Asset Management Pension Fund Indicators 2012 A long-term perspective on pension fund investment For Professional Clients only Pension Fund Indicators 2012 Production editor and enquiries Ben Lloyd, telephone 020 7901 6263 Media enquiries Telephone 020 7568 9982 Contributors Agnes Bartha (Performance measurement and data) Ben Lloyd (UK pension assets, Asset allocation and Alternative sources of return) Bernard Hunter (Bonds) Bronte Somes (Infrastructure and Private Equity) Dan Edelman (Hedge Funds) David Roberts (Real Estate) Ian Barnes (Current thinking in UK pensions) Ian Howard (Performance measurement and data) James Collyer (Equities) Kevin Barker (Equities) Liz Troni (Real Estate) Mark Deans (Risk measurement and Derivatives) Matt Bance (Global tactical asset allocation and Currency) Neil Olympio (Asset allocation in the presence of liabilities) Paul Moy (Infrastructure and Private Equity) Stephan Schnuerer (Infrastructure and Private Equity) Uta Fehm (Bonds) © UBS 2012 The key symbol and UBS are among the registered and unregistered trademarks of UBS All rights reserved July 2012 Crown copyright material (sourced as “National Statistics”) is reproduced under the terms of the Open Government Licence from HMSO/National Archives While every care has been taken in the compilation of the data in this book, neither UBS Global Asset Management (UK) Ltd nor any of the other data sources quoted will be liable for any consequences arising from the inclusion of inaccurate data Some historic data may no longer be available from the original sources but is reproduced from earlier editions of Pension Fund Indicators Pension Fund Indicators 2012 Foreword Our aim with Pension Fund Indicators is to deliver to our readership an objective and educational source of investment data and practical explanations, covering the range of investments available to pension funds and the various techniques for combining them In this Olympic and Diamond Jubilee year, it is with great pleasure that we celebrate a milestone of our own: the latest edition of Pension Fund Indicators, now in its 40th year The first edition, released in 1973, focussed solely on UK equity and gilt markets Today we cover the broad spectrum of asset classes utilised by occupational self-administered pension schemes which, we estimate have total assets in excess of GBP trillion (see figure A.5) Whilst somewhat clichéd, it is true to say that change is the only constant Over the years, the publication has sought to draw in new topics: 1978 saw overseas investment and property merit their own chapters for the first time At one point, alternatives only commanded one page and it wasn’t until 2000 that this chapter was significantly expanded Today, alternatives are covered extensively in Chapter In this edition, we have maintained our topical chapter, ‘Current thinking in UK pensions’ (Chapter 1) This looks at some of the recent trends and news in the UK pensions industry and sets them in their longer term context Turning to global markets, 2011 saw a return of some of the volatility experienced during the extreme financial events of 2008 and 2009 This came after the somewhat relative calm of 2010 The key driver of equity markets was macro news flow and the ensuing gyration between ‘risk on’ and ‘risk off’ behaviour The eurozone sovereign debt crisis dominated headlines while investors shunned ‘risk’ assets, such as equities, in favour of perceived safe havens In this extremely volatile environment, world equity markets returned -6.2% (as measured by the MSCI AC World Index in Sterling terms) despite a strong finish to the year Recession, coupled with the sovereign debt crisis, means that market uncertainty – and thus volatility – looks set to linger This volatility is borne out in the figures showing the aggregate funding position of corporate pension schemes in the UK Based on the PPF-7800 Index, the aggregate position went from a surplus of GBP 21.7 billion to end the year with a deficit of GBP 255.2 billion during 2011 2012 and beyond brings with it many challenges for pension schemes There is no doubt that many schemes will continue to look at diversification, as well as seeking out new sources of alpha and improved risk management 2012 also heralds the ‘go-live’ of auto-enrolment Set against the backdrop of just 19% of Defined Benefit schemes in the UK remaining open to new members in 2011, compared from 23% in 2009, alternative arrangements for individuals saving for retirement are even more pressing During these challenging times, we hope that this publication provides you with some informative facts and valuable insights, which you are able to draw upon when thinking about your pension fund investment strategy Ian Barnes Head of UK & Ireland UBS Global Asset Management July 2012 Contents Current thinking in UK pensions Asset allocation in the presence of liabilities The focus on liabilities 2011 - a challenging year for maintaining funding ratios The implications for sponsors and trustees A failure of asset allocation? A failure of risk management A new metric Structuring investment policy Asset liability investment solutions Liability hedging strategies Return generating strategies Dynamic risk management Reducing/eliminating longevity risk Implementation considerations When to hedge liabilities? Return generation – the role of derivatives Looking ahead 11 Equities Introduction Equity characteristics What is an equity? Uncertain long-term returns Volatility Diversification Sensitivity to interest rates and inflation Equity valuation Equity markets The global equity market Emerging market equities Equity management Approaches Active management Style Value Growth Momentum Small company equity Unconstrained equity investment Short extension or 130/30 funds Active quantitative techniques Passive equity Corporate governance and socially responsible investment How suitable are equities for pension funds? 21 Bonds What is a bond? Who issues bonds? Credit risk and the growing importance of non-government bonds The global bond market Some important bond terminology Pension fund allocation to bonds Emerging market bonds 41 Pension Fund Indicators 2012 Real Estate What is real estate? Gaining exposure to real estate Real estate derivatives Key benefits and challenges of investing in real estate Global real estate investment The UK and European real estate markets Market performance Differences in market practices Commercial real estate sectors The US real estate market Market performance Commercial real estate sectors The Asia Pacific real estate market Market performance Within-region diversification benefits Growth of Asia Pacific real estate markets 53 Alternative sources of return What are suitable alternative investments? Hedge funds Hedge fund strategies Performance Private equity Private equity as an asset class Private equity investment characteristics Increasing investor interest The private equity industry in 2011 The private equity market in 2012 Infrastructure A defensive component in portfolios can enhance long-term overall returns Defining infrastructure assets Infrastructure as an asset class How does infrastructure compare with other asset classes? Risks Investing in infrastructure Key attributes of best-in-class infrastructure managers Key issues in 2012 and beyond Global tactical asset allocation Currency How does currency affect returns? Equilibrium risk and return Currency effects in non-equilibrium conditions The case for dynamic management Separation of currency investment decision Gold Commodities Art 67 Appendices A - UK pension assets B - Asset allocation - the historical perspective C - Risk measurement D - Derivatives E - Performance measurement F - List of tables and graphs 92 95 106 112 117 121 Current thinking in UK pensions Current thinking in uk pensions Over the past 39 years that we have been publishing Pension Fund Indicators, the various authors of this chapter have commented on the many trends and challenges that the UK pension market has faced Sometimes the tone has been upbeat and optimistic, other times more sombre and introspective Unfortunately, the subject of this chapter for this edition is possibly the most challenging that UK pension schemes have ever had to face, as it deals with the breakdown of a fundamental relationship between asset returns and inflation Whilst this topic may be dry (unlike the start of summer 2012), it is no less important than the other topics that have been featured in previous editions Preaching to the converted? Pension funds the world over have become converts of the asset-liability study, the process by which the expected returns from the mix of assets held is linked to the expected growth of a pension scheme’s liabilities Key to these studies is the data input on the expected returns of different asset classes To be consistent with certain truisms about capital markets (such as “over the long-term the return on capital must exceed the cost of capital”), these expected returns are usually built up from an assumed risk-free rate of return (or cash) plus a risk premium which varies from asset class to asset class So, the higher the perceived risk of the asset, the higher the size of the risk premium to act as compensation Looking at a real world example, equities are deemed more risky than bonds, and so the equity risk premium is higher than the bond risk premium For pension funds, managing interest rate and inflation exposures remains a core objective Therefore, the goal of the asset-liability study is to find a mix of asset classes where the combined risk premia from these assets will exceed inflation by a certain margin in order to keep the cost of meeting those liabilities relatively manageable The cash coming in must match the cash going out A typical pension fund will aim to beat inflation by about 3% Under normal market conditions, the risk-free rate is expected to exceed the prevailing rate of inflation by a modest amount Usually the size of the risk premium required to achieve inflation plus 3% will be somewhere between the risk premium for equities and the risk premium for bonds, hence most pension funds have a mix of these two basic asset classes The importance of these two main asset classes for pension funds over a 49 year period is shown in Figure 1.1 It is interesting to see how the asset allocation of the average pension fund has changed over this time period Exposure to bonds and equities still dominate, yet there are a number of interesting themes: • Reduction in exposure to UK equities, with a larger exposure to global equities • Fixed income exposure hit a low in the 90’s and whilst bigger now, a significant portion is in Index-Linked Gilts • The exposure to alternatives, non-existent in the 1960’s, 70’s, 80’s and most of the 90’s has seen a general increase from 2005 on Despite these changing asset mixes, the overall inflationbeating objective still remains So far, so good Well, much like the unpredictable nature of the weather, when markets not behave like they are meant to, what happens then? Surely the return differential between the cash rate and inflation is relatively stable? Actually, no, and this is the root of the significant challenge facing UK pension schemes in 2012 and for the foreseeable future The real rate challenge One of the biggest investment problems that pension funds face in the current climate is the magnitude of negative real short rates In other words, the short-term interest rate is too low and is actually below the prevailing rate of inflation By drawing in data from across our investment teams, our analysis indicates that the risk premium for equities should be about 3.75%, and for government bonds about 1% Whilst the current risk-free rate yields only 0.5%, an expectation for the total return to equities is about 4.25% Clearly then, it is difficult to exceed an inflation rate of around 3% (at the time of writing) by any significant margin, and certainly a return of inflation plus 3% is very difficult to achieve A government can shrink its fiscal deficit by allowing inflation to erode the debt away Although not an explicit policy objective of the Bank of England’s Monetary Policy Committee, the inflation and interest data over the last few years would appear to suggest that such a plan is being followed This means that it is possible that negative real rates could persist for some time to come Indeed the indexlinked bond market is forecasting that real short rates will remain negative for the next seven years To put this into perspective, in ‘normal’ circumstances we would expect the short-term interest rate to be some 2.4% higher than the inflation rate What about timing issues? Of course it is possible that a better outcome than this expected return might be achieved in equity markets This could come to pass if equities start from an undervalued position Regrettably, by our measures at least, global equities are not particularly cheap at the current time (with the exception of European equities, and we all know why this is the case) Pension Fund Indicators 2012 Figure 1.1 Asset allocation – average pension fund, 1962-2011 100% 80% 60% 40% 20% 0% 1962 UK equities 1969 Overseas equities 1976 UK fixed income 1983 Overseas fixed income 1990 Cash Real estate 1997 2004 Index-linked gilts Alternatives 2011 Source: National Statistics (until 1995), WM (1996 onwards) As at December 2011 Furthermore, there would appear to be many reasons why UK equity prices may suffer downward pressure in the coming years: • Solvency II in the insurance world is likely to make insurance companies sellers of equities • Defined Benefit pension schemes will continue to close and mature, with an associated shift out of equities into matching assets • The Retail Distribution Review (RDR) in the UK and other similar reviews elsewhere in Europe will ban the payment of commission to financial advisors Retail investors who want advice will now have to pay up-front fees for this advice, which is likely to shrink the population of investors taking advice In the absence of advice, it has been shown that people on average tend to be overly conservative and so we expect greater retail flows into money-market and guaranteed products rather than equity-oriented, growth products • Finally, given lack-lustre equity returns over the past decade or so in many developed markets, often referred to as the lost decade for equities, you may also see a whole generation of retail investors put off ever buying equities again In our view these pressures are a good reason not to count on unusually high equity returns in the coming years – however they are not reasons to despair! As various countries around the world come out of recession over the next few years, this is usually the environment where equities best These two factors are likely to balance each, leading us to predict equity returns within normal bands between now and the end of the decade Current thinking in UK pensions Figure 1.2 Asset allocation – average pension fund, 1962-2011 (%) End UK Eq Cash RE 51 51 50 2 2 1 48 49 45 36 2 5 52 50 56 57 2 36 34 31 25 10 1973 1974 1975 1976 48 34 45 44 4 5 26 27 26 28 16 14 19 15 16 1977 1978 1979 1980 45 45 45 46 5 28 28 26 25 6 17 16 17 17 1981 1982 1983 1984 45 44 45 49 10 12 15 14 21 22 20 17 3 4 4 18 15 13 12 1985 1986 1987 1988 51 53 54 52 14 16 13 16 17 14 14 12 3 3 1 1 11 10 10 1989 1990 1991 1992 52 52 55 56 20 18 20 21 8 3 3 2 3 4 10 1993 1994 1995 1996 57 54 55 53 24 23 22 22 6 5 3 4 5 5 1997 1998 1999 2000 53 51 51 48 20 20 24 23 9 10 6 4 3 5 1 1 2001 2002 2003 2004 46 39 39 37 25 25 28 29 10 13 12 13 9 3 2 7 1 1 2005 2006 2007 2008 33 32 26 21 32 32 31 28 13 12 15 17 9 11 13 4 2 7 7 2009 2010 2011 23 21 18 28 29 25 17 16 18 13 14 17 4 2 6 7 1962 1963 1964 1965 1966 1967 1968 47 43 47 54 1969 1970 1971 1972 OS Eq 47 45 46 UK FI ILG OS FI Source: National Statistics (until 1995), WM (1996 onwards) UK Eq= UK Equities OS Eq= Overseas Equities UK FI= UK Fixed Income ILG= Index-linked Gilts OS FI= Overseas Fixed Income Cash= Cash RE = Real Estate Alt= Alternatives Alt So what are pension schemes doing? As has been the case for some years, a number of existing themes for pension funds continue to play out As we spoke about earlier in this chapter, the move out of equities and in particular UK equities in favour of fixed income assets continues While pension funds’ exposure to overseas equities is higher than that to UK equities, exposure to this asset class has also fallen, from a peak of 32% in 2005/06, to 25%, a level last seen in 2001 The focus of schemes on their liabilities remains key There is also continued interest in absolute/total return strategies as well as alternative asset classes As can be seen in Figure 1.2, pension funds exposure to alternatives has been increasing steadily Indeed, some of the alternative asset classes that pension funds have been considering would also appear to have many of the same attributes as equities and bonds Private equity, for example, is also a claim on future cash flows derived from corporate profits The difference is that, unlike traditional equity investments, these companies are not publicly listed and so the investment is relatively illiquid and there should be a premium paid to the investor for this liquidity In a low interest rate environment, the need for income is key In the final section of this chapter, we cover the increasing demand for income from DB and DC pension assets As DB schemes increasingly mature, and as annuity rates remain challenging for those retiring who derive the bulk of their pension assets from a DC scheme, more and more people are looking at drawdown rather than annuitisation As a consequence, the demand for income generation from pension schemes is increasing Most schemes address this income need (at least initially) by stripping the dividend flow from their equity investments This is all well and good when your expected returns are above your inflation plus target Now that returns are severely challenged, stripping such income out simply lowers the total return on these equities to an unacceptably low level If you are not reinvesting dividends, you are not earning a return on those dividends and so your compounded return drops Figure 1.3 shows the impact on returns of the FTSE ALL-Share with income reinvested and not Pension Fund Indicators 2012 Figure 1.3 Value of GBP 100 invested in FTSE All-Share 1,200 1,000 GBP 800 600 400 200 1985 1990 FTSE All-Share CR 1995 2000 2005 2010 FTSE All-Share TR Source: Lipper Data based in Sterling terms to 31 May 2012 CR= capital return with income paid out TR= Total return with income reinvested Rather than these simple and naïve income mechanisms, what is required is a more fundamental investment programme engineered to generate income in a more appropriate way The market has few such products at the moment and we encourage the industry to concentrate on developing solutions for this problem, else a bad situation will be made worse As the challenging market conditions we face at the time of writing look set to continue, more will be written about the cost and most appropriate way of providing pension provision for all in society As we mentioned in the Foreword and as the British weather has shown, change is the only constant and the need to be flexible and alert, is key UBS Global Asset Management About us UBS Global Asset Management, a business division of UBS, is one of the world’s leading asset managers, providing a diverse range of traditional, alternative, real estate and infrastructure solutions to private clients, financial intermediaries and institutional investors worldwide Our aim is to deliver consistent, long-term investment results to our clients from distinctive and innovative products and services Invested assets totalled GBP 394 billion as at 31 December 2011, with around 56% for institutional clients, making us one of the largest global institutional asset managers We offer a wide range of investment products and services from boutique-like capabilities delivered through a global 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Indicators is to deliver to our readership an objective and educational source of investment data and practical explanations, covering the range of investments available to pension funds and the... fund allocation to bonds Emerging market bonds 41 Pension Fund Indicators 2012 Real Estate What is real estate? Gaining exposure to real estate Real estate derivatives Key benefits and challenges