Around £1.2 trillion of UK pension fund assets lies in around 5,000 defined benefit schemes that primarily invest in Gilts and corporate bonds. With a suite of initiatives, the government is attempting to get the country’s fragmented DB (and DC) pension sector to invest more in illiquid assets and help fuel economic growth, as well as exploring how to consolidate these funds into larger pools.

The biggest UK pension funds like Railpen, Nest and LGPS already invest in alternatives and nine of the UK’s largest defined contribution (DC) pension providers have pledged to allocate 5 per cent of assets in their default funds to unlisted equities by 2030 as part of the Mansion House Compact. Discussions on how to consolidate fragmented defined benefit pension funds have begun led by the Pension Protection Fund and Brightwell.

Rory Murphy, trustee chair of the Merchant Navy Officers Pension Fund, MNOPF, believes the transformative benefits and opportunity of the push are clear, but says it will require nothing short of a pensions revolution if the government is to successfully persuade funds to invest in alternatives rather than low-risk, liquid government bonds.

“Why can’t money be released and invested in infrastructure that would support the whole economy and improve society? All the ingredients are there, and it would help pension funds, members, corporates, and society but it requires someone with real flair and imagination to go figure how to do it.”

Murphy links resistance to enduring factors. Pension funds multiple service providers from investment, fiduciary and covenant advisors have a vested interest in the status quo. While a pervasive risk aversion from the UK regulator has steered the country’s defined benefit pension funds onto de-risking paths. Meanwhile rising bond yields have reduced scheme deficits and provided an opportunity for corporate sponsors and trustees to negotiate so-called risk transfer deals, where responsibility for payments is shifted to insurers like Legal & General who promise to pay employees’ retirement payments at a fixed level – and continue to invest in the least risky assets.

“It’s hard to change from the slow lane to the fast lane,” says Murphy, who notes that the low-risk strategy actually failed protect these funds from dangerous exposure to interest rate risk in last year’s LDI crisis.

Murphy is well positioned to flag the issues at hand as a trustee of the MNOPF. The pension fund, which represents around 350 employers and currently manages around £2.5 billion, is illustrative of the strategy in action. The MNOPF hasn’t had any alternative exposure for years and is steadily de-risking, handing assets under management over to insurers. “In the next 2-3 years we will wind up,” he says. It abandoned any in-house investment ten years ago when it switched to a delegated fiduciary manager which implements a strategy enshrined in investment principles and a clear de-risking journey plan.

Trustees tend to be risk averse, admits Murphy. “Trustees employ skills and decision making defensively. They don’t want to do anything that puts them at risk. If they take advice and it goes wrong, they are not to blame but if they don’t take advice and it goes wrong, they are.”

He believes trustees should take a more active role by questioning and challenging advisors view of the world. “Why aren’t trustees saying hang on, this could be a great idea. Trustees need to challenge advisors but that requires the government to fundamentally review how pensions work and the role of the regulator.”

Part of the problem is that many trustees’ lack investment expertise. In recognition of this, the government has launched a call for evidence to explore how to support trustees to improve their skills, overcome cultural barriers and realise better outcomes. Elsewhere, larger funds like Railpen spend time educating their trustees on alternatives investment.

But Murphy believes the lack investment expertise shouldn’t impact the important role trustees play in holding advisors to account. Simple questions, he says, are often the most difficult to answer. “It is these people who cut through the jargon that surrounds investment and what advisors are saying, and remind everyone that pensions belong to beneficiaries because they are deferred pay.”

The MNOPF is also proof that trustees can shake up governance, he says. When the fund adopted an outsourced fiduciary management model, trustees pushed to scrap the investment committee in an important adjustment to governance.

Under the old structure, the board would “nod through” investment strategy on the assumption it had already been approved by the investment committee. Now the fiduciary manager reports directly to the whole board and the investment committee no longer filters what information reaches the board. In another pro-active strategy, Murphy is supporting education and wellbeing initiatives for members, including efforts to secure beneficiary payments twice a month.

Many institutional investors are increasing their allocations to private credit, jumping on the idea of lending to companies on a floating rate in the current interest rate cycle. But Charles Van Vleet, CIO of the $10 billion corporate pension fund for US aerospace and defence giant Textron, is not going to get lured onto the rocks of high yields.

He remains resolutely in favour of private equity over private credit when considering how best to tie up money long-term in illiquid, draw down vehicles.

“Where I have limited ability to tie up my money, I am not going to tie it up in private credit,” he says, speaking from the fund’s headquarters in Providence, Rhode Island. “Investing in private credit in a 7-8 year tie up and expected IRR or yields of 10-12 per cent is attractive but with bonds you can never get back any more than par, and you will soon wish for the asymmetrical upside of equity rather than the asymmetrical downside of bonds.”

Adding: “I hear lots of people saying my gosh, who needs to buy equity when you can buy high yield bonds with a 9-10 per cent coupon but my focus remains on equity.”

A year ago in July, Textron (which has returned 4.6 per cent year to date) stopped all new commitments to private credit and cut its spread exposure in half as Van Vleet opted to gain exposure to corporate growth through junior equity tranches over senior fixed income via private credit.

“We replaced spread exposure with beta-weighted allocations in the S&P. High yield bonds are correlated with the S&P at 0.6 per cent so when we sold 1 per cent of high yield we bought 0.6 per cent of the S&P.”

Van Vleet’s aversion to private credit is twofold. On one hand he believes that although the next default cycle (about to begin) will witness fewer defaults, the ability of investors to recover assets will be significantly lower. The problem lies in the absence of residual assets available for bond holders because the type of companies most likely to default are in tech.

“The nature of what America makes is different compared to a decade ago,” he says. “For many of these companies the most valuable asset goes down the elevator at night.”

Another reason that recoveries will be lower is that many of the covenants binding the loans are wanting. In the past, investors set covenants around the amount of cash to keep in the bank, leverage and margins, but these once weighty documents are notably lighter today. “By the time a lot of these companies are bankrupt they have bled the balance sheet. There just aren’t the covenants in place for lenders to come in and give the business a stern talking.”

The other reason for ditching private credit is wholly positive. Van Vleet is an enthusiastic investor in the corners of the US equity market that capture the scale of change ahead and offer the kind of unlimited return impossible to tap in bond markets.

Take technological leaps like LLM (large language models) powering the AI revolution visible in ChatGTP; the new generation of weight-loss drugs know as GLP1-agonists. mRNA, the biological unit that Pfizer and BioNTech used to make Covid-19 vaccines that scientists now believe will help the body fight other diseases or Crispr, the first drug to make use of revolutionary gene-editing technology. Not to mention innovations like cellular meat or when-not-if technological take off in fusion.

“Six weeks ago, we did not know of GLP-1. Six months ago, the term LLM was unknown. Three years ago, mRNA was non-existent, as was Crispr, two years prior. Some people think fusion is 20-years away but for long-term investors that’s tomorrow  – and it will take the carbon challenge away. All of these are transformative events and inventions. In short, North America equity investing is the best place to find the winners and losers of the exciting decade ahead.”

Apart from a small pocket of passive that Textron keeps for liquidity purposes, Van Vleet has an active stock picking strategy around these themes. But despite Textron’s focused investments he doesn’t believe only active strategies will reap the benefits.

“A rising tide will lift all boats, just be invested in boats, just be invested in equity,” he says. “Who is going to reap the benefits of this productivity? Its not going to go to labour – it’s going to go to the capital providers; to the equity investors, and it’s already priced into the market.”

And these themes are accessible across all asset classes. For example, Textron’s 12 per cent allocation to real estate comprising 22 direct investments in buildings and with no fund investment includes ownership of data centres fitted with the complex cooling requirements needed for vast servers.

In another nod to his contrarian approach, Van Vleet concludes that real estate investors continue to overlook opportunities in life sciences, cold storage and multifamily because they have been wholly focused on plummeting office values.

“They are throwing the baby out with the bathwater,” he concludes.

Sriram Lakshminarayanan, chief investment officer of $38 billion Iowa Public Employees Retirement System (IPERS) has spent recent months carefully paring back and moulding the allocation to active risk in a three-pronged approach.

Active risk exposure is currently minimal, as it has been for a few years, he tells Top1000funds.com in an interview from the fund’s Des Moines offices.

“Portfolio construction in public markets begins with a default of all passive, all the time. We have a low active risk allocation because we can’t convince ourselves there are enough managers out there who provide what we want at a reasonable price.”

The approach has involved axing the active risks he didn’t want in the portfolio and then, in a more complex process, onboarding the risks he seeks – aka uncorrelated returns that can be integrated alongside these market betas. That quest follows a systematic three-phase approach comprising a portable alpha overlay framework, alternative risk premia (ARP) and a tactical asset allocation program.

Lakshminarayanan particularly likes portable alpha because it allows IPERS to actively seek returns across all asset classes, regardless of whether they are part of the strategic asset allocation.

“We might find a commodity manager that we like and want to add the active return, inflation or equity hedge they provide but can’t because we don’t have commodities in the portfolio. Using portable alpha, opens up active strategies we wouldn’t otherwise have the opportunity to tap through traditional implementation.”

Portable alpha involves separating the beta and alpha returns, he continues: “Sometimes you need the beta, so you buy the manager, but sometimes you just want the excess return, so you have to go to a counterparty and swap out for another beta you do want. Our goal is to create a potential shield against short-term downturns while aiming for longer-term gains.”

Another component of active risk has involved beefing up IPERS’ ability to tactically allocate when opportunities arise – the strategic asset allocation contributes to 90 per cent of returns. Rather than something that can just be turned on, tactical asset allocation requires a change in mindset that is rooted in constant communication with managers and their views on the market.

“Our oversight of managers is not based on the idea that we know best. It’s based on knowing what they are doing. It requires active readjustments and wanting to learn. It’s a mindset change around how much risk you can deploy and if you can monetise it.”

The alternative risk premia allocation, the third element, has only been in place for a year and therefore hasn’t been tested as much as he’d like. The small allocation comprises a $300 million investment at 10 per cent risk, which could increase if the risk goes down.

“For example, if we set the risk at 5 per cent, we could allocate $600 million,” he explains.

Another facet of successful active investment comes via the team dedicating much of their time to manager selection, particularly eliminating unconscious biases from the selection process. About a decade ago, IPERS initiated a comprehensive effort to document essential characteristics, both quantitative and qualitative, to guide the fund in selecting active managers.

Since then, it has consistently applied this systematic approach to all searches within public markets to identify what it considers to be alpha. “While it has been challenging to find managers who fully meet our criteria, we remain committed to the pursuit. An encouraging outcome is that active risk in our portfolio has significantly decreased, and the limited active strategies we do employ generally align with our expectations.”

reshaping Private markets

In another initiative, Lakshminarayanan is in the process of establishing an internal private market co-investment program. The portfolio is already well established (including a 17 per cent allocation to private equity and 8 per cent allocation to private credit) and IPERS will use these existing relationships with managers to tap high quality co-investment and cut costs.

“Our approach involves initially selecting a handful of core managers to establish a strong foundation in the asset class. From there, we seek complementary satellite strategies to create a well-rounded portfolio in the given asset class.”

The co-investment program in private markets also aims to provide the team with much greater transparency on IPERS’ exposure. The fund is in the process of onboarding an administrator to run a program that will introduce a new level of transparency of all the alternatives holdings.

“It really makes sense to centralise all our strategies so we can see the whole picture and avoid concentrated risk in the portfolio. A co-investment program with each manager risks the investment team not knowing what each of the other managers are doing.”

The private markets portfolio is currently in line with target allocations apart from slightly higher exposure to private equity because of the denominator effect. “We don’t intend to make abrupt shifts in our allocations to private markets in the short term. Instead, we control our commitments and pacing to regulate this.”

A few central themes run through Lakshminarayanan’s investment approach. He counsels on the importance of embracing the fundamentals and staying humble, yet not shying away from taking a contrarian stance when needed. He says successful long-term investment reuqires a healthy dose of patience and he also adhere to the 20-80 principle.

“Allocate 20 per cent of your time to discover promising ideas and dedicate the remaining 80 per cent to their steadfast long-term implementation,” he suggests.

He thinks that the best asset ownership organisation revolve around a flat structure comprising generalists, complemented by a diverse team of analysts with varying expertise. Instead of designating asset class leaders in the six-person investment team, he has focused on aligning individual skills with the organization’s needs.

“It has proven to be a successful and satisfying approach.”

A spanner in the wheels to recruiting the skills he requires (and a plan to double the size of the investment team) comes courtesy of a recruitment challenges. “Iowa has lot of large insurance companies who are also talent thirsty. We are all fishing from the same pond, and hiring young professionals is hard.”

Still, he’s encouraged by progress over the past few years, and says board approval to increase compensation is helping recruitment.

For the third consecutive year the retirement income systems of The Netherlands, Iceland and Denmark were given the highest rating in the Mercer CFA Institute Global Pension index, with Israel also joining the top rank this year.

The Netherlands had the highest overall index score for 2023 (85.0), followed by Iceland (83.5), Denmark (81.3) and Israel (80.8). The index has been measuring retirement systems since 2009 with new countries added each year. Israel was only added in 2020 and has improved its score in every subsequent year, moving from a B+ rating last year to the highest A-rating in 2023.

Speaking to Top1000funds.com’s sister publication Investment Magazine, David Knox, senior partner at Mercer and lead author of the report, said there is one thing that all the top countries have in common.

“The top four countries that are A-grade – The Netherlands, Iceland, Denmark and Israel – all of them require that most of your benefit be taken as a pension or income,” he said.

By comparison he said countries such as Australia (overall score 77.3) in the B+ tier needed to be more sufficiently geared towards decumulation and focus on retirement income.

The index compares 47 retirement income systems around the globe with three new countries introduced this year – Botswana, Croatia, and Kazakhstan. It covers around 64 per cent of the world’s population.

The index is made up of three sub-indices: adequacy, defined as the system’s design features and how well it caters to people with different levels of income and wealth; sustainability, defined as whether it can continue to perform over the long term; and integrity, which is how well governed the system is.

Countries such as Italy and Spain had a reduced sustainability score this time due to falling birth rates and consequently greater pressure on the pension system. Meanwhile, several Asian systems including those in China, Korea, Singapore, and Japan, have undertaken reform to improve their scores in the last five years.

This year the report also took a deep dive into a topic of special interest and the potential for artificial intelligence (AI) to improve pension and social security systems.

“The ongoing expansion of AI within the operations and decisions of investment managers could lead to more efficient and better-informed decision-making processes, which could potentially lead to higher real investment returns to pension plan members,” Knox said.

“AI by itself is not the complete answer. There will always be a need for human oversight. Despite these risks, AI has the opportunity to deliver a higher standard of living in retirement — a worthwhile objective for all pension systems.”

Meanwhile Marg Franklin, president and CEO of CFA Institute said pension funds face increasingly complex challenges that impact retirees in significant ways and the index plays an important role in pension system accountability.

“More and more often, individuals will have an increasingly important role to play as it relates to their own retirement. As investment professionals, we need to help them prepare for that. Each year, this index serves as a critical reminder that there is a long way to go in many jurisdictions to make pension plans function at their best and for the long-term financial security of beneficiaries.”

France’s €41 billion civil service pension fund l’Établissement de Retraite additionnelle de la Fonction publique  (ERAFP) has just boosted its allocation to private credit, renewing and building out existing mandates in a €8 billion allocation begun in 2009 as it seeks to benefit from the higher cost of borrowing.

“The increase in interest rates over the last 18 months makes private credit particularly relevant for us given our liabilities,” says Bertrand Billé, head of credit investment who explains that the buy and hold mandates are mostly focused on investment in high-quality corporate bonds.

“The current absolute level of interest rates seems attractive to us. The aim is to ensure a good match between our assets and liabilities over the medium to long term,” he says.

However, within the mandate the managers also have the option to invest in certain complementary segments (like high-yield bonds and private debt, for example) in order to diversify the portfolio and improve the risk/return. The initial duration of the mandates is six years with the possibility for ERAFP to renew it for a period of two years.

ERAFP is one of the largest public pension funds in the world in terms of affiliates with nearly 4.5 million beneficiaries, 44,000 employers and nearly €2 billion  in contributions collected in 2022.

Manager selection takes time

As a public sector entity, ERAFP must comply with French public procurement rules when it comes to selecting its external asset managers. The process around public tenders has two distinct phases that make hunting for new managers a time-consuming process – RAPF launched this search in March 2022.

Phase one involves an “application” phase, through which RAFP assesses the overall professional, technical and economic capabilities of the candidates and their ability to meet its objectives in terms of exposure, performance, or ESG. This assessment mainly relies on “quantitative” data covering the asset manager’s expertise, track record on the strategy, access to resources like research and IT, and economic and financial soundness, adds Olivier Bonnet, head of asset manager selection at ERAFP.

Phase two, or the “offer” phase, involves asking pre-selected asset managers to answer a detailed questionnaire to “deeply understand” how they intend to implement ERAFP’s investment guidelines, he continues.

Responses to questions are gathered into three main buckets comprising the investment process and insights into the team that will be dedicated to the ERAFP account. A second bucket combines insights on manager’s trading, risk management and control, operations and legal prowess. Thirdly, responses focus on fees. “Based on this assessment, RAFP selects the best offers,” says Bonnet.

The latest mandates follows on the heels of other boosted allocations including European real estate, US dollar corporate bonds as well as an allocaiton to small and mid cap equites using a climate benchmark.

Managers’ ability to integrate ESG is another key element of the selection process. RAFP has its own ESG policy comprising an ESG rating framework detailing criteria against which managers are assessed. ESG integration includes contributing to the implementation of RAFP’s climate roadmap that it has committed to as part of its participation in the Net Zero Asset Owner Alliance (NZAOA).

“This ESG policy is part of our contractual documentation, so asset managers have to implement it on RAFP’s behalf,” says Bonnet.

ERAFP’s private credit managers are Amundi Asset Management, Ostrum Asset Management and HSBC Global Asset Management (France). Two stand-by mandates are attributed to Candriam and Groupama Asset Management. The five management mandates comprise three assets and two so-called stand-bys which means that ERAFP reserves the right to activate them, particularly for the sake of dispersing risks.

While the title of this thought piece might appear a little strange (“as small as possible please!”), my original (more accurate) title was even stranger: “When it comes to damage functions, are you a quadratic or logistic person?” All will become clear, very soon.

I have previously suggested that our breaching of various planetary boundaries is proof that we are increasing systemic risk. In this piece I aim to explore what might be the consequences of breaching planetary boundaries and triggering systemic risk. Specifically, I will focus on the carbon emissions boundary, because that is where most of the modelling is.

The phrase ‘damage functions’ is part of the jargon used within the modelling of climate risk. The damage function in a model relates the amount of predicted warming to an amount of predicted economic damage. The choice of damage function matters. They can be more, or less, aggressive. So, different models of climate risk will show a different amount of economic damage for the same amount of warming. It is therefore important to understand the damage function, and choose one that corresponds with your climate beliefs.

To illustrate this with examples, a really aggressive model (eg Burke et al 2015) would suggest a 23 per cent loss of GDP at 4C of warming. A less aggressive model (eg Khan et al 2019) would suggest a 7 per cent loss of GDP at 4.5C of warming. These answers are materially different, and we would expect different impacts on asset prices. However, both these models – and, in fact, the majority of models of climate risk – use what is known as a ‘quadratic’ damage function.

Our TAI paper Pay now or pay later? argued that the results above were substantial underestimates. And in a previous thought piece, Climate tipping points change everything, I argued that the wrong baseline was being used. Instead, I suggested a better baseline was to consider a 100% loss of GDP as currently measured due to unmanaged climate change and to work back from there.

Now seems a good time to push harder on that idea. It is clear to me at least, that there is some level of warming at which all economic activity ceases. Sometime before that, it would appear reasonable to assert that humans will lose interest in measuring GDP or other conventional measures of growth because survival is more pressing. At what temperature might this occur? In the appendix of our Pay now or pay later? paper we listed physical damage as set out by the IPCC[1]. Among other effects, a temperature rise between 2.5 and 4.5C is expected to lead to the ‘widespread death of trees’ and ‘reduced provision of ecosystem services’. I will leave you to decide the level of warming associated with a 100 per cent loss of GDP – but it could be as low as 5C.

The question now is what shape of damage function should we draw between where we are[2] and a 100 per cent loss of GDP. It could be linear, but I would suggest a ‘logistic’ function (sigmoidal, or S-curve) is more realistic. Damage will accumulate slowly in the near term and then accelerate. How quickly it accelerates will depend on the temperature limit you chose above. But for any reasonable range of temperature limits, a logistic damage function will suggest a loss of GDP that is a multiple of the damage suggested by a quadratic function. In turn, this would suggest that the potential risk to asset prices is way, way higher than any modelling results you have seen to date.

So, what do you believe about climate? Do you believe the physical damage it will cause will rise at a faster rate (non-linear) as temperature rises? Do you believe that indoor work will be adversely affected, as well as outdoor work[3]? Do you believe that climate tipping points exist, and some could be triggered at low levels of warming? The more strongly you believe these, and similar aspects, the more I would suggest you consider a logistic damage function. Forewarned is forearmed.

[1] From the IPCC WGII Sixth Assessment Report’s Technical Summary

[2] Over the decade to 2020, annual climate damage was estimated to be around 0.2% of world GDP (Equity Investors Must Pay More Attention to Climate Change Physical Risk, IMF blog, May 29, 2020). This level of damage was associated with a level of warming rising from around +1C to +1.1C. A Grantham Institute policy publication dated 30 May 2022 estimated climate damage in the UK at 1.1% of GDP (What will climate change cost the UK? Risks, impacts and mitigation for the net-zero transition)

[3] Many models, and their damage functions, assume that 85-90% of GDP will be unaffected by warming because the activities are performed indoors

 

Tim Hodgson is co-founder of the Thinking Ahead Institute at WTW, an innovation network of asset owners and asset managers committed to mobilising capital for a sustainable future.