Mercer Investment Consulting is calling for investment managers to take account of liabilities when managing pension fund assets, and to be assessed against performance targets that relate more closely to fund liabilities. The firm says research amongst managers suggests the investment community is willing to embrace this approach.
“In the last three years, many managers have outperformed their index benchmarks, but schemes have still suffered dramatic falls in their funding levels,” says Andy Green, Head of Investment Strategy at Mercer. With the consensus expectation of lower absolute returns and continuing uncertainty in equity markets, Mercer anticipates that scheme trustees will need to diversify their sources of investment returns outside equities in order to restore funding levels.
“Trustees need a transparent framework for allocating risk across a range of investment strategies, whilst also capturing their managers’ best ideas,” says Green. “This needs to be set in a wider context than the traditional focus of equities versus bonds. It’s not about removing risk – those wishing to do that can simply move to investing in bonds It’s about having a reasonable chance of delivering the return required, without having all your eggs in one basket.”
One potential solution, he says, is ‘liability benchmark’ mandates. “Managers would be asked to manage a discretionary mandate with an out-performance target set against an individual scheme’s liabilities. Typically, this would be most closely defined by a portfolio of index-linked and fixed interest bonds,” says Green. “This liability benchmark approach would require managers to determine the exposure to asset classes at any point in time, as well as the best use of their active management skills across asset classes.”
Green says the reaction to this new benchmark has been generally positive amongst the 30 fund managers that Mercer recently surveyed. Nearly three-quarters (22) said they would participate in mandates using this basis, even though they are not commonly used at the moment. Only eight declined on the basis that they had not yet developed their thinking sufficiently in this area, or were unconvinced of the relevance of the mandates.
More than two-thirds (70 per cent) were willing to accept the more modest out performance targets of gilts or cash +2 per cent a year. A smaller proportion – approximately half – said they would take on a mandate against the higher performance targets of gilts or cash + 4 per cent; this was on the basis that these mandates would be more difficult to achieve and would require higher levels of risk to be taken.
Virtually all managers proposed using a combination of active management and tactical asset allocation, with some exposure to asset classes other than bonds or cash (typically equities) for the higher out-performance target mandates. Many managers proposed using alpha transfer* techniques to capture their active management skill, in some cases incorporating the use of hedge fund strategies.
Many of the managers highlighted the need for extended performance assessment periods of up to 10 years, suggesting these strategies need a “full market cycle” to deliver on stated targets. However, a few did say they would be prepared to be assessed over three year periods, the current norm.
“Clearly there is wide interest within the industry in providing alternative approaches to pension fund investment, concludes Green. “Unlike traditional balanced management, fund managers would adopt a wide range of different methods for the same mandate, and this diversification is encouraging. A number of associated complexities arise with this type of mandate, and a lot more dialogue will be needed between trustees, consultants and managers to make liability benchmarks workable in practice. They are not a panacea to all the issues facing pension funds, but can form part of the broader framework for trustees.”
At this stage, Gren says Mercer envisages that trustees pursuing this approach will consider investing part of their assets against liability benchmarks. The proportion of assets is likely to be small at first while each party becomes more familiar with the workings of the benchmarks.
As trustees adopt more transparent risk frameworks for developing their investment policy, Mercer expects that strategies will encompass a broader mix of active management and long-term allocation to asset classes, leading to more sophisticated derivative-based strategies, such as alpha transfer, becoming more mainstream.