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ITEM PF6
PENSION
FUND COMMITTEE – 26 AUGUST 2005
ASSET ALLOCATION
Report by
the Head of Finance & Procurement & the Independent Financial
Adviser
Background
- Asset allocation
is the distribution of investments across categories of assets, such
as equities, bonds, property and cash. Asset allocation affects both
risk and return and is the most important component of a Pension Fund’s
overall investment strategy. It has been estimated that up to 80% of
investment performance can be attributed to asset allocation.
- In March 2001
the Myners review of Institutional Investment was published and it covered
the subject of asset allocation in some detail, describing it as "an
under-resourced activity." Prior to the review the majority of pension
funds operated a peer group benchmark whereby a manager’s investment
performance was measured against a chosen peer group. The Oxfordshire
Pension Fund’s benchmark was the CAPS median fund return, which was
made up of over 1600 UK pension funds, predominantly in the private
sector. The consequence of this arrangement was that Schroders and Deutsche
Asset Management, who were Oxfordshire’s managers at this time with
multi asset briefs, tended to structure their portfolios in line with
the CAPS benchmark.
- Myners was critical
of the Peer Group arrangement arguing that the resulting "one size fits
all" asset allocation was not necessarily the right one at the individual
pension fund level. He further argued that strategic asset allocation
should primarily be determined by an individual fund’s liability structure
and that each fund should consider having its own customised benchmark.
- In 2002 the Oxfordshire
Pension Fund Committee decided to move to a customised benchmark. This
process involved the then Actuary, Watson Wyatt, being appointed to
carry out an asset liability study for the Oxfordshire Fund. This exercise
culminated in a new asset allocation, which was considered to be a better
match for the Fund’s liabilities. The main outcome of this exercise
was a reduction in equities (UK and overseas) from 75% to 67% and an
increase in bonds from 15% to 22%, together with a rise in alternative
assets (property, private equity and hedge funds) from 6% to 11%.
- Bonds are currently
considered by many to be the best match for pensions in payment because
they are perceived to match actuarial projections and their prices in
the shorter term tend to be less volatile than equities. However, over
the longer term equities have tended to outperform bonds so there needs
to be an acceptable balance of risk and reward when constructing an
asset allocation strategy. The agreed strategy will impact on employer
contribution rates and council tax.
- Following the
asset liability exercise, which also coincided with a period of manager
underperformance, the Pension Fund’s management arrangements were reviewed.
The review culminated in the implementation of a more specialist management
structure with the existing four managers being appointed in July 2003.
- The asset composition
of the strategic benchmark, together with the managers and the assets
for which they are responsible, is shown in Annex 1 (download
as .xls file).
- In February 2005
the Pension Fund Committee agreed to a process for reviewing the strategic
asset allocation, coupled with a report on a tactical asset allocation
overlay strategy. It is felt that now is the right time to review the
asset allocation, following the results of the 2004 actuarial valuation
and changes that have occurred in the investment markets since the last
review was undertaken. This report considers these issues.
The Strategic
Asset Allocation Review Process
- In accordance
with best practice as set out in the Myners Review of Institutional
Investment and the Review of the Actuaries Profession by Sir Derek Morris,
discussions were held on the strategic asset allocation with the actuary
and the investment managers, particularly with UBS, who was appointed
the multi-asset manager partly because of their expertise in asset allocation.
It was evident during the manager selection visits that few multi-asset
managers had a sound asset allocation process and that none of them
matched UBS. Officers and the Independent Financial Adviser also attended
several seminars and conferences on asset allocation over the past year
to keep abreast on the latest thinking. In addition, officers discussed
asset allocation with Barings ING and Legal and General to obtain further
independent views.
Findings
of the Review
- Annex 2,
Table 1 (download as .doc file)
compares the Pension Fund’s current liability profile with the one prevailing
in 2001, which was used for the 2002 asset liability study. This shows
the profile has only changed modestly between 2001 and 2004. The main
development being a 4.6 percentage point decline in pensioners, balanced
by rises in deferred pensioners and contributing employers, meaning
the Fund is slightly less mature than in 2001.
- The Actuary was
consulted on his forecasted longer-term changes to the Fund’s liability
profile. He reported "I would expect pensioner liabilities to remain
close to the current levels of around 40% of the liabilities for some
time to come unless there are significant changes in membership profiles,
changes in the scheme liability profile or assumed rates of investment
returns."
- Since the last
review was undertaken in 2002 a number of factors has changed and trends
developed including the following:
- Most pension
funds are now showing funding deficits compared to the years up to
2000, the peak of the equity market, when surpluses were a norm. Most
local authority pension funds are now heavily in deficit, with Oxfordshire
at a funding level of 65%. It was decided in the Funding Strategy
Statement that this would be recovered over a period of 25 years.
- Alternative
assets such as commercial property, private equity and hedge funds
are looked on with increasing favour as they are regarded as having
a lower correlation, to a varying extent, to equities.
- Equity markets
have become much more global and there has been a gradual reduction
by Pension Funds in their UK equity allocations and an increase in
their overseas equities. The WM Local Authority statistics show that
between 2001 and 2005 the proportion of UK equities held by local
authority pension funds fell from 50% to 40%. Over the same period
there was an increase in overseas equities from 21% to 29%. This trend
is expected to continue in recognition that a more diversified equity
portfolio produces a better risk reward trade off.
- The trend to
higher bond weightings, particularly in corporate defined benefits
schemes, has gathered momentum. The reasons for this trend are discussed
in more depth later in this report.
Recommended
changes to Oxfordshire’s Strategic Benchmark
- Officers and the
Independent Financial Adviser considered a number of different strategic
asset allocation strategies and the main ones of these are set out in
Annex 3 (download as .xls file).
UBS ran the different strategies through their own portfolio computer
model in order to analyse their long-term risk and reward characteristics.
The results of this exercise are also shown in Annex 3 (download
as .xls file) and include the longer-term investment return
and risk projections. The sharpe ratio, which is explained on Annex
3 (download as .xls file) , attempts
to show the most efficient portfolio in terms of both its risk and return
characteristics.
- The most appropriate
asset allocation for Oxfordshire is dependent on members risk appetite
and whether the emphasis should be on a lower risk/lower potential return
or higher risk/higher potential return objective. If a stable, or even
modestly declining, employer contribution rate to give greater certainty
in the level of council tax, is the main objective then this would indicate
a higher level of investment in bonds. Portfolio model A in Annex
3 (download as .xls file) has
the largest holding in bonds at 36%. This is the portfolio with the
projected least risk but also the lowest longer-term investment return.
Annex 2 (download as .doc file)
shows that the actuary is projecting that the deficit can be eliminated
in 25 years if the longer-term investment return is 6.2%, all other
factors being equal. Therefore, portfolio A would comfortably achieve
this objective with its projected return of 8.68%. However, this strategy
would tend to lock in the funding deficit for a longer period.
- If on the other
hand the main objective is to reduce the deficit, sooner rather than
later, then a higher level of equity investment should in the long term
provide rising real returns. However, equities tend to be far more volatile
than bonds in the shorter term giving less certainty on the employer
contribution rate and so the level of council tax. The current trend
towards liability driven investment (i.e. just focusing on a fund’s
liability profile) with an emphasis on bond investment does not normally
over the longer term produce as high real returns as equity investment.
- The trend to a
higher proportion of bonds in pension funds, particularly defined benefit
funds is driven to a considerable extent by the corporate sector, particularly
quoted companies. Pension funds and funding deficits now feature prominently
in company balance sheets with the result that corporate treasurers
can only take a three to five year view of funding the pension fund
and this drives them to higher bond investment even though it locks
in deficits. Furthermore, the large closure of final salary schemes
in the corporate sector is generating an increase in their maturity
profiles, which encourages a higher bond weighting.
- In contrast local
authority funds are less mature and in paragraph 11 it was reported
that the Actuary does not foresee changes to this position over the
longer term. Furthermore, Oxfordshire, along with many other local authorities,
has decided to reduce the funding deficit over 25 years and this would
facilitate a higher weighting in equities, but with shorter term volatility
and so a shorter term risk to the employer contribution rate and level
of council tax. However, for long term investors inflation is the main
risk. The historical returns of equities, bonds and cash over the long
term, together with the probability of equities under-performing bonds
and cash over varying time periods are shown in Annex 4 (download
as .doc file). The estimated future returns of asset classes
by UBS are shown in Annex 5 (download
as .doc file). These returns were compared to Hewitt Bacon and
Woodrow’s Investment Consultancy Arm’s own returns and appear to be
fair.
- The Independent
Adviser’s favoured asset allocation is shown in Annex 3 (download
as .xls file) column C. This model produces the best projected
investment return but has the second highest risk characteristics. The
sharpe ratios were very similar for all four portfolios, which implies
that the risk reward trade offs are of a similar nature. The changes
proposed by the Independent Financial Adviser are not a radical departure
from the existing strategic asset allocation in the customised benchmark,
but they do represent a move against the current trend by recommending
a reduction in the bond weighting from 22% to 16%.
- There would also
be an increase in alternative assets from 11% to 17%. The Myners Review
recommended that pension funds should consider the attributes and diversification
benefits of alternative assets. Alternative assets not only offer the
potential of good real returns but are also lowly correlated to equities
and bonds and therefore help to reduce the Fund’s overall volatility.
- There would be
no change in the Fund’s 67% overall equity weighting but it is proposed
that there would be a more even split between UK equities and overseas
equities, in order to achieve more diversification and thereby achieve
a potentially better risk and reward trade off. Hedging back to sterling
can eliminate any concerns with currency risk within the overseas portfolio.
The most effective means of achieving a more even split on equities
is covered in paragraph 22.
- The reason for
recommending the asset allocation model C is that the Pension Fund is
able to take a 25 year view (the recovery period for the deficit) and
the forecasted higher returns, albeit at the expense of shorter term
volatility, should eliminate the deficit sooner rather than later. The
sharpe ratio of 0.40 for asset allocation model C (see Annex 3 (download
as .xls file)) is similar to those of the other portfolios and
provides a reasonable balance between risk and reward on a 25-year view.
Recommended
change to Alliance Bernstein’s Investment Process
- The most effective
way of achieving a more even split on equities, discussed in paragraph
20, would be by changing the method by which Alliance Bernstein manages
global equities. Currently Alliance Bernstein manages global equities,
including the UK, within an Oxfordshire customised Global Diversified
Value platform, which has provided extremely good investment performance.
Annex 1 (download as .xls file)
provides a breakdown of the current global equity benchmark, which has
a 36.4% weighting in the UK and a 63.6% weighting overseas.
- However, it is
proposed that the Fund moves into Alliance Bernstein’s standard Global
Value product. This portfolio is more concentrated, with 100-140 stock
holdings against 150-200 and so it has a higher risk profile than the
existing arrangement but it does have the potential to produce a higher
return. However, by switching into this portfolio it is also likely
to provide the desired split, at the total fund level, between UK and
overseas equities. The Global Value product would be constrained by
market capitalisation rather than the existing customised global equity
benchmark set out in Annex 1 (download
as .xls file). Currently under a market capitalisation basis
the global equity portfolio weighting in the UK would only be 10% compared
to 36.4%. This would have the effect of producing a more even split
in equities at the total fund level, though this would fluctuate depending
on changes to Alliance Bernstein’s investment strategy. As a consequence
of this proposed change to the recommended strategic asset allocation
(column C in Annex 3 (download as .xls
file)) the percentages for UK and overseas equities respectively
are shown in brackets since they will fluctuate.
- Annex 6
(download as .doc file) compares
the two different Alliance Bernstein investment products. The management
fees for the Global Value product are higher but to date the extra fees
would have been dwarfed by the excess investment returns achieved.
Rebalancing
the Portfolio
- The recommended
changes to the strategic asset allocation will necessitate a rebalancing
of the existing portfolios. However, it is not envisaged that this will
produce major changes because the proposed asset allocation is not too
far adrift from the current actual asset allocation (see Annex 3
(download as .xls file)). Furthermore,
the Fund has a large in house cash balance at the present time which
should help avoid, or at least minimise, any disturbance to the managers’
portfolios. In February 2005 the Pension Fund Committee agreed that
the strategic benchmark should be rebalanced every 12 months.
Tactical
Asset Allocation
- While the proposed
long term strategic asset allocation of the Fund is structured with
the main objective of eliminating the Pension Fund’s deficit sooner
rather than later, it does not take any account of the valuation currently
placed on assets in the market. Thus, equities could be overvalued absolutely,
as in March 2000, or relative to bonds, or visa versa. A tactical asset
allocation overlay strategy would seek to take advantage of perceived
market misvaluations on a short-term basis by super-imposing a different
asset allocation for the whole fund, whilst leaving the underlying long-term
strategic asset allocation in place and the managers’ underlying portfolios
undisturbed.
- UBS is a natural
choice to operate a tactical asset allocation overlay strategy for the
Pension Fund as they are already manager of the multi-asset section
of the portfolio and operate asset allocation within that portfolio.
Officers received a presentation from another manager who also operates
a tactical asset allocation overlay strategy, but using that manager
would add a fifth manager to the Pension Fund Management team and the
company might operate a strategy at variance to that of UBS, the Fund’s
existing multi-asset manager.
- The tactical asset
allocation (TAA) overlay strategy operated by UBS is operated through
a separate fund. The Oxfordshire Pension Fund would contribute around
3% of the total Fund’s assets into the UBS TAA fund. The risk reward
target would determine the exact percentage. The TAA fund operates through
derivatives (futures in the equity and bond markets, forwards in the
currency markets etc), which are both quicker and cheaper than buying
or selling actual securities. The TAA fund operates within tight control
ranges to limit the downside risk. In fact operating a tactical asset
allocation overlay strategy reduces the overall risk level of the total
Pension Fund, while it raises the expected return. It will be necessary
to rebalance periodically the TAA Fund back to its agreed percentage
weighting (around 3%).
- The details of
fees for operating the UBS TAA Fund are shown in Annex 7
(download as .doc file). The fees
have been compared to those operated by another manager who offers a
similar TAA product. The latter’s fee would be more expensive than UBS,
particularly as UBS would not charge a fee for operating tactical asset
allocation over the multi asset portfolio they already manage for the
Pension Fund and also their rates are marginally lower than those of
the other manager. It is not considered necessary that tactical asset
allocation should be put out to tender, as the Fund would be merely
using UBS Services across a broader area of the overall Pension Fund
portfolio.
RECOMMENDATIONS
- The Committee
is RECOMMENDED to:
- approve
the new strategic asset allocation in Column C in Annex 3 (download
as .xls file) and to rebalance the existing portfolios to
reflect this;
- approve
that the portfolio managed by Alliance Bernstein should be moved,
phased if necessary, from their Global Diversified Value platform
to their Global Value platform;
- approve
that UBS be appointed to manage the tactical asset allocation
strategy and that officers negotiate with UBS the exact percentage
(around 3%) of the total Pension Fund assets to be contributed
to the tactical asset allocation fund.
SUE
SCANE
Head of Procurement & Finance
A F BUSHELL
Independent
Financial Adviser
Background Papers: Actuarial Valuation Financial Assumptions, UBS Global
Asset Management investment strategy papers, Hewitt Bacon and Woodrow’s
long-term investment risk and return assumptions.
Contact
Officer: Tony Wheeler, Pension Fund Investments Manager (01865)
815287
August
2005
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