BlackRock's Justin Arter, Head of the Institutional Client Business for the UK, Middle East and Africa, and Andrew Stephens, Managing Director, UK Institutional Business, outlined the top five mistakes UK pension schemes are making and the actions that trustees can take to overcome these and get closer to meeting their funding objectives.
|
Too much focus on the micro, not macro
Two thirds of trustees spend five hours or less per quarter on investment matters, according to recent industry surveys and scheme trustees are not using this small amount of time to best effect. Many focus on the intricacies of investment decisions, such as which securities are held or which manager to select. They don’t look at the areas that are most likely to affect funding levels such as the overall asset allocation and the effect of changes in interest rates and inflation on their portfolio.
Trustees could improve their focus on the macro issues by relying more heavily on the input of their service providers (consultants, actuaries, asset managers) and indeed delegating some decisions where appropriate.
Not recalibrating investment strategies
Despite changing market conditions, liabilities increasing materially to £1.7tn[ii] and a relatively poor forward looking return environment, some pension schemes haven’t been reviewing their overall investment strategies.
Trustees should evaluate all of the options available to them, whether that be a deliberate decision to do nothing; consider different betas and exposures (e.g. smart beta, LDI) explore a greater allocation to active management; or capture the illiquidity premium, which can be well rewarded for long term investors.
Underestimating time horizons
Pension schemes are in a unique position because of their long term investment horizons, and the ability to tie up capital for long periods of time – typically 20-30 years. However, many are overly worried about illiquidity risk and as a result are underexposed to private market assets.
These less liquid asset classes can offer investors premia of up to 2% over public market equivalents by taking some illiquidity risk and many pensions schemes are able to do so.
Pension schemes will gain from realising that the challenges of investing in private market assets (e.g. additional governance) can be more than offset by the attractive yields and diversification benefits on offer.
Not managing the total risk profile
In 2007, pension schemes, in aggregate, were almost fully funded[iii]. Now, they are approximately £227bn in deficit. The primary cause of this fall in funding levels has been the fall in gilt yields and the commensurate rise in the value of liabilities. By paying attention to only one side of the balance sheet (the assets) and not considering how liabilities would be affected by market changes, pension schemes have been under hedged against changes in interest rates and inflation.
For pension schemes, interest rate risk and inflation risk are the same as any other investment risk, and should be evaluated by trustees in the same way. BlackRock estimates an average hedge ratio of 50 per cent, which suggests schemes’ largest investment bet is that interest and inflation rates will go up faster than the market expects.
Not evaluating advice regularly
In the UK, trustees are obliged to get advice. The quality of advice is a critical component of a scheme’s success in achieving full funding, as it drives everything from strategic asset allocation and governance structure to the smallest detail. Trustees should critically assess the focus and quality of the advice they receive. This should be regular and thorough, and provide the trustees with a transparent mechanism through which they can challenge the quality of the advice, such as an independent trustee.
|
