U.K. pension plan sponsors have begun to construct the investment framework through which they will manage existing final salary plans down to zero over the next generation while transitioning employees to defined contribution structures.
The results of Greenwich Associates’ 2007 United Kingdom Investment Management report reveal that corporate plan sponsors in the United Kingdom have become the world’s earliest and most active adopters of new strategies designed to limit volatility within their investment portfolios and eliminate some of the risk associated with managing final salary plans. U.K. local authority pension funds are also making a strong move into so-called “portfolio-wide strategies” such as asset-liability matching, general liability-driven investing and various absolute return approaches.
Meanwhile, U.K. plan sponsors are moving quickly to put into place the defined contribution structures that will serve as the cornerstone of their retirement programs for employees closed out of traditional final salary plans. Unfortunately, they are moving at a much slower pace when it comes to making critical upgrades that can improve long-term investment outcomes for DC participants. Because the vast bulk of U.K. pension assets still reside in final salary structures, plan sponsors are devoting most of their attention and resources to perfecting their final salary management practices.
“Most U.K. plan sponsors today have yet to address the many challenges they will need to overcome to get defined contribution plan performance to the levels required for DC plans to work as a viable long-term replacement for final salary plans,” says Chris McNickle, consultant at Greenwich Associates. “When it comes to pension fund infrastructure, the new foundation has been laid, but the cement is not yet dry.”
In 2003, slightly more than 40% of U.K. companies had closed their final salary plans to new employees; in 2006 that share reached 61%, and over the past 12 months it increased to 68%. Another 3% of corporate plan sponsors expect to close their plans in the next two-to-three years. Meanwhile, nearly 85% of U.K. plan sponsors have established defined contribution plans and another 13% say they expect to add a DC plan in the next two-to-three years. While DC plans currently hold a miniscule amount of pension assets just 4.3% of the U.K. total they are projected to account for roughly 20% of overall U.K. pension holdings within 10 years’ time.
The next step in this transformation is now beginning to unfold: Plan sponsors are rethinking the most basic tenets of final salary portfolio management. “U.K. plan sponsors make up the vanguard in a global movement toward portfolio-wide management strategies designed to tie final salary assets more closely to liabilities,” says William Wechsler, consultant at Greenwich Associates.
Greenwich Associates research suggests that, to date at least, U.K. plan sponsors have not considered the full ramification of the risk/return profiles associated with these new strategies. U.K. pension funds say they expect their investment portfolios to outperform the market by an average 118 basis points (bps) per year. U.K. corporations are especially aggressive in their outlook; they expect their investments to outperform the market by 124 bps each year. These expectations far exceed those reported by institutions in other countries. For example, in Continental Europe, where equity allocations remain low relative to those in the U.K., pension funds expect their portfolios to outperform by an average 88 bps.
“Frankly, we do not believe that the expectations of U.K. pensions are realistic,” Wechsler says. “In the United States, a very small share of institutions achieve 100 bps or more in annual alpha over a long-term horizon in their equity portfolios. The 118 bps expectation reported by plan sponsors in the United Kingdom includes many asset classes with less opportunity for alpha generation.”
Allocations to domestic equities by U.K. pension funds declined to 28.4% of total assets in 2006 from 32.0% in 2005. Since 2002, pension fund allocations to U.K. equities have fallen some 9.6%. These declines have been driven largely by cuts made by corporate plan sponsors, which have been prompted by mark-to-market accounting to try to reduce portfolio volatility. Overall allocations to fixed interest were essentially unchanged from 2005 to 2006. Likewise, allocations to alternative asset classes have not benefited to any meaningful extent from the reduction in equity exposure. Private equity allocations inched up to 1.3% in 2007 from 1.2% in 2006 while hedge funds allocations were flat at 1.1%. Looking ahead, among the more than 70% of U.K. pension plan sponsors that expect to make significant changes to their asset mixes in the next two years, one-third are planning to make substantial increases to their property allocations.