As private investors, we are constantly having our expectations managed. We are reminded to ‘think long-term’, to ‘extend our investment horizons’ and to ‘ride the peaks and weather the troughs’. Not only does this reflect the fundamental nature of investment markets, it also highlights the fact that precious few investment managers can lay claim to anything resembling consistent, long-term outperformance. With this in mind, it is of some significance that the UK’s largest private pension fund, the BT Pension Scheme (BTPS), recently announced 10 years of consistent outperformance.

The BTPS, the bulk of whose assets are managed by Hermes Pensions Management (Hermes), notched up a 12.7% return during 2006, compared to a benchmark return of 11.3%. This excess return similarly closed out a decade of outperformance over which time the BTPS has averaged a return of 9.3% compared with a benchmark gain of 8.9%¹.

By any measure, such a protracted run of consistent outperformance is exceptional, but it is particularly so when considered against the volatile environment of the early decade. Global equity markets slumped in the wake of the dot.com bubble collapse, the extent of which is reflected in the performance of the MSCI World Equity Index, which posted -7.1%, -13.7% and -26.8% losses in 2000, 2001, and 2002, respectively² .

These were dark days indeed for UK pension funds, as defined benefit (DB) schemes first saw their asset-to-liability ratios slip into deficit, and then stood by helplessly as these deficits ballooned toward crisis levels. The importance of robust investment performance during this period is immeasurable, particularly as legislation and increased regulation means funds now face even greater pressure in trying to bridge their deficit gaps.

Pension deficits narrowing
The poor performance of the early decade, as well as steadily increasing human longevity, means that a number of UK pension funds are still struggling with under funded scheme positions. Certainly the performance turnaround in global equities and property in particular in recent years has been nothing short of stellar, considerably boosting overall scheme returns and, in turn, narrowing fund deficits.

In 2006 for example, overall DB scheme funding levels improved around 6%, rising from 81% to 87% at the close of 2006³. And at the end of January 2007, the Watson Wyatt Pension Deficit Index indicated the industry’s deficit stood at £31.8bn, its lowest level since minimum funding was introduced in 2002. This represents a major turnaround from March 2003 when, at its highest point, the pension funding deficit had blown out to £90bn.

Matching longevity is the key
While such shrinking numbers are hugely encouraging, the issue of matching increasing longevity remains the key consideration for pension schemes. The difficulty in accurately predicting mortality rates is highlighted in a recent survey by leading UK actuarial consultancy, Lane, Clark & Peacock⁴ . They found significant variance in the assumptions adopted within the 37 FTSE 100 companies producing longevity assumptions to calculate their deficit gap.

The odd year or so of difference between calculations may seem trivial, yet the Lane Clark & Peacock survey estimated that the difference between the highest and lowest mortality assumptions is equivalent to more than 10% of the accounting liabilities or an aggregate deficit of around £40 billion across the FTSE 100 companies. Similarly, a 2007 article by Ted Clack, Annuities Director at Prudential, determined that each year of extra life assumption, adds approximately 3% to a pension schemes liabilities⁵.

The shift to alternatives
Significantly, Hermes attributes a great deal of BTPS’ performance success over the past decade, to a marked shift towards alternative asset classes. A greater focus on newer market areas such as hedge funds, commodities, private equity and tactical asset allocation, reflects Hermes’ aim of diversifying the BTPS investment strategy, enabling better risk management and enhanced long-term performance.

The imperative to generate consistent returns in order to reduce liability deficits is prompting similar trends across the wider DB fund environment. More and more schemes are moving money out of traditional asset classes, in favour of meaningful allocations into alternative asset classes. In their 2007 report, Mercer Investment Consulting surveyed 493 UK pension funds⁶ , highlighting trends in UK DB scheme asset allocation. Their findings included:

• Equity exposure continued to reduce, easing from 62% to 61% during 2006.
• Domestic equity allocations reduced from 57% to 53% during 2006
• International equities preferred to domestic, fund allocations rising 3% in 2006.
• The average fund allocation to bonds in 2006 was 36%.
• Property is the most popular ‘alternative’ to equities and bonds, with 20% of all funds having some allocation.
• Other popular alternatives show 8% of funds employ active currency strategies and 6% invest in hedge funds
• Increasing use of swap overlays and fund-specific benchmarks for bond mandates, with 10% of funds either using or considering each strategy.
• 10% of respondents showed interest in adding exposure to fund of hedge funds, active currency and global tactical asset allocation.

Further evidence of the gradually shifting mindset of scheme trustees, away from a concentration on domestic equities in particular, and toward assets providing alternative sources of premium, is provided by a 2006 Watson Wyatt UK survey⁷. The study, charted below, compared the number of searches conducted on behalf of institutional fund clients, including pension schemes, between 2001 and 2005.

UK Institutional Asset Selection Searches 2001 - 2005

UK Institutional Fund Alternative Investment Allocation

The same Watson Wyatt survey goes on to provide a more specific insight into the growing interest and activity within the alternatives domain.

‘Knowledge Gap’ a possible hindrance
One of the issues frequently cited as stunting the wider development and implementation of alternatives by pension schemes, is a general reluctance on the part of pension fund trustees - be it due to over cautiousness or simply through a lack of understanding or knowledge gap. Whatever the reason, matching the expectations of members, the employer and the scheme trustees has never been an easy task, as it involves marrying different aims, knowledge bases and risk tolerances. The expanding range of investment options and the need for innovation in strategy, has only added to the complexity of this relationship.

The primary concern of trustees for example, rests with the interests of the scheme members and as such, security is the key consideration. The emergence of new and complex vehicles such as derivatives, commodities, liability driven investments and private equity, have further added to the burden of knowledge and understanding expected of trustees. It is hardly surprising then, to find that the general reaction by scheme trustees has been to thus far, err on the side of caution when considering alternative investments.

In a 2006 co-sponsored survey entitled ‘Tomorrow’s Products for Tomorrow’s Clients’⁸, a group of pension scheme sponsors/trustees were asked the question: Out of a list of 20 ‘new’ asset classes, which Top 5 will be most suited to meet the needs of DB plan sponsors over the next 5 years? The responses were as follows:

DB Scheme Sponsors/Trustees Survey Responses

Asset Manager's Survey Responses

At the same time, a group of asset managers were asked the same question and responded in the following way:

The indication provided by these results is that, as one would expect, asset managers are clearly more familiar with the technical workings of alternative asset classes. While at the same time, scheme trustees tend to focus on and select ‘safer’ investment options that they are more familiar with. This is not to say that there aren’t examples of trustees taking the lead in facilitating and supporting new avenues of investment. The BTPS trustees’ support of Hermes increasing investment into alternative assets is a perfect example, and has been a key factor in driving the outperformance generated for the scheme over the past decade (see table below). Elsewhere, trustees at BAe and M&S have encouraged investment into their sponsors’ property portfolio, while those at WH Smith took a strong lead in facilitating the early development of the schemes’ liability driven investment (LDI) strategy.

BT Pension Scheme Strategic benchmark asset allocation⁹

In the end, if DB schemes are to be successful – meeting the needs and expectations of both sponsors and members – they need to be better able to absorb the impact of market downturns, and dextrous enough to adapt to changing market and company circumstances. Hermes and the BTPS have been quick to understand and embrace the importance of asset diversity in meeting stubbornly high liability levels, while at the same time, reducing the overall risk of the portfolio. Ten years of outperformance says the strategy is working.

In 2006, of schemes surveyed:

• 50% added property exposure
• 17% added hedge fund exposure
• 11% added global TAA exposure
• 11% added some form of Liability Driven Investment (LDI) strategy

Aon Consulting survey of 150 UK DB schemes (Nov 06—Feb 07)