Five lessons from UK Pensions for SWFs and Others

UK pension funds have been through a hell of a ride over the last 10 years, and more. changes in regulation, longevity, interest rates, equity markets and the changing fortunes of sponsoring companies have all contributed to making the UK pension industry a tricky place. But are the lessons learnt relevant to other investors, particularly Sovereign Wealth Funds in the current climate?

  1. Why having an over-arching objective helps set investment strategy
  2. Incorporate future expected cashflows (in & out) into investment decision making
  3. Risk managing a portfolio which experiences large outfows has unique challenges
  4. Tracking liquidity of the portfolio is a key metric
  5. Recognising the cashflow properties of assets is important
  1. Why having an over-arching objective helps set investment strategy

This is the first of our recently-published investment principles, so needless to say we think its pretty fundamental. If anything, it might sound obvious but all too frequently we hear of funds looking at exotic or niche investments or managers that may be interesting (and may be perfectly good investments) but are inconsistent with the objectives (either on grounds of return, risk, or liquidity). Simply testing each new idea, asset or manager against the test “does it move us closer to our objective” makes life massively easier (and can simplify governance), If each incremental decision aligns itself with the objectives then it makes it a very transparent decision making process.

Going further, an overarching objective allows for the setting of an investment policy framework – which is very powerful for effective decision making. There is a reason why professional scrabble players always arrange their letters in alphabetical order: because patterns emerge more easily when you look at things in a consistent way. Having an investment framework is exactly the same, specifically it has the following benefits:

  • Avoids knee jerk decision making (which can be sub optimal) ;
  • Avoids “flavour-of-the-month” decision making;
  • Makes decisions more transparent and accountable.

2. Incorporating future expected cashflows in and out is essential to setting investment strategy

Pension funds are generally subject to significant inflows (sponsor contributions) and outflows (benefit payments) through their life cycle. A projection model that can succesfully take these into account, and allow for them to be varied or updated is essential to understand where the fund is “aiming” for. Without this, the fund may unnecessarily be taking too much investment risk, or conversely may be locking itself into failure to meet objectives. It also allows the ability to set more realistic goals, sometimes given cashflow constraints a certain funding goal may just not be really achievable given likely asset returns.

3. Risk managing a portfolio which experiences large outfows has unique challenges

At some point in their life cycle all defined-benefit pension funds will become net cashflow-negative. Many already have. This presents a challenging risk to deal with, that has become known in some quarters as “sequencing risk”. Put simply, the challenge here is that if the fund experiences a particularly negative investment return, followed by the need to make a large payment out, this can be very detrimental to ability to achieve its long-term return goals. The existence of this risk makes precise risk management all the more important. Risk measures like required-return-at-risk can really help.

4. Tracking liquidity of the portfolio is a key metric

Illiquid assets can be a fantastic investment, and it is often said that one advantage a pension fund has when investing is it’s long-term horizon which may enable it to commit capital over a long period of time, and earn a higher return. Some assets are very clearly illiquid (eg private equity), and some are very clearly liquid (government bonds or large-cap equity). However many assets and strategies now sit in a very wide spectrum of semi-liquidity. As a pension fund you want to know that when you need it the liquidity in your portfolio is there – and to ensure this it helps to dive a little deeper into the liquidity level of the components of the portfolio, categorizing a broad swathe of the portfolios as “alternatives” for example can be particularly unhelpful, as parts of this could be very liquid and parts illiquid. Much more helpful to categorize asset classes according to their liquidity, and track the overall liquidity layers in the portfolio as a key KPI.

5. Recognising the cashflow properties of assets is important

A second basis on which to categorize assets, that is more helpful than the standard equities/bonds/alternatives categorization is the extent to which the assets’ return is linked to a contractual payment stream or not. For example a bond provides contractual cashflows (absent default), whereas equities are principally dependent on changes in the market value for their return. Understanding the contractual cashflow properties also helps manage the liquidity of the portfolio correctly.

combining these last two points gives a 2×2 matrix, which we believe is a more helpful way of categorizing assets that conventional definitions. This was designed to reflect the characteristics (liquidity and cashflow) that matter most to pension funds, but this applies equally to many other investors who have requirements for liquidity and cashflow.

2x2

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