Engaged Investor

The Questions

A. Why has asset allocation become more important for trustees over the last few years?

B. How often should trustees review their asset allocation – and what should that review entail?

C. Are there any risks involved in changing a scheme’s asset allocation?

Simon Hill, Buck Consultants

A. A growing realisation that pursuing traditional long term asset strategies may be sub-optimal as economic correlations have fundamentally altered. Lower returns on traditional asset classes at a time when the requirements of meeting liabilities have risen sharply, increased volatility in the relationships between asset classes, the development of new alternative investment products and approaches, and the development of capital market solutions to end-game for DB pension funds. The deployment of new investment thinking for DC schemes.

B. Trustees should review their asset allocation relative to their investment strategy at least quarterly. The investment strategy should receive a high level review annually, with a thorough reappraisal at least every three years, or when major changes to the Scheme take place.

C. The main risk is of confusing short term tactical issues with medium or long term strategic thinking and of getting whip-sawed by volatility in the markets. There are also significant direct and indirect costs of changing asset allocation.

Paul Niven, F&C Investments

A. The asset allocation position of a pension fund has always been the most important consideration for trustees but recent years have seen an increasing recognition of this fact. Traditional approaches to asset allocation have advanced to incorporate a more explicit consideration of funding and matching of the future liability stream which individual funds face. This has led to greater use of financial instruments, such as swaps, in the matching component of the portfolio, designed to meet future liability cashflows and hedge interest rate risk. Aside from greater focus on effectiveness of the match on the portfolio, there has been a move towards greater diversification on those assets which are expected to deliver real returns over the medium term. Historically, trustees have often relied upon equity holdings to drive returns but a combination of factors have forced trustees to consider wider investment opportunities and to create portfolios which are more highly diversified and better designed to meet future obligations.

B. There is no set period over which it is appropriate for trustees to review asset allocation as they should seek to balance longer term objectives with shorter term considerations. Trustees should continually review whether their fund allocation is fit for purpose and whether available risk budget is being spent appropriately. This should involve detailed assessment of the liabilities matching approach and consideration of the risk budget available to be spent on generating real returns. Our view is that a balance should be struck between having a core diversified mix of assets on the return element of the portfolio, which will be expected to deliver real returns over the medium term, with a more dynamic approach.

C. There will always be risks and potential opportunity costs involved in altering asset allocation positions. It is vital that trustees understand and manage the target risk budget of their fund versus liabilities. More than this, trustees should have clarity on exactly how the risk budget is being spent.

Ken Tymms, Grove Corporate Pensions

A. The Pensions Regulator, via its Trustee Knowledge and Understanding (TKU) syllabus, requires trustees to demonstrate a thorough understanding of market and scheme related risks. This inevitably leads to a more scheme specific approach to asset allocation.

However, the real driver has been the move towards marking to market pension scheme assets and liabilities that has occurred over the last decade. This means that liabilities are increasingly valued by reference to current, rather than long term, market conditions, prompting a focus on short term volatility. Trustees must now have regard to the nature and structure of their liabilities and be able to take a view on the way that they behave together in a variety of future market conditions.

B. Review process and frequency will depend on the trustees’ objectives and how proactively and tactically they want to manage their investments. Logically, most trustees will want to review their asset allocation at least triennially alongside the valuation. The review should revisit the advice and methodology used to formulate strategy and consider how it worked in practice. Beyond that, review frequency will depend on appetite, time and resource to monitor short term market changes and make frequent adjustments to reflect tactical market views.

B. Yes, very much so. Every time investments are made, there are risks in the process: Is the advisory input and methodology sound? Will the manager pick the ‘right’ stocks? Will they produce the expected return?

When you’re changing asset allocation, the risks are repeated and added to by transaction risks. For example, are you selling and buying at a good point in the cycle for each asset class? What will the cost be if you’re investing overseas and there are adverse movements in exchange rates? How long will funds be ‘out of market’? All of these factors need to be considered, with advice and judgements recorded, each time an adjustment is made.

John Mulligan, World Gold Council

A. The importance of asset allocation should be clear from our article on page 47 ­– over the long term, asset allocation is key in meeting a pension scheme’s strategic investment objectives. At the World Gold Council, we stress the importance of strategic asset allocation and of diversification because we think the latter has been neglected, misunderstood or underestimated by many within pensions. Assets need to be understood in terms of their fundamental drivers and how these behave over time, and then an analysis needs to be made as to how assets ‘fit together’ as a portfolio and the probable profile of the portfolio over time and in different environments. We perform analyses both with and without gold to evaluate its impact on ‘optimal’ portfolio performance. The results show that, statistically, relatively small allocations can have a significant impact.

B. I am not qualified to give such advice and, even if I were, any guidance would need to consider many factors specific to each scheme. That said, I think there appears to be a general trend to more regular allocation reviews and most consultants and commentators perceive this as a positive move.

C. There are very few risk-free investments and therefore very few risk-free investment decisions. The key is to better understand the risk involved in any shift in asset allocation strategy. There are also many types of risk to consider when evaluating a specific asset or asset class and how an allocation to it might affect the overall risk profile of a scheme’s investment strategy. For example, we frequently argue that gold is fairly unique when compared to many other assets under the ‘alternatives’ umbrella – its volatility is lower than the majority of commodities, it is far more liquid than most commodities, and it offers a simplicity and transparency that is often lacking in many investment vehicles. It can also be proven to reduce risk inherent in a broader portfolio over time. More attention is now being given to the impact on investments of previously unforeseen events – gold represents a useful ‘insurance asset’ to reduce the risk associated with them.