As portfolio institutional celebrates its fifth anniversary, Emma Cusworth looks at how investors have changed their approach over the last five years.
The last five years have been eventful to say the least and have seen significant changes in investor behaviour. Words like deficits, dynamism, delegation, de-risking, diversification, diversified growth funds, although not new, have come to the fore while others, including self-sufficiency and smart beta have emerged into the language of institutional asset management. The implications for how investments are managed are profound.
The period has been marked by sluggish economic growth, but has simultaneously been very kind from an asset-based perspective. The FTSE 100, for example, has returned 34.3% for the five years to 30 October 2015 giving an annualised return of 6.1% with an average volatility of 11.8%. Over the last three years the index has posted annualised returns of 7%. Similarly, the annualised total returns of the S&P 500 have been 14.33% over five years and 16.2% over three years to the end of October.
“The last five years have seen a nice run in equities and bonds supported by ultraloose monetary policy,” says John Belgrove, senior partner at Aon Hewitt.
But although quantitative easing has been positive for the asset side of the balance sheet, it has played havoc with liabilities. Despite the significant gains in asset values, funding levels have fallen. The PPF 7800 index shows that while assets have grown 32% from £935bn to £1.2trn between September 2010 and September 2015, liabilities increased on a far greater scale, up 70% from £912bn to £1.5trn. This has wiped away the 3% surplus in 2010 and leaves the finding level at 80%.
DEFICITS
With so many schemes now on the path to decommissioning, and the growing recognition there is an end point to liabilities, the problem of mark-to-market deficits has become all the more urgent. The result is a growing focus on cashflow and equity management as schemes are maturing bringing the need to pay benefits and manage liquidity into focus. According to Shajahan Alam, head of solutions research at Axa Investment Managers: “Just concentrating on assets doesn’t help. It’s about locking down the risks and ensuring that the firepower available through those assets is working for you. This hits many areas of
how to invest assets.”
Regulation and increased oversight has also helped push liabilities up the agenda, as has the heightened tension between pension plans and their sponsors, which
makes mark-to-market deficit volatility a particularly big problem. As interest rates have fallen, those tensions have increased and, in turn, the demands on governance structures have also grown. The renewed focus on managing liabilities has resulted in what Belgrove says is an “increased professionalism” in the way assets are stewarded and managed.
This professionalisation of investment management has manifested in a number of ways, not least in helping institutions to establish clear long-term objectives.
According to Aon Hewitt’s Global Pension Risk Surveys, the number of respondents who selected ‘none’ as their long-term objective over time fell from 30% in 2009 to just 6% in 2015.
DYNAMISM, DELEGATION AND DGFS
The professionalisation of trustee structures has also lead to a marked increase in how dynamic investment strategies are. Asset allocation has historically been very asset driven with a focus on a relatively stationary long-term strategic asset allocation. “We are moving to a more dynamic approach and use of medium-term market dynamics,” Aon Hewitt’s Belgrove says. “If you focus on liabilities, it becomes more feasible to flex asset weightings to the market conditions.”
Stefan Dunatov, CIO of Coal Pension Trustee Services, argues: “A long-term strategic target should always be able to achieve your objectives. In other words, your strategy should be right at any point in time, which means it should be flexible enough to change as necessary. Long-term strategic targets or reference portfolios that don’t change don’t therefore make a lot of sense to me.”
The increased focus on liability management and the need for greater dynamism has also driven a charge towards diversification and delegation as governance structures come under greater pressure. Delegated models, whether fiduciary management or outsourced CIO functions have become enormously popular and tend to be more liability-oriented.
The significant uptake of diversified growth funds is further evidence of investors increasing willingness to outsource investment decisions as the need to respond more dynamically to the economic and market environment becomes more widely recognised. The Standard Life Global Absolute Return Strategies (GARS) fund, which launched in January 2008 and had gathered
over £26bn in assets by the end of September 2015, is just one piece of evidence pointing to how strong the trend towards delegated, dynamic and diversified strategies has become.
SELF-SUFFICIENCY
One of the most notable changes of the last five years has been the emergence of ‘selfsufficiency’ as a long-term objective, a phrase that has quickly gained traction in the institutional landscape. As the phrase suggests, the key idea behind self- sufficiency is to reach a point where a scheme is able to function without having to call on the sponsor to provide additional funding, which in
turn means lowering the volatility of deficits and managing the portfolio in a manner that creates a higher probability of discharging liabilities in a smooth fashion. Having previously targeted buyout as their ultimate goal, many schemes have since realised how unobtainable that is for the majority of institutions. According to Aon Hewitt figures, FTSE 350 pension schemes had an average wind-up ratio of 64% at the end of October 2010, which had fallen to 63% by the same time this year.
Not only are wind-up deficits growing, but the sheer scale of the demand/supply imbalance for suitable assets has also dented the market for buyouts. With around £2trn in total liabilities chasing a fraction of that value in available hedging assets, the outlook for supply looks bleak. Recent years have seen the UK authorities focusing on reducing debt, leading to a downward-spiral in the issuance of hedging assets. Meanwhile, the Bank of England has made clear it will not start unwinding its massive store until short-term interest rates hit 2%, which could be a long while
off.
The extent to which buyouts have become too expensive and have fallen down the agenda for many institutions is evident in the decline in buyouts carried out this year. After posting record numbers in 2014 as the bulk annuities market clocked up £13bn in transactions, expectations had been for 2015 to see another record-breaking year. However, by the end of the third quarter,
bulk annuity business totalled just over £6bn and looked set to complete the year around £10bn, nearly a quarter down on 2014.
Aon Hewitt’s Global Pension Risk Survey shows self-sufficiency was cited as a longterm objective by 49% of respondents in 2011 – the first time it appeared on the list – and rose markedly to 65% by 2015. Those targeting buyout fell from 46% in 2009 to 27% in 2015 (but bottomed out at 20% in 2013).
“Self-sufficiency, whereby schemes have enough assets to lock out most of the risk and therefore have very limited reliance on a sponsor to stump up money, is more achievable,” Axa’s Alam says.
THE NEXT FIVE YEARS
Yet, despite the considerable learnings of the last five years, there is little evidence so far to suggest that institutions are better off on average as a result and considerable hurdles remain in the path of deficit reduction.
Many institutions have been relying on higher future interest rates to help rid themselves of the problem, but the outlook for interest rates reaching historical highs is also bleak. “While rates might not go down much further,” says Alam, “investors cannot wait for them to go up. Schemes that have accepted this fact have done quite well in the last few years.”
The long-term secular trend for nominal and real interest rates has been downwards over the last 20 years. Looking at five-year periods between 1995 and 2015, the change in 30-year real yields has been consistently negative, dropping from 3.91% between 1995 and 2000 to -0.67% between 2010 and 2015.
“Investors have been kidding themselves that rates will go up [enough to solve the deficit problem],” Alam warns. “That has stopped people from hedging the interest and inflation rate risk they have borne either explicitly or implicitly.”
Coincidentally to the developments in the investment world over the last five years, there has also been what RBC Global Asset Management chief economist, Eric Lascelles, calls a “profound demographic shift”. “The working-age population cratered in 2006/07,” he says, which means investors probably shouldn’t expect more than 2% growth in the future. “This coincidental
change is structural,” he warns. With the outlook for growth and interest rates more modest than the past, the level of unhedged interest rate exposure that continues to exist among pension funds
suggests many have yet to learn one of the most important lessons of the last five years.
Furthermore, central banks have used much of their firepower in delivering economic stimulus since 2010, which Lascalles says has left the economy “brittle” as their ability to deal with the next recession or crisis has significantly diminished. “Downturns could be deeper as a consequence,” he says, adding that investors should have modest expectations of returns going forward as the period of monetary expansion comes to an end and assets are less likely to deliver the strong returns of the last five years. “Sluggish growth is the more relevant narrative for stock markets going
forward,” he argues.
If that scenarios unfolds, and the brittle economy is less able to cope with shocks, investors will reap the rewards of the changes they have made in response to the lessons of the last five years. The increased professionalism, greater focus on liabilities and risk, and the more dynamic, diversified approach to asset allocation inherent in the target of reaching self-sufficiency should help to smooth the path for institutions in the next five years.
Belgrove says: “Funding levels are as poor today as they were at the start of this five year period, but the average trustee set-up is more sophisticated and weather-proofed so we expect the average funding level to be smoother. Investors have spent five years adapting to the lessons of the past. Those lessons have been learned and governance structures are now more robust. We should
see that pay off in the next five years.”
Despite the advances already made, however, further lessons have yet to be fully digested and integrated into institutional investment management. Coal Pension’s Dunatov believes institutions have “focused too much on the minutiae” in the past rather than focusing on the big-picture strategy.
“The industry has inverted in favour of implementation rather than strategy, which still needs fixing,” he says. “Strategy has always been important. It accounts for 80% of returns, which is widely
acknowledged, but investors have not followed the mantra and spent 80% of their time on the overarching strategy.”
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