The agenda at the United Kingdom’s National Association of Pension Funds (NAPF) annual shindig in Liverpool’s Echo Arena on the banks of the Mersey couldn’t have been broader. From early analysis of auto-enrolment, the biggest shake-up of the industry in a generation and just days old, to life expectancy, Britain’s role in the European Union, and even man’s place in the universe, there was something for every one of the record-1400 delegates. But for all its breadth and interest, the gathered trustees came in search of leadership and clarity from their representative organisation on just a handful of investment issues.

Reporting transparency

European regulation is one of the biggest dangers hurtling towards UK schemes. In what one trustee said was “the last straw” and another labelled “incomprehensible”, the European Commission’s planned new occupational-pensions directive could have profound implications for defined-benefit provision. In a plan modelled on the Solvency II insurance directive, the Commission wants to inject greater transparency into the way pension funds report their assets and liabilities. It would demand huge capital buffers and force companies to divert investment into their pension schemes. It would also push schemes towards low-risk investment strategies because of greater sponsor cash commitments for growth seeking portfolios. NAPF estimates the new rules could cost UK pension funds an extra £300 billion ($484 billion) and argues that companies faced with extra funding demands from their pensions would be forced to shut their final salary schemes.

At he heart of the proposals lie a new valuation method, a so-called holistic balance sheet or HBS. Worryingly, when the $54-billion Universities Superannuation Scheme, one of the UK’s biggest, applied HBS criteria to its scheme, it pushed liabilities from $56.5 billion to $105 billion. “These are not good numbers for a regulator to look at – it is not a good place to be. We want to avoid it all together,” said Tom Merchant, chief executive of the fund. “This looms large on the risk register and would have a serious impact on every scheme.”

Gabriel Bernardino, chief executive of the European Insurance and Occupational Pensions Authority, the body advising the European Commission on the proposals, tried to mollify critics: “We are not a bunch of lunatic, crazy guys in Frankfurt and we are not out to kill defined-benefit pension plans,” he said. Despite infusing his language with compliments about the UK industry and assurances that new rules would only be supervisory, trustees were left unconvinced. The worry is that supervisory measures will come with a 10-year deadline for full compulsion. “There is a great deal of fear and confusion in the different messages,” said Charles Pender, at the $589-million Lloyds Superannuation Fund. Even funds supportive of European federalism had their doubts. “There is a lot of concern among the audience about regulation coming out of the EU, but there is also a lot of mythology here – like the EU decrees cucumbers or sausages have to be straight,” said John Pantall, a councillor representative on the $18-billion Greater Manchester Pension Fund. “What I would say is that we must have the opportunity for overweight positions, to take risks and outperform.”

Quantitative easing is not pleasing

The impact of quantitative easing, so-called QE, pushing UK gilt yields to historic lows was the other top grumble among trustees already juggling deficits. The Bank of England Asset Purchase program stands at $605 billion, with a further $80 billion expected next month; because the government spend has been almost exclusively targeted at buying gilts, rather than any other asset class, it has pushed yields down below historic lows, where they were already languishing. Today the yield on a 10-year linker is minus 3 per cent and on a 10-year conventional, 1.74 per cent. “Our assets are healthy but our funding levels have dropped because of the low gilt yields,” said one trustee. Another remarked how negative yields leave buyers of UK gilts “in effect paying a premium to the government in return for inflation protection.” NAPF estimates QE has added $145 billion to the UK’s pension deficit, which, according to the Pension Project Fund’s June figures, stands at $430 billion.

It’s a call to arms NAPF chairman Mark Hyde Harrison heard. “This is an issue that requires urgent government and regulatory action,” he said. “We cannot afford to wait. Pension schemes need help and they need it now. In the US, Sweden and the Netherlands, governments have acted.” It is lobbying the government to apply an explicit uplift, or margin, to gilt yields. “Even a 0.5-per-cent rise in gilt yields would cut the pension deficit of the FTSE 350 by about 40 per cent,” said Hyde Harrison. Trustees welcomed the news, with one commentator saying she wanted more evidence that QE was actually working. “NAPF lobbying will spark debate as to its benefits,” she said.

Critical mass at the core of PIP

The why and wherefore of infrastructure investment was also much discussed with six funds pledging $161 million each to the government’s Pension Infrastructure Platform (PIP). The Railways Pension Scheme, Strathclyde Pension Fund, the Pension Protection Fund, the West Midlands Pension Fund, BAE Systems Pension Funds and BT Pension Scheme have provided what NAPF called “a critical mass” of investors for the scheme that will channel money into “core” projects such as energy and transport free of construction risk. It will feature low leverage – no more than 50 per cent per project and fees will be low, at around 50 basis points. Investments will be inflation linked and the fund is seeking long-term cash returns for Retail Price Index plus 2 to 5 per cent. “We believe the PIP is an important development that will help schemes like ours gain access to infrastructure on terms that are aligned to the long-term interests of pension funds,” said David Adam, chief investment officer of BAE Systems Pension Funds.

Founding investors only account for a third of the $3.23 billion the PIP hopes to raise in its first year. Although the scheme has confirmed “strong interest” among other pension funds, many remain lukewarm on the idea. They cite their own, existing infrastructure allocations and a preference for debt investment in infrastructure, rather than equity, as reasons. A reluctance to invest in schools or hospitals, where greater expertise would be needed, was also a reason to hang back.

The city of Liverpool’s regenerated Albert Dock was a fitting backdrop to the industry gathering, rejuvenated and buoyed by the early success of auto-enrolment. European legislation clouds the horizon and gilt yields weigh on portfolios, but with NAPF lobbying on their behalf, trustees are confident they will get their message across.

 

The European Union is threatening to drive pension funds out of real estate investments, experts warn.

That could be one of the undesirable results of plans to put pension funds under new risk regulations akin to the Solvency II requirements for the continent’s insurers.

What most concerns John Forbes, a PriceWaterhouseCoopers real estate expert, is the European Commission’s determination to require investors to hold enough capital to cover a 25-per-cent drop in the value of their real estate holdings.

Forbes says that the application of this level of market shock “would be as unappealing to defined-benefit pension schemes as it is to life insurance companies.

“Even if it doesn’t push pension funds en masse out of real estate investments, this will surely focus pension funds more than ever on their risk-adjusted returns from different types of real estate and bits of the capital stack.”

Disputing the value of market shocks

The European Insurance and Occupational Pensions Authority (EIOPA) is charged with advising the European Commission on a new European directive for pension funds.

A point bothering the European pensions industry is the crossover from EIOPA’s recommendation for pension funds to the proposed Solvency II regime for insurers.

This is designed to prevent insolvency in the case of more financial crises.

The need for pension funds to cover a 25-per-cent market shock in real estate holdings, for instance, is a Solvency II proposal that made its way into EIOPA’s assumptions for an impact study of the new pension regulations.

The real estate-investment industry argues that 15 per cent is a more realistic measure of the average volatility of European real estate to market shocks.

It claimed in a joint submission to the impact study that the 25 per cent figure is based on “flawed data”.

The Federation of Dutch Pension Funds has said in an EIOPA-consultation response that they “plead to decrease the proscribed stress levels” around property investments.

This effort to get the European Commission to soften effects has been met by a “cursory and rather unhelpful response” says Forbes.

Real estate and pension funds

European pension funds with more than €2.5 billion ($3.2 billion) in total assets currently hold 8 per cent in real estate on average, according to Mercer.

There is continued confidence that real estate can hedge against both unexpectedly high and low inflation.

Stephen Ryan, a principal at Mercer, says that real estate allocations in Europe have begun in the past few years to creep back towards historical highs. Ryan reckons that this trajectory is threatened by the proposals from Brussels.

He says that “allocations in the double digits used to be fairly common across Europe, but you might never get back up to that”.

Other alternatives, such as absolute-return strategies, are less tarnished by the proposals and stand to benefit from any outflows, Ryan says, whereas “real estate seems to have been lumped together with equities.”

The consultants’ figures show that UK pension funds are actually alone in wanting to increase their real estate holdings in the near term on the whole.

This forms part of a trend to diversify away from equity-heavy funds.

Bricks and mortar: direct, pooled or debt

Funds to have taken weighty real estate holdings include the $61 billion BT Pension Scheme.

As the UK’s largest fund, the BT scheme has some $6.6 billion in the asset class, most of which are direct holdings in core UK office and shop complexes.

Generally, only the biggest pension funds have the means to take direct real estate holdings, meaning that they could be disproportionately affected by any regulatory impact on the asset class.

Ryan reckons it might be medium-sized funds that invest in pooled-property funds that are the biggest losers, however.

He says that if the proposals pass unchanged, there will be a disincentive to invest in traditional pooled funds and directly held buildings. This capital could potentially be diverted to real estate debt – which is treated much more favorably.

Larger funds might find it easier to finance such debt offerings.

Ryan explains that smaller pension funds could also be disadvantaged by a requirement for each investor to models its own solvency.

In the insurance industry, smaller firms that lack resources to run their own models are set to be stuck with a less flexible standard formula under proposals from Brussels.

“There might be a two-speed world for real estate allocations between large and small defined-benefit pension funds,” Ryan suggests.

Breaking promises not to ‘copy and paste’

Great frustration is being vented at the process in Brussels.

Pension funds across the continent complained to EIOPA that the very idea of providing any capital as a buffer against higher-risk assets is unnecessary.

The $2.7 billion Deutsche Post Pensionfonds from Germany said in a recent consultation response that “in the current environment where interest rates are kept extremely low due to artificially low reference rates and exceptional quantitative easing measures, a Solvency II-approach would lead to unaffordable capital requirements. We do not see any argument why this should be considered as risk-oriented.”

Many have also argued that enough support is already provided for pension funds to avoid insolvency.

Sponsor companies frequently inject capital into troubled funds, while official safety nets exist for insolvent funds such as the UK’s Pension Protection Fund or Germany’s Pensions Sicherungs Verein.

The European Federation for Retirement Provision (EFRP), a grouping of national pension fund associations, has accused the European Commission of breaking promises not to ‘copy and paste’ insurers’ Solvency II requirements into new rules for pension funds.

As things currently stand, pension funds look likely to face the same demands as insurers over the next few years.

Risk is everywhere

The regulation – as is on the table – seems poised to push pension funds out of high-risk assets across the board.

Only government debt is classed as risk-free and therefore not in need of a capital buffer under the proposals.

The EFRP calls this decision “remarkable” on the basis of the recent European sovereign debt crisis. Ryan says “there are highly indebted governments out there whose paper is surely no safer than prime real estate”.

The EDHEC Risk Institute has warned in an academic paper that corporate bonds rated BBB or lower would be unappealing under Solvency II requirements.

It argues that the capital needed as a buffer for such high-yielding bonds would be excessive for the returns expected.

As many bonds issued for infrastructure projects are rated BBB or lower, the requirements could also threaten a concerted effort to encourage pension funds in the UK to invest in the asset class.

Equities would be significantly disadvantaged should pension funds face the Solvency II requirements.

The BT Pension Scheme foresees in its EIOPA-consultation response “a substantial disincentive for long-term investment in corporate debt and equity, which could have permanent impacts on the willingness of pension schemes to invest in the wider corporate economy”.

Forbes argues, however, that pension investors will need to stick to their risk appetite in spite of what emerges.

He says that “if pension funds do not generate returns, they will get further and further behind. You can’t just invest in government debt”.

Funds would have the option of passing some of the cost of capital buffers on to members by asking for higher contributions or cutting payments.

Those lacking the capacity for that might struggle with the financial demands of retaining their current risk profile though.

Forbes is far from alone in saying that applying requirements similar to Solvency II “generally will hasten the demise of defined-benefit pensions.”

Defined-contribution schemes will not be covered under the new directive.

Next steps

The European Commission plans to issue a draft pension-fund directive in the summer of 2013.

The pensions industry claims that this does not allow enough time to produce cohesive plans or respond to their concerns.

The European Insurance and Occupational Pensions Authority has indicated that it would like to launch further studies to assess the impact.

Additional studies and consultations are European Union investors’ major hope to avoid a forced exodus from higher risk asset classes such as real estate.

However, the indications on whether their hopes can be realised are far from clear.

Suspicions remain that the European Commission is determined to force a version of Solvency II on pension funds.

The Commission possibly wants to placate insurers that have dominated retirement-savings markets in countries such as France and are unwilling to compete with pension funds free from Solvency II requirements.

One thing for certain is that until a directive is presented, it will be difficult for investors to plan around it.

For instance, the speculation that investments into real estate or infrastructure could be redirected into loans depends on how such loans will be viewed by the new pensions directive.

Forbes argues that as the treatment of loans of this type is not clear yet, such speculation is premature.

Likewise, some lower risk real estate funds hope to gain exemption from a 25-per-cent volatility assumption, but there is no indication of this yet.

The world’s largest asset managers should be using the advantages of their size and scalability to adjust their fee structures, according to Craig Baker, the global head of manager research at Towers Watson, which just released this year’s Pensions & Investments/Towers Watson World 500.

“The advantage of large managers is [that] they could structure their fees to be more advantageous,” Baker says. “They should decrease fees as their asset size goes up. This should be an advantage of being a large asset manager.”

He says manager charges should be specific to a particular investment strategy with a distinction of how much it costs to run that strategy divided across the client base, and then a performance fee charged on top of that.

“The way fee structures work in this industry is that everyone charges the same, which doesn’t really work.”

How they lined up

According to the World 500, Blackrock remains the world’s largest funds manager by assets under management, with $3.512 trillion, followed by Allianz Group, State Street Global Advisors, Vanguard and Fidelity Investments.

The total in assets under management by the 500 managers was down 2.5 per cent for the year to $63 trillion.

Baker says market or beta movement accounts for a lot of the fall, as well as the fact equities markets fell compared with bond markets, and there was less merger-and-acquisition activity among the largest managers globally.

The top 20 managers make up about 40 per cent of the total.

United States managers dominate the list, with about half of the total assets. Further, the US managers in the top 20 managed about 64 per cent of that group’s assets.

From 2006 to 2011 the fastest growing managers globally have been Great-West Lifeco from Canada, Nippon Life Insurance from Japan and Wells Fargo from the US.

Baker is now head of investment research across Towers Watson, as well as head of investment research. This means the Thinking Ahead Group and the asset research team also report to him, which he says allows for coordination across research themes, ideas and implementation.

At Towers Watson those themes include sustainability, smart beta, and risk and governance.

Baker says the asset research group has a view that most government bonds are very expensive.

In the past few years the £34-billion ($54.7 billion) Universities Superannuation Scheme (USS) has substantially diversified its asset allocation, including a large alternatives allocation, and extended its investment team from 65 to 105. In the latest chapter of the fund’s investment department reincarnation, from October this year a separate but fully owned USS company, USS Investment Management, will manage the fund’s assets. Amanda White spoke to chief investment officer of USS and now chief executive of USSIM, Roger Gray, about the fund’s development.

USS Remake

In the three years since Gray has been at the helm of USS – coming across from Hermes, which coincidentally operates under a similar structure to the new USSIM entity, being the funds management arm owned by BT Pension Scheme – the complexity of the investments has increased both from what the fund invests in and how it is managed.

Until 2006, Gray says USS invested in listed equities, government bonds and property.

“I’ve brought in specialist emerging markets equities, internally managed, and debt and non-government bonds, externally managed. And in a more fundamental change we’ve developed the alternatives business both in its funds investments and increasingly in its direct investment activities,” he says.

These alternatives come in the form of private equity and private debt, infrastructure, hedge funds and some extras such as timber.

In the past year it made the first investment as part of its new infrastructure strategy to be a direct acquirer of assets. The scheme was the lead investor in the acquisition of Australian toll-road company, ConnectEast, and more recently provided long-term inflation-linked financing to South East Water in the UK. The alternatives team, now about 25 people, has also made 18 direct private equity and debt investments to date.

 

USS asset allocation at March 31, 2012

asset  

 percentage

Overseas equities

  34

UK equities

  17

Alternative investments

  17

Cash and other assets

  8

Property

  8

 

Over the past three years there has been a progressive reduction in developed equities, from 70 per cent to around 50 per cent. In the past year, as part of the fund’s triennial review, developed market equities have continued to reduce. There was also a small reduction to property, an increase in the allocation to emerging market equities and infrastructure, and a new allocation to emerging market debt.

As part of the reduction to equities, the one remaining external equities mandate – global equities with Capital International – was terminated. The assets will be used over time to fund new investments in infrastructure and emerging market debt.

Shaping up

Broadly, the internal team is the preferred manager and all of the developed market equities and government bonds are managed inhouse. There are about 30 people in the equities team, and a further four employed in the investment risk team, two in operational risk and five lawyers in the legal department.

“I am hesitant to say it’s a continuing trend to inhouse management because it depends what we invest in,” Gray says.

“If an investment is opportunistic, as opposed to permanent, then it doesn’t make sense to create a team to do that; similarly, if it’s not economic or timely to build a specialist team to manage the scale of assets allocated, as with emerging market debt at the moment.”

As the business has grown, the executive structure has been renewed and this summer a new management structure within investment management was put in place.

Gray has become the chief executive of the investment company subsidiary and has formed an executive committee with four of his direct reports: the chief operating officer, the head of alternatives, and the new heads of equities and fixed income and liability management.

Elizabeth Fernando, former head of European equities and deputy CIO, has become head of equities, and USS is still finalising recruitment for a head of fixed income and liability management, which Gray has slated as a significant area of development in managing asset liability risk.

“There were some important governance benefits in separating a complex investment business,” Gray says of the new USSIM structure.

“Overseeing that activity requires a specialist board and the investment subsidiary company allows that. We were unusual to be still reporting directly to the trustee board. It was inappropriate to take the electrics and plumbing of an investment operation up to the trustee board.”

Now a USSIM board – made up of the CEO, COO, CFO and two non-executives – will provide oversight and filter information up to the main trustee board.

“Some of the things that have been clarified include the responsibility for selecting external managers being clearly delegated to the investment company. The USSIM board has to be comfortable that we have the expertise and operations to manage assets internally and that there are cost savings. We are operating under a comprehensive investment management agreement,” he says.

While most of the investment teams are “fully grown”, Gray says there is still some work to be done in filling out the resources and team in fixed income and liability management.

“We will be looking at activities including liability hedging with derivatives, and a modern pension fund needs credit risk management, which is also underdeveloped. Pension schemes are under pressure because of funding levels, but recently it has not been because of the asset side, but the liability side of the balance sheet,” he says. “The ability to hedge liabilities when opportune to do so makes a lot of sense. It’s a very twenty-first century role.”

Risk and reward plus

In the financial year to March 31, 2012 the fund’s assets increased by by 4.4 per cent to $54.5 billion. But because UK gilt yields have continued to fall, the value of the liabilities went up – by 24 per cent. So now the fund is only 70-per-cent funded.

In order to get fully funded, USS will have to perform above its target return of UK gilts plus 1.7 per cent. It will have to be more like gilts plus 3 per cent for the next 20 years. Relative to 30-year gilt yield of about 3 per cent, the 10-year yield is close to 2 per cent.

“I think our asset allocation is capable of delivering that kind of return,” Gray says.

This will be achieved through its newly diversified asset allocation, but also because at USS there is a fundamental belief in active management, with about 90 per cent of its equities asset actively managed.

“Successful asset management requires discipline and understanding of what your process is and why it has a chance of outperforming, as well as good cost control,” Gray says.

Responsible investment is another of USS’ central tenets. First developing a responsible investment policy in 1999, it has been a global leader in the field.

USS’s internal team seeks to encourage the companies in which it invests to focus on delivering durable shareholder value, giving due consideration to the full range of long-term risks to performance including environmental, social and governance factors.

“We make investments on the basis of financial risk and reward, but we do believe we should understand all of the risks,” Gray says. “A polluting company could find its financial standing impacted, so we want to be aware of all risk factors. We take governance seriously and want management to act in the interests of shareholders.”

 

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121031_The 300 Club

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