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The Co-op’s equally split strategy

The United Kingdom’s Co-operative Group, a chain of food, funeral and financial services outlets, markets itself on a popular loyalty scheme whereby customers earn points that are converted into a profit share, or dividend, directly linked to the group’s annual profits. It’s a founding philosophy that can trace its roots back a hundred years and goes a long way towards explaining the Co-op’s longevity on the UK high street. It attributes a similar loyalty among its customer-base workforce to key perks like a defined benefit pension scheme, still open to staff after a two-year qualifying period.

Strategy at the £7-billion ($10.65-billion) pension fund, which provides for 12,000-odd active members and 40,000 deferred, is focused on improving funding levels with an interest rate and inflation hedging strategy. Assets at the fund are currently portioned equally between growth and liability matching strategies, but if funding levels, which are regularly monitored, improve, the scheme plans to tilt its portfolio towards a bigger matching allocation in the coming months. “If the funding level is better, we will use the opportunity to adjust this 50/50 allocation and push towards more liability matching assets, taking more risk off the table,” says Mike Thorpe, pensions finance and risk controller at the scheme.

Equally split

The decision to split the scheme equally between growth and matching assets dates from 2006 and targets 100-per-cent funding by 2026. The scheme is currently 77-per-cent funded on a self-sufficiency basis. “This, of course, is open to review over time, but you need an objective to have a strategy and I would say there is a reasonable likelihood of meeting this target,” says Thorpe, a chartered accountant by trade who joined the pension scheme in 2007 from the insurance industry. It’s a funding position that has gradually improved thanks to returns over the last three years of 10.3 per cent, against a benchmark of 8.7 per cent, and over the last year of 7.4 per cent, against a benchmark of 5.2 per cent, with the liability matching side of the portfolio doing “particularly well.”

Hedge protection

In an interest rate and inflation hedging strategy, the liability matching portion is split between bonds (20 per cent) and liability-driven investment (30 per cent) that together hedges 58 per cent of the interest rate risk and 72 per cent of the inflation risk with plans to increase this to between 75 and 77 per cent. “It’s a program of hedging that has protected us very well,” he enthuses. “From the last triennial valuation in 2010 we can see that if we hadn’t had that inflation and interest rate hedge in place, we would have been 16-per-cent worse funded on a self-sufficiency basis.”

The scheme hedges risk with index-linked and fixed interest gilts (although Thorpe says he is wary of locking in the current low returns from gilts) index-linked corporate bonds and a range of derivatives (interest and inflation swaps, gilt repos and total return swaps). “Compared to other asset classes, like active equities, the LDI portfolio is not expensive but it is complex,” he says, adding that he has found the big US endowments a surprising source of inspiration for the Co-op’s own strategy through their aggressive growth allocations. “They don’t have our liabilities, so invest in a different way, but their growth portfolios are interesting to watch,” he says. A case in point, he explains, is the Co-op’s allocation to GSO Capital Partners high-yield debt fund made at the end of 2011, targeting the full range of sub-investment grade credit. The allocation sits within the 20-per-cent bond allocation in the liability matching side of the scheme’s portfolio to help ensure that part of the portfolio meets its return expectation. “The fund has done well since the investment was made, comfortably beating its target,” he says.

Growth side

The 50-per-cent growth side of the portfolio, which targets returns of LIBOR plus 4, includes a 30-pe-cent equity allocation. It is split between eight different managers with investments in the UK (5.5 per cent), US (7.5 per cent) Europe excluding the UK (7.5 per cent) Japan (2.5 per cent) Asia excluding Japan (2.5 per cent) and emerging markets (4.5 per cent). The emerging market allocation is divided between a dedicated emerging market manager and a global equity manager. The scheme’s global passive manager also has a “tiny” emerging market allocation. Only 10 per cent of the equity allocation is run on passive mandates and this is skewed towards markets in the US and Europe. The reason for the small passive allocation is owed to one of its active mandates actually being “very low risk,” managed by the Co-operative Group’s own Co-op Asset Management. “We didn’t want to over-allocate to the passive equity,” he says, adding: “The trustees believe in active equity management, but keeping an allocation to passive diversifies the equity portfolio. Active management continues to add returns over the higher fees.” Elsewhere in the growth portfolio the scheme has a 5-per-cent property allocation, directly invested in UK property assets spanning retail, commercial and industrial properties. Here the goal is to outperform the IPD UK Monthly Property Index by 1 per cent.

The remaining 15-per-cent growth allocation is portioned to alternatives, steadily built up over recent years. Two per cent of this allocation is with manager Fortress in a multi-strategy fund of funds. The remaining 13 per cent is managed and implemented by Mercer in a bespoke, Qualifying Investor Fund, with investments in an array of alternatives spanning currency, insurance-linked bonds, private equity, tail risk and private debt placed with around 45 different managers. The fund targets returns of LIBOR plus 4 and volatility of 10 per cent per annum. “The idea is to achieve a correlation with equities of 0.3 per cent; we’re after equity-like returns but diversified,” he says. The strategy was born out of the scheme’s desire to tap into alternatives, but without the risk of going it alone. “Because of the wide and complex nature of alternative assets, we came to the conclusion we’d be more comfortable with a specialist team to manage the allocation,” says Thorpe adding that the strategy, begun in 2006, has demanded patience but is now close to paying off. “We’ve spent three years building it up; we’ve put in around $12.2 million in three different tranches. We’ve not hit the target of LIBOR plus 4 yet – it’s all about building up the J-curve with returns coming through in later years. So far we’ve done about 2.5 per cent per annum. Last year was 6.1 per cent so we’re satisfied with progress,” he reassures.

Strict ethics

Environmental, social and governance factors are increasingly prevalent in the fund given the Co-op’s own strong ethical brand. “They want the pension fund to reflect this,” says Thorpe. The scheme hasn’t adopted ESG mandates with specialist managers or “made investment decisions on specific ESG factors” but it does ask its managers “to take account” of ESG factors “and report back to them on how they are doing this.” More boldly however, in a strategy also present among some Scandinavian schemes, it doesn’t hold any allocation to emerging market debt on ESG grounds. “The Co-operative Bank has a strict ethical policy not to do business with countries with questionable human rights records and this is now reflected in the pension scheme. We don’t explicitly allocate to emerging market debt due to ethical concerns and the potential reputational risk for the sponsor.”

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