August, 2016 Print
Matthew Craig, LAPF Investments.
Equities are a key asset class for pension funds looking for long-term growth, but their role may be changing as investors become more defensive
The change in investors’ use of equities can be seen as the investment pendulum swinging back and forth over many years. In the UK, George Ross Goodey, an actuary who ran the Imperial Tobacco pension fund in the 1940s and 1950s, famously realised that equities made a better long-term asset than government bonds, and persuaded the fund to invest heavily in the asset class. This change was seen as triggering a wholesale move into equities among British pension funds and bringing in an equity culture. This made sense when defined benefit (DB) schemes were open to new members, liabilities were relatively low and fluctuations in scheme funding levels could be smoothed out by opaque actuarial calculations. As a result, for many years a large equity holding was a key feature of Anglo-Saxon pension funds, although for various reasons equity investing was less prevalent at pension funds in continental Europe.
We can now look back and see that “peak equity” among pension funds was reached around the turn of the millennium. At that time, a bull market which culminated in the early 2000s technology boom pushed up equity allocations. In the UK, the rules meant that overfunded pension funds could take a contribution holiday, creating an incentive for funds to have a bias to growth assets such as equities. But over the last 15 years, the pendulum has swung away from equities due to a combination of factors. Demographic trends and a marked increase in pensioner longevity mean that DB funds now have a higher proportion of older to younger members, which has led to a greater focus on liability matching. This has been exacerbated by tougher funding rules, with the use of real-time market values, which have encouraged prudence. These changes have coincided with falling interest rates, raising liability valuations, and a severe equity market fall in 2008-2009; all of these factors have led many investors to reduce their exposure to the equity risk premium.
This story is clearly backed by the data. In the UK, overall pension fund allocations to equities have fallen from an average of 71% in 2001 to 45% in 2015. The same pattern can be seen in other countries that invested heavily in equities in the past; in the USA, the fall has been from 59% to 50% over this period, while in Australia, it has been from 63% to 46%. At the same time, fixed income allocations have risen in the UK, from 20% to 37% in the UK, as many private sector DB plans have moved into liability-matching approaches. Because they are not subject to quite the same pressures as private sector funds, in terms of regulation and funding, the £260 billion or so managed by the Local Government Pension Scheme (LGPS) members still had a relatively high equity allocation of 54% at the end of March 2016, according to pensionsperformance.com. This compares to an equity allocation in the mid-thirties for corporate funds. Interestingly, there is relatively little performance difference between LGPS funds and corporate funds over five and 10 years, although the LGPS funds have produced slightly better results over these two time periods. In a commentary on these findings, State Street Investment Analytics (SSIA) noted: “We expect to see more funding moving from positive to negative cash flow in the relatively near term. This will create new challenges in terms of setting strategy and is ultimately likely to result in a more conservative asset allocation, as funds worry about being forced sellers of volatile assets such as equities. To date, most funds are continuing with their relatively high equity commitment and we have not seen a widespread ‘derisking’ or move into liability-matching investments in the same way that we have seen across corporate bonds.” This quote shows how the investment approach of LGPS funds could be converging with private sector DB plans which have been pursuing de-risking strategies for a decade or so. If this is the case, then LGPS funds have the opportunity to study the de-risking approaches in use and learn from them. Given that the UK’s corporate DB funds have an average funding level of around 88%, they and the LGPS funds face the same challenge of reducing investment volatility, finding income, and at the same time generating enough growth to close a funding gap. While equities will still have a role to play in this scenario, it will be as one of a number of assets in a carefully calibrated investment strategy.
Another aspect of equity investing, which is becoming increasingly important, is helping implement the environmental, social and governance (ESG) beliefs of pension funds. One of the leading funds in this area is an LGPS member, the Environment Agency Pension Fund. It has stated that considering the adverse impact of ESG factors, including the impact of climate change, is in the best long-term interests of the funds’ members and therefore is part of its fiduciary duties. As a consequence of this, the EAPF is taking steps to address the impact of climate change through its investment strategy, including equities. In an October 2015 statement on its policy on addressing the impact of climate change, EAPF said it intends to decarbonise its equity portfolio by reducing its exposure to future emissions of greenhouse gases by 90% for coal and by 50% for oil and gas by 2020. In addition, it intends to invest 15% of the fund in low carbon, energy efficient and other climate mitigation opportunities. Plenty of other LGPS members now share the view that maximising short-term financial returns, with no regard to the wider long-term consequences, is no longer a valid approach for responsible asset owners. For instance, Greater Manchester, Norfolk, West Midlands and West Yorkshire were also named as being among the top institutional investors worldwide by the global Asset Owners Disclosure Project on climate-risk management.
Looking ahead at how LGPS funds might invest in equities in the future, much depends on the current asset pooling reforms, which may see 90 or so LGPS funds eventually consolidate their investment assets to an expected eight large asset pools of £25 billion or more. It is planned that administering authorities will make strategic asset allocation decisions, as now happens, but these will be implemented by the managers of the asset pools. So for the London Collective Investment Vehicle (CIV), a London borough’s investment team might decide to rebalance their equity allocation to increase emerging market exposure which then means that assets move between fund vehicles managed or chosen by the London CIV.
In its consultation process for LGPS reform, the government pushed for greater use of passive investment, with active investing only used where it can be shown to add value. Combined with the greater scale of eight asset pools, this could lead to an emphasis on reducing costs in equity investing by a shift to passive. Colin Pratt, the communications workstream leader for eight LGPS funds in the Midlands and the West Midlands Integrated Transport Authority commented: “The move to pooling might make some funds question whether active management has actually added any value (net of costs) to them, and whether they have any conviction that it can do in the future. Combined with incredibly low passive fees that have been negotiated, it seems inevitable to me that there will be more assets managed passively than there were before the pooling debate commenced. But I am not convinced that there will be a mass exodus to passive.”
In-house investment could also become more important, as funds such as West Midlands have used this to carry out active investment at lower costs than using external managers. Internal management of equities can also help investors ensure that ESG criteria are made an integral part of their investment process. While it remains to be seen how equity investments are handled with the new asset pools, it is also possible that these pools will invest more in assets such as infrastructure, real estate and private equity to the detriment of listed equities. Certainly, central government is keen to see the asset pools invest in UK infrastructure, but each investment decision will have to be taken on its merits. What is clear is that equities are no longer seen as a panacea for pension funds, as they were in the past. Instead, a judicious equity allocation is part of the overall investment solution, alongside other asset classes, in a bid to produce growth, but without too many unpleasant surprises.