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.”

There continues to be potential for pension capital appearing where bank lending no longer wants to go. Commentators in the UK and continental Europe have heightened expectations that pension funds will step in to help fill the continent’s bank financing gap. Societe Generale, for instance, recently predicted further “disintermediation” by investors sidestepping banks and looking for greater seniority than bond holding. Over in the US, the news that average yields on high-yield debt have fallen below 5 per cent for the first time, according to the Barclays US High Yield Index, could also give added impetus to funds exploring the higher reaches of the capital structure.

The consultant call

David Bennett, head of investment consulting at Redington, says his consultancy is advocating moves into direct lending investments in the majority of its asset allocation reviews for institutional clients. He argues that the relative value appears quite strong: “The general trend in credit spreads has been considerable tightening, and there are not as many opportunities any more in high-yield or investment grade debt to make the returns that funds need.”

Bennett is confident that the area of direct lending will progress from its relatively exotic status to something more mainstream in time. “Provided a fund has capacity for investments in illiquid assets, there seems to be considerable interest as the asset class offers exceptionally attractive risk-adjusted returns,” he reckons.

Bennett says the European direct lending market is much less developed than that of the US despite the greater need for post-crisis refinancing. Relatively unattractive pricing is a major barrier in Bennett’s view. He expects the pricing to become more attractive though, as European borrowers seek out non-bank funding in response to the challenging environment they face when refinancing the so-called “maturity wall”.

 The fund angle

Investors have also raised uncertainty over the structuring of direct lending investments as a stumbling block. Steven Daniels, chief investment officer of the $10-billion Tesco scheme’s inhouse investment arm, told this year’s UK NAPF Investment Conference that pension funds are “potentially good banks, but we are not mugs”, pointing out that it would scrutinise any investments in the area. In a similar vein, Niels Jensen, investment director of the $11.8-billion Lægernes Pensionskasse in Denmark, recently told top1000funds.com that checking that “the spreads are attractive enough” is a vital consideration to the interest his fund has gained in the credit opportunities space after seeing bank credit squeezed.

Brett Cornwell of Callan Associates adds that fees remain a sticking point for many US funds, with a “hedge-fund style” fee structure of 1.5 to 2 per cent in management fees, plus additional performance fees the norm. “Five-year-plus lock-ups are part and parcel of the illiquidity downside,” Cornwell adds.

Cornwell accepts the return advantages can outweigh these concerns in many cases. Andrew Bratt of the Pension Consulting Alliance in California, while also accepting the advantages of direct lending, believes some of the slow take-up among pension funds can be explained by difficulties in “finding the proper portfolio segment for this type of investment”.

Bratt argues that direct lending is “not liquid compared with traditional fixed income and it does not present the opportunity for private equity returns. I see this as a problem for many pension funds, save for those who specifically allocate to this type of product.”

Larger public pension funds are proving thus far to be the most common US direct lending investors, adds Cornwell. He characterises the typical fund exploring the asset class as “having healthy fixed income investments already, and liquidity in other parts of the portfolio, seeking yield, generally being more sophisticated with alternatives, active in private equity and having larger staffs to vet managers.”

The $9.9-billion Orange County Employees Retirement System and $8.4-billion San Diego County Employees Retirement Association are two US funds recently reported to be exploring the direct lending option.

Lending in all shapes and sizes

The most accessible way for funds to benefit from banks’ limits appears to be through direct lending funds. Plenty of skilled providers are competing in this area, Bennett says, despite significant challenges in checking credit worthiness, structuring loans and providing sufficient governance. The likes of M&G Investments’ UK corporate financing fund have been the most notable recent European offerings for their linking of pension funds with small and medium enterprises.

Some of Europe’s biggest investors have gone for something seemingly more ambitious though – making their own infrastructure loans or snapping up debt from banks’ hands. Dutch fund manager APG made an inflation-linked loan in a €80 million ($105 million) road-financing deal last October, a uniquely valuable investment in a country whose government does not issue inflation-linked bonds.

Bennett recognises that infrastructure loans are more of a specialist niche for large investors, saying, “You really need a manager with a specialist hat on”. A great attraction of infrastructure loans, argues Stefan Lundbergh, head of innovation at Cardano and board member of the $35-billion Swedish fund AP4, are their inflation-linking properties – especially if done in partnership with a government.

Lundbergh cautions that funds wanting to take the direct route on infrastructure loans must recognise the level of expertise needed – underwriting loans being far from a simple exercise. His reckons these complexities can limit the number of opportunities, saying “all the legal work, paperwork and negotiations to get the loan in place are worth it for big-ticket investments, but this becomes more difficult for smaller ones”. Liquidity and valuation difficulties will also be acquired when the loans enter the portfolio, but there is no reason why talented medium-sized funds should not be able to rise to this challenge though, he adds.

PensionDanmark also made waves last year by acquiring $350 million in infrastructure loans from the Bank of Ireland as part of a $750-million secondary loan mandate with JP Morgan. Secondary loans also require a “very different” skill set, says Bennett.

New equilibrium?

While Bennett believes “one day it’s possible that long-dated institutional investors can take a significant proportion of the corporate lending market”, Lundbergh reckons that competition issues will prevent pension funds from making too many inroads into traditional banking territory. Pension funds’ tax-free status in the Netherlands derives from their status as passive investors, which could be compromised by directly underwriting loans, he says. He adds that despite some expectation that pension funds could cover for retrenching investment banks,“I would expect more in the way of partnerships with underwriters”.

Cornwell argues that while externally managed direct lending remains an exotic option, “comfort levels” are definitely increasing. “Ten years ago, high yield was more exotic than nowadays. As you become more comfortable with the capital structure of these corporations and how the lending mechanism works, it opens up space in the marketplace for those able and willing to loan,” he says

As professional investors, any expectations that pension funds can fill in the worst gaps in European lending might be over-ambitious though. Projects in countries saddled with government debt worries might after all only find pension capital offered at rates as unappealing as those offered by the continent’s cautious banks, says Lundbergh.

Then there is the question of how long the window of opportunity will stay open for, as in healthy times banks generally have no trouble lending money. Longer dated infrastructure loans could prove to be the most durable of the current bout of lending from funds, Bennett says. While banks can be expected to eventually expand balance sheets again, instead of simply muscling pension funds out of the direct lending space, a “new equilibrium” could emerge, he argues. The edge institutional investors can gain over banks in long-maturity lending is one Bennett expects them to keep beyond then.

 

An investment-beliefs workshop for the CalPERS board, held in April, revealed five areas, including active management, where the views of the board and staff lacked consensus.

The contentious, or unsettled, topics for discussion were active management, private asset classes, sustainability (environmental, social and governance), investment performance targets and stakeholder considerations.

At the board workshop, Janine Guillot, chief operating investment officer, presented the findings of work the CalPERS investment staff had already completed on distinguishing their own beliefs. This included the summation of 85 detailed questions to the chief investment officer, Joe Dear, his direct reports, the chief actuary, Alan Milligan, and the senior portfolio manager and director for global governance, Anne Simpson.

The process also asked those staff to construct a sample portfolio and how that connected back to the investment beliefs.

Dynamic but doubting ability

The results of the staff questionnaire revealed a support for dynamic asset allocation as a value-added activity, but mixed views on the ability of the staff to carry it out.

With regard to active management, the CalPERS investment staff also had strong consensus to use index strategies where market efficiencies were the greatest, such as public equities, but not fixed income, and there was strong support for alternative indices or alternative beta.

There was also scepticism about the staff’s own ability to select managers that could add value, emphasising that what mattered most was the overall portfolio rather than individual manager performance.

As part of the active management discussion, staff had low conviction that hedge funds should be an important part of CalPERS’ strategy, but despite that most of the staff surveyed still allocated to hedge funds in their model portfolio exercise, albeit a smaller allocation, around 1 to 2 per cent.

Following the board member questionnaire and roundtable consultation, feedback from board member Richard Costigan supported the staff’s skill levels, and was at odds with the staff’s view of their own ability.

“The board members commend staff because we think you can achieve alpha, but the staff says it is difficult to get alpha.”

Strategic bases covered

The aim of the workshop was to draw up a preliminary set of beliefs to discuss at the board’s July offsite, with the goal of adopting investment beliefs at the September investment committee meeting.

The idea is that the investment beliefs provide a strategic basis for the management of the portfolio, a framework for assessing new investment strategies and avoid making changes on an ad-hoc basis, and ensure that alignment between board and staff becomes part of the culture.

The project kicked off in January and has been guided by head of investment content at Towers Watson, Roger Urwin.

Urwin says setting investment beliefs is a feature of big asset owners wanting to sort out their investment process.

They are the “softer” issues that provide the foundation on which to build the portfolio.

Guided by Urwin, staff and the board at CalPERS undertook a detailed questionnaire, which revealed the areas of consensus and those that were contentious.

“We need to understand what we are achieving here,” Urwin said to the board. “And I like to quote JFK: ‘Belief in myths allows the comfort of opinion without the discomfort of thought.’ The investment world has a lot of myths, and we want to talk about them.”

Guillot also emphasised that the investment beliefs don’t exist in isolation.

“We don’t want them to be parked on a shelf and not influence anything,” she says. “We want them to drive the strategic asset allocation to be done in November/December.”

Workers’ models

With regard to the staff’s model portfolios, the strongest consensus was about the role of real estate, with most staff maintaining or increasing the allocation.

“There was an alignment of ideas that the characteristics of real estate deliver something valuable to the fund, cash flows and inflation hedging,” Guillot says, adding there was some concern about the cost of real estate.

Private equity attracted mixed views on whether the returns were sufficient for the illiquidity and complexity of the investments. However, overall the staff would still allocate a significant proportion of assets to private equity, reducing it a little from the current 14 per cent to 7 to 10 per cent due to the concern about deploying that much capital.

There was also concern around infrastructure, Guillot says, and while the staff could see the virtues of the asset class’ characteristics, there was concern about the ability to execute and deliver on infrastructure deals to “move the dial on the fund”.

The staff had strong support for corporate governance and engagement, but there was weaker consensus on environmental and social themes.

Various world views

CalPERS is hosting a sustainability and finance symposium on June 7, with its partner University of California Davis Graduate School of Management, which will be followed by a board workshop on sustainability.

With regard to the investment performance targets, staff say their aim is to deliver a target rate of return and then improve the funding status.

The bigger deliberation was whether there could be alignment of interest between the fund, external managers and staff.

“We tend to measure on relative returns and how that fits in with a total return target, and there were concerns about the time horizon and how to make that work with incentive plans,” Guillot says.

There was also a staff belief that the investment program should be simplified, but there was a difference in how to achieve that.

In addition to the questionnaire put to Dear’s direct reports, the INVO+3 staff was interviewed, which comprises more than 90 people. The issues discussed were the long-term time horizon, active management and alignment of interest.

“The most interesting thing that came out of that,” Guillot says, “is strong feedback that we are saying we are a long-term investor but we don’t act like it, with short-term performance reporting and incentives.”

The most interesting differences in the staff sample portfolios were in the amount of equities or growth risk.

The samples were almost split down the middle, with one camp maintaining or increasing equities and the other would reduce it.

“When asked why they had that approach to equities allocations, both started with the underfunded question but had different world views on how to improve the funded status.”

Nine consensual themes

These investment belief themes had strong consensus among CalPERS board and staff:

  1. Liabilities inform the asset structure.
  2. Strategic asset allocation is the dominant determinant of return and risk.
  3. An expectation of return premium is required to take on risk.
  4. A long-term investment horizon is an advantage.
  5. The market is not perfectly efficient, but inefficiencies are difficult to exploit after costs.
  6. An appropriate premium is required for illiquidity risk.
  7. Cost matters more than most investors think.
  8. Risk is often expressed as volatility or tracking error, but neither measure captures the essence of risk to CalPERS.
  9. CalPERS needs effective teamwork and governance.

 

Pension funds and social housing: it looks like a perfect match as schemes in the United Kingdom seek long-term, index-linked cash flows and housing associations, the not-for-profit providers of this type of affordable housing for low income households, hunt the long-term finance they can’t access via banks. Broad residential housing represents just 1 per cent of UK institutional fund investment compared to 47 per cent in the Netherlands, 15 per cent in France and 13 per cent in Germany. In America, New York City’s five public sector pension funds with combined assets of $128 billion have just upped their existing 2 per cent allocation to the asset class, voting to invest $500 million in residential rebuilding efforts in the wake of hurricane Sandy. Decades of chronic underinvestment have left the UK’s social housing sector in a tailspin similar to the havoc wreaked by Sandy. Now pension funds, scrambling for an alternative to gilts, could ride to the rescue.

Early adopters and their strategies

Local authority schemes have been among the first to dip their toes and are presumed likely trailblazers given any investment’s local impact. The small, £800-million ($1.2-billion) London borough of Islington has invested $31 million with Hearthstone Investments residential property fund. “Our decision reflects our view that investment in this sector will produce good long-term returns for local taxpayers and the members of our pension fund,” says Councillor Richard Greening. Elsewhere, the $16.2-billion Greater Manchester Pension Fund has invested in the construction of 240 new homes in the Manchester area.

Strategies include investing in long-dated index-linked debt where the housing association issues debt secured against its property portfolio – schemes buy the debt either directly or through a pooled vehicle. Another route is to set up partnerships directly with housing associations, while sale and leaseback offers a third strategy. Here, schemes invest in funds that buy existing homes from an association, which then leases them back over a 30-to-50-year period. Social housing bonds typically return between 1.5 per cent to 2.5 per cent above inflation-linked gilts, with higher returns for riskier investments via development partnerships, and sale and leaseback agreements.

Prudential-owned M&G has just finalised a $194-million sale and lease-back deal with a London housing association. “This is a high quality investment with a 35-year retail price index-linked lease that will help us to deliver inflation-linked returns, with good security, to our pension fund clients for a generation,” says M&G’s Ben Jones. “There is significant demand from pension funds for investment into housing and social infrastructure provided it is delivered on a transparent basis and directly assists with their desire for long-term inflation-linked cash flows to match their liabilities.” M&G’s $2.1-billion Secured Property Income Fund has invested in 32 UK assets delivering an annualised return of 7 per cent over inflation in the last three years.

Social benefit versus returns

Protagonists reassure lending to social housing is a safe bet despite its exposure to the moribund UK property market. One thousand seven hundred housing associations provide social housing across the nation but only two have ever run into financial trouble. Moody’s rate the 26 biggest between AA2 and A1 thanks to housing stock acting as collateral and implicit government guarantees. The majority of associations’ rental income comes from local government, with robust rent collection rates, and demand outstrips supply with around 2.5 million households currently living in social housing but another 2 million on waiting lists with housing associations needing to borrow around $23 million to fund planned regeneration and maintenance projects between now and 2015.

Yet changing UK pension funds lukewarm enthusiasm for urban revitalisation could be challenging. A discussion hosted at NAPF’s annual investment conference last February revealed schemes’ enduring worry that investing for public purpose impacts fiduciary duty, sacrificing returns for social good. “The real returns are there but they aren’t as big as we are looking for,” argued Clare Scott, investment manager at the Edinburgh-based $5.4-billion Lothian Pension Fund, which considering the asset class but yet to invest. It’s a sentiment endorsed by a Smiths Institute survey of 100 local authority pension funds that found none would be prepared to accept lower returns in exchange for social benefit.

Complicated risk

Lothian’s Scott says counterparty risk is also an issue – housing associations aren’t risk free. “There has never been a default but that doesn’t mean it’s not going to happen,” she warns. Security around rental income, she says, is also a factor in Scotland, where housing associations don’t own all the housing stock.

Change in government policy is another risk. Since 2005 the government set rent increases for housing associations at retail price index plus 0.5 per cent, linking rental streams to inflation. “Any disconnect between what is collected in rents and what is paid to investors would be a risk,” admits NAPF speaker Phil Ellis, client portfolio director at Aviva Investors, which offers a sale-and-lease-back model with yields of 2.5 per cent. Policy around welfare is already a source of concern since housing associations in the 18 local authority schemes that have piloted new welfare proposals have been reporting arrears in rent payments. “Not all social housing tenants are on welfare benefits, but we believe welfare reform will increase the risk of non-payment,” says Scott, adding, “You have to consider reputational risk too. Would it be acceptable to put rents up?”

It’s a concern shared by other trustees, with one commentator suggesting a preference to invest in social housing outside the boundaries of his own local authority to ward against the pension fund becoming “the evil landlord”. A further layer of complication comes from the fact many housing associations are actually members of local authority pension schemes – and some are in arrears. “It would be imprudent to lend to local housing associations when they actually owe the local authority scheme liability payments,” observed one commentator.

Social housing offers UK schemes liability-matching properties and potential returns that exceed inflation-linked gilts. Investment in the asset class is bound to benefit from funds boosting their broader infrastructure allocations and investment vehicles, still in their infancy and struggling with illiquidity, will develop in time. Twenty-odd years ago, before banks muscled in on long-term lending, pension and insurance funds used to be the biggest lenders to social housing in the UK. Today’s feet finding could see the cycle come full circle.

Gert Poulsen, chief investment officer of the €3-billion ($3.9-billion) Danish charity Realdania, likes both property and the risk of earthquakes. The connection, Poulsen quickly adds, is not because he welcomes natural disasters, but due to Realdania’s distinctive history. Based in Copenhagen, Realdania was founded in 2000 when Danske Bank, the country’s largest lender, bought the mortgage bank Realkredit Danmark. Under the deal, Realkredit Danmark ceased issuing home loans. The net capital of about $1.8 billion was set aside to create Realdania as an endowment fund to improve the quality of Denmark’s built environment, with the new charity holding a strategic stake in Danske Bank.

Those origins explain both Realdania’s substantial Danish real estate assets, which accounted for 9.9 per cent of its total portfolio in 2012, and the fund’s large exposure to the financial sector through its Danske Bank holding. At the end of last year, Realdania owned almost 10 per cent of Danske Bank, more than made sense from a purely investment perspective; indeed, the stake made up 43.8 per cent of Realdania’s global assets. In addition to the Danske Bank stake and real estate assets, Realdania had an allocation at December 31, 2012 of 13.1 per cent to listed equities, 26.2 per cent in bonds and 5.5 per cent in private equity. Overall, the portfolio returned 17.2 per cent in 2012, compared with a negative 21.3 per cent return the previous year.

The attraction of non-correlation

Poulsen’s interest in natural disasters, such as earthquakes, stems from his desire to counter the market risk in Realdania’s portfolio, especially because of the heavy exposure to Danske Bank. He cites catastrophe bonds as a particularly effective hedging instrument for Realdania. Since 2010, the charity has accumulated a $25-million holding in these specialised securities, which are issued by insurance companies to reduce their liabilities when natural disasters occur. “Catastrophe reinsurance risk and bonds have the great attraction of being absolutely not correlated with our other investments,” explains Poulsen. “The risk of an earthquake is different from market risk.”

Timber is another alternative asset favoured by Poulsen. In 2008 Realdania made an initial $10-million investment in US timber in order to learn about the forestry market. “We felt we needed to be careful,” Poulsen recalls. “Now we have a better understanding of the drivers and issues in the sector, and have increased our holdings.”

To date, alternative assets – which also include hedge funds, commodities, and other insurance products – only represent about 2 per cent of Realdania’s total portfolio. Yet over time, Poulsen expects to expand its allocation, following a broadening of the investment mandate in 2010 to allow coverage of all asset classes. One of Readania’s eight investment managers specialises in alternative assets; in theory there is no esoteric product or security the fund would not consider buying, provided the perceived risk was not too great.

More than a financial investment company

While Realdania’s investment strategy has changed radically in recent years, the charity has retained its unusual governance model. When it was set up, Realdania simply took over  Realkredit’s mutual structure. The charity is ultimately owned by about 160,000 property owners in Denmark, who elect its 109-member board of representatives. They in turn elect the supervisory board. Flemming-Borreskov-150x200

This organisation has led some critics in Denmark to contend that Realdania is essentially a financial investment company, rather than a proper charity. The charge is vigorously denied by Realdania, which points to about $1.8 billion in grants disbursed since 2000 for building projects ranging from landmarks such as Copenhagen’s Danish Architecture Centre to small community developments. In addition, Realdania sees itself as a hub of architectural and construction expertise. “We don’t just offer money, we also offer knowledge,” argues Flemming Borreskov (pictured right), Realdania’s chief executive, in a video presentation on the foundation’s website.

Kind of like a foundation…

Against this very Danish background, Poulsen is at pains to stress that Realdania has much in common as a financial investor with other large charitable foundations in Europe and worldwide. In particular, many philanthropic endowments – for better or worse – are heavily invested in the same way as Realdania in one sector, asset class or company due to the manner of their establishment. In Portugal, for instance, the $3.65-billion Calouste Gulbenkian Foundation derives the majority of its income from the Partex Oil and Gas Group, the company founded by the Armenian philanthropist Calouste Gulbenkian and bequeathed to the charity that bears its name. Similarly, the $7.7-billion Garfield Weston Foundation in the UK is largely financed through its controlling stake in Associated British Foods, the conglomerate created in 1935 by Willard Garfield Weston.

…but not really

Where Realdania differs from some endowments is in acknowledging that its own over-exposure to Danske Bank is an investment headache. In March, Realdania sold 5.2 per cent of the lender in a share sale that raised $955 million and reduced its overall stake to 4.9 per cent, with the proceeds ploughed back into the portfolio. According to Poulsen, “the reinvestment in other assets has contributed to achieving a more balanced investment portfolio to support philanthropic projects.” He adds that while Realdania has not yet decided how much more of Danske Bank it will sell, the charity’s desire to diversify its holdings is open knowledge.

Volatile and vulnerable

The need for more diversity is laid bare by the volatile performance of Realdania’s portfolio since the 2008-9 financial crisis, due in large part to its exposure to Danske Bank’s stock market performance. Like other Nordic lenders, Danske Bank was not heavily exposed to Greece and other debt-ridden southern European markets and, as a lender outside the eurozone, was insulated from the worst shocks of Europe’s sovereign debt crisis. However, as Poulsen observes, Danske Bank still suffered considerable collateral damage as a lender in a small country whose economy and currency are inextricably tied to the eurozone. “When the euro goes down, so does the Danish krone, and vice versa,” Poulsen notes. “Our country is not in this sense a safe haven from the euro crisis, even though some foreign investors seem to think so.”

Bouncy but unpredictable

By the same dynamic, Danske Bank recovered sharply in 2012, as fear of a eurozone break-up receded, with the lender’s shares gaining almost one-third in value. Realdania bounced back, posting the same return from its Danske Bank investment, which was almost double the portfolio’s overall return. Although the revival was welcome, Poulsen would much rather achieve smooth, consistent returns over time in line with Realdania’s annual average for the past 10 years of 5.6 per cent. In that way, he could ensure dependable income flows back to Realdania for philanthropic grants, which totalled about $200 million last year. That suggests Realdania will continue to sell down its Danske Bank stake, while exploring further the risk-reducing potential of alternative assets.

On one hand, the decision by one of the United Kingdom’s leading foods businesses, Dairy Crest, to plug its £84-million ($130-million) pension deficit with cheese smacks of desperation. Any proactive investment strategy to get the $1.2-billion pension fund back on track has been abandoned for a funding measure using unconventional sponsor assets to plug investment losses. On the other hand, isn’t the strategy whereby trustees get $93 million worth of maturing cheddar as security against the deficit if Dairy Crest goes bust a way to help ensure the beleaguered scheme survives in the long-term and a bid to recover a deficit in a more adventurous way? As funding and investment strategies become increasingly intertwined for the UK’s debt-riddled defined benefit schemes, it certainly shows a new creativity emerging in the market.

Asset backed funding, in which a company uses business assets to generate cash, which is then paid to the pension fund, first appeared in the UK back in 2007 when a handful of retailing groups used their property portfolios to fund pension deficits. It involves transferring the assets into a separate entity, such as a special purpose vehicle or partnership. Typically, assets used will generate income such as rent or royalties. According to consultancy KPMG, there were 10 asset-backed deals in 2010, eight in 2011 and seven in 2012. Deals involved blue-chip names such as engineering group GKN using intellectual property income from its patents as security, and drinks group Diageo, makers of Johnnie Walker and Smirnoff vodka, pouring $568 million worth of whiskey into its $1.3-billion deficit. Now the concept has gone one step further with companies exploring income receivables as pension guarantees and even brand value. Asset-backed funding hasn’t taken off outside the UK but, regulatory issues aside, there’s no reason why US corporate pension funds just waking up to the defined benefit nightmare (Boeing is the latest to close its scheme with liabilities of $75 billion) couldn’t make the leap.

Single solution

It seems to answer all kinds of knotty problems with one solution. Defined benefit schemes can’t expect asset growth to plug deficits in the current climate of low interest rates and poor returns, where static asset allocations definitely don’t deliver. Many funds won’t challenge traditional thinking, with only the biggest schemes with the strongest covenants recruiting the skills to push bolder strategies such as alternatives. And because gilt yields are at record lows, many companies hope deficits are inflated anyway – pension liabilities are calculated referencing bond yields so when yields are low, deficits are high. It has left sponsors even more reticent to put large amounts of cash into their pension schemes, which under UK law they wouldn’t be able to recover should the fund return to surplus. Asset-backed funding even neatly ticks this box as the assets are ultimately controlled by the business, reverting to the company at the end of the term.

Investment strategy too

It’s a funding strategy that positively impacts investment strategy too. Dealing with the deficit helps solve the bane of mismatched investment strategies in which schemes have plumped for risk despite ballooning liabilities. Asset-backed funding was the catalyst in a turnaround at the $9.6-billion defined benefit scheme of UK retailer Marks and Spencer, which slashed its deficit from $2 billion in March 2009 to $450 million last year. In 2007 the 120,000-member fund transferred $2.3 billion of the company’s property assets into a Scottish limited partnership with the M&S UK Pension Scheme. Under the partnership agreement, M&S retains control over the properties, however the pension scheme is entitled to receive an annual profit distribution earned through leasing the properties back to M&S. As a result, the M&S pension scheme was able to recognise the fair value of these future income streams as an asset in its accounts, leading to an improvement in its funding position. The scheme has pared risk to a 16-per-cent equity allocation, with the rest in bonds and fixed income, in contrast to most UK funds, which still allocate on average half their portfolios to equity.

More room to manoeuvre

But shaving deficits through asset-backed funding can just as easily help schemes maintain their levels of investment risk. Strong sponsor covenants mean schemes can better withstand shocks – the current wave of de-risking is attributable to weak sponsor covenants. It could offer confidence for cautious defined benefit schemes, which have whittled down their growth portfolios in favour of fixed income assets and derivatives, to push the risk premium of equities once again. Or, as one commentator put it, “help kick overly prudent investment strategies that manifest in holding too high an allocation to government bonds into touch.” In short, asset backed funding gives struggling defined benefit schemes more room to manoeuvre. They could hold their risk allocations, reduce risk or just use it to reduce the levy they pay the Pension Protection Fund, the lifeboat fund that says the UK’s 6316 defined benefit schemes hold a collective deficit of $366 billion, with the average workplace pension 83-per-cent funded.

The real value of cheese

Yet surely hazards lurk in the more unusual asset-backed funding structures. Are trustees getting the risk at the right price and how do they assess the value of cheese? How will the value of the asset change over time and what if salmonella infects the cheese or it melts and becomes worthless? And if cheese is suddenly such a valuable asset, why is it only fit for pensioners? Why not pay our corporate big cheeses in cheddar too? Trustees must be careful what assets they use and satisfied that they will hold value in the event that a company ceases to trade. I can see why companies and trustees increasingly consider asset-backed funding. Deficits are ballooning but sponsors lack cash and the 1990s era of contribution holidays is a distant memory. Members need security and investment strategy a kick-start. It’s just the cheesy strategy that smells a little off.