The pension fund industry, coping with issues such as yawning deficits and mounting liabilities, has had to embrace innovative asset management ideas. But while there are differences, pension funds have much to teach wealth managers.

Increasing longevity, Madoff, credit crunch loses and the potential threat of renewed inflation from quantitative easing conspire, amongst many other factors, to heighten the challenge facing the wealth manager.

Clients’ expectations and aspirations need to be met in an ever less certain environment. The options available can appear bewildering and there is no shortage of suggestions, published almost daily.  It can be difficult to differentiate between tactical opportunities and strategic goals.

Fortunately, a model already exists to meet these challenges that have been faced by pension fund trustees.  This paper seeks to identify some principles that could serve wealth managers and their clients for the future.  At its heart is the identification of the long-term liabilities of an investment portfolio and an efficient allocation of assets to meet those liabilities. The paper draws on insights gleaned from the pension fund world.

Asset allocation of pension funds has changed dramatically in recent years.  There are three general trends:

A shift away from equities, particularly UK equities, from the 75 – 80 per cent overall equity allocation that had persisted for most of the 1990s.

A marked increase in bonds but equities remain by far the largest single asset class.  

A greater degree of diversification both within the major asset classes and by a growing (albeit modest) allocation to alternative investments. 

What these average figures do not show is the more dramatic move of institutional investors to adopt strategies specific to their needs and objectives rather than being bunched around the average allocation.

Ten years ago the asset allocation of most UK pension funds mirrored closely the profile of the average fund.  It is now not unusual to find a pension fund with, say, over 80 per cent of its assets invested in bonds and alternative investments and for those investments to be structured in a specific and non-standard way. Derivatives such as interest rate or inflation swaps, unheard of in pension funds just five years ago, are now relatively commonplace.

How it happened

Institutional investors have been subject to increasing regulation and transparency.  And risk, for long the Cinderella of investment, is taking centre stage.

Changes in accounting rules have probably been the most significant single factor but there are others around funding, disclosure and solvency.  These, together with growing and high profile deficits, have led inexorably to the conclusion that investment policies that largely ignore the characteristics of the liabilities that they are intended to cover are deeply flawed. 

Investment policies that largely ignore the characteristics of the liabilities that they are intended to cover are flawed. 

For many funds, the effect of the dot.com bubble was their first graphic experience of how risky a mismatch between assets and liabilities can be. Subsequently, most funds reduced their exposure to equities in favour of bonds and alternatives such as real estate and hedge funds. A small minority went a lot further.

There is rarely a clear-cut answer. Different investors have different priorities and circumstances, in which human emotion is an important ingredient. A balance has to be struck between potential investment returns and the need to control risk. 

Hence, the definition of risk and tolerance to not achieving an investor’s goals will be unique and is likely to involve art as much as science. One of the key roles of an adviser is to help identify the goals and priorities and test the client’s risk tolerance in order that an appropriate and practical strategy can be put in place.

How to set assets in the light of liabilities

Every situation is different.  A common theme is that the investor has to ensure there are sufficient assets to meet certain specified obligations in physical cash flow as payments fall due and at periodic disclosures to show that assets are on course to be able to meet future obligations with a suitable level of caution. 

The obligations could include a single or a fixed series of payments or a pension where the number of payments is unknown as they are linked to a variable, such as life expectancy. The payments may be fixed in nominal terms or may be linked to an index, such as prices inflation. 

Once these parameters are known the objective(s) is defined. This in turn defines the level of risk that underpins a particular investment strategy. It is the risk the strategy will not achieve the objective. A cautious investor should adopt a strategy that is highly likely to achieve the objective – whatever that might be. This is not necessarily the same as the risk, for example, that an investment might lose money. 

If the objective is to save for a known amount, say £10,000 to buy a car in a year’s time, then capital security of the investment is generally important for a cautious investor.  But if the objective is to purchase an annuity starting in ten years’ time of a fixed annual amount (of say £1,000 a year payable for life), the minimum risk strategy is one that focuses on the cost of annuities in ten years – a cost that can rise or fall, often sharply, depending on, amongst other things, long term interest rates in ten years’ time.  Capital security of the investment in this situation is not necessarily a priority.

Setting the investment strategy involves two components: liability hedging and return generation.

Liability Hedging

The liability hedging component seeks to achieve the objectives (as defined) with as much certainty as possible. Typically, this will involve portfolios of nominal bonds, inflation linked bonds, cash and derivative overlays such as swaps. The bonds will be backed with a suitably strong issuer such as a government to be as sure as possible that payment will be received and will be of a length (or term) that is consistent with the liability. The liability hedging component may also hold a generally small proportion in other investments, such as equities. This would be appropriate where some of the liabilities are not known precisely – for example wage inflation or an annuity that is dependent on life expectancy for which there is no readily available matching investment.

Return generation

A return generation component is there to deliver return over and above that needed to secure the liabilities, generally over the longer term. By its nature, it is introducing risk to the process. This may be because the investor does not have sufficient assets today to achieve the investment goal or the investor wishes to defray future costs by taking a risk that these can be met in part from future excess investment returns.

The art is to identify the right balance between the level of return sought relative to liabilities and the risk of not achieving the goal.  Increasingly institutional investors spend a high proportion of their time and resource, working with their advisers, to address these key issues. 

The return generating component is a balance of a diverse set of investment strategies.  The simple approach adopted in the past was to invest in a broad portfolio of equities possibly divided by geography and between more than one third party investment manager. But the events of the past decade have shown this is too reliant on a single factor – the level of equity markets – that have all tended to move in the same direction at the same time. The approach was not diversified and a more sophisticated approach is required to generate a stable return profile. 

There are three components to a diverse strategy for a long-term investor: diversify market risk, incorporate the liquidity premium within illiquid assets and balance exposure to market risk with active management risk.

Individual components of the strategy may be sub-contracted to specialist managers that could be actively or passively managed. If a portfolio or manager is to be included it should be in the context that it contributes efficiently to the whole under one of the above components. 

Overall, the components should be brought together in a way that produces appropriate diversification and rewarded risk that taken together with the Liability Hedging component in a practical manner is appropriate for the client’s needs.

All together

This is a process that involves judgement.  Ultimately, a balance has to be struck between theoretical elegance and the practicality of day-to-day management and cost.

An essential tool in effective risk management is the ability to be able to drill down into a complex structure of investment portfolios to understand their characteristics.  This seeks to identify over-reliance on single elements of risk – e.g. equity market risk or a particular sector within equity markets – and to ensure an appropriate degree of diversification of broadly unconnected (or uncorrelated) sources of risk relative to the minimum risk strategy.  This is by no means easy as the portfolio will almost certainly contain a number of different components quite probably managed by more than one third party and there will be overlaps – global equities, for example, may be held in an active specialist portfolio, a passive portfolio and an asset allocation portfolio. The increasing use of derivatives to construct portfolios adds a further layer of complexity. 

A true understanding both at outset and for ongoing monitoring and tactical decisions is only really possible with a sophisticated risk management system. The system should be able not only to identify and combine the sources of risk but also to show them in terms of the client’s goals not just the pure investment risk.

It is important to add caveats about the reliance on a single system and, indeed, the application of common sense. All systems model the future to some extent based on what has happened in the past. Some are more sophisticated than others but, as we know, the past is not necessarily a good guide to the future. How often have we heard in recent years of one in two hundred year events occurring one after the other in quick succession?  It is always worth looking at risks in, at least, three different ways:

The big picture – looking at for example the level of active risk or the topical value at risk to see the overall level of risk being run relative to the client’s goals. 

Sensitivity analysis – assess how sensitive a strategy is to specific scenarios or combinations of scenario such as interest rate rises or a stock market correction; and

stress-test the impact of different types of extreme situations such as a collapse in credit markets.

Finally, apply common sense and practicality. If you cannot explain to a client in a rational way why a particular decision was made you should probably think twice (at least) before doing it.

And keep a sense of perspective. It is easy to create a structure that is theoretically sophisticated but expensive and difficult to manage. Often a simpler structure that addresses the key risks will be a more practical and cost-effective option for all concerned.