February, 2016 Print
Matthew Craig, LAPF Investments.
Matthew Craig emphasises the increasing importance of risk management for pension funds and summarises the main investment principles for minimising risk, including adoption of clear objectives and avoidance of investing in areas which are not fully understood
Risk management is now rightly seen as one of the most important aspects of running a pension fund, particularly a defined benefit (DB) pension where the relationship between assets and liabilities determines solvency. In turn, the solvency is a barometer of how well positioned a pension fund is to pay the promised pensions to members. As most local authority funds are underfunded for a variety of reasons, risk management is now part of the overall solution for LGPS members, along with reforms and other measures.
For all pension funds, strategic asset allocation decisions are a key element of risk management. In deciding their asset allocation, pension funds need to have a risk budget, based on their capacity to withstand shorter-term volatility in pursuit of their long-term goals. The bigger the risk budget, the more that can be invested in riskier assets. At the same time, a diversified asset allocation should, in theory, give higher returns for the same level of risk taken. John Jones, the independent chair of the pension board at the Dyfed and Tower Hamlets pension funds, commented: “One of the keys to risk management is diversification by allocating investments across a range of asset classes. The case in favour of this approach is well documented and understood, and will be based around the long-term investment strategy and the scheme’s liability profile.”
For local authority pension funds, the triennial valuation is a key milestone for strategic asset allocation decisions. Bridget Uku, group manager for treasury and investments at the London Borough of Ealing, commented: “We will have the next valuation as at 31st March this year and we will be looking at the results from it towards the end of the year. After the last triennial valuation, we cut the equity allocation and put more into property. Having said that, we still have a relatively high equity allocation of 65%, but that is in line with other local authority funds. We need to secure high returns to help close the funding gap, but we will be reviewing investment options within other return-seeking asset classes which may well reduce our equity exposure.”
A range of factors feed into strategic asset allocation decisions. As Uku says, a higher annual return target can mean a higher allocation to risk assets, such as equities. Another important issue is the investor’s time horizon; can they take a long-term view, or do they have more immediate cash flow requirements? Jones commented: “If you have a long-term outlook, you can consider strategies, such as private equity or infrastructure, which lock up assets for some time, in order to take advantage of an illiquidity premium.” Jones added that while listed equities can be traded on a daily basis, because of their volatility and the costs of implementing changes to a portfolio, it makes more sense to hold them over the medium term.
The question of equity allocations at UK local authority funds also raises a point about how country-specific factors can play a role in risk management decisions. Jones said: “In countries such as Italy and Germany, public pension funds often have much lower equity allocations than the equivalent funds in the UK. Their equity allocation might be 10% or less, compared to 50% or 60% for a UK fund.” He added that this difference illustrates how national boundaries, culture and regulation have a big bearing on asset allocation decisions.
Once the strategic asset allocation is decided, there is still scope for it to be adjusted on a short-term basis, if, for instance, equities look good value due to a correction. Here, tactical decisions may either be taken by the pension fund investment staff, or delegated to external managers responsible for a mandate in a particular asset class. Uku commented: “We have a strategic approach and we don’t make tactical changes in the light of short-term market movements; that is something we would expect our external managers to do as part of their mandate requirements.” In deciding who should take short-term decisions relating to asset allocation and risk management, having the ability to move quickly is paramount. Here, giving a flexible mandate to a manager can help, as many LGPS funds have a committee-based governance structure which can slow down decision-making, unless a smaller group is empowered to take certain decisions. Jones added: “Having a decision-making structure that allows you to make decisions quickly can be beneficial from a risk management perspective. A strong governance structure with delegation and in-house expertise is important in achieving this.”
But even with a strong governance structure and in-house expertise, there can still be a case for giving an asset manager scope to make some asset allocation decisions. For example, in fixed income, there is a move to appoint managers for unconstrained mandates, which allow them to invest across the fixed income universe, from sovereign bonds, to high yield debt and emerging market debt, in order to find higher yields than those available on core fixed income, such as UK Gilts or US Treasury bonds. Jones noted this trend, saying: “There is a lot of interest among LGPS funds in multi-asset credit, where a fixed income manager has discretion to move around the credit universe to diversify and find yield, in order to produce risk-adjusted returns.”
Alternative asset classes, such as hedge funds, are another area where investors can decide to keep control or delegate to a manager. In the past, a fund-of-funds was widely used for hedge funds, but this approach has gone out of favour, due to the relatively poor performance of some funds-of-funds offerings and the extra layer of fees that they can incur. At the same time, investors with experience of using hedge funds may decide over time that it makes more sense to select hedge fund managers themselves; picking three or four hedge fund strategies with different managers can give useful diversification and downside protection, should equity or bond markets crash.
Downside protection is an aspect of risk management that is considered periodically by pension funds. On one hand, there is a view that as long-term investors, pension funds should be able to ride out market squalls, and diversification acts as a bulwark against adverse markets. The opposing view is that a severe blow to funding is worth avoiding. In this case, options and futures can give protection, at least in theory. The worry for many investors is that a derivatives-based protection strategy can be expensive and might not work as planned in a crisis. Furthermore, local authorities are limited in their ability to use swaps, a legacy of the Hammersmith and Fulham Council case from the early 90s, when the use of interest rate swaps by the local authority was ruled unenforceable.
If investors are concerned about over-valued equity or bond markets and want protection, then there are other options to a complicated strategy relying on derivatives contracts. One example could be to build up some “dry powder”, or liquid assets, which can be deployed quickly if markets crash and equities or bonds suddenly look a bargain. Another option would be to make an investment in “safe haven” assets such as gold; ETF Securities reported inflows of $1 billion into gold and oil exchange-traded products in early 2016, as investors sought refuge in gold from falling markets, or saw an opportunity to take a position in oil at an attractive price.
While risk management can become complex, the main principles for investors remain the same, whether they are LGPS funds or ordinary investors. These can be summed as having a clear plan and objective, acting prudently and taking advice where necessary, not investing in areas which you do not understand, diversifying, and getting an appropriate balance between risk and return. Investors should also bear in mind that “reckless prudence”, such as holding everything in cash, may not turn out to be good risk management, should the bank fail, or inflation rise above the interest rate on offer. While these principles sound simple, putting them into practice is not always easy and risk management is always an area that investors need to keep under review. This is particularly the case for pension funds, where making significant changes to an investment strategy, in order to avoid a bad outcome, can be difficult, time-consuming and expensive.