Michael Trotsky, executive director and chief investment officer of the Massachusetts Pension Reserve Investment Management Board (PRIM), managers of Massachusetts $53.2-billion Pensions Reserves Investment Trust fund, PRIT, is planning a raft of cost-saving measures from co-investment to more passive strategies and much harder fee negotiation.

He’s mid-way through evaluating the fund’s many managers and strategies, determined to shave costs and improve returns.

The fund has just posted 12.7 per cent for the 12 months ending June 30, beating its 10.9-per-cent benchmark and adding $6.2 billion to its assets under management, but cutting costs is now a central theme.

“We spend of a lot of time evaluating performance and analysing our costs and fees. It’s prudent and it’s what Project SAVE is all about,” says Trotsky (pictured right), in reference to the cost saving initiative he launched earlier this year. Michael_Trotsky_-_July_11

Costs were an issue on which Trotsky grasped the nettle soon after his appointment in 2010 when, drawing on his hedge fund background, he restructured PRIM’s unwieldy hedge fund portfolio.

At the time the fund had five fund-of-funds managers, with $4 billion in 237 underlying hedge funds.

“The portfolio was struggling to beat its benchmark,” he recalls.

The fund now invests directly in 21 hedge funds and one fund of funds, managed by PAAMCO, specialising in emerging market hedge fund managers and amounting to 15 per cent of the portfolio.

It’s a process which Trotsky says has saved PRIM around $29 million in fees this financial year, and should be on course to save approximately $40 million per year once fully in place.

“Our hedge fund allocation is designed to reduce portfolio volatility with returns between equity and bonds. We are two years into our direct program and testimony to us doing a good job is the 3 per cent volatility for the allocation, compared to 12 per cent for the entire portfolio,” he says. For the fiscal year 2013 hedge funds returned 12.2 per cent.

Equities returns

Discussing the latest batch of returns from PRIM’s headquarters in the old quarter of Boston’s financial district, it’s equities that have been the star performer. The equity allocation, overweight accounting for 45 per cent of assets under management, posted returns of 18.4 per cent, beating a benchmark of 17.1 per cent. Now the plan is to pare back to target, says Trotsky.

“At 45 per cent our equity allocation is big against a target allocation of 43 per cent. It’s been based on the strong performance of equities; the normal rebalancing process will correct that overweight position.”

Of the sub allocations, domestic equity did best, returning 22.1 per cent.

Here a quarter of the portfolio is invested in enhanced index strategies benchmarked against the S&P 500 Index, with most of the remainder passively invested in a Russell 3000 Index fund.

Around 4 per cent of the domestic allocation is in an active mandate to small and mid-cap US corporates, the only “pocket” where Trotsky believes active management still pays in the domestic equity market.

Elsewhere in the equity allocation a developed-markets portfolio is split between a passive MSCI World Ex-US IMI Index fund and three active Europe, Australia and Far East mandates. An emerging markets allocation is split 50/50 between active and passive management.

More strong suits

Private equity and real estate, each accounting for 10 per cent of assets under management, were other strong suits, returning 14.1 per cent and 13.5 per cent respectively.

The private equity allocation, built up since the late 1980s and where PRIM considers itself “a pioneer”, includes over 100 managers and 200 different funds. Hamilton Lane has consulted since 2007 and the allocation aims to generate returns 3 per cent higher than US equities. It’s an area where Trotsky “does worry about the fees” but counters: “We have been doing private equity for a long time. The result is that we are in some of the best partnerships around the globe and have some very mature investments.”

The real estate allocation comprises core and none-core real estate strategies.

Core strategies include equity investment in both directly owned properties and real estate investment trust securities.

“We’ve had good performance from our direct ownership,” says Trotsky, adding that here investments are characterised by well-leased operating properties in the US that provide regular cash flows.

Non-core real estate includes more opportunistic investments such as properties that are not fully leased or require modest capital improvements.

Recently, in a bid to take advantage of low interest rates, the fund placed a moratorium on property-level debt in favour of portfolio-level leverage, issuing a $1-billion debt program in March 2013 through a combination of bank loans and private debt, but still maintaining a “relatively low” loan-to-value ratio of about 35 per cent.

“We were able to achieve an average duration of seven and a half years at 2.9 per cent; leveraged enhanced returns are a big kicker,” says Trotsky in reference to the cheap cost of borrowing and the enhanced return from investing the debt proceeds.

Positively, PRIM maintained its 6-per-cent expected five-to-seven-year return for real estate when it refreshed its asset-class return expectations earlier this year. Most other asset-class return expectations were cut, said Trotsky.

Other assets

Elsewhere value-added fixed income, comprising high yield bank loans, high yield bonds, emerging market debt and distressed debt, returned 7.6 per cent.

The worst performing asset class at PRIM was core fixed income, in which strategies include Barclays Capital Aggregate benchmarked active and passively managed portfolios, treasury inflation-protected securities and global active inflation-linked bonds.

The portfolio was down at minus 0.3 per cent although “still 88 basis points above benchmark”.

The fund is now mulling reform of its entire fixed income allocation ahead of an anticipated change in US interest rates.

“We saw the effects in May and June of interest rates going up,” says Trotsky. “The environment has changed with the economic recovery and interest rates will slowly begin to rise off of historical low levels. The consensus view is that the 30-year bull-run in fixed income will be reversed. We haven’t made any decisions yet but we are definitely thinking about it.”

The manager also has a 4-per-cent allocation to timberland in the US and Australia. It is the fund’s only natural resource play and Trotsky particularly likes the diversity it brings. “The thing about timberland is that if you don’t like the price today, you wait. It grows and you get more,” he enthuses. But PRIM’s robust results come against a backdrop of deficit and underfunding. As of January 2012 the fund was labouring under a $23.6-billion deficit, only 65 per cent funded. It is governed by a state legislature-set return of 8.25 per cent and, like other public schemes, has struggled to retain talent, fighting to fill its top posts because it can’t match salaries in the private sector. It limits Trotsky’s ability to develop an internal team, something he acknowledges “others are doing”. For now it’s business as usual. “Our performance over the benchmark is proof that our managers are earning their keep,” he says.

Getting Europe’s swelling institutional capital to support long-term projects that could benefit its uninspired economies was an idea that sent heads nodding around the continent as it suffered the brunt of the financial crisis. Get pension, insurance and foundation money into where it is most needed with the attraction of reliable long-term cash flows and you will get Europe moving again went the idea.

Despite some noble initiatives in the past couple of years, this grand vision remains just that. Governments appear enthusiastic, yet many investors feel more action is needed – coupled with a dose of empathy – to truly get long-term infrastructure investing going.

The respected EDHEC-Risk Institute in Paris recently summed up the feeling by stating that matching the supply of such investments with demand is “not self-evident.” It asked for “a policy and regulatory focus on the type of instruments that long-term investors need, rather than which sectors of the economy qualify as long-term investment.”

Mark Gull, co-head of asset management at the United Kingdom’s £9-billion ($14-billion) Pension Insurance Corporation, says, “Ultimately, what I think is required is a major shift in the government’s understanding of investors’ requirements.” British policy makers might not take too kindly to that criticism, as they have arguably been the most active in Europe. The UK is targeting some $300 billion in primarily private infrastructure investment and has simultaneously supported the development of a national Pension Infrastructure Platform.

Nonetheless, “There is a disconnect between what the government is trying to do and what most investors are focused on,” says Duncan Hale, head of infrastructure research at Towers Watson in London. For now he thinks that is low-risk existing infrastructure with steady yields. Those are sensible investments no doubt, but not the kind of projects likely to rejuvenate a continent.

Mixed signs?

One of the oldest but most apt clichés in institutional investment is that the devil lies in the detail. That is where European authorities are currently failing, argue the critics. Regulatory frameworks can complicate long-term investments and there is little indication that governments are willing to provide the kind of financial support that would spur long-term funding of bold new projects from scratch.

The Solvency II framework will not apply to Europe’s pension funds, for the time being at least, but looks set to steer insurance capital clear of risky long-term projects. Philippe Herzog of civil society group, Confrontations Europe, says an “obsession” of European policy makers on stability after the financial crisis has only recently been matched with a desire to encourage growth.

Existing accounting regulations do little to entice investors into long-term infrastructure projects many argue. The $52-billion Universities Superannuation Scheme recently stated to a UK parliamentary committee that current mark-to-market accounting standards are “detrimental” to infrastructure investing. The fund wrote that “the introduction of IFRS mark-to-market accounting for pension funds has exposed funds to increased volatility and some difficulty in incorporating assessments that markets have overshot in either direction”.

Matching the buzz in the UK on infrastructure investing has been the interest from Danish investors in igniting a market in public-private partnerships (PPPs). The country’s large pension funds have joined forces to lobby the Copenhagen government to pledge its support for the deals. The roughly $600 billion in assets controlled by the county’s funds are projected to double the size of Denmark’s GDP in 20 years – a powerful statistical argument for unlocking infrastructure investment.

Public-private partnerships have been short on the ground so far though, with deals supporting schools and old-age homes marking a tentative start to pension funds’ exposure to the financing models. The partnerships are lacking altogether in so-called greenfield infrastructure, which involves the construction of new projects rather than developing or taking over existing works, known as brownfield.

Michael Nellemann Pedersen, investment director at $34-billion PKA says there is reluctance on the government’s part despite the best efforts of Danish pension funds. Pedersen feels the government has got its sums wrong in calculating that it would be cheaper to invest itself after borrowing from bond markets than support PPPs. While it may look that way at first, such assessments fail to account for the notoriously high long-term risk of major new projects that pension investors are willing to share, Pedersen argues.

Splitting risk is a difficult business that will be central to any publicly backed infrastructure efforts in Europe. Many argue that governments stepping in to shield investors from construction risk is a necessary step. Given the limited number of existing infrastructure projects, Hale is confident that increasing numbers of investors may take the initiative themselves to look up the risk spectrum and acquire greenfield risk.

“We can easily see some infrastructure projects where pension funds cover full risk, including construction risk, but we will need to be compensated in the return,” Pedersen says. He is hopeful that some big infrastructure PPPs can be launched in Denmark in the next year or two as a pilot project with more following. “We are still waiting for a breakthrough, but things take time and our government has to get used to the idea,” he adds.

The way ahead

Efforts such as the UK’s Pension Infrastructure Platform seem a bold attempt to kick start long-term infrastructure investing. The European Commission also has a role to play in coordinating governments’ efforts, but Herzog feels “it will be many years until a doctrine is clear as the problem is being addressed for the first time”. Highlights of activity at the European level include the European Investment Bank piloting a project bond scheme.

Pedersen is unsure of the need for any grand ideas in the Danish PPP space though, saying: “I think you should start on a minor scale and look to improve and evaluate.” In a similar vein, Hale urges patience, arguing that investors have only been looking at infrastructure for a few years so there is still a lot of learning going on in the asset class.

“Anything that can help articulate where the risk is divided will help” he says. Attention to development and planning-permission regimes could also play an important part in reducing construction risk, and efforts to prevent capital gains being accrued by PPP backers in the UK are another unhelpful element that could be tackled, Hale reckons.

Investors can lead

Aside from looking to leads from governments, investors can also play their part in making the infrastructure dream a reality. Hale calls for investors to avoid “shying away from construction risk”, as there have been many investments that have been rewarded handsomely for taking on this.

Nicolas J Firzli, head of the Paris-based World Pensions Council research group, points out that pension funds are being courted at a time that few are equipped for the complexities of direct long-term infrastructure investing. “We’re talking about a dozen North American pension funds, two or three from Australia and maybe five or six European pension funds,” he says.

Many European funds are therefore playing catch-up with their overseas peers. European investors were “easily outmaneuvered” by Canadian pension funds, according to Firzli, in a 2010 competition to acquire the UK’s only high-speed rail route linking London to the Channel Tunnel, known as High Speed 1.

Firzli also cautions that whatever they do, governments might be best advised to tread carefully. “All our experiences tell us that governments and pension funds might not always have converging interests,” says Firzli. “The steering of private pension capital by public or semi-public entities, even indirectly and benevolently, isn’t necessarily a good idea.” However, some careful listening and patient fine-tuning might just pave the road to infrastructure riches in Europe.

Even using the assets of the pension plan was not enough of a leg-up to save the city of Detroit from bankruptcy. As the last words in the song Put your hands up for Detroit by Fedde Le Grand say, it is system shutdown. The fiscal demise of this city may be a lesson for other public funds about the unqualified need for a reality check. Now, (finally) it must be time to talk.

I’ve always been a fan of intervention. And sitting down with the stakeholders of US public pension funds is my idea of fun. Let’s talk. What are you afraid of? Why is there not a real conversation about the underfunding situation America’s public pension system is facing? What is stopping them from “manning up”, as we say in the West, to the unbelievable unreality that that pension fund world is living in?

Readjust your mindset

So what is the reality? For one, a return of 8 per cent a year for the next 30 years is not possible. Further as academic research, including the most recent paper by academics at Maastricht and Notre Dame, Pension fund asset allocation and liability discount rates: camouflage and reckless risk taking by US public plans? shows, linking liabilities to return expectations is not the optimal way to structure a fund. As a demonstration of that fact, defined benefit public and corporate funds in Europe and Canada do not have actuarial structures that dictate that connection, and neither do US corporate funds. US public pension funds are unique, in a bad way.

This structure also hides the fact that the underfunding situation is actually worse than it appears. One of the authors of this paper, Martijn Cremers, says that while the average funding level of US public pension funds is reported as 80 per cent, in reality it is much worse, with Pew Research Center estimating it is more like 57 per cent.

According to the paper, the fact that US public funds equate the liability discount rate to the expected rate of return results in the funds “camouflaging the degree of underfunding”.

“It makes liabilities very hard to measure. It is subjective and hard to argue about,” Cremers, who is professor of finance at Notre Dame, says. “Liabilities shouldn’t be hard to define or be so subjective.”

Invalidate complexity

Politics, finance and ethics. It’s a murky stomping ground, but the world of US public pension funds, more than ever is a political quagmire.

The complexity of the politics in these funds, and the power and financial validity it gives the state, unions and staff, means that the reality is being ignored.

Solving the underfunding issues in these funds will require political courage, starting with an honest assessment of the reality of the underfunding position. In simplistic terms, you can’t get from A to B if you don’t know that you’re at A.

To this point Cremers says US pension funds need to be as objective as possible about their liabilities, which would allow an equally objective assessment of the outcome and current promises.

It is then possible to do asset liability modelling and think about asset allocation with the right perspective.

“If a more realistic liability discount rate is used, then it is a more dire picture of funding status. But then we can talk about how to respond, and at least there is a conversation about where we are,” Cremers says.

“As a financial economist, I can say that you make better decisions if you are realistic about where you are.”

It’s old chat

But this is not a new conversation.

In 2009 a brief by Pew found that 30 US cities at the centre of the country’s most populous metropolitan areas faced more than $192 billion in unpaid commitments for pensions and other retiree benefits, primarily health care.

As part of its American Cities research, Pew says that “unfunded pension and retiree health care obligations pose a significant concern for city budgets. Although these unpaid bills are not due immediately, they limit policymakers’ ability to invest in other priorities because they place a claim on future revenue. Every dollar that goes to plug a hole in a city’s retirement funds is a dollar that cannot be spent on education, public safety, libraries, and other services.

It also becomes a vicious cycle of robbing Peter to pay Paul.

“The longer unfunded liabilities go un-addressed, the larger the bill facing future city budgets and taxpayers. To shore up retirement funds, local officials may have to cut services, reduce the workforce or raise taxes. Cities also can pay a price through higher borrowing costs because credit rating agencies incorporate unfunded retirement costs into their analyses,” the Pew report says.

No creative luxury

The Detroit story couldn’t have been summarised better.

The city has a liquidity crisis for some time. Without intervention the city would have run out of cash before the end of the 2013 fiscal year. Enter the pension fund. In order to get a positive cash flow of $4 million in fiscal year 2013, it deferred about $120 million of current and prior year pension contributions and other payments. But the pension fund is about $3.5 billion underfunded, and at this level of underfunding it is estimated the city would have to contribute approximately $200 million to $350 million annually to fully fund currently accrued, vested benefits.

Some perspectives on the city’s bankruptcy, such as that of a recent Atlantic Cities article reckon that all is not lost for Detroit. The argument is that the difference between fiscal and economic crisis is marked, and that Detroit’s bankruptcy signals a beginning.

This may be true for the music industry or entrepreneurs and investment capital, but retirement and the funding of it does not have the luxury of such creative ventures.

There is a David-and-Goliath feeling to the battle Michael Johnson, a research fellow at the London-based think tank the Centre for Policy Studies, is waging against the pension industry. His research, which lays out the case for radically simplifying all aspects of the United Kingdom’s pension sector, has earned him a reputation as a maverick. But it’s a label he welcomes in a sector where he says powerful lobbying from the fund management industry has drowned the interests of savers and threatens to damage the country’s savings culture. One of the central themes to Johnson’s research is that pension funds must employ different investment strategies to stop the constant erosion of their capital through costs. As pension funds increasingly strive to cut costs, it’s an argument on which Johnson, who worked for Towers Watson after two decades as an investment banker and most recently ran Prime Minister David Cameron’s Economic Competitiveness Policy Group, is taken more and more seriously.

Active waste of time

Active management is Johnson’s particular bugbear. “I don’t believe stock picking works. I am an absolute advocate of passive funds,” he says. He says the poor returns earned between 2008 and 2010 by the 1100-odd actively managed funds in the UK equity pool prove that active management doesn’t equate to better returns. “Only 16 of the 1188 actively managed funds reached top-quartile returns on three consecutive years, which is about 1.35 per cent. This is less than what pure luck would produce at 1.5625 per cent.” He adds that only 5 per cent of all these funds outperformed their own benchmarks consistently over the same period. “What on earth are you paying for?” he asks. “The skills premium you pay for in active management is a waste of time when you look at the results.”

Johnson calculates that actively managed funds earn investors only 30 per cent of the upside with the rest lost in fees and costs. “I don’t understand it. That upside should be 65-70 per cent.” It’s a calculation he makes on the basis that investors pay significantly over and above the total expense ratio that fund managers charge because it excludes transaction costs which multiply with active management. These include costs around the bid-offer spread, fund turnover and commission which, he lists, quickly add up. “The transaction costs of actively managed UK equity funds typically come to 1 per cent per annum. This is based upon 100 per cent fund turnover if the assets are bought and sold once a year, 0.5 per cent stamp duty on transactions of over £1000, 0.1 per cent commission each on buying and selling and a bid-offer spread of 0.2 to 0.3 per cent for mid-cap shares, the typical area of fund interest.” He describes costs around fund turnover – the costs each time a portfolio is bought and sold – as a particular “tyranny” in actively managed portfolios. “The more frequently a portfolio is traded, the greater the accumulation of costs amounting to a performance drag. A high turnover dramatically increases costs and chews away at capital,” Johnson says. “Finding out what the turnover rate of these funds is before putting money in is extremely hard, but that’s what you want to know.”

Consolidate and save

His cost-saving campaign includes urging England and Wales’s 89 local authority pension schemes, where he says not one single one is in surplus, to merge into bigger funds. “If you are managing £20 to 30 billion in assets you can turn around to the industry and demand that they cut costs by a factor of four; it brings real economic clout. If you are relatively tiny you are taken to the cleaners.” In fact he argues all small schemes should merge. The UK has just under 7000 defined benefit schemes; 5600 have less than 1000 members and 2600 have less than 100. He urges them to follow the lead of countries such as The Netherlands, which used to have 3000 schemes but has now consolidated this to 450, with each having an average membership of 11,000.

Keep it simple

Elsewhere he urges investors to avoid fund of funds, where a “long chain of agents” add to the cost of investing. “We should get rid of funds of funds,” he says, adding that he believes many trustees are unaware of the layered costs. Johnson also thinks the UK market is too complex, arguing that 6000 retail funds, 200-plus fund managers and over 300 insurance companies have created one of the most difficult investment landscapes to navigate. “It amounts to about 360 million combinations. How on earth are you supposed to make a decision?” He argues for funds to diversify their investment strategies and increase exposure away from the UK particularly. “Most people derive their earnings from the UK, they own a house in the UK, and they are enormously exposed to the UK doing badly.” He believes a UK investment-bias among many domestic pension funds and “unimaginative” strategies explain why many funds missed out on the rise in emerging markets.

Johnson challenges the orthodoxy within the fund management and investment community. But as fees collected by fund managers add up to a rising portion of the returns they generate, Johnson’s message has increasing clout. “Few people enter the financial services industry with the goal of enriching others,” he concludes.

For many institutional investors, surviving the financial crisis in good shape has been the challenge of a lifetime. Few have had to deal with an asset seizure from Napoleon and two world wars being fought on its soil. It is a history that Italy’s Compagnia di San Paolo is proud of, yet in its asset strategy the foundation shows no inclination to blindly cling to tradition.

Davide Tinelli, chief executive of Fondaco, the foundation’s outsourced investment office, says the troubles thrown up by history since its founding in 1553 are an answer to conference-circuit banter as to why it hasn’t been able to develop infinite assets over 450 years. In any case, its current total holdings of €5.2 billion ($6.8 billion) certainly place the Compagnia di San Paolo among the elite of European foundations.

Safeguarding assets for the future takes precedence over reflecting on the past, of course, and the foundation has launched a major diversification drive to meet this objective. Tinelli says this has been spurred by the need to counterbalance a large stake in a single stock that is the most notable quirk of its extensive history. Until a change of regulation in the 1990s, the portfolio was 100-per-cent invested in the Intesa Sanpaolo bank. The dependence has since been reduced to below 38 per cent, but Tinelli admits this brings concentration and volatility risks that he works hard on smoothing.

Balancing a large exposure to equity markets and credit activity picked up in the   huge single share in a bank has seen the range of alternative investments become a hallmark of the foundation’s asset strategy. The alternatives allocation has been speedily increased to 21 per cent of assets from initial moves into hedge funds and private equity a decade ago. Reinsurance, commodities and currency have all been brought into the asset mix as the alternatives portfolio has developed.

International diversification

The Compagnia di San Paolo possesses a high degree of geographic diversification too, with significant investments in emerging markets equities and bonds. At the end of 2012, its entire 8.5 per cent liquid-portfolio equity stake was invested to an emerging market benchmark. In a strategic move, it has since almost doubled this equity bucket at the expense of fixed income and simultaneously developed more of a global focus.

An equally weighted smart-beta approach has allowed the foundation to emphasise markets it is particularly keen on and ensure it does not add to its heavy exposure to the banking sector from the Intesa Sanpaolo stake. “Positions on countries such as the Nordics, Malaysia, Australia and New Zealand are an important component of diversification for us, while they are just noise in a normal portfolio,” Tinelli explains.

Having embarked on an international drive a few years ago, Tinelli says: “We were right to diversify when we did. We weren’t able to predict the euro crisis but our Intesa Sanpaolo stake gives us lots of European exposure.” The desire to decouple has led the investor to avoid its domestic government bonds, even though Tinelli says he could have gained high returns from Italian government bonds with well timed investments.

Instead, the foundation has looked internationally in sovereign debt with European, global, and global inflation-linked government bond mandates currently running in the investment mix. Is an international approach able to avoid sovereign debt pitfalls? “We are aware of the risk of government bonds although it is not a risk we can eliminate entirely,” Tinelli says.

Compagnia di San Paolo is happy to allow diversification into its currency exposure too, with 50 per cent of assets held in euros, 25 per cent in US dollars and the remainder in other currencies. “As we are heavily reliant on the not-so-brilliant growth of the euro area, we like to have some assets denominated in currencies that reflect growth elsewhere in the world,” he explains.

Tinelli thinks that the foundation’s years of attempting to diversify mean the strategy is already bearing fruit. For instance, the decade-old $420-million private equity portfolio has passed through a J curve to generate rich returns, he says. Having such an extensive experience of diversification also allows the foundation to stick by asset classes in times of disappointing performance. It will persist with its commodity portfolio that returned well under the benchmark at minus 4.71 per cent in 2012. Tinelli says it has underweighted the asset class and has been considering dropping a manager, though, because of the troubling performance.

 High yield future?

Looking ahead, any future diversification considerations must be held with the list of alternatives that the Compagnia di San Paolo does not currently invest in being limited and relatively exotic. Tinelli says its next asset class addition will be in the corporate credit or high yield space as soon as it can find a mandate with the right risk-return profile.

Tinelli says the foundation feels like it “operates within an international framework” as an active participant in European foundation forums. Usng its international knowledge, Fondaco has set up funds in Luxembourg to help to “foster diversification without an excessive administrative burden”. “Setting up funds has also allowed us full transparency, this and the outsourcing of the investment office, is a model that other foundations might like to follow” says Tinelli, who enthuses about the improved governance the move brought about. He has a good perspective on governance matters having worked as Compagnia di San Paolo’s chief investment officer before the outsourcing.

Overall returns in 2012 were a solid 6.09 per cent, with the portfolio overseen by Fondaco yielding some 7.1 per cent. That comfortably exceeds the 2.7 per cent real return that the charity targets to meet the needs of its grants program. The figure Tinelli feels best vindicates his work, though, is the low volatility rate of 2.4 per cent last year. He is more cautious on keeping volatility low in the foreseeable future, with the portfolio’s open currency risk and divergent rates of economic growth now seen across economies.

Total assets remain down from around $12 billion before the financial crisis hit, largely a result of the Intesa Sanpaolo share price diving over 50 per cent from its 2008 high. However, Fondaco’s dedicated 20-strong staff in Turin and small Luxembourg subsidiary can be counted on to ensure the foundation does its best to thrive with a diversity of assets as it enters another chapter of its long story. After all, Tinelli jokes, “I don’t want to be the person to put an end to over 450 years of history.”

Antony Barker has only been director of pensions at the £8-billion ($12.2-billion) Santander Pension Fund, a defined benefit scheme for employees of the UK arm of the Spanish-owned bank, since August last year. Charged with rejuvenating the pension scheme, a worrying source of risk blighting the fortunes of the bank and a thorn in the side of a planned 2014 listing on the London Stock Exchange, Barker, a seasoned pensions professional, has all the support and resources of one of the eurozone’s biggest banking groups. It’s enabled him to shape an innovative strategy to boost returns and hedge the portfolio that is starting to reap real rewards.

The Santander Pension Fund is an amalgamation of seven different schemes gathered through the course of the bank’s UK acquisition trail, including the former pension schemes of UK building societies Abbey National, Bradford and Bingley, and Alliance and Leicester. These schemes, all bringing different strategies and maturities, were amalgamated into one Trust last year. Labouring under a $6-billion deficit on a buyout basis and with only 5000 of its combined 65,000 members active, strategy is now wholly focused on hedging the entire portfolio and steering the scheme to solvency within the next 10 years. Assets are split between fixed income (50 per cent) equities (25 per cent) and illiquid assets (25 per cent), with the scheme targeting returns of just under 6 per cent. It returned 10.7 per cent last year, buoyed both by its large index-linked gilts portfolio along with good returns from alternatives and real estate. “The outperformance is welcome, but we are acutely aware that it is performance relative to the liabilities that is all that matters,” counters Barker.

Replacing physical assets

A proactive strategy means that allocations have been overhauled or de-risked, with derivatives often replacing the holding of physical assets. In the equity allocation, an equity collar put in place in 2011 (but now taken off since equities corrected down) protected against market falls throughout 2012. The strategy, which gives downside protection in return for relinquishing some upside in equity returns, generated profits of up to $213 million. Now, in a new tack, the fund is looking at developing a synthetic equity allocation through holding multi-term, multi-strike, multi-market call options. Replicating the underlying equity market performance without actually having a physical equity position is an effective way to manage tail risk and frees up assets for a common collateral pool for liability hedging, argues Barker.

In another example, Santander reworked its inflation-hedging strategy in anticipation of a change in the United Kingdom’s inflation policy at the beginning of 2013. Government reform threatened profound implications for UK schemes such as Santander with large gilt exposures where interest and capital payments are linked to the Retail Prices Index (RPI). Santander took profits on its inflation-linked gilts allocation and structured an inflation-swap contract whereby a series of cash flows linked to RPI were exchanged for a series of fixed cash flows linked to short-term interest rates. In the event the government decided not to change RPI as a measure of inflation, but the strategy paid off given how pricing had reduced in the uncertain months prior to the decision. “We sold down our pool of linkers but increased our synthetic inflation exposure via swaps just before the CPAC announcement,” says Barker referring to the ‘no change’ announcement by the Consumer Prices Advisory Committee. “Inflation was as cheap as it was in 2004 at the time, so we decided to swap out on a derivative basis.”

Elsewhere the scheme has built a diversified fixed income exposure that ranges from government debt to global credit and higher yielding private debt and insurance-linked securities. Within the mix, the scheme also holds inflation exposure through assets like property leases and is looking to source privately placed primary issuance of corporate debt securities by utilities and supermarkets.

Real world risk

Illiquid allocations account for 25 per cent of the portfolio and investment is aggressively opportunistic. The fund seized on the sought-after commercial property portfolio of Royal Mail Pension Fund, sold off by the government earlier in the year in its bid to prepare Royal Mail for privatisation. Rich pickings in property assets with a return profile that will help meet the scheme’s liabilities included Cambridge Science Park and regional shopping centres. Santander eschews prime real estate to avoid competing with foreign buyers, particularly Canadians “who know the market well”, instead finding opportunities in off-prime areas in London and outside the capital in the next best cities.

He believes UK social infrastructure is still expensive and is unimpressed with the slow progress of the Pension Infrastructure Platform, (PIP), designed to spur pension fund investment in infrastructure. “We will probably invest in the PIP when they get anywhere near making an investment, but given our funding deficit and the opportunities we see, we need to get our money invested now,” he says. In fact, Santander is increasingly looking at global and esoteric infrastructure such as shipping and agriculture in assets that Barker picks according to three primary risks: economy, duration and volatility. “We only see these risks – we are agnostic as to where we get our exposure.” He says that the fund increasingly blurs the line between its infrastructure and private equity pool looking, in both cases, for secondary investments buying from “keen sellers” or “people who need cash now” to move more quickly up the J curve. The fund accesses emerging markets through debt and private equity rather than quoted equity, he adds.

Of all the illiquid allocations, hedge funds have proved the most troublesome. Returns haven’t been any higher than quoted equity and Barker, who says he has grown “cynical about hedge funds”, is selling down Santander’s multi-strategy. Instead he plans to buy stakes in hedge fund managers and invest in synthetic replications of hedge fund strategies, which he believes are both more effective and cheaper.

Sponsor and peer relations

The risk the pension fund poses to the bank’s fortunes has spurred an unusually proactive approach. The scheme can use the bank’s financial expertise to both improve returns (particularly using Santander Asset Managers real-estate expertise) and reduce risk. “We have gone beyond the conventional and built out our own model,” says Barker describing a process that combines the traditional asset and liability projections used by most pension schemes, with the associated accounting and capital impacts for the bank. It has allowed the production of “real time” management information on the true level of the risk the scheme represents to the bank’s profitability and balance sheet. The fund doesn’t use any consultants and runs about 60 separate mandates.

As well as sharing services with its sponsor, Santander works with other big pension schemes. “We have a lot of conversations with other schemes; large pension funds do talk to each other,” he says. Santander has formed two property “clubs” with other schemes to access specialist investments in a strategy now being extended to other illiquid investments. Joint ventures with other schemes with dedicated inhouse resources bring down the management costs of alternatives to something closer to quoted investments, he says.

Environmental risk

Barker doesn’t expect volatility to ease just yet. “The market doesn’t behave as expected so everything, even the good news, is often construed as bad. The volatility in the UK equity market nowadays is such it can move 2 per cent in an afternoon. What used to be the definition of an emerging market is now a feature of the FTSE.” He believes most schemes still miss out on opportunities because they hold more liquidity than they need. “During the financial crisis, banks were crying out for liquidity but pension funds held onto their cash – they missed a trick.” Nor is he relying on any rise in interest rates to help with Santander’s liabilities. “The reality is interest rates will stay low for longer and the current market conditions will persist. We haven’t factored in the hope that rising interest rates will help reduce the cost of our liabilities, but as and when they do, we will look to increase our hedging ratios,” he says. For now he is using other tools to navigate the fund out of deficit and hedge the portfolio. “The pension is the biggest single non-core source of risk to the bank’s future profitability and capital,” he says.