Most pension schemes remain focused on de-risking, but there is a growing emphasis on diversification strategies and using investment opportunities, reports Graham Buck

Five years on from the first stirrings of global financial crisis, the rewards available to risk-averse investors have grown increasingly meagre. Such is the appeal of ‘safe havens’ that in May Germany was able to sell more than €4.5 billion of two-year government bonds with a 0 per cent coupon – in other words investors got no provision for inflation. At the same time reports suggest many funds are piling out of euro assets on fears of ‘Grexit’, a disorderly exit from the single currency by Greece.

Yet there is little to suggest that investment opportunities created by uncertain times has changed pension schemes’ focus on de-risking. Evidence such as the just-published report by Clear Path Analysis, Pension De-risking Investment Strategies Europe, suggests most are still following this path. What is changing is that an increasing number are exploring the wider range of de-risking strategies now available – from long/short equity and liability-driven investing (LDI) to newer options such as absolute return funds and tail risk management.

“We’d advise schemes to regard managing risk and de-risking as a journey and not a point-in-time issue, says Mercer chief investment officer for Europe Hooman Kaveh. “So it’s a journey that combines a conservative approach with taking good investment opportunities as and when they arise.” Opportunities currently proving attractive include emerging market debt and equity, high yield bonds and infrastructure, and real estate debt.

Unlike individual investors, pension schemes are constrained by the employer covenant in their ability to increase their risk exposure and pursue better returns. As law firm Stephenson Harwood head of the pensions practice Mark Catchpole notes: “Trustees will only take on greater risk where the scheme is relatively strong and well-funded. Confidence in the covenant is key, as it represents the last call should the investment strategy fail.”

The question is whether many funds actually want to develop greater risk appetite. Pension Corporation co-head of business origination Jay Shah echoes a widely-held view when he observes: “It would take a very brave set of trustees to sanction a move to riskier assets at the moment.”

Deliberate under-hedging?
Pension Corporation’s own recent survey suggests that many UK schemes remain under-hedged against risks causing them greatest concern. Its survey of trustees found that 53 per cent of respondents had taken no action to reduce their longevity, inflation and investment risk exposures.

“Pension schemes generally are taking too much risk – the main risks being equity, interest rate and inflation,” agrees Cardano UK head of clients Richard Dowell. “The last two relate to the lack of liability hedging, which has been painful for a number of years.

“De-risking shouldn’t always mean de-returning though. When taking on risk it’s important to select those you believe are going to be rewarded and remove those that you don’t. Although interest rates are currently low, the expected benefit over the next three years from being under-hedged is not significant – so we think trustees should have a plan in place to reduce this risk.”

Referring to Pension Corporation’s survey, Morgan Stanley Alternative Investment Partners managing director Joe McDonnell comments that many funds are “chronically under-hedged” through choice rather than any lack of awareness. He cites various reasons: “Trustees may feel that valuations aren’t right to lock in at this time, they may feel that their sponsor is strong enough to support an ‘unmatched’ growth strategy or that the safe-haven associated with hedging/risk reducing is likely to deteriorate in quality,” he suggests.

Scheme trustees have come to accept that removing risk entirely – even via buyout, which many now regard as too expensive an option – isn’t possible, says Buck Global Investment Advisors senior consulting actuary Tony Winterburn.

“Instead many are focusing on removing specific risks; a strategy that makes good sense when it can be achieved without either the need for a significant contribution from the employer or an impact on the funding position.”

Deciding which risks will be retained and managed depends on each scheme and its specific circumstances. The big question is which methods of de-risking are most reliable and efficient?

Franklin Templeton Investments director of performance analysis and investment risk Wylie Tollette suggests that changing the pension terms to reduce the gap between expected liabilities and available assets could have the most meaningful impact on the size and volatility of the net funding gap. It also addresses the risk that pension plans should be most concerned about. As he admits though this “can be a very difficult endeavour”.

In the investment area, he suggests the following options, roughly in order of reliability:

• Taking less risk by moving into lower volatility assets such as cash.
• Short term domestic fixed income.
• Increasing diversification by including less correlated asset classes in the plan allocation.
• Tactically allocating between asset classes in an attempt to avoid drawdowns.
• Active risk hedging, including tail risk hedging.

Technological advances are assisting the task of de-risking. As Kaveh notes, five years ago risk management tools existed separately on the asset side and the liability side but the two are now more integrated.

New tools that have become available include risk reduction calculators, longevity education tools, buy-in trackers (indicating the current price of buy-in) and risk management information dashboards that give trustees monthly information to influence their decisions.

Recent initiatives also include the launch of a buy-in monitoring service by consultancy firm Hymans Robertson, which can calculate for DB schemes the relative cost of a full buyout, a buy-in to hedge the liabilities of older scheme members, and using gilts or swaps to hedge liabilities.

De-risking strategies in the area of longevity risk, such as Dutch group Akzo Nobel’s recent €1.75 billion contract with Swiss Re to cover pension obligations for its UK employees – have gained popularity since early 2011. “It’s another example of a scheme acting to take advantage of opportunities that now exist to manage risks without reducing holdings in growth assets or locking into low yields,” comments Mercer head of longevity swap consulting Andrew Ward.

Previous transactions completed by companies such as Rolls-Royce, Pilkington, BMW, ITV and British Airways won a good reception and boosted the share price.

“It’s no longer a new market and as there have now been a number of transactions, a degree of standardisation has been introduced,” says Aon Hewitt managing principal Martin Bird.

This could lead to some future transactions involving smaller schemes, taking advantage of some precedents that have been established, adds Ward.

De-risking vs re-risking
A more bullish note is struck by Natixis Global Asset Management head of UK/Ireland business and global consultant relationships Terry Mellish. He reports that despite more cautious risk appetites in many schemes, a variety of “compelling investment options” now offer to deliver returns while managing risk in periods of increased market volatility.

“LDIs and diversified growth funds are proving popular means of de-risking; however pension funds need to be looking at re-risking, given the current situation in equity and bond markets,” says Mellish.

“Diversifying through alternatives presents an opportunity to deliver new sources of alpha while, most importantly, protecting against rising correlations across asset classes.”

Among the options now being considered by some schemes are high conviction equity and fixed income strategies which, as he notes, can “sit in both the alpha and beta camps”. By incorporating risk budgeting they offer a means of generating reasonable returns at appropriate levels of risk.

On the alternative side, Mellish suggests that funds consider incorporating risk through hedged equity and hedge fund beta overlay strategies that dampen down volatility. “These strategies are similar to hedge funds in that they cash in on the upside but protect against the downside, making them attractive portfolio components to complement traditional holdings.”

Principal Global Investors Europe chief executive Nick Lyster also supports diversification, which he believes briefly got a “bad name” in 2008-09 but ultimately proved itself during the crisis.

For schemes still loathe to take on more risk, he suggests following the example of one of the group’s clients. “The trustees recognised that the pension fund’s structure made it hard to take advantage of opportunistic investment opportunities,” he reports.

“In response, they created a ‘bucket’ into which they put no more than 10 per cent of the fund’s assets and over which their advisor could have discretion.”

Written by Graham Buck, a freelance journalist

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