How smaller schemes can optimise their investment portfolios

For smaller schemes, certain investments may well be inaccessible or unattractive.  

For the trustee board of a typical UK DB scheme, there are three key objectives when designing an optimal investment portfolio: 

Investment returns. The objective is to generate sufficient overall returns to beat the liability benchmark, typically the scheme’s discount rate used for the liability valuation. 

For underfunded schemes, the assets will need to generate additional returns to keep up with the growth asset outperformance assumed for the recovery plan. 

Risk levels. This aim is to maintain an overall level of risk commensurate with the strength of the employer covenant. 

This could be translated into assessing the likelihood of the employer having to increase cash injections by more than a defined amount, and this should be tested over a medium term with three-year checkpoints in between. 

Liquidity strategy. This objective is to formulate an explicit liquid strategy to ensure sufficient cash flow to pay pensioners and minimise selling at inopportune times. 

This has become increasingly important as DB schemes begin to mature rapidly. Selling at a low could materially impact overall returns.  

Before trying to improve their asset allocation, trustees should first identify what assets they are realistically willing to invest in, thereby creating a 'trustee-compatible universe' of assets. 

Identify your constraints 

Including assets in which trustees are unlikely to invest in will lead to suboptimal conclusions. It will also detract from the problem at hand. Similarly, dismissing certain asset classes outright could be very limiting. 

This is particularly true in a world where institutional investors continue their search for suitable assets for the purpose of diversification, yield enhancement or improved liability-matching qualities, so the competition is fierce. 

Ruling out asset classes too early can also lead to unintended consequences. 

According to a National Association of Pension Funds survey published in July 2013 there was a very notable difference in approach taken to equity allocations between the smallest and largest schemes.

The smaller schemes held half of their equities in UK investments, whereas bigger schemes invested about a quarter. 

Trustees will know they have arrived at an investment opportunity set which includes only trustee-compatible assets – those in line with the principles the trustees have adopted

The 2014 results from the Purple Book also support similar investment trends between small and large schemes. 

The implication is smaller schemes that do not access alternative asset classes, by default, take a relatively larger position in UK equities – mostly subconsciously, by virtue of not having found or considered appropriate alternative asset classes. 

While trustee boards that choose not to invest in more esoteric asset classes can sometimes be wrongly accused of not embracing ideas or being innovative, there are many valid reasons why some trustees just refuse to invest in certain asset classes.  

These include:

• Some investment funds lack the transparency trustees desire;

• The trustees feel the fee levels do not justify the potential performance and diversification benefit;

• Some investment funds are too complex to understand. 

Whether a trustee board invests in only mainstream asset classes or the most exotic investments, what makes a it effective is the approach it takes to get to the answer. 

If the trustee board has thought through its reasons and acted within the principles of its investment beliefs, it will reach the right solution for the scheme. 

Following this process, the trustees will know they have arrived at an investment opportunity set which includes only trustee-compatible assets – those in line with the principles the trustees have adopted. 

Identifying the investable universe that meets the trustees’ principles is important. But the universe is not static. 

Many market solutions were developed as a result of demand from large schemes before being adopted and widely rolled out by the industry. 

It is therefore important that schemes put in place a mechanism to review new developments in the marketplace. 

Celene Lee is a senior investment consultant at Buck Consultants