over the longer term, it's difficult to know which way that's going to go. My view is that governments will do what they can to prevent that step-change in inflation, as it's ultimately linked to interest rates and how much they pay on debt.
Higher inflation would have a massive impact on portfolios and schemes need to decide whether they want to protect against that. For DB schemes, LDI is the main tool we see being used, and since the start of the year we've seen an uptick in inflation hedging.
John Reade: The work we've done suggests gold can be a component of an inflation hedging strategy, but it's not the only thing. The relationship with the US Consumer Price Index (CPI) has weakened over the last 20 years, mainly because there hasn't been any high CPI. Historically, gold tends to perform well as an inflation hedge when inflation is particularly high, but if you're worried about inflation going from 1.5% to 2%, then gold is not the right hedge. We see some big pension funds, particularly in North America, that have gold as a component of inflation strategies, but it's not a panacea.
How do you think ESG will impact asset allocation?
Marcus Hurd: If you're investing in a simple equity fund with exposure to the airline industry, for the past year you haven't been invested in aeroplanes, you've been invested in how much the government is willing to support a non-ESG friendly organisation. That's a frightening place to be.
ESG is the next thing, and it's not going to go away - nor should it. We must be mindful when we're re-jigging our portfolios about working towards the Paris Agreement. It's not good enough to say it's too difficult - we've got to tackle these issues head on.
John Reade: It feels like this has been a rehearsal for what we'll see with climate change. When making investment choices - which benchmark to use, which industries or assets to exclude - we must consider the real economic impacts of a transition to carbon neutrality. For example, we won't be able to buy new petrol or diesel cars from 2030, which is a huge change.
I hope when we speak to investors about ‘unknown unknowns' that we can point to the performance of gold in 2020 when it was one of the best performing asset classes out there. That's a further demonstration that it belongs in a portfolio.
Tony Filbin: Whether you're talking about diversification, inflation or ESG, it is a different conversation with a £1bn fund than with a £10m fund. The art of the possible differs depending on the size of the fund.
Asset managers will tell you they're all investing with ESG principles now because everybody is on that particular bandwagon. Sorting out the reality from the good intentions is a task in itself. As pension schemes, we have to do our TCFD reports this year, which will have an ongoing impact during the course of the year.
Let's go around the table for your concluding thoughts.
Graham Jung: Uncertainty is going to increase and that's going to bring opportunities to make and to lose money. Within that, smart investors need to consider every asset, including things like gold, because they could be great opportunities. We're going to get a lot less certainty going forward, and we need to be nimbler than we have been.
Marcus Hurd: Over the past few years, diversification has come under a lot of pressure. Those that are going to win through this are those who are genuinely diversified, not just bundled in a whole bunch of complexity.
The other major change is the prominence of ESG. That is here to stay, and given we managed to find trillions globally to fight the Covid-19 pandemic, we're going to see a similar thing with ESG. Portfolios tilted towards that will be in good stead.
Angela Winchester: ESG is here to stay. At the moment in many organisations it often sits apart from the rest of the business in a separate team but in say five years' time it will be fully integrated. I don't think we have yet hit critical mass in terms of what the execution of ESG strategies looks like in terms of strategic or tactical allocation but there will be changes and we need to ensure that through this transition and beyond we continue to consider value for money and management of risks for our scheme.
Mohamed Fazal: While the macro-econmic outlook is very interesting - indeed we've never seen this combined level of fiscal and monetary stimulus - trustees need to make sure they have clear decision-making frameworks and keep have their investment objectives front and centre. Where they're taking risk, it must be appropriate, right-sized and deliberate. That's the best way of trying to achieve your objectives: stick to the plan, remember to focus on what's important, and manage the risks you want to control.
John Reade: I like the idea of simplicity, and the focus on costs. We all recognise that ESG is a big factor, but we need to remember that the government has got a lot bigger during the pandemic, and debt has got a lot larger. As we move to tackle climate change over the next few decades - you haven't seen anything yet. We're in this economic recovery that everyone is predicting and expecting, but there's not enough attention currently being given to this.
Claire Lincoln: As disruption, risk and uncertainty all remain heightened, it might be an opportunity to scale back and think more simply. Don't mix up an asset allocation to incorporate overly complicated things. There are a variety of different diversifiers out there. If you've looked at certain asset classes in the past and they haven't been for you, maybe it's the time to review them again. Be open-minded.
This webinar was held on 25 May in association with World Gold Council