Until a few years ago, every aspect of the investment strategy at the UK’s £20-billion ($32-billion) coal industry pension scheme was outsourced. The main inhouse task at the pension fund was benefit payment but now, in a fresh approach spearheaded by straight-talking 38-year old New Zealander, Stefan Dunatov, the new chief investment officer of the Coal Pension Trustees Investment (CPTI), the scheme is coming home.

The decision to rebuild the investment arm of the UK’s closed coal-industry pensions – the Mineworkers’ Pension Scheme and the British Coal Staff Superannuation Scheme – actually began in 2007. The CPTI registered with British regulator the Financial Services Authority in 2011 and Dunatov, who used to work for Deutsche Asset Management and as a portfolio strategist at Equitas, was promoted to the helm from head of strategy earlier this year. He’s just hired two more inhouse strategic experts, both with asset management backgrounds, bringing his City-based team to eight. Apart from the passive equity allocation, none of the assets are pooled; the two funds are run as separate pension schemes with a separate board of trustees. They do, however, share a guiding mantra – to constantly question what we own and why we own it – and both currently target overall returns above a real discounted rate of around 3.5 per cent. Combined monthly pension obligations stand at about $160 million.

How the coals burn

The CPTI has a 65-per-cent global equity allocation, which includes 10 per cent in private equity, a 10-per-cent mostly UK property allocation, and a 5-per-cent uncorrelated bucket. The remaining 20 per cent is in global fixed income, made up of sovereign, corporate and emerging market debt. Both schemes divested from UK gilts “a few years ago,” escaping the effects of the government’s successive monetary-easing measures on yields. Apart from property, there is no home bias in either fund’s asset allocation; only a “tiny” amount is invested in infrastructure alongside the property allocation, which is managed by LaSalle. “We’ve never really done infrastructure,” Dunatov says. “It doesn’t yet achieve our objectives.”

All management is outsourced to 20-odd fund managers, not including the private equity relationships. Wellington and Western manage most of the fixed income allocation, while Legal and General Investment Management and BlackRock handle the passive equity allocation depending on the scheme. However, since strategy is now thrashed out inhouse, decisions regarding which manager to use don’t take long. “You need to get the cake right; managers are just the icing on the cake. In my opinion far too much time can be spent choosing and then monitoring managers,” says Dunatov. The funds’ requirement for proactive managers is also diluted by large passive portfolios – half the total equity allocation. The default is for passive management; active management is only used where it clearly adds value, he says.

Investment decisions have a three-to-five-year horizon and are made according to key themes the team identifies as important. Today these include well-told stories like emerging markets, but also US re-emergence and, precisely because of all the turmoil, Europe. “Europe is not going to go away and the euro will survive despite the naysayers,” Dunatov says. “Europe is very cheap at the moment.” Investment there, not excluding peripheral countries, is focused on fixed income and equities. Going forward, the team is starting to consider the best way to access African growth via private equity.

Short-termism, liabilities and the really exciting stuff

Despite CPTI’s determination to innovate, Dunatov flags an inhibiting caution among many UK fund trustees. Apart from the likes of the $23-billion Wellcome Trust, the UK’s biggest charitable investor, and the clutch of other big UK schemes such as Railpen and the $48-billion University Superannuation Scheme, he believes most British schemes have grown short-term in their approach to investment. One reason for caution is the fact that many funds still measure their liabilities off gilt yields. They have fallen, forcing a rise in liabilities. “We value our liability according to our expected return,” he says.

Another part of the problem lies with FRS17 accounting rules. Used by all private-sector companies, these rules highlight huge gaps between liabilities and assets in many schemes. “It drags pension liabilities onto companies’ balance sheets and takes away the ability of many funds to focus on the future. A time horizon becomes replaced by a risk horizon,” he says. In stark contrast, the coal industry’s pension funds prove a rich seam for their corporate sponsor, the UK government. Surpluses generated from the funds are split between members and the government; over the last 20 years the government has pocketed around $7 billion.

Clawing back control of investment strategy has injected a new energy, freedom and ambition into one of the UK’s biggest pension funds. If Dunatov has his way, it’ll transform the old coal industry schemes into the nearest thing the UK institutional market has to Denmark’s ATP or even the big US endownement funds. “Now they are doing the really exciting stuff,” he says.

 

Sulzer is a Swiss manufacturer with a proud past. From pioneering the diesel engine to making the specialist pumps that drive power production around the world, it has been around for 178 years.

Perhaps leveraging off such a rich history, the company’s pension scheme is very much looking into the future thanks to solid returns so far in 2012.

The 3.6-billion Swiss franc ($3.8-billion) Sulzer Vorsorgeeinrichtung has seen returns of 6.1 per cent up until the end of October, almost a full percentage point over the fund’s benchmark.

Dr Urs Schaffner, who heads the fund, says the good showing is the result of intelligent investment picks by the inhouse investors, who manage 90 per cent of bond and equity assets.

Schaffner says he is “positively surprised. Investing in an interest-rate safe haven like Switzerland and assuming normal risk premiums, our expected returns for the next few years amount to between an annual 2 and 3 per cent.

“Given this expectation, combined with the many risk factors currently connected with the US and European debt situation, we hadn’t expected performance to be so good.”

Buoyant equity markets have helped things, with a 14.57-per-cent return in the fund’s overseas equity holdings assisting a 13.28-per-cent return in domestic equities based on “good picks”, according to Schaffner.

Schaffner explains that the Sulzer Vorsorgeeinrichtung has also been able to navigate the European sovereign debt crisis well.

The fund withdrew from peripheral bond holdings before their yields spiked and has acted quickly to shed poorly or even negatively returning safe-haven government bonds in favor of corporate debt.

Keeping it simple

While picking winners within asset classes seems to be paying off, Schaffner says the investment strategy on the whole at Sulzer Vorsorgeeinrichtung has been defined by continuity.

The fund has a conservative investment mix principally because a large proportion of its members are claiming benefits.

Some 70 per cent of the liabilities are linked to pensioners as a consequence of major restructuring at the sponsoring company in the 1990s.

This leads to a “rather rigid investment risk budgeting process” says Schaffner, with the risk appetite staying on the conservative side for a good number of years.

A declining pensioner pool may see some change for this in the years ahead.

For its beta, Schaffner explains that the fund has established target allocations in each asset class, and a bandwidth allocation range designed to avoid over or underexposure.

The bandwidths and target allocations were designed with the help of a consultancy, PPC Metrics, which completes an asset and liability study for the fund every three years.

Choosing where to pitch the asset allocation within that bandwidth is where alpha can be won or lost.

In 2011 the Sulzer fund made the wrong call in underweighting domestic bonds, going for a 29-per-cent holding, with the long-term target being 35 per cent.

This saw the fund miss out a little on a debt boom and miss its benchmark that year.

Schaffner explains that the fund has gone for fairly narrow bandwidths “to limit the alpha risk” but at the same time ensured they are wide enough “to allow the flexibility needed to absorb some natural market fluctuation”.

For instance, the domestic bond holdings are currently permitted to fluctuate between 27 and 40 per cent, while domestic equity is limited to 5 to 7 per cent.

No-nonsense investing

Overall bond holdings at the fund are now at 48 per cent after recent increases, with equities making up 21 per cent.

Those equity holdings are outsized by a 23-per-cent stake in real estate – not an unusual amount in Switzerland and a reinforcement of the fund’s conservative outlook.

Real estate continues to perform well for Sulzer Vorsorgeeinrichtung, with indirect real estate allocations increasing by over 7 per cent in the first nine months of 2012.

Further, Sulzer co-owns a real-estate asset-management firm with about 70 experts, allowing it to retain control over its direct real estate investments that comprise about 90 per cent of its total real estate investments.

The 4-per-cent alternatives holding is divided down the middle between private equity and commodity investments.

Schaffner says the conservative identity of the fund is reinforced by its avoidance of “complicated instruments”, such as structured products.

Hedge funds are no longer in the portfolio, with Schaffner saying that the fund’s investment committee “lacks confidence” in the ability of hedge funds to perform over the next few years. He adds that “hedge funds really are tactical investments rather than the strategic investments we are looking for”.

Emerging market bonds and infrastructure are asset classes that the Sulzer fund has an interest in acquiring, with others also on the ‘watch list’.

Schaffner says that even though these are being evaluated, “it will take a long time to work these through to the investment strategy”.

Discussions between the fund’s investment team, investment committee and management board are usually protracted when concerning a significant new investment venture.

Entering into new asset classes would also change the risk dynamics that the fund prioritises and likely require adjustments in existing asset classes.

No room for complacency

Funding is good at Sulzer Vorsorgeeinrichtung, with a $214-million surplus on the accounts at the end of 2011.

Schaffner says this “does not take any pressure off investment at all”.

“You just need to look at the numbers behind that to see that there is no room for complacency”, he suggests, indicating that the official discount rate in Switzerland inflates funding ratios.

The Swiss discount rate for pensions is 3 per cent, significantly higher than a 10-year government bond yield of 0.4 per cent.

The fund is aiming for a 17-per-cent surplus, which equates to around $636 million at the fund’s current size.

As the benefit level of the Sulzer fund exceeds the legally required minimum contributions considerably, it has a release valve in the form of its hybrid status.

Thus, it aims – but does not guarantee – to credit the legal minimum interest rate to the retirement savings of all active members.

Anything beyond that is usually the subject of intense negotiation.

The pension and funds management industry is self-serving.

There are too many players, there’s too much jargon, too much leakage and too much patting each other on the back.

And that’s not just my opinion: the results of a 12-month research project, across 60 countries and more than 3000 investors concur.

The research by State Street’s Center for Applied Research sought to find the forces that will shape the future of the investment management industry over the next decade, and has concluded that there is too much of everything in this industry.

It says that the delivery model will have to be streamlined at both industry and organisational levels to eliminate complexity and bring strategic priorities in line with what investors want most: personal performance.

It’s the system, stupid

According to this research, the system itself is in the way, and will need to be rationalised.

If you look around for a minute or two, this is self-evident. A simple example is the sheer number of pension plans in the UK – around 10,000!

In Australia there has been rationalisation on the buy side – with the number of APRA-approved superannuation funds falling from 1244 in 2004 to around 300 now.

Many consultants – including Jeremy Cooper, who chaired the MySuper reforms – believe this will, and should, continue.

However, while the pension funds have rationalised, the Australian market remains over serviced. Mercer reports there are more than 130 funds managers offering largely similar strategies in Australian equities and yet Australian equities makes up about 2 per cent of the MSCI.

While choice is a product of the free world, it also comes with costs and unintended consequences. Further, if choice is good, does that make more choice better?

The paradox of choice is at the core of attention economics – first articulated by economist and psychologist, Herbert Simon, in the early 1970s – that a wealth of information creates a poverty of attention.

Two Australian academics, Ron Bird and Jack Gray from the Paul Whoolley Centre for Capital Market Dysfunctionality at the University of Technology, have been proposing the need for rationalisation for years.

Too much of everything

In the Rotman International Journal of Pension Management article, Improving Pension Management and Delivery, the authors say the plethora of agents – trustees, fund staff, managers, consultants, custodians, lawyers, financial advisors, regulators, ratings agencies, government, academics, placement agents, even journalists – create substantial indirect and direct costs.

This plethora is driven by the ready availability of money, massive and intrinsic uncertainty and growing complexity, sometimes intentional.

Estimating the indirect costs of an excess of agents is especially difficult because almost all agents genuinely believe they are adding value net of their costs, just as each of us believes we are in the top quartile in intelligence and driving ability, the authors say,

“This belief justifies agents resisting market forces aimed at reducing their number. We expect total unnecessary agency costs to be substantial. The most evident and dominant direct agency cost is active equity management, a predictable consequence of competing on performance. Because active management is effectively a zero-sum game, aggregate retirement incomes are reduced by at least the cost of 1 per cent per annum of playing the game.”

Bird and Gray question whether more than 80 active Australian equities managers, managing more than 150 broadly similar strategies are needed to achieve efficient pricing in such a small market.

Writing this article five years ago, Bird and Gray concluded that fewer agents and less-destructive competition will force a sharper focus on members’ long-term interests.

Five years later and nothing has changed, State Street’s comprehensive research, interviewing more than 3000 industry participants, concludes the same thing. There are too many players and there needs to be a sharper focus on personal performance.

 Artscience embraces change

So what happens next? A little less conversation, a little more action! But how do you make change happen?

Change happens out of necessity, if there is opportunity and if there is strong leadership.

Clearly change in this industry is necessary if it is going to take seriously the very large and very global problem of funding retirement.

Leaders in the industry are needed to embrace the conclusions of the State Street research, and the pontificating of academics, and actually facilitate change.

Apparently, change doesn’t happen quickly, according to the Nobel-prize winner, Max Planck, who was considered to be the founder of quantum theory, “science advances one funeral at a time”.

His view was that new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it. Fortunately, funds management is not a pure science.

In fact, most participants in the industry like to believe investment management is part art and part science. And while science may advance one funeral at a time, the art world changes quickly – there have been 36 contemporary art periods since the term was defined in the 1960s.

Maybe there is hope for change in this industry.

When Hurricane Sandy descended on the east coast of the United States and headed inland, it forced the closure of all the nation’s financial markets. Christopher Finger and Oleg Ruben at MSCI thought this was important because, although there are plenty of precedents for natural disasters in terms of economic impact, the storm was singular in forcing the closure of equity markets on Wall Street.

Well and good, but unexpected events such as market closures require some degree of assumption about risk modeling. The authors were driven by the need to find out whether those assumptions lived up to the potential of the havoc Sandy wreaked.

Read the report to make up your own mind.

In a landmark project, the £11-billion ($17.5-billion) Greater Manchester Pension Fund (GMPF), a scheme for 10 local councils and hundreds of small regional employers including schools and charities, will invest in a series of residential housing projects with local authorities. Lauded as a completely new way of funding house building in the city, Manchester council is providing the land while the pension fund is coming up with $40 million in finance; returns will come both on rental income and through selling the properties. “The return is better than on property; we expect more than 7 per cent because of the development risk,” says councillor John Pantall, who hopes the model, which will start with just 240 homes, will soon be rolled out to member councils outside Manchester, also with land to develop.

In another venture – again indicative of the fund’s shift away from pure real estate investment to a broader infrastructure play focused on community assets – the GMPF is helping finance the refurbishment of central Manchester’s iconic St Peter’s Square. Via its real estate development arm, Greater Manchester Property Venture Fund, it has co-invested in the office and retail venture with Argent, the property arm of telecom operator British Telecom’s pension fund. Testimony to the allure of Manchester’s infrastructure assets, foreign funds are also pouncing. Industry Funds Management recently bought a $1.6-billion stake in Manchester Airports Group. The planned developments around Airport City are on the GMPF’s sights, says Pantall.

Value for money throughout the kingdom

Manchester’s innovation and success is music to the ears of the UK government, which is pushing infrastructure investment to support growth in the stuttering economy. Hunting for new sources of capital to fund housing, roads and hospitals, it has just turned to its local council pension funds. In a consultation process that will run until December, it is floating the idea of unlocking town-hall pension pots and allowing them to double their investment in limited partnerships – the asset vehicle they use to invest in private equity, hedge funds and infrastructure. The Local Government Pension Scheme for England and Wales is administered by 89 separate, often tiny, local funds but with combined assets of $250 billion. The hope is that raising the allocation ceiling from 15 per cent to 30 per cent will unleash a wave of additional investment in infrastructure and meet funds’ needs for long-term, inflation-linked returns.

“By lifting the restrictions controlling local pension investments, councils could pump a further $35 billion directly into job-creating infrastructure projects that will boost our economy,” said community and local government secretary, Eric Pickles. “This is potentially a huge development and investment opportunity we simply cannot afford to ignore that also allows us to maintain long-term value for money for the taxpayer.”

Caps off for small fry, but so what?

Although the proposals have been broadly welcomed, the government’s latest initiative to conjure up more investment in infrastructure – it is also developing a Pension Infrastructure Platform with the National Association of Pension Funds and the Pension Protection Fund to encourage more fund investment in the sector – may not have the impact it hopes. In reality, few local authority schemes hit the existing allocation cap anyway. Although GMPF is planning $80 million to $160 million of new infrastructure commitments in the coming year, new investment will only boost its allocation to 3 per cent. “We’ve never had an investor unable to invest because of the allocation ceiling,” commented one infrastructure manager of a pooled fund.

Small and medium-sized local authority funds, which make up the bulk of local authority schemes, will probably stick to straightforward pooled vehicles. These are made up of a diversified mix comprising everything from global infrastructure to clean energy and private fund initiative (PFI) projects. They won’t want to “dabble” in major developments demanding management time and oversight, best suited to large, diversified funds. The notion of local pension funds investing in local infrastructure also carries a health warning. “There could be a temptation amongst politicians to push pet projects, but pension funds mustn’t be diverted into local projects too easily; their primary responsibility is generating returns for members,” argues councillor Peter Jones, head of the $3.2-billion East Sussex Local Government Pension Scheme.

Costly management fees may also put off smaller local authority schemes that are upping their infrastructure allocation. They have neither the inhouse expertise to increase their infrastructure allocations alone nor the negotiating power of larger funds. “Few UK government schemes understand the infrastructure space,” says Graham Robinson at consultancy, Pinsent Masons, “nor do they have the scale to build the intelligence and expertise around infrastructure investment without using fund managers.”

Creating scale and a bubble

A solution to the infrastructure conundrum could be for schemes to join together as one giant fund, creating an economy of scale, argues councillor Jones. “The typical local authority fund only has assets of between $1.6 to $6.4 billion, so their infrastructure allocation will only ever be modest,” he says. By combining all the schemes of England and Wales – Scotland’s local authority schemes fall under the jurisdiction of the Scottish Public Pensions Agency – the total fund would be in excess of $160 billion. “It would put us up there with the major funds. Only then would we have the scale to invest meaningfully,” says Jones.

The government proposals have built on the buzz already circling infrastructure, helping increase understanding of the asset class among council pension funds with small allocations. More pooled vehicles, through which local authority schemes can invest, are likely to spring up and the governance required to assess infrastructure opportunities should get easier. However, some local authority trustees can’t help seeing the latest initiative as another call on pension funds to bail out the government. For seasoned infrastructure investors, politics stepping into the debate is a cause for concern. “The asset class has been around for a long time – all this interest could create a bit of a bubble,” said Pantall.