DB schemes under pressure

The latest casualty in the UK defined benefit market was Fujitsu who last month closed its DB pension scheme to future accrual.

In a statement issued at the time, Fujitsu said: "Whilst this action is regretted it is a prudent step to enable us to manage the pension risk." The necessity to take such action, however regrettable, is a sad but all true reminder that the DB market is really feeling the pressure from the crunch.

Elsewhere in the UK, the outlook is equally gloomy for DB. Preliminary results from the £29.3bn BT scheme revealed it is battling with a £2.9bn deficit compared with a surplus of £2bn at the same point last year. To tackle this, it is to make pension contributions of £525m a year for the next three years.

Similarly, in the US the steep drop in the markets in 2008 wiped out five years of gains in the pension plans of the 100 largest corporate DB plan sponsors, research conducted by Milliman in March revealed. The consultant's pension funding status report revealed the 100 largest DB plans lost a combined US$300bn in 2008.

Indeed, trustees do need to take a "prudent" approach to managing risk and for this reason added pressure is placed on them to implement an adequate asset allocation programme in order to meet the ever present liabilities.

So what changes are DB schemes making and where are they allocating assets in order to continue to meet their pressing liabilities?

A recent poll conducted by the Pension Management Research Panel of 157 executives overseeing pensions ranging from £10m to over £1bn in assets across Canada, Hong Kong, Netherlands, UK and US, revealed market volatility has led to 64% of pension funds making changes in the past year, 38% in the past six months and 23% in the past three months.

The poll also uncovered 27% of funds were diversifying out of equities and into bonds, 21% out of equities into alternatives, 12% were considering or had already implemented interest rate swaps, and 6% were considering or had already implemented inflation rate swaps.

For a long time now schemes have looked to diversify their investment portfolios but it seems the recent turmoil has seen a global shake up in asset allocations with renewed vigour.

To equity or not to equity?
Mercer principal Crispin Lace observed that Western European countries, in particular the UK and Ireland, have traditionally had heavy weightings in equities compared with other European and global countries. The UK and Ireland, said Lace, have predominantly relied on equities rather than bonds, which is a phenomenon you do not really see in many other DB pension markets around the world.

"In the rest of Europe and the US, bond markets have historically produced reasonable levels of real return," said Lace.

In the glory days from 2003 to early 2007 schemes with a decent weighting in equity - 55% to 70% - benefited because markets were stable and producing solid returns. Moving into 2007, however, it became increasingly clear that what had worked in the previous 20 years was not going to work in the next 20.

It is in the traditionally equity biased countries that investors have felt the greatest need to reduce equity allocations in order to combat raging volatility in financial markets. "You have seen a gradual reduction in equities over the last three to five years. Over the last six to nine months many schemes have seen their equity allocation reduced through relative market movements," said Lace.
He added: "In the high equity focused markets this is happening. In the other markets this is less so because other countries have had significant chunks in government bonds anyway and there isn't much corporate debt issuance."

Some experts observed that two groups of DB investors have come to light in the financial crisis.
First, schemes that diversified their assets at an earlier date by largely reducing allocations to equities; and second, schemes that did not reduce equity allocations prior to the downturn whose returns have really been hit hard of late.

Hewitt Associates global head of asset allocation Colin Robertson said: "If you are diversified away from equities already you are in good shape and will be looking to take advantage of market movements - make more medium term or tactical moves around a sound strategic backdrop, and buy more equities.

"The other camp, who are still very invested in equities, are faced with trying to sort out the strategic aspect, how to diversify given the performance of equity markets, what to do and when to do it."
Whether or not a pension fund decides to stay invested in equities or reduce allocations largely comes down to if existing assets are being invested or if a fund is investing new contributions.

"For many trustees equities are proving to be more volatile than expected but the right thing to do is to ride it out and not sell and crystallise losses," said Ortec UK managing director Andrew Slater. "But if it is new contributions then the conversation will be around whether equities are cheap and is now the time to buy them instead of fixed income."

Now, while equities are cheap is the ideal time for some investors to re-enter the market and grasp the opportunities that are present.

Baring Asset Management head of UK institutional business Richard Graham observed that in the current environment Barings had in fact increased equity weightings sharply in some areas. "We are up to about 50% equity in a multi-asset portfolio," said Graham.

Graham was keen to note that people tend to respond to yesterday's news so those who had, for example, 60% equities at the beginning of 2008 got massacred during that year. "If they are starting to cut their equity positions now that would be unfortunate timing," he added. "They will have taken all the downside and may miss out on the upside."

The name's bond... corporate bond
At present, one certain branch of fixed income is causing a stir among pension funds the world over. Corporate bonds seem to be flavour of the month, owing to their huge spreads. There has certainly been a notable shift towards this asset class in recent months.

Hewitt's Robertson said that Hewitt advised its clients to come out of corporate bonds before the credit crisis set in but it is now very positive on them.

Robertson, however, was quick to question the reasons people might look to corporate bonds.
"If you are buying corporate bonds instead of gilts then you should be buying them now," said Robertson. "But if you are buying corporate bonds as a good investment in the return seeking part of the fund they stack up less well against the other return seeking assets like equities. But against gilts you should be in corporate bonds."

SEI European head of institutional solutions Ashish Kapur added that some corporate bonds in the market are offering great value but that value might not come through for the next 12 to 24 months.
"Trustees who want to benefit need to buy into the fact that if they are willing to let go of the liquidity requirement then there are opportunities, but if they insist on liquidity then the opportunity set is a lot lower," said Kapur.
In April the Royal County of Berkshire Pension Fund increased its bond allocation from 19% to 24%, and slashed its equity allocation from 70% to 32.5%.

Elsewhere, in April, Japanese corporate pension funds increased their allocations to domestic bonds and reduced exposure to equities, a survey by JPMorgan Asset Management Japan revealed. The research found 56.5% of respondents increased their allocation to domestic bonds and 68.1% and 60.9% of respondents reduced allocation to domestic equities and foreign equities, respectively.

Alternatives
There are signs that an increase in diversification taking place in the industry. In April Mercer's annual European Asset Allocation Survey highlighted that more schemes were diversifying into alternative asset classes to manage risk.

Allocations to alternative asset classes had increased from 10% to 11% in Germany, from 9% to 11% in the Netherlands and from 4% to 6% in the UK.

In the UK, the Royal Berkshire Pension Fund recently appointed 10 new managers in a bid to diversify its investments for a broader and more global portfolio intended to improve returns.
HSBC Global Asset Management head of European consultant relations Chris Gower emphasised the fact that pension funds are long term investors and with this in mind perhaps some of the less liquid investments, such as carefully selected government-backed projects within infrastructure, can still generate on a global basis very good returns. "It is all about liquidity at the moment and for people that have the assets and can invest in illiquid assets we believe there is a real opportunity for pick up over the next five to 10 years," said Gower.

Likewise, there are prospects within property despite the fact that many investors have got out in the last few years because of valuations: "Within property you are seeing some opportunistic distress opportunities. The long-term investor who does not need the returns in the next few years is able to pick up from those in real distress."

Barings' Graham added: "We are beginning to build up positions in commercial property and private equity."
Looking forward, it will be interesting to see when pension funds will return to the equity allocations seen before 2007. At present, it could develop in one of two ways. Either no one will invest so returns from equities will not be picked up, or the really strong companies who remain in equities will survive, shore up balance sheets and look to increase corporate governance.

For investors who reduced equity allocations there are some real opportunities but for those who did not and are having a tough time of it, Robertson had some advice: "Our advice to clients is hold off and don't buy equities at the moment but I can see our advice being to buy equities before too long and certainly this year when they will be able to buy cheaper than today."

Barings' Graham added that trustees should avoid simply buying the latest bright idea from their investment consultants.

"The tendency is to chase yet another specialist product that will have its day in the sun but there will also be years when you really don't want to have anything at all in certain asset classes," said Graham.

"Concentrate on the biggest picture of asset allocation, choose a manager who is good at it and allow them to get on to deliver an absolute return objective for you."