Read the Top 100 full report - Engaged Investor

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Read the Top 100 full report - Engaged Investor

SPECIALREPORTSPECIALREPORTAlteredstatePension schemes have found themselves in anew and uncertain world, says LouiseAshford, opening Engaged Investor’sanalysis of the top 100 schemesIn the past five years investors havewitnessed a series of paradigm shifts inthe world economy, each sending tremorsthrough the stock market. Britain’slargest pension schemes have reactedby employing a variety of different investmentstrategies according to their own – or their assetmanagers’ – world views. Many schemes havesuffered great losses; others have seen thesedifficult years as an opportunity to diversifyinto new asset classes, with varying degreesof success.Engaged Investor has taken a fine-toothcomb to the UK’s top 100 pension schemes anddiscerned some significant patterns of behaviour.We have examined data from AP, which scourspension schemes’ annual reports and extractsthe most pertinent information about the topschemes’ size and investment strategy over theyears. Where data is sometimes incompleteacross the top 100, we have taken a sample fromsmaller sub-groups of schemes. This will beclearly specified when it is the case.Some trends will come as no surprise toreaders, while others may be more unexpected.We’ve spoken to some of the country’s top assetallocation experts to help complete the picture.The decisive shift from equities to bonds hasbeen well observed, and this is backed up inthe research. Out of the schemes, 32 reportedallocations for bonds and equities in 2008 andin the most up-to-date Pension Funds Onlinedatabase information available.These schemes have cut back their allocationof domestic equities from £50.9bn to £44.8bnbetween 2008 and this recent data, while thatfor overseas shares was down even further, from£47.9bn to £28.8bn. By contrast, allocationsfor domestic fixed interest doubled from£16.5bn to £33.5bn over the same period,although overseas gilts barely budged from£4.1bn to £4.3bn.However, these headline pictures maskchanges within schemes. Some of the largest,including BT and the Railways PensionScheme, have weighted their asset allocationmore heavily towards overseas assets inthe hope of finding better performance incountries such as China, which have few ofthe structural debt problems so endemic inEuropean markets.Schemes have also broadened their mindsin terms of the types of investments they areprepared to consider.Schemes are becoming more interestedin alternative assets, with interest growingin timber, frontier emerging markets andemerging markets private equity, to namea few. Part of this interest reflects schemes’desire to hedge inflation risk.We examine the results of a specific assetclass, real estate, which is often described as analternative, on page 32.Yet the UK’s top schemes continue to divergein some aspects of their investment strategy,making them difficult to characterise. Forexample, some have remained fairly heavilyinvested in equities; others have decided to useliability driven investing strategies, with mixedresults. What is clear throughout the findingsis that the past five years have been extremelydifficult for most schemes. nBonds & EquitiesTop funds’ exposure to domestic fixedinterest assets doubled overall between2008 and 2011, Engaged Investor’s analysisof the top 100 schemes’ data shows,reflecting a widespread lack of confidencein European markets. Of the 32 schemesthat reported data on bonds and equitiesallocations for the two years, holdingsof domestic fixed interest doubled from£16.5bn to £33.5bn, although overseas giltsbarely budged from £4.1bn to £4.3bn.Some schemes’ allocation to domesticfixed interest far more than doubled: forinstance, Royal Mail’s increased from£1.8bn in 2008 to £8bn, according to thescheme’s latest reported figures on PensionFunds Online. “It’s still predominantly UKgovernment bonds that pension schemes areinterested in,” says John Dewey, BlackRock’smanaging director of multi-asset clientsolutions. Combined allocations for fixedinterest and equities fell from £121.8bn to£111.7bn (see right) for the 32 schemes.In a time of uncertainty, pension schemeshave looked to hedge their liabilities bybuying traditionally safe assets, such as UKgovernment bonds. “What you’ve seen isa move into fixed income as pension fundshave become much more alive to the risk ofInvestmentAssets under management 2006-10£500bn£400bn£300bn£200bn£100bn£0bn2006 2007 2008 2009 2010their portfolio. They’re looking to hedgethat risk and have become less tolerantin terms of risks relative to that notionalbenchmark,” agrees Paul Niven, directorand head of multi-asset investment anddeputy head of investment solutions atF&C Investments.The sharp downswing in the pensionschemes’ allocation to overseas equitiesfrom £47.9bn to £28.8bn, is the surprisefinding of this survey. The popularassumption is that schemes have movedtheir money into overseas equities as aresult of the lacklustre performance in theUK equity market, but this is not the case.There are a few possible explanations.These results are for the 32 schemessurveyed here, which could represent aminority. Many schemes which recordeda drop in their allocation to overseasequities in this period moved money intoother asset classes.Some of the biggest schemes – theUniversities Superannuation Scheme andBT’s pension scheme among them – didmove substantial sums into overseasequities between 2008 and 2011,following the more widely reported trendaway from UK assets.At the tail end of the Noughties boom, major pensionschemes’ total assets under management increased rapidlybefore falling post-recession, Engaged Investor’s analysisof the Top 100 funds shows. The 67 schemes, which havereported results across the five years from 2006 to 2010shows that AUM increased from £312.6bn to a zenithof £409bn in 2008, before slipping back to £383bn twoyears later.Frances Hudson, global thematic strategist at StandardLife, says that “one of the fall-outs from the crisis wasthat people put a premium on liquidity for safety reasons”.She also blames new regulation for fostering a culture ofshort-termism by marking down investments that aren’tliquid. Pension funds traditionally take a longer view oninvestment and increasing liquidity should be counterintuitivesays Hudson. This could explain the continueddecline in the overall value of assets under management.Figure 22008 2011£121.8bn £111.7bn13.8%overseas overseasFixed Fixed interest interestdomestic domestic40.2%overseas overseas3.5% 3.9%42.6%domestic domesticEquities EquitiesFixed Fixed interest interest30.1%domestic domesticoverseas overseas26%overseas overseas40%Figure 1domestic domesticEquities Equities2 WWW.ENGAGEDINVESTOR.CO.UK WWW.ENGAGEDINVESTOR.CO.UK 3


SPECIALREPORTSafetygamePension schemes may bemissing a trick by shying awayfrom equities, says Mark LeftlyInvestmentDomestic index-linked gilts20082011£11bnFigure 3£11,165,447,778£18bn£18,649,144,000Biggest risers & fallersFigure 4BarclaysGrew by £11.99bnHSBCGrew by £8.59bnRoyal MailGrew by £4.20bnRolls RoyceGrew by £3.89bnSPECIALREPORTThis summer marks the fifthanniversary of the point at whichthe credit crunch started – widelyconsidered to be the trigger for theglobal financial crisis. There weresigns of the forthcoming problems– suchas defaults on sub-prime mortgages – in the monthsbefore BNP Paribas announced a “completeevaporation of liquidity” in the market on9 August 2007.Initially, the FTSE 100 proved resilient, andcontinued trading at far above 6,000 points and thebenchmark index even grew 2.1% that year. However,the year since have not been kind to equities. TheFTSE was ravaged the following year, with thecollapse of Lehman Brothers acting as a symbol of thedreadful corporate bets that bankers had wagered.And every time the FTSE seems to recover, anew crisis emerges, such as the Greek sovereigndebt disaster or JP Morgan’s ‘London whale’ tradercausing at least $2bn of losses for the US bank andhitting investor confidence.The upshot for pension funds has been a thoroughreview of asset allocation, with investments in riskyequities significantly reduced to stem the possibility oflosses. Engaged Investor has analysed the investmentdata of the top 100 pension funds for the past fiveyears and found that the balance between equitiesand fixed income has shifted sharply in favour of thelatter.The correlation between bonds and equities hasseen a dramatic shift in favour of the former – theshare of assets under management accounted for byfixed interest has doubled, with shares seeing acorresponding decline (see fig 2, page 29). Investmentin index-linked gilts is also up, as is real estate. Citysources acknowledge that the figures accurately reflectthe shift that they have experienced in recent years.One pension fund trustee notes that equities haveslipped from dominating his portfolio at 75%, to just aquarter of its assets today.The £6bn Marks & Spencer defined benefitscheme is a good example. In 2006, assets wereskewed towards equities and corporate credit, but thenew head of investments, Brian Kilpatrick, movedM&S into areas with more stable returns, such asreinsurance and private equity.Today, equities makes up just 13% of its portfolio,many stakes having been recently offloaded as partof a £1.3bn shift to UK gilts, now the asset class withthe highest allocation at 29%. One asset managerjokingly describes this lack of equities exposure as“almost criminal” – stable but risk-free investmentsalso mean less potential upside.However, M&S is also a DB scheme that, like thevast majority in the FTSE, has been closed to newentrants for a number of years and is effectively inrun-off. It has 125,000 members, but only around14,000 are still working.DB pension funds value stability over the potentialto build up surpluses, as they need to be certain thatthey can fulfil their obligations in the short term.There is something close to an end-date for theirschemes, so the trustees have to make sure that theeconomics are sound, even if that means sacrificingpotentially lucrative investments. The reasoningseems sound when looking at one of the biggest FTSEstocks, BP.The oil giant has attracted billions of pounds ofpension fund money, with at one point, for example,the Daily Telegraph newspaper’s pension fundallocating 4% of its assets to the company.Managers were attracted to BP with good reason:the dividends were enormous, accounting for onepound in every six that pension funds were paid outfrom their stock investments.However, the Gulf of Mexico spill in 2010wiped off nearly half the value of BP’s stock in justthree months, while the dividend was temporarilysuspended and has yet to hit its previous heights. BPwas one of the soundest equity investments a pensiontWho’s in?Schemes that have enteredthe top 100 since 2008• GlaxoSmithKline Pension Fund• Rolls-Royce Group Pension Scheme• Santander Pension Fund• Pension Protection Fund• British American Tobacco DB Section• Centrica Combined Common Investment Fund Ltd• Alliance Boots Defined Benefit Scheme• Esso UK Ltd (Exxon Mobil Pensions)• Effem Holdings Ltd (Mars UK Ltd Pension Plan)• Nationwide Building Society Pension Fund• Smiths Group plc Smiths Industries PensionScheme & TI Group Pension Scheme• Babcock International (Group, Devonport Royal• Dockyard, and Rosyth Royal Dockyard and VTGroup Pension Schemes)• Siemens plc Defined Benefit SchemeSiemens Transmission & Distribution Ltd PensionScheme• Pernod Ricard (Allied Domecq Pension Fund)• Middlesbrough Council (Teesside Pension Fund)• Morrison Supermarkets plc (The ‘Morrison’ and‘Safeway’ schemesWho’s out?Schemes that have left the top100 since 2008• Scottish Public Pensions Agency• Civil Aviation Authority Pension Scheme andNational Air Traffic Services Pension Scheme• Nestlé Ltd Pension Fund• British Energy Generation Group of ESPS• FirstGroup plc (The First UK Bus Pension Scheme)• EDF Energy (EDF Energy Generation and SupplyGroup of the ESPS)• Lafarge Pension Plan• Vauxhall Motors Common Investment Pool• Cable and Wireless Defined Benefit Section• Scottish Power Pension Scheme• RHM Pension Scheme• Merchant Navy Officers Pension Fund• Total UK Pension Plan• Norfolk County Council Pension Fund• Xerox Pensions Ltd Final Salary Scheme• Royal Insurance Group Pension SchemeMPS*Fell by £2.56bnBCSSS*Fell by £2.76bnBTFell by£3.09bn*MPS = CoalPension TrusteesMineworkers’Pension Scheme*BCSSS = CoalPension TrusteesBritish Coal StaffSuperannuationScheme4 WWW.ENGAGEDINVESTOR.CO.UK WWW.ENGAGEDINVESTOR.CO.UK 5


SPECIALREPORTtReal estateAn asset classFigure 5£3.6bnTThe biggest current allocation(BT Pension Scheme) to domesticreal estate by a top 100 scheme£20bn£15bn£10bn£5bn0£857mfund could make, yet it still proved a flawed move formany fund managers.Concerns over volatilityJulian Le Fanu, a policy adviser at the NationalAssociation of Pension Funds, points out that thistrend away from risky assets goes back a little furtherthan five years, as big corporates started closing thosehugely generous, financially draining DB schemes.“The move from the risk of equities into fixedincome is quite a long-term thing, over 10 years,”Le Fanu argues. “The decisions about the overallstructure of the asset allocations come very muchfrom the sponsoring company, because the companystands behind the obligations and the trustees have toconsult with them.“If the company is thinking that there is volatilitywith assets, they will worry about their triennialvaluations: that equities could be low, that they willhave to put extra money into the scheme,” he says.A trustee might think it is the right time to put someof the fund into equities, but the company will onlybe thinking that there is an end date in sight. Thecompany’s board is unlikely to risk a deficit, no matterhow great the probability of a surplus, if it can beassured that the scheme is fully funded in safe fixedincomeassets.However, most City pension and assetThe biggest current allocation(BBC Pensions Trust) to overseasreal estate by a top 100 schemeSource Pension Funds Online2008 2011The 2007 credit crunch hit commercialproperty faster and harder than anyother part of the economy. However,pension funds have not lost theirfaith in bricks and mortar judging byEngaged Investor’s analysis of the top100 scheme data.Out of the top 100 schemes in2008, 33 have reported allocations toproperty for that year and in PensionFunds Online, which contains thelatest data. These schemes reporteda combined allocation £14bn todomestic and overseas real estatein 2008, a total which has increasedto £17.75bn, according to the latestPension Funds Online. Overseasreal estate remains a minority sport,played by just a handful of the third ofthe top 100 under the microscope.The biggest investor in this assetclass out of the 33 schemes remainsthe BT fund, which has £3.6bninvested in domestic real estatetogether with a further £305m inoverseas property. However, buckingthe wider trend, the UK’s biggest fundhas reduced its weighting towardsreal estate, which stood at £4.3bn in2008 – more than half the total that itinvested in UK equities- with a furthermanagement experts seem to agree that the shifthas sharpened since 2007, which is unsurprisingas it became clearer just how volatile the markethad become. Indeed, the NAPF’s own survey of itsmembers shows that DB trustees have reduced theirschemes’ allocation to equities from 21.1% in 2009to just 14.3% last year, while UK index-linked giltshave grown by 3.2% in the same period to 16.4%.And, despite historically low interest rates, the NAPFsurvey reflects our own survey that shows cash tohave roughly doubled in recent years.Getting the timing rightThere is a problem here, though, in that there arefundamentally strong companies whose stocks havebeen badly hit by the crisis. These undervaluedequities are great opportunities for pension funds,as the share prices seem sure to increase, but theyare opportunities that trustees are ignoring as theyflee to safety. Hargreaves Lansdown investmentmanager Ben Yearsley says: “The general rule is thatpeople will go into bonds at the wrong time. They’rereactive – when bonds are up, people go followingthem and vice versa. You can apply this to individualinvestors too, they invest most when markets are attheir highest rather than lowest levels. They would bebetter to buy [in a bear market] and hold.”Paul Mumford, a fund manager at specialist£119m in overseas bricks and mortar.This shift out of real estate by theUK’s most heavyweight fund suggeststhat smaller funds across the rest ofthe top 100 have been building up theirexposure to property.For F & C head of multi-assetinvestment and deputy head ofinvestment solutions Paul Niven, theshift into property is part of a broadermove by schemes towards more diverseportfolios. He says: “You’ve seen amove into alternatives – obviouslyproperty to some extent as well andabsolute return types of products.”Pension Corporation co-head ofbusiness origination David Collinsonsees the shift into property as part andparcel of an increasingly risk-averseapproach to investment by funds,particularly those defined benefitsschemes which are closed to newentrants or even future accrual.He says: “If they have negativecashflows they will need to sell assetsto pay pensions, but they don’t wantto be forced to sell in a distressedmarket.” Property leases are longterm, low risk investments which offera stable income stream and someinflation protection he adds.long-only equity boutique Cavendish AssetManagement, points to telecoms giant BT, which puta £2bn top-up into its pension fund in March, as ascheme that “got out of equities at the bottom of themarket”.He believes that pension funds continue to be tooscared of volatile assets at just the time when theirlosses should become gains.For DB schemes, he suggests, that’s fine, as theyneed the certainty mentioned above. But in moneypurchase schemes there is likely to be conflict betweenthe views of its more demographically balancedmembership.“Is this way of de-risking the right way?” asksMumford. “The money purchase funds are adifferent kettle of fish, because this isn’t a definedliability at the end of the day. There is a broadvariety of people making contributions. The youngermembers will be interested in getting the most growthout of the investments, whereas the older people wantto iron out fluctuations.”Mumford also points out that bonds are notinherently safe. Forgetting the sovereign bonds thathave proved so costly, such as Portugal’s slide to ‘junk’status, corporate bonds always come up with a riskthe firm could go under and interest rate hikes canbadly hit their values.tPartnering for successThe need to maximise returns while successfully managing riskcan be a difficult balancing act, so fund managers are increasinglyusing the expertise of specialist partners, says Ian MizrahiPension fund managers are embracinginnovation in their approach to investmentand are making use of new intellectualcapital and resources that are available toprofessional investors in order to deliverbetter investment outcomes.Mainstream asset managers areincreasingly investing in new asset classes,regions and instrument types, whiledeploying techniques and technologies thatwere once the domain of those operating atthe alternative end of the spectrum.The desire to enhance or diversify returnsand improve risk management is motivatingpension fund managers to consider newmodels to achieve these ambitions, and toask how best to understand and harness thebenefits of new approaches.Broadening the investment universeInvestors are now looking for additionalsources of value across a broader universeof exposures and instruments, such ascommodities, emerging markets andderivatives, as well as the ability to golong and short and use options to reducevolatility and help protect capital.Pension funds are increasingly investing inthese non-traditional asset classes. However,establishing these capabilities in-house canbe challenging. It requires a combinationof investment and trading expertise, a morecomplex risk management and operationalcontrol framework, ISDA agreements andlegal and operational know-how to make itwork.An alternative approach to accessinggreater markets is to partner with a specialistasset manager, with the aim of offering aplatform that pension funds can leverageto invest across all asset classes. This canfree the pension fund to focus solely oninvestments and asset allocation, leavingthe front-to-back implementation to a thirdparty.Nimble investmentA greater capacity to react quickly to marketevents and take advantage of opportunitiesor amend risk profiles promptly is anotherpractice that pension funds are increasinglyseeking to adopt. Traditional models builton sub-advisory mandates and investmentsinto third-party vehicles can createsignificant lead times to adjust exposures.To enable faster implementation ofinvestment views, pension funds are nowusing tactical asset allocation overlaysthat sit over the strategic portfolio but arecomposed of highly liquid or unfundedinvestments, such as exchange tradedfutures and other derivatives.These overlays enable managers to changethe overall risk profile of their portfolio inminutes or hours (depending on the size ofthe portfolio), after the investment decisionhas been made. If the pension fund wantsto make a permanent reallocation betweenasset classes, the transition can take placemore slowly, adjusting the overlay and themain portfolio in tandem. This approachprovides continuity in the overall assetallocation and avoids taking on unintendedrisks or trading costs.Specialist partners can implement theoverlay to match the level of ongoinginteraction that a pension fund wants. Somemay want to make the investment calls onthe tactical asset allocation themselves onan ongoing basis, while others may preferto focus on the strategic portfolio andrely on specialists to manage the tacticaloverlay. Both solutions rely on experiencedcross-asset investment management teamsusing flexible and scalable platforms. Inaddition, portfolio look-through capabilitiesare essential, as they enable pension fundmanagers to access a consolidated, granularview of their portfolio across all investments,including the overlay.Tailored risk solutionsGiven the significant uncertainty thatmarkets have been experiencing, manypension funds are actively looking atmore sophisticated approaches to riskmanagement, such as tail risk hedgingand principal protection strategies. Theyare also increasingly focused on ways toimmunise the portfolio against unwantedEXPERT VIEWSPECIALREPORTor unrewarded risks, such as credit risk orforeign exchange, or the new generationrisk factors driving markets nowadays suchas market sentiment, political risk, fundingand illiquidity.Designing and implementing a strategyto address these risks can be challenging.Its effectiveness depends on the ability todraw together position level data, generatean aggregate view of portfolios and havingthe necessary quantitative systems toperform risk-factor analyses and present theinformation in a meaningful way.Finally, it requires the risk managementexpertise to design and implement hedgingstrategies that meet the specific riskobjectives of the scheme.Many pension fund managers are startingto address these issues in-house, usingtheir own capabilities, while others areteaming up with specialist managers. Thirdpartymanagers can provide the benefitof new generation risk technology andhelp pension funds design and implementcustomised solutions to meet their overallrisk and investment objectives. Finally,comprehensive reporting and performanceattribution of hedging strategies are essentialfor the continuing development and successof any risk management scheme.ConclusionThe breadth of investment, the speedof implementation and active downsiderisk management are key ingredientsfor enhancing investment value. Thereare, however, significant challenges indeveloping some of these capabilities inhouse.Partnering with the right specialistmanagers can offer flexible solutions thatallow pension funds to manage thesechallenges. nIan Mizrahi is Head of PortfolioManagement and Structuring, Fundsand Advisory at Barclays.6 WWW.ENGAGEDINVESTOR.CO.UK WWW.ENGAGEDINVESTOR.CO.UK 7WWW.ENGAGEDINVESTOR.CO.UK 7


SPECIALREPORT0LiabilitiesThe number of active members is down andpensioners up – that’s the perhaps unsurprisingconclusion from Engaged Investor’s analysis ofthe Top 100 pension schemes. For the 55 of thebiggest schemes, which reported membershipfigures in 2008 and in the Pension Funds Onlinedatabase, the total number of members rosefrom 4.75m to 5m. But within that overall figure,the past four years has seen an increase in thenumber of pensioners from 1.8m to 2m. Overthe same period, the total of active membershas dropped from 1.6m to 1.4m. The balance isaccounted for by deferred members.However, there were some apparentanomalies where the total number of membersdecreased significantly between 2008-11,such as BT, which saw a fall of 13,486 in itsmembership over this period.Engaged Investor also crunched the numberson the 41 Top 100 schemes for which annualcontribution data is available for the four yearsfrom 2008-11.This shows that contributions from thesponsors of the schemes dipped in 2009 butrose in 2010 and again in 2011, reflectingongoing difficulties schemes faced in achievingstable funding levels. Contributions fell by 5.9%in 2009 from £8.4bn to £7.9bn, but recovered in2010 by 12.2% to £8.9bn. This increaseaccelerated to £10.3bn in the latest set of£11,165,447,778 £18,649,144,000Total membersmberPensionersActivemembersTotal membersmberPensionersActivemembersmersContribution levelsFigure 6Scheme membership make-up200820111million 2million 3million 4million 5millionFigure 7t2008200920102011£0bn £2bn £4bn £6bn £8bn £10bn £12bnPension Funds Online figures – a 22% increasecompared to 2008. Of the selection of schemesunder the microscope, Diageo increased themost over the four years, almost quadrupling itscontributions. There were some notableexceptions, however – between 2008-11 Marksand Spencer’s contributions dropped by£340.3m.Kevin Le Grand, chairman of the Society ofPension Consultants, explained the overall riseby saying: “It is probably down to two factors,which I’d say are increases in average longevityA role for infrastructureLooking ahead, though, the likes of Mumford,who believe that a pension fund’s average equitiesallocation should be in the region of 35-40%, arelikely to remain disappointed.A spokeswoman for the Association of InvestmentCompanies says: “Anything with the word ‘income’ init is impressive to the market and trading at apremium at the moment, as people are desperate toget hold of asset classes [with predictable returns] suchas private equity and infrastructure.”This should be good news to the government, whichis banking on pension funds to back a large chunk ofits £200bn infrastructure programme to kickstart theBritish economy. However, the evidence is not clear,as most research shows that infrastructure, such asprivate finance initiative (PFI) projects, remains only afew percent of funds’ asset allocation.More importantly, it is unlikely that pension fundswill invest in major capital 5000000 projects at just the timethe government wants them to, which is during theconstruction phase. This is the period that is generallyconsidered the riskiest 4000000 part of the infrastructureprocess, as there can be problems with delays andfluctuations of building materials2011and labour costsforcing projects over budget.Indeed, under the old 3000000 PFI schemes, many investors2000000figures and having to compensate for poorerinvestment performance.”He added: “There’s been a big effort by alot of companies to try to reduce the deficit.Anecdotally, a lot of companies are holding on toa lot of cash and it may be that [the contributionsincreased] around about the time that they weredeciding that they could actually spend some ofthis cash on reducing the deficit in the pensionscheme.”were looking to come in a few years after the school,hospital or road had become operational, when thereis evidence that it is a safe, stable income stream. Asa result, the secondary market, when a constructionfirm or infrastructure specialist fund sells on theirequity stakes, is far more vibrant.In November, 2011 the NAPF signed amemorandum of understanding with the governmentto form a ‘pool’ of its members’ resources in order toencourage at least £20bn of pension fund money intothe government’s infrastructure programme.However, most pension fund managers privatelyadmit there is a lack of historical evidence thatinvesting in infrastructure early would be anythingother than risky, meaning that the typical allocationof around 2% to the asset class is likely to remain thenorm.It would seem to be more likely that managerswill play it safe with traditionally stable assets thathave performed well throughout the financial crisis– such as the top-rated sovereign bonds – ratherthan move into anything without results or classes asunpredictable as the stock market. nMark Leftly is associated business editor(Sunday) of The IndependentManaging asset riskThe growth of liability-driven investment reflects an increasingfocus on solutions that help funds to control uncertainty,says Mike WalshThe understanding and managementof risk has become more importantto pension schemes over the past twodecades. This trend is most prevalent inthe area of liability-driven investment,with the expansion of solutions tomanage the risks faced on both sides ofthe pension scheme balance sheet, ie,liability risk and asset risk.The typical focus of LDI solutions hasbeen on the liability side, recognisingand managing interest rate and inflationrisk. Increasingly, it is equally importantfor an LDI provider to have experiencein managing broader asset risk, such asequity exposure.Equities still account for a significantportion of assets for many pensionschemes and while they have thepotential to produce significant growthover time, historical returns show thatequity markets can suffer from extremeperiods of volatility. Rather than leavingthese swings to fate, more schemes areseeking ways to control their exposure.This means they can benefit fromequity market gains yet restrict losses– particularly as their funding levelsimprove.Equity options allow a scheme to placea ceiling or a floor on the returns froman equity portfolio. However, buyingprotection via options outright may beunattractive to schemes as it requires anupfront payment for what is effectivelyan insurance contract. Fortunately, asa wide range of such structures areavailable, a scheme can both buy andsell options such that the net initial costis zero.A common example of this is knownas a put-spread collar. Figure 1 showsthe pay-off profile of a typical equityprotection strategy (with a term of oneyear) adopted by a scheme in order toFigure 1: Put-spread collar payoffreduce the variability in expected returns.The blue section represents downsideprotection, meaning the potentialreduction in portfolio value avoided byusing equity protection. The red sectionrepresents the increase in portfolio valuegiven up in order to fund the structure(the equity protection).The parameters of such strategiescan be tailored to reflect the desiredterm and acceptable range in equitymarket movements for an individualscheme. LGIM’s philosophy of providingaffordable, risk-aware solutions to allclients means such equity protectioncan be accessed by even the smallestschemes via cost-effective equityprotection pooled funds.A great example of how our clients areusing these structures is where they haveseen an improvement in their fundinglevel through equity market rallies butare still some time away from their nextformal investment strategy review. Inthe interim, they have looked to utiliseequity options as a means to lock insome of the asset gains until such time asthe longer-term strategy is defined.EXPERT VIEWSource: LGIM, for illustrative purposes onlyWhile the principles behind an equityprotection solution are relatively simpleto understand, implementing them is farmore complex. A successful executionrelies on the skill of the team effectingthe structure. As such, pension schemesare finding that partnering with amanager who understands their longertermstrategic goals and developinga scheme-specific solution is a morerewarding approach than focusing onproducts that are neither tailored totheir specific scheme circumstances noradaptable to their evolving needs. nMike Walsh is Head of SolutionsDistribution at Legal & GeneralInvestment Management.8 WWW.ENGAGEDINVESTOR.CO.UKWWW.ENGAGEDINVESTOR.CO.UKWWW.ENGAGEDINVESTOR.CO.UK 9


EXPERT COVER VIEW STORYManaging risk in emergingmarket allocationsEmerging markets can offer good investment potential, just as longas the risks are managed carefully, explains John P. Calamos, Sr.SPECIALREPORTThe rise of emerging markets (EMs) is wellrecognised as a scenario that presents manyinvestment opportunities. The expansionof a middle class is fuelling demandfor technology, consumer products,infrastructure, health care and education,and creates new revenue streams forcompanies that meet those needs.The migration of populations to citiesand the growing role of EMs in the globaleconomy has also resulted in significantinfrastructure demands.Historically, many have viewed EMs astactical allocations. Given the magnitudeand durability of the trends supported byEMs, we believe investors should also lookto EM allocations strategically.However, the economic and politicaluncertainties in EMs can produceunwelcome volatility, which runs counterto strategic allocation. There are ways toincrease emerging markets exposure whilepotentially dampening the risks associatedwith EM investing.Managing emerging market riskCapital moves quickly across borders towhere it is treated best, and a numberof emerging markets are increasinglyembracing economic freedoms.In India, we view proposed tax reformsand the opening of more sectors to directforeign investment as favourable signs.Similarly, the creation of the Hong Kongoffshore dim sum bond market is veryencouraging, as this fast-growing marketcan potentially change the way companiesfinance their growth.Despite these macro positives, volatilityremains high. Economies are often evolvingagainst the backdrop of political and socialconflict. The challenge facing investors ishow to harness the opportunity of EMs withless risk. Tactical asset allocations requireaccurate timing to achieve investmentresults, and this can be difficult. In contrast,a strategic allocation relies on a riskmanagedapproach. There are periodsEM Consumption Drives Revenue Opportunities for Global CompaniesOther Asia is defined as Asia excluding Japan, India and China. Source: Homi Kharas, “The Emerging Middle Class inDeveloping Countries.” OECD Development Centre. 26 Jan. 2010. Web. Mar. 2011. http://www.oecd-ilibrary.org.when a higher-risk tactical allocation mayoutperform, but those returns are verydependent on market timing.Our risk management encompassesmultiple factors. Because the volatility risk ofinvesting directly in EM companies needs tobe actively managed, we proceed cautiouslyin regard to these direct investments. Wefocus on a company’s source of revenues,not where it is domiciled. We seekopportunities in global companies thatgenerate significant revenues in emergingmarkets; in some portfolios, we includeUS-based companies. These companiesmay not have headquarters in developingnations, but they provide services andproducts that are in great demand there.To further manage risk, we utiliseequity-sensitive convertible securities.As convertible securities combine theopportunity for equity participation withpotential downside protection, we viewthem as lower-volatility equity securities.We also seek to mitigate risk by identifyinglong-term trends. It is not unreasonable thatthe pace of economic growth in EMs willebb and flow. However, we must not losesight of global long-term trends which, bydefinition, transcend market volatility.ConclusionWe believe there are ways to accessemerging market growth while mitigatingrisk, thereby supporting the case for EMsas a strategic asset allocation. We believeEM risk can be managed through thecareful selection of equities of companiesthat have revenue streams generated fromEMs, as well as through the selective use ofconvertible securities. nJohn P. Calamos, Sr. is CEO and GlobalCo-CIO at Calamos Investments.For more information, please visitwww.calamos.com/EMopportunity.The opinions referenced are as of the dateof publication and are subject to changedue to changes in the market or economicconditions and may not necessarily cometo pass. Information contained herein is forinformational purposes only and should not beconsidered investment advice. Past performanceis no guarantee of future results. Investinginvolves risk, including potential loss of principal.Diversification does not insure against market loss.A flight to safety is the keylesson from PensionsInsight’s Top 100 schemesanalysis, finds ProfessorAndrew ClareTakingcoverThe Eurozone crisis continuesto mesmerise and terrorisethe markets in almost equalmeasure. As a directconsequence of these concerns,liabilities of the averagepension scheme have risen.If this were not bad enough, since June 2011the fall in discount rates had already increasedthese liabilities by between 15 and 20percentage points. This repression of longterm interest rates over the last year would belike waking up tomorrow to find that thenominal value of your mortgage had risen byaround 25%, despite the fact that you had notmissed any of your mortgage payments!Of course, interest rates have been on adownward trend for some time now, and thistrend has put increasing pressure on pensionfund trustees to find assets that will keeppace with the rapid increase in the markedto market value of their liabilities. Pensionliabilities are now widely viewed as beingbond-like – indeed they are bond-like bydefinition if the discount rate applied to themis derived from bond yields(!) – as such the“Holdings of gilts andindex-linked gilts haverisen as a proportion oftotal assets. Some of thisrise has been due to agenuine increase inallocations to UKgovernment bonds”net move out of equities and into fixed incomeinvestments has continued unabated over thelast few years.Holdings of gilts and index-linked gilts haverisen as a proportion of total assets, a trendconfirmed by Engaged Investor’s analysis ofthe top 100 scheme’s holdings. Some of thisrise has been due to a genuine increase inallocations to UK government bonds, eitherbecause of a desire to increase these holdingst10 WWW.ENGAGEDINVESTOR.CO.UK WWW.ENGAGEDINVESTOR.CO.UK 1110WWW.ENGAGEDINVESTOR.CO.UK


SPECIALREPORTEXPERT VIEWWhere will we be in 2017?The trends set in the past five years are likely to set the pace for thenext five but, Mark Homer warns, we need to factor in a great dealof uncertainty if we are to make the right long-term decisionstoutright, or because such holdings are neededas collateral to back swap positions. But asubstantial proportion of the increase in theseholdings is also simply a direct consequence ofthe increase in the market value of gilt andindex-linked portfolios as the yield curve hasfallen.Although trustees might prefer to hold UKgovernment bonds, their high prices and lowyields make them very unattractive in aninvestment context. The main fixed incomedestination for pension assets over the pastfew years has therefore been the sterlinginvestment grade corporate bond market,which EI’s analysis confirms.But recent concerns about too muchexposure to this one market has encouragedsome schemes to diversify their exposureto corporate credit risk through allocationsto both US and European investment andsub-investment grade bond markets. Andgiven the healthy finances of some developingcountries’ companies, some schemes have alsomade tentative allocations to emerging marketgovernment and corporate debt markets.“Pension schemetrustees have tried toreduce the equity riskin their portfolios andto increase the liabilitymatching qualities oftheir asset portfolios byinvesting in bonds andbond-like assets.”But as well as getting their fixed income“fix” from bond markets, trustees have beenseeking out and investing in asset classes with“fixed income characteristics”. These arereferred to as “liability-linked assets” becausethey generate cash flows that closely resemblethe characteristics of liability outflows. Mostare based upon the cash flows generated eitherdirectly or indirectly from property. It seemsthat trustees have rediscovered property as anattractive asset class, judging by the results ofthis analysis.On the whole pension scheme trusteeshave tried to reduce the equity risk in theirportfolios and to increase the liabilitymatching qualities of their asset portfoliosby investing in bonds and bond-like assets.This broad trend, which will continue for theforeseeable future, has helped to reduce theimpact of falling discount rates to some extent.But most schemes continue to rely heavilyon the cash flow from their most valuableasset: the employer scheme covenant. Overthe past few years sponsor contributions haveincreased substantially, and if the Eurozonecrisis propels us into a deep recession, discountrates will plummet further and sponsorcontributions will have to rise further still. nAndrew Clare is co-author of ‘The TrusteeGuide to Investment’ and Professor of AssetManagement at Cass Business SchoolAn awful lot can happen in five years.The introduction of auto-enrolment, anongoing uncertain economic outlook andchanging trends in investment may meanprivate sector pensions becomes a verydifferent world in a relatively short time.The decline of final salary schemes iswell publicised. 2011 Pensions Regulatorfigures show only 16% of definedbenefit schemes remained open to newmembers and 24% were closed to futureaccrual. Add the continuing pressure onscheme funding and the shift towardsdefined contribution, and it is perfectlyconceivable that by 2017 at least 95%of final salary schemes will be closedto future accrual, with fewer than 100remaining open.Following negative press andprogressively closer regulatory scrutiny,enhanced transfer values are likely tobecome less common. So, while activemembership decreases, the ‘deferredmember problem’ grows. However, wemay be able to better manage pensionerliabilities. By 2017, an ongoing lowinterest environment could see arise in pension increase exchangeexercises.In an attempt to limit future pensionliabilities, it has become increasinglypopular to move from a final salaryscheme to a career-average revaluedearnings (CARE) one without switchingto DC. However, generally, moving toCARE only makes a difference if salariesincrease at a rate greater than inflation.In the current environment, whereaverage salaries are not keeping pace withinflation, CARE may be just as expensiveas final salary with the same accrual rate.By 2017, will employers have foundthat CARE has not been the solutionthey thought it would be?In the rush to move to CARE or DC, itseems cash balance schemes have oftenbeen overlooked. These offer membersa defined amount of money for theirpension pots, for example 15% of salary,and each year’s payment is revaluedup to the date they retire. At this pointthe member uses their pot to secure aretirement income by purchasing anannuity, sometimes at rates guaranteed bythe employer, or by using drawdown, etc.Cash balance started to be seen in theUK in the 1990s but, in an era of finalsalary scheme surpluses, the balance ofrisk in a pension scheme was not at theforefront of people’s minds. By 2017, wemay have realised that cash balancewas the solution we missed as wemade the move to DC.The fact that the vast majority of openprivate sector schemes will be DC seemsto be assured. Between now and 2017 allbut the smallest and newest UK employerswill have implemented auto-enrolment.This alone is accelerating the move to DC,with the National Employment SavingsTrust and other specialist providersjoining insurance companies in thegroup pensions market. By 2017, 80%of DC schemes could be contractbased and the flurry of activity aroundmastertrusts may have fallen away.According to the Office for NationalStatistics, the average total contributionrate in DC schemes in 2011 was 9.4%.This is simply not enough. With relativelylow contributions and possibly poorinvestment returns, by 2017 pensionpots may be too small and everyonemay accept that they cannot retireuntil they are at least 70.Setting aside the biggest economicuncertainty – the eurozone crisis –inflation is already challenging and couldrise significantly. If gilt yields also rise,a small improvement in annuity ratesmay lead to a rapid increase in pensionbuyouts as trustees and sponsoringemployers look to de-risk their schemes.By 2017, will the buyout capacity inthe insurance market be saturated?Trends in scheme investments alwaysoccur as prevailing economic conditionschange. Will the fashion for liabilitydriven investment continue or will therebe another new ‘big idea’? By 2017, willpension fund assets be more heavilyinvested in infrastructure, alternativesand social housing bonds?The popularity of delegated investmentmandates and fiduciary management,which are typically used to ensure trusteesdo not miss opportunities to lock ininvestment gains when working to a setde-risking plan, is increasing. By 2017,with more plans on a flight path tofull funding, delegated investmentcould be in place in the majority of DBschemes.The concept of lifestyling, developed asa response to the October 1987 equitymarket meltdown, is now commonly usedin DC schemes as the default. However,it is still early days to know whether itworks, particularly for individuals withsignificant DC savings. By 2017 will wehave realised that lifestyling doesn’twork?Whatever the future holds, including thechancellor’s continuing changes to the taxefficiency of pensions, there will certainlybe ongoing challenges for employers,employees and the pensions industry.Perhaps the biggest question in 2017will be ‘what happens to pensions in thepublic sector?’ nMark Homer is Scheme Manager atPS Independent Trustees.12 WWW.ENGAGEDINVESTOR.CO.UK WWW.ENGAGEDINVESTOR.CO.UK 13WWW.ENGAGEDINVESTOR.CO.UK 13


SPECIALREPORTShape ofthingsto comeAs these uncertain times show no sign of abating, theEngaged Investor team canvassed a range of investmentspecialists for their views on what the future holdsIt’s not such hard work followingtrends once they have beenestablished. And insightfulcommentary is devalued as the timeit focuses on recedes into the past.The real challenge is looking ahead,squinting, and imagining where thepeaks, troughs and steady flats will fall in thefinance land of the future.Now that we have trawled through fiveyears’ worth of pension data it’s time to askthe experts what schemes should preparethemselves for from markets and otherinvestors. We cupped our ear to a broad rangeof voices across the City – from insurers andasset managers to academics – and found aplethora of predictions.All agreed that the traditional model ofinvestment would continue to be supplanted bygrowing diversification, within both portfoliosand asset classes.Infrastructure cropped up as an alternativeinvestment area with its promise of inflationprotectedincome streams and governmentbacking. Likewise, commodities and property,with their more stable returns, look as if theyhave potential as schemes desperately tryto match their bulging liabilities.Most thought that the shift from disappointingequity markets to more stable fixed-incomeholdings would continue unabated. However,the reputation of corporate bonds has risen asa result of the perceived increased risk aroundgovernment finances.Cass Business School’s Professor AndrewClare said at May’s Engaged Investor Trusteeconference, that the FTSE100 was likelyto remain at its current level for most ofthe next decade, which converged with thethoughts of other professionals who forecasta rising reliance on actively managed fundsas tracking indexes becomes ever moreunreliable.It was predicted that equity weightingswould still be high, but gradually moving infavour of overseas stocks.While many expect growth in developingeconomies to slow, the potential for massivenew consumer markets and increased politicalstability will only make emerging marketsmore attractive for funds searching for proven,sustained progress. nPaul Niven, director and head ofmulti-asset investment and deputyhead of investment solution, F & C“As it stands, pension schemes arestill reasonably concentrated in termsof the risk that they hold in equitiesoverall. Therefore I think that thatprocess [of diversification] is goingto carry on further, whereby theywill move towards some other assetcategories to diversify their portfolio.”“There is also an increasedawareness that you can’t necessarilyrely on strategic asset allocation todeliver returns. You can’t just put yourrisk budget into a view on the likelylong-term moves in equity markets,for example, simply because thecertainty in terms of pay-off fromthat investment is actually quite low.Investors are responding to that bymanaging their market exposure moreactively over the cycle, so you’reseeing more active asset allocationdecisions being implemented,either at the portfolio level or interms of specific strategies. Again,I think that’s a trend that’s likely tocontinue becausepeople recognise theycan’t just sit on theportfolio and waitfor it to perform. Itneeds to be activelymanaged in termsof the allocationcomponents.”David Collinson, co-head of businessorigination, Pension Corporation“Pension funds are getting more riskaverse. There is a strong incentiveto buy assets that more closelyresemble their liabilities and producean income stream. Most schemeshave closed to new entrants, andsome have closed to future accruals.If they have negative cashflowsthey will need to sellassets to paypensions, butthey don’t want tobe forced to sellin a distressedmarket.”So much effort is devoted to getting peopleinto pensions these days, yet what abouthelping them on the way out? It’s an easyaspect to brush aside. Retirement processeshave no regulatory deadlines or autoenrolmenttimeline to meet.This is perhaps why the NationalAssociation of Pension Funds and PensionsInstitute commissioned a report earlier thisyear entitled ‘Treating DC Scheme membersfairly at retirement?’.It outlined a number of retirementconcerns and warned annuities are the“weak tail” in defined contribution (DC)pension provision. Making poor retirementchoices could cost scheme members upto 40% of their pension. What’s more,once an annuity is set up it cannot usuallybe cancelled so that poor decision (andresultant income loss) could last a lifetime.The NAPF report explains unless a schememember is lucky enough to be pointed inthe direction of a specialist annuity brokercovering the whole of the market; theyare unlikely to secure a good outcome.A specialist annuity broking service hasbenefits for the scheme too: it can helpensure a Trustee’s fiduciary duties are met; itboosts income from the pensions membershave been saving into all those years, andmeans they are not simply cast adrift whenthey reach retirement.A fast-changing at-retirement spaceThe way we retire is changing. Annuitiesare now only half the picture at retirement.Gone for most are the days whenemployees walked out of the office onthe dot at age 65. A traditional annuity – asecure income paid for life – will still be thechoice for the majority, but an increasingnumber of retirees will be drawn to flexiblealternatives that keep their options open.It’s true what you read in the papers aboutannuity rates. They are at an all-time low.Some of today’s retirees are looking forother options particularly if they have otherincome to fall back on.Then there is the changing market itself.In 1994, less than 20 years ago, the choicewas simple. Many of today’s optionsdidn’t even exist. Aspecialist retirementservice will exploreall the options.Scheme memberswill base their buyingdecisions on theinformation they aresent in the run upto retirement. It’s anessential browsingphase. Making thesealternatives readilyavailable for retireesto explore is a keyquality to look for ina retirement serviceprovider. The qualityof informationavailable, thebreadth of optionson offer and an ease of comparison arecrucial.Top pension schemes should look for afull retirement service with all the optionsavailable on display to encourage browsingand active comparison. Members shouldbe offered information and education onannuities, enhanced annuities, drawdownand flexible drawdown, or a mix and matchapproach.How the Hargreaves Lansdownretirement service can help:• At retirement we search the open marketto find scheme members one of the bestannuities available in the UK. We showa range of different incomes and annuityoptions for comparison.• 48% of our clients secure enhancedannuities¹• There is no default to fall into, and nobarrier to entry. We offer a service formembers with pension funds of allsizes.• The service is available online using liveannuity rates. We provide clear simpleexplanations in plain English. We providesupport and help by phone, via post,online, or by email.• For those members who do not want toEXPERT VIEWDecisions that last a lifetimeClear information on all retirement options will help scheme membersmake the right choices – and the most of their pension, says Katie Hooperbuy an annuity we can providespecialised help on alternatives. We canalso offer advice if required.The NAPF report concludes: “We foundexcellent examples of good governance atboth ends of the spectrum”. Which end ofthe spectrum are you? nKatie Hooper is Head of CorporateAnnuities at Hargreaves Lansdown.To chat about this further you can callus on 0117 314 1783 or simply email usat corporate@hl.co.uk with your phonenumber and a good time to call.This article is not advice and you should not take anyaction without first seeking specialist advice. You mightbe interested in viewing our annuity website www.hl.co.uk/annuity – it shows how our service is alreadyhelping thousands of retirees each year. HargreavesLansdown is independent and not owned by or tiedto any insurer, employee benefit consultancy, or bank.More DC scheme members use us for their retirementthan any other annuity broker². To get in touch, callKatie Hooper on: 0117 314 1783¹Source: 12 months to 1 July 2012, HL individual clientswith an annuity purchase price of £10,000 or more.²Source: MyTouchstone.14 WWW.ENGAGEDINVESTOR.CO.UK WWW.ENGAGEDINVESTOR.CO.UK 15 15


SPECIALREPORT“There is less focus on equities.Typically, clients are looking to getgeographical exposure from whatequities they hold. Increasingly,clients are looking at newerstrategies to generate returns; oneexample is hedge funds. Givenevents of the past few years there isnow a lot of focus on due diligence inthat area.“The bigger funds are seekingnewer, more innovativeinvestments, likerenewable energy.There’sa lot ofdiscussionaboutinfrastructureand its potentialto give long-term,inflation-linkedreturns,whichFrances Hudson, global thematicstrategist, Standard Life Investment“With an ageing population and a moveaway from defined benefit pensions, bondswill be more popular. There will be a long-termtrend shift towards bonds, partly because ofregulation. The regulations coming in underSolvency II give a higher rating to bonds,which is unfortunate at the time whenbonds are giving negative real yields.”John Dewey, managing director, in BlackRock’s multi-assetclient solutions groupis what pension schemesultimately want.“One of the big surprisesover the past few years is thatdiversification hasn’t really worked.We’ve seen an environment whereassets have moved in line witheach other so portfolios weremore risky than people thought.In consequence, our clients arekeen to hunt out the genuinediversification and look for thingsthat don’t just look different butactually perform differently.“I think we’re going to seea continuation of the volatileenvironment, it really pushes peopleto focus on their risk. We don’texpect yields to rise any time soon.I think we’ll see a gradual reductionin risk and a move from equities tobonds while making both sides workharder to chart a course throughdifficult conditions.”Mike Turner, head of global strategy and assetallocation, Aberdeen Asset Management“The bonds to equities switch is the big trend. Ithink we’re now in a self-sustaining momentum.The industry tends to gravitate around one centralparadigm, which at the moment is for pensionschemes to de-risk. It’s early days but I think you’llfind more and more of it happening, not only herebut in other parts of the world, such as the US.“Certainly, consultants are looking at diversifiedgrowth funds (DGFs) more closelyand beginning to talk totrustees about them. I don’tthink the trustee communityhas wholesale gone in fordiversified growth funds indefined benefit schemes,but some have started.DGFs appeal both to definedcontribution and DB pensionschemes. I think that theDC world has taken themup more than the DBworld. The jury’s stillout, but there are afew that have donethe job and othersthat haven’t doneit so well.”Colin Tipping, director, unit linked investments,Friends Life“We are hearing interesting thoughts aroundthe idea of outcome-oriented investing. Peopleare not so much thinking about what goes intothe mix but about the ultimate target. What areinvestors really looking for? Certainty of incomein retirement. We’re seeing interesting ideas fromthe US around the idea of managing away theupside: people being prepared to sacrifice theupside for more certainty on the downside.“There is still way too much focus on what goesinto the investment mix and maximising the sizeof the pot, and not enough thinking about whatthat means in terms of income. We’re seeinginteresting ideas about how to lock down profitson the way through, the emergence of definedcontribution banking, collectiveDC. It’s becoming less about theinvestment thesis and moreabout locking down income ata future point in time.“My challenge to the fundindustry is – where’s theinnovation? You can havevery high-level academic[investment] theses but turningthem into something thatworks at a schememember level willalways be thechallenge.”Current issues in pensionscheme financingEmployer covenant risk is a factor that needs to be consideredat a time of corporate volatility. Donald Fleming looks at whatneeds to be done to maximise the security of member benefitsCorporate defined benefit pensionschemes make up some two-thirds of theUK’s top 100 schemes but, of these, onlyhalf are supported by FTSE 100 sponsorsand the rest are now largely in the handsof overseas parents and mainly closed tonew entrants. Over a single generationthere has therefore been a fundamentalshift in the nature of the ‘covenant’risk borne by the largest UK pensionschemes, which presents considerablechallenges to both UK pension trusteesand to senior company management.Gazelle (a specialist pensions advisoryfirm) researched what has happenedto the companies that made up theFTSE 100 Index in 1985. While 7%have defaulted and 26% experiencedfinancial stress in the period sincethen, the surprise was the exceptionallyhigh incidence of corporate change:83% experienced one or more majorcorporate transactions – with over halfbeing due to takeovers.We conclude that a differentiatedapproach to covenant risk is appropriatefor such schemes, and perhaps there arelessons to be learned by regulators, too.From the pension scheme perspective,there has quite rightly been increasedfocus on how the change in covenant willaffect the security of members’ accruedbenefits, while from the overseas acquirerperspective the UK pension is oftenregarded as a legacy financial issue that isbut one competing interest among manystakeholders worldwide.However, care must be taken withgeneralisations: while all FTSE 100employers have now closed theirschemes to new entrants, a numberof the top 100 schemes are supportedby overseas groups and remain open,suggesting in some cases a levelling-up tomultinational benefit structures.For much of the past quarter centurylack of transparency and differences invaluation approaches have meant thatpensions risk and covenant risk havebeen mis-priced by investors and thepensions community alike. Regulationhas begun to change this: the 2004Pensions Act and formation of ThePensions Regulator in 2005 introducedsome ‘pricing’ of covenant into takeoversthrough the clearance regime; and theproposed changes to the Takeover Code ,by formalising trustee rights to engage intakeover bids, should increase valuationtransparency.However, market practice is stillunsettled and in many cases the fullimpact of covenant change is not fullypriced into transactions, with the resultthat the true cost of scheme funding isoften unwittingly borne by one or otherset of shareholders.The sponsor covenant is, according tocurrent regulatory formulation, viewedin terms of the financial strength thatderives from the legal support structure(participating employers, guarantees)rather than including, as formerly,intangibles – ‘willingness and ability’to support the scheme. One challengetherefore is to give due credit in valuationto informal business, management,treasury and structural linkages that runthrough complex but fundamentallyhealthy organisations.A subsequent study by Gazelle of thetop 100 pension schemes indicates thatthose in the hands of overseas parentsfollowing takeovers are supported bycompanies that are not just leadingnational ‘blue-chips’ in their ownEXPERT VIEWcountries, but also globally.One conclusion that we at Gazellehave drawn from our research andour experience from advising someof the UK’s largest schemes is that, forlarger schemes supported by majorcorporations, The Pensions Regulatormay be too focused on default outcomesand protecting the Pension ProtectionFund compared to the challenges topension funding presented by corporateand business change. The currentproposals by the European Insurance andOccupational Pensions Authority (EIOPA)in relation to the ‘holistic balance sheet’approach for occupational pensionsalso reflect a similar static approach tocovenant.The danger is that simply looking atcovenant in terms of attachment ofpension schemes to historic participatingemployers, rather than addressing thechallenge of how to look dynamicallyat the covenant as an ultra-long termfunding relationship may well, over time,‘erode’ covenant support by confining itto mature and declining businesses ratherthan building funding support fromgrowing business units.Given the long-term nature of pensionliabilities, the need to build a sustainablefunding structure is crucial. nDonald FlemingManaging Directorwww.gazellegroup.co.uk16 WWW.ENGAGEDINVESTOR.CO.UK WWW.ENGAGEDINVESTOR.CO.UK 17

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