At a recent event hosted by Aviva Investors, industry experts considered three important issues facing the pensions industry: DC pension schemes investing in real assets; the pros and cons of outsourcing investment decisions to a third-party; and liquidity optimisation.
In his opening address at the Aviva Investors Pensions Summit, held in London on September 28, Aviva Investors’ chief executive Mark Versey said real assets, which represent more than half of the combined value of public and private market assets, offer valuable diversification benefits, as well as the ability to beat a common enemy facing investors - inflation. Versey went on to argue real assets give pension schemes a chance to better connect their members to the assets they own.
Noting the recent improvement in the funding position of UK defined-benefit (DB) pension schemes, Versey said the focus is increasingly turning to buyouts or self-sufficiency. In turn, more plan sponsors are making use of third-party investment management specialists, so-called outsourced chief investment officers (OCIOs). Versey questioned whether this model would be applicable to defined-contribution (DC) plans as well as other investor types.
With cash yielding high rates of interest, at least in absolute terms, it is no longer just a risk management tool or something to assist in repositioning portfolios, but an asset class in its own right. Versey said this, along with last year’s liability driven investment (LDI) crisis, meant schemes were paying much more attention to optimising cash balances.
Real assets and DC
The first panel discussion, “Considerations for DC plans investing in real assets”, focused on the potential impact of the changing UK regulatory landscape. The Financial Conduct Authority recently finalised rules relating to so-called Long-Term Asset Funds, or LTAFs. The new rules are designed to encourage investment in long-term, illiquid assets by open-ended fund structures, while offering appropriate structural safeguards. UK authorities hope investment in such funds will support economic growth and the transition to a low-carbon economy.
Laura Myers, head of DC at investment consultant Lane Clark & Peacock, said the introduction of LTAF rules was a “game changer” and had already started to shift behaviour, particularly of larger DC schemes.
“The LTAF has changed the ability (to invest) and we’re finally seeing schemes allocating and also saying that they're committing to these types of funds, particularly in the larger single trusts where we see most innovation,” she said.
Gregg McClymont, executive director at IFM Investors, a global asset manager owned by 17 Australian pension funds, was asked if there were any lessons to be learned from Australia, where pension schemes often allocate as much as 20 per cent of their assets to illiquid investments and private markets.
He said while there were some similarities between the two countries, there were also differences. For a start, the UK DC system is much more fragmented than its Australian counterpart. Moreover, Australian funds tend not to obsess about liquidity or daily pricing. He added while there are trigger mechanisms for more regular valuations if there is an extraordinary event, Australian schemes are comfortable with the idea of quarterly asset valuations. That quarterly price is then inputted into the overall daily calculation of a member’s fund value.
The introduction of LTAF rules was a game changer
“It’s actually a philosophical difference, as well as a technical one, that emerges from a different view of what DC pensions are, that they are more efficient when collectively managed,” McClymont said.
Allocating to unlisted investments was about long-term value enhancement, which means buying and holding assets, looking to increase their value over decades. For this reason, IFM only operates open-ended structures.
“That's been a successful way to invest, in terms of returns, good governance and contributing to a healthy economy,” he said.
Myers said in her conversations with trustees, issues such as liquidity management and member fairness remain high on the agenda. While DC scheme members are generally long-term investors, and should be comfortable investing in these assets, trustees and advisors need to do the modelling to ensure they are comfortable they have got a sensible, diversified allocation and fund structure.
She said while schemes would want to have a large enough allocation to illiquid assets to impact member outcomes in a meaningful way, equally there was a need to know that allocation was not going to significantly impact liquidity, especially in a time of crisis.
Say there's another global financial crisis again and all the contributions into the DC scheme stop, are we comfortable we can still have this amount in illiquid assets?
“If we think about things like liquidity, how much can we have in illiquid assets and still be comfortable if something happens. Say there's another global financial crisis again and all the contributions into the DC scheme stop, are we comfortable we can still have this amount in illiquid assets?” she asked.
Daniel Meehan, growth leader, retirement and superannuation at Link Group, said that in his previous role, trustees had strong views on the benefits of diversification, illiquidity premia and the investment opportunities presented by climate change.
“You package those things up together, all roads were leading to implementing private markets across the board into the portfolio,” he said.
McClymont argued high costs were another potential barrier to bigger allocations to illiquid assets. He noted a recent report by the government’s actuarial department (GAD) published with the Mansion House Compact, in which they stated greater investment in private equity would be in members’ interest, fees would have to halve.
“That’s obviously going to be a challenge in the UK… The Australian approach, which was to create a collective vehicle, is one option. The other option is the government creates a platform of its own to try and create scale. One way or another, scale will be needed to drive down those fees,” he said.
The pros and cons of the OCIO model
Speaking on the second panel, Dan Melley, UK commercial leader of investments for Mercer, and Sion Cole, managing director and head of UK OCIO for BlackRock, said while there are similarities between the service their respective organisations provide, there are also sizeable differences.
“We're both trying to solve similar investment problems, but there are important differences in structure – the consultant’s open-architecture platform versus the use of in-house asset management capabilities. There are different fee structures that come with those different models as well,” Melley said.
Cole agreed, saying that while both consultants and asset managers such as Blackrock were trying to solve the same issue in terms of governance - trying to get a DB scheme fully funded and possibly through to buyout - the historical nature of these organisations is quite different.
He said this influences the type of solution provided by each type of organisation. While both offer similar solutions, they have expertise in different areas.
“As an asset manager, we're very close to the investment landscape; investing and risk management is inherent in our DNA. As Dan mentioned, on the consultant side, open architecture is inherent in their DNA,” Cole said.
The panellists identified several factors that continue to make OCIOs attractive to different types of investment organisations. Cole said cost had been a big driver, particularly for larger schemes. For instance, schemes that until recently might have been looking to generate growth are now looking for income-type assets, which means the investment expertise of their in-house investment teams may need to evolve. Rather than changing their in-house investment team, a more practical solution is to outsource.
It's hard to argue that outsourcing isn't a sensible thing to do
“Our OCIO clients have been able to get the outcome they want in terms of transitioning their assets, bringing the necessary investment expertise in and lowering cost. It's hard to argue that outsourcing isn't a sensible thing to do,” Cole said.
His argument was backed up by Chris Hogg, chief executive of National Grid plc’s pensions unit, who said it became progressively harder to justify employing investment managers as schemes mature.
“Moreover, if you compare having maybe one or two managers to the resources you see in some of the OCIO providers where you're talking maybe 200 to 300 research managers across the globe, there’s no comparison,” he said.
As for Melley, he said some of the “complexities of the investments that have been put in place” by DB schemes had made trustees’ jobs more difficult.
“There are a certain number of things that need to be done as a pension scheme. And if you don't have those resources and expertise yourself, you need to find them somewhere. That’s the argument for any outsourcing, but it's acute here,” he said.
Hogg said his scheme had outsourced to Russell Investments, primarily to enable senior stakeholders to focus on more strategic matters. That followed a significant governance review.
“One of the challenges we'd had was the trustee was really in the weeds. If you try and get into the detail as a trustee on every topic, you can't do your job because there's not enough time,” Hogg explained.
Melley argued more firms were questioning why they had in-house investment teams
Melley argued more firms were questioning why they had in-house investment teams, especially where a scheme’s funding position had improved.
“If there are ongoing human resource benefits to your employees, maybe you can justify that. But if it's for legacy employees and the plan is closed, you really have to ask yourself what that is doing within your organisation,” he said.
Both he and Cole said while DB schemes continued to outsource investment decision making to companies such as theirs, growth was starting to come from other types of clients.
“If I look at the new business enquiries we have right now, more and more are outside of UK DB, in channels such as wealth, insurance, charities and endowments,” Cole said.
In terms of the potential drawbacks of employing an OCIO, Hogg said reversing a decision was not as straightforward as terminating an underperforming asset manager. For that reason, it is vital schemes work out and are very clear about their needs so that both sides have a detailed understanding of the mandate.
However, both Cole and Melley argued it was not as difficult as some envisaged to make a change.
“If I were appointing an OCIO provider, I’d like to know that this is something I’m not locked into. From an OCIO provider’s perspective, it is not as difficult as you think to revert back to investment advisory if it’s not working for the scheme,” Cole said.
Liquidity optimisation post-LDI
Introducing the third panel, Alistair Sewell, liquidity strategist at Aviva Investors, said all client types were increasingly focused on liquidity. He asked the panellists what are the primary factors they are considering when determining the amount of liquidity required.
Natalie Winterfrost, director at Law Debenture Pension Trust Corporation and a professional trustee, said the people managing schemes had learnt following the fallout from the UK mini-budget fiasco just how much cash might be needed at short notice.
She said whereas she previously was happy to run portfolios with as much as four times leverage, being resilient to changes in interest rates is now much more of a focus.
I have different consultants telling me different things. Some are pushing to make sure we've got cover should rates move by as much as 700 basis points (bps)
“I have different consultants telling me different things. Some are pushing to make sure we've got cover should rates move by as much as 700 basis points (bps). That can be a problem where you held a reasonable allocation to illiquid assets,” she said.
She argued while cash might increasingly be being talked about as an asset class, following the rise in cash yields in 2023, that is not necessarily the case for pension funds. For pension funds using LDI, the primary role of cash remains as derivative collateral. Gilts are the mainstay of pension fund liquidity pools, although some will use other types of assets that can be quickly and easily accessed.
Niren Patel, head of LDI at Aviva investors, said while it was natural schemes want to hold more cash as a buffer against a repeat of the LDI market turmoil of last autumn, there was a cost to this.
“Holding buffers for a 700bps move in yields is huge. Whilst it clearly could happen, if you’re holding cash to cover yourself against it happening every day of the week, it feels like there’s a missed opportunity because you could be getting paid to put that cash to work, even for one or two days,” he said.
Ben Clissold, Head of fixed income, treasury and trading at the Universities Superannuation Scheme, said while he faced somewhat different challenges, the important thing from his perspective was to understand collateral requirements and liquidity provision and make sure those are both well diversified.
“We work very hard on making sure the derivatives contracts we run meet our needs. In some cases, we may want extra liquidity because we have cash requirements for initial margin and variation margin. But we also trade over-the-counter derivatives to enable us to post government bonds and sometimes even corporate bonds as collateral,” he said.
He said pension schemes with high dollar asset exposure hedged to sterling would have found last year’s plunge in the value of the pound problematic.
“If you’re losing money on your hedges, there’s cash going out of the door, and you’ve got to be able to fund that. While you may be making money on your dollar assets, it’s pretty tricky to pay for your foreign exchange hedge if you've got to sell a stake in a toll road in Illinois,” he said.
By contrast, with significant liquid US equity and government bond assets, and having the ability to use equity futures to raise cash and to repo its government bond portfolio, meant USS did not face such problems.
In terms of the composition of schemes’ liquidity pools, all three panellists agreed on the need for diversification.
In terms of the composition of schemes’ liquidity pools, all three panellists agreed on the need for diversification
“It should be a broad mix because you do not want to tie up everything. Well, maybe you do if you're well-enough funded. But most of my schemes, even if they are fully funded, they're only fully funded if they can achieve their assumed level of return,” said Winterfrost.
However, she warned schemes needed to be cautious given the risks of market liquidity suddenly drying up in a crisis. For instance, while it might make sense to have an allocation to corporate bonds for the yield pick-up, it was important to understand just how much liquidity that might provide.
“We learned this in the last crisis; the last thing you want to be doing is trying to sell into a difficult market when a lot of other schemes are doing the same thing,” she said.
For Clissold, the important thing was to layer assets, so the fund had the right amount of liquidity over any given period. He said a large percentage of his scheme’s assets are in private markets.
“We've been pleasantly surprised by how liquid private markets have been, when you aren’t a distressed seller and can take your time as you aren’t liquidity constrained” he said.
Patel agreed the diversity of assets within a liquidity portfolio was a key consideration. It was also important to consider each asset class’s investor base.
“If I think back to a year ago when the sterling credit market convulsed, we were helped by the fact we were also trying to sell Japanese government bonds. They’ve got a wider investor base, without the concentration of investors looking to do the same thing, making it far easier to sell them.”
The investor base matters not only at an asset level but also at a fund level. The panel noted that a liquidity fund with a diverse investor base would be more resilient to shocks than a fund with a narrow investor base. This can be an important consideration for pension schemes looking to use a liquidity fund as part of their liquidity pool.
Sewell summarised the panel with a single word: “deliquescence”, the chemical process by which a solid absorbs moisture form the air to become liquid. He pointed out that optimal liquidity pools need to have the right combination of ingredients and understanding of the chemistry of markets to ensure liquidity can be delivered at the point of need.
