Where should tomorrow’s schemes allocate their assets?

Then-chancellor Gordon Brown had announced his vision of a future “built not on the shifting sands of boom and bust, but on the bedrock of prudent and wise economic management for the long term”. 

We’ll go back towards taking more investment risk and increase risk exposure to risk assets like equities, venture capital, illiquid assets

Ros Altmann, former pensions minister

Schemes brimming with equities began to reverse an historic decline in fixed income exposure. Alternatives emerged as an asset class. Liability management came to rival the industry’s hunger for returns. Environmental, social and governance evolved from an afterthought into a serious risk factor, and an investment opportunity.

Past performance is not an indicator of a return to old ways. Twenty years ago, not even our most prescient readers could have anticipated the investment challenges that face the industry today. In 2017, schemes must reconcile their investment responsibilities to their members with their duties to society. Finding yield in this environment is harder than ever before.

A return to equities?

In 1998, 21.7 per cent of UK equities were held by pension funds. Ten years on, this figure had dropped to 12.8 per cent. In 2014, it lay at 3 per cent.

This rotation out of UK equities is reflected in the historic progression of average pension fund asset allocation. Research by UBS Asset Management indicates that while an average of 53 per cent of scheme assets were made up of the asset class in 1997, funds held a mean exposure of just 16 per cent in UK equities in 2016.

Former pensions minister Ros Altmann is concerned by the industry’s departure from growth assets. She anticipates a return to equities.

“I would expect the pendulum to reverse,” she says. “We’ll go back towards taking more investment risk [and] increase risk exposure to risk assets like equities, venture capital, illiquid assets.”

Altmann sees increases in long-term interest rates as a catalyst for change.

“I think once rates start rising… you would normally expect that you would be wanting to move out of fixed income and have a different type of portfolio, because if rates are rising, they’re going to be inflating losses,” Altmann adds.

Ben Gold, head of investment consulting, north at Xafinity, expects investment strategies to instead adapt with a focus on liabilities, as the number of mature schemes grows.

“They’re starting to become cash flow negative. I think that will have a huge impact on investment strategy,” he says.

“Income-generating assets will become much more attractive and will drive strategy. Bonds, property, [there will be] less in the way of equities.” Gold predicts schemes will be less reliant on manager skill, but moots the possible return to favour of hedge funds.

Get on top of your liabilities

Swelling liabilities have forced a rethink in investment philosophy. Managing these liabilities now sits in a strategic trilemma alongside targets for capital growth and stable cash flows.

This trend began at the turn of the millennium when John Ralfe, then head of corporate finance at Boots, initiated a seismic change in investment thinking that saw his scheme adopt a radical liability-driven investment strategy.

Jonathan Crowther, head of UK LDI at Axa Investment Managers, says schemes will continue to invest in LDI “over the next five to 10 years”, owing to prolonged low interest rates on long-dated bonds.

Pension schemes were long exposed to a collapse in long-dated interest rates. A failure to respond to this risk resulted in soaring deficits when these rates eventually fell, according to Crowther. This attitude to rates will have to change, he argues.

“What you really cannot do is wait it out. If you want to wait it out you’ve got to have a very long time horizon and be prepared to experience potentially some quite strong mark-to-market pain,” he says.

It's time to invest responsibly

The appetite for responsible investment has surged over the past 20 years. The Investment Association’s data indicates that ESG funds under management rose from approximately £2bn in 1996 to circa £10.5bn in 2015.

Schemes are under pressure to invest in ESG and reconsider their involvement with so-called ‘sin stocks’.

Mark Fawcett, chief investment officer at Nest, identifies activist engagement as the sensible approach to ESG thinking over a blanket divestment policy. Nevertheless, Nest has excluded certain investments from its portfolio.

Cluster munitions, landmines and controversial weapons are off Nest’s radar. “Pure coal plays” and family-controlled companies are also screened out of certain underlying funds where they represent a particular risk factor.*

Fawcett identifies battery technology as a potential target for institutional investment. He predicts a rise in the costs of carbon emissions, which will demand alternative sources of energy and the means to harness renewables.

Engagement with companies that risk exposing themselves and their investors to ESG risks remains the most appropriate way to deliver performance through ESG activity, according to Fawcett.

“You can hassle management to improve and work on, for example, having a clear plan to shift to a low-carbon economy in case of environmental risk [and] social risk,” he says.

“If you just sell the shares, you’re basically selling to someone who may or may not care about these issues, and therefore you’re not going to improve the outcomes for members over the long term,” Fawcett adds.

Scott Thompson, head of institutional business at Impax Asset Management, views ESG engagement as essential to scheme management.

Schemes are responding to pressures from members and wider society.

Thompson says that funds are recognising that “the economy is going to go through a massive transition and is going to have to focus far more” on renewable sources of energy, and will have to build this outlook into their long-term investment strategies.

*This article has been updated since original publication to clarify that Nest excludes 'pure coal plays' and family-controlled companies only from certain underlying funds.