When thinking about portfolio construction, we often fall into thinking that the ‘best’ investment strategy for a pension scheme is the one with the highest return for a given unit of risk.
In reality, particularly when constructing portfolios for schemes in difficulty, there are other factors to consider in addition to risk and return. These can be investment considerations that do not show up in simple risk and return metrics, as well as operational and liquidity needs.
While these factors might not seem as immediately important as the overall risk and return profile, it is crucial to consider them, as they will determine whether your investment portfolio really works for you in practice.
Investment considerations beyond risk and return
There are always several different investment portfolios that can achieve a given risk/return combination. A classic example is a diversified approach compared to a more contractually orientated approach. Either portfolio can usually be constructed to yield similar overall risk/return profiles. However, the portfolios will generate quite different liquidity and cash flow profiles, which may each suit different schemes at different stages of their journey.
Most pension schemes will also need to implement a Responsible Investing policy. Again, you can almost certainly create a portfolio with a Responsible Investing tilt that has a similar overall risk/return profile to a classic investment portfolio, but with the added benefit of ESG and climate change risk mitigation.
There could be other parameters to consider as well – e.g. whether you prefer to skew your investment risk towards broader market-driven risks (beta), or more toward active management risk (alpha) with a higher degree of delegation of decision-making to asset managers.
Liquidity requirements
Often overlooked when constructing a portfolio, a pension scheme’s liquidity requirements are vital operational considerations that can put strains on cashflows.
While pension schemes are nominally long-term investors, they often have a surprising need for liquidity and flexibility in the short to medium term. This means that understanding these needs and how they may evolve is key to portfolio construction:
Managing collateral for your LDI/hedging portfolio – With interest rates at historically low levels, the potential for rates to rise should be on a trustee board’s radar. Any rise would create a collateral call on a leveraged LDI portfolio, potentially forcing the sale of assets to meet a demand for cash. While rising interest rates are in essence a positive for schemes due to their liability-reducing qualities, dealing with them requires careful planning to minimise the risk of selling the wrong growth assets at the wrong time. This can be done by creating collateral “waterfalls” of liquid and diversified growth assets, and potentially managing the operational risk by delegating the process to the LDI manager.
For schemes running a significant LDI portfolio, making small operational tweaks to your collateral process can also help achieve more “bang for your buck”. This could include allowing your LDI manager to use third party funds as a collateral source and increasing the frequency of re-balancing, with excess collateral being allocated to growth assets to target additional investment returns
Paying members/transfer values – If you are already cash flow negative, the ongoing strain on your assets from paying member benefits should be factored into your thinking – it is worth remembering that the number of transfers out of your scheme may apply more pressure in terms of cash flow requirements. Any known benefit cash flows should be allowed for when considering liquidity requirements of the portfolio, as well as running a buffer for any unexpected cash calls.
Planning for risk transactions
In recent years, many pension schemes have found themselves in the fortunate position of being able to undertake partial or even full buy-ins with insurers earlier than anticipated as pricing has improved significantly.
However, surprisingly often a scheme’s assets can throw a spanner in the works. Schemes should not assume that an insurer is willing to take your illiquid assets, no matter how “insurer friendly” they may seem. Even if they might seem to fit the profile of what they hold in their own portfolios, it is unlikely any insurer will take on illiquid assets they have not chosen for themselves. In fact, it is more than likely that holding such assets will reduce the trustees’ negotiation powers, divert their focus from other important areas of the deal and could ultimately end up even scuppering the desired outcome altogether.
Illiquidity can sometimes be hiding in less obvious places, too. Don’t forget that LDI portfolios can contain non-standard derivatives and other less liquid instruments.
The only answer here is planning: Make sure you fully understand the liquidity terms of all your assets, including your LDI portfolio, and that you have clear contingency plans in place for their disposal if you have a buy-out target for your scheme. Even if this is some way off, you may want to monitor how many illiquid assets you are set to hold by your target date – and make a plan for disposing of them.
Below is an example of how a pension scheme can incorporate all these key collateral and liquidity considerations in a simple monitoring framework, giving you the full picture at a glance.
These metrics are also useful for testing any new assets you may be considering. For example, use it to ask: would this proposed new illiquid credit mandate meaningfully improve my cash flow position over the next five years? Could it mean I end up with too many illiquid assets by the time I reach my target buy-out date?
Making confident decisions and effective choices
While it is largely true that complex and highly sophisticated investment strategies often produce higher returns, there is little value in adopting something that consumes hours of a board’s time – or even worse, is not well understood.
It is vital that as a board, you both understand and believe in the investment thesis of a strategy so you can take a long-term view based on your overall objectives and avoid making decisions based on short-term performance.
Equally, it is important to be able to explain your choices to a range of third parties, so trustees need to honestly consider their willingness and ability to take on very complex strategies.
Ultimately, trustees need to focus on their endpoint and main objective. Spending hours unpicking complex investment strategies takes them away from more important strategic issues.
The investment strategy which works best for you will reflect your risk/return requirements but should also align with your liquidity needs, longer term objectives and should also ensure you are not distracted by complexity such that you lose focus on more strategic considerations.
