New investment thinking for trustees

by Dr. Ros Altmann

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It's a brave new world out there for pension fund investment.  LDI (Liability Driven Investing) and TKU (Trustee Knowledge and Understanding) are the latest buzzwords.

Until recently, trustees expected 'superior' long-term equity returns to meet their scheme's liabilities.  Exceptionally strong equity markets in the 1980's and 1990's lulled the pensions industry into a false sense of security, believing that the equity risk premium would finance pension liabilities over time.  Trustees seemed unconcerned that 'expected' returns might not actually materialise, or that liabilities might rise more than predicted.

In essence, traditional trustee investment thinking was to 'manage returns' and 'take risk', almost welcoming risk-taking - primarily in equities - because it was assumed that the rewards for taking these risks were the secret to pension affordability.  There was no protection against sharp falls in equities, but this was considered relatively unimportant for long-term investors, because markets would always recover, so trustees should not worry about short term setbacks.

Trustees ignored the fact that equities carry two kinds of risk, but they can only expect to be rewarded for one of them.  The 'risk premium' for volatility and company credit should be rewarded eventually, but the risk that equity returns may not actually keep up with pension liabilities was ignored.  This has proved an expensive oversight and has led to rethinking traditional investment approaches, hence the rise of LDI.

Trustees need to focus far more on managing risk and meeting liabilities.  However, LDI is not just about switching from equities to bonds to 'reduce risk', on the premise that pension liabilities are more like bonds than equities.  Pension liabilities may be 'bond-like', but they are not bonds.  They entail risks which cannot be matched by fixed income investments, such as duration, salary inflation, mortality, credit and limited price inflation.

Switching to bonds can reduce interest rate and inflation risk somewhat, but only at the cost of much lower expected returns.  This necessitates increased contributions which many weak sponsors will be unable to afford.  Furthermore schemes in deficit need to outperform the liabilities, not just match them.  Relying solely on bonds, even gilts, will almost certainly underperform pension liabilities, increase or 'lock-in' deficits and hasten entry to the Pension Protection Fund.

So what can trustees do?  Although no instruments match pension liabilities perfectly, there are strategies which can minimise the risks of worsening the funding position, while still preserving upside potential from investing in 'riskier' assets.  Trustees' investment strategies should explicitly consider controlling downside risk and meeting long-term liabilities.  LDI should aim to achieve the 'reward' for taking investment risk, while minimising 'unrewarded' risks associated with holding equities.  This demands greater investment expertise from trustees and understanding of modern investment techniques.

For example, diversifying investment portfolios into new assets - such as hedge funds, venture capital, currency or infrastructure - rather than just switching between equities and bonds, and maybe some property, should offer superior long term return potential.  Just relying on equities to deliver all the added value is more risky than trying to benefit from the many different sources of market inefficiencies - beta - and manager skill - alpha - that exist in global markets today.  A diversified portfolio across several assets and managers, with judicious use of derivatives to hedge against unexpected changes in liabilities, is not a high-risk strategy, but actually less risky than over-relying on equities or bonds alone.

Focussing on managing both returns and risks is a vital part of LDI, but also represents huge new challenges for trustees.  For example, if implemented correctly, swaps are probably better able to reduce specific risks faced by pension funds, than any other instruments, but most trustees have not yet acquired the expertise necessary to use derivatives effectively.

Meeting the liabilities requires more imaginative and risk-focussed investment approaches, especially now that most schemes are in deficit and most sponsors cannot afford to commit unlimited resources. Investment consultants are starting to help trustees understand how derivative strategies, swap overlays and alternative investments can help meet liabilities, while structured products are also available to help with the enormous administrative challenges that such investments entail.

Constructing a diversified portfolio takes time and requires significant investment expertise.  Understanding the returns and risks associated with new asset classes and also considering the sensitivity of the scheme funding position to changes in expected returns and risks is important, but demanding.  Trustees need to appreciate which risks have been removed or reduced and which risks still remain, as well as any new risks entailed in more diversified investment approaches.

Modern money management can help trustees manage their assets in a more risk-controlled manner, focussing on actually paying the pensions, which is surely what this should all be about anyway. There are no easy answers, but just switching to bonds is not the solution.

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