George Inderst charts broad trends in the allocation of pension fund assets

It is stunning how things have changed in the field of asset allocation of pension funds. It is now considered of crucial importance not only for investment performance but also for the risk management, funding policy, and securing the pensions deal between employers and employees in general.

These days, it is difficult to imagine how underrated asset allocation was only 10 years ago. Now you can hardly find a pension plan that is not undertaking major work on asset allocation policy. It is not just about shifting the asset weightings somewhat, but about reforming the whole structure and process of strategic investing. How to approach it? How to implement in practice? How to ensure good governance?

First, there is the question of how to approach asset allocation conceptually. A great deal of thinking is going into asset allocation these days, not only by academics but also by an investment industry that has sensed big business in this field. Now pension trustees are faced with a series of new terms like liability-driven investing, stochastic asset liability management, risk budgeting, multi-asset and multi-strategy investing, dynamic asset allocation, return-seeking portfolio, life-styling, and many more. It will be interesting to see when fatigue will set in.

A second, and well-reported area of change, is the much broader use of assets and derivative instruments. This is in order to achieve better diversification and find additional returns. Connected to this, pension executives are undergoing major education and selling exercises on new products and ideas. Given the growing list of ‘alternative investments' and structured investment vehicles of all sorts, this process is likely to continue for some time.

Third, there is a major governance challenge. Many trustees have painfully realised what effect investment policy can have on benefit security and on their sponsors' willingness to support the pension funds. Furthermore, pensions supervisors have raised the bar.

There is not much clarity about the best way forward in terms of organising investment decision-making. Different countries have different rules about the role of trustees, sponsors, regulators, consultants, managers and even members. There is often confusion about who drives asset allocation decisions and who carries the ultimate responsibilities.

The days when strategic and tactical asset allocation were clearly distinct are gone. New trends have emerged. Pension boards spend more time on asset allocation than in the past, and try to relate it more closely to liabilities. More investment committees and specialist external consultants are being used. But some bigger pension plans have insourced core asset and risk management function.

Things are on the move and some players are changing their roles in the asset allocation game. Investment banks now want to advise and consultants want to implement. New models, like fiduciary management, have been introduced, perhaps also shifting the goalposts for fiduciary responsibility.

 With so much being talked and argued about the optimal set-up for asset allocation, what is actually happening to the real allocation of pension funds? The answer is, from a macro perspective, surprisingly little. The distribution of global pension fund assets shows a remarkable stability over time (see graph).

Over the last 10 years, the proportion of equities has gone from about 52% to 60%, bonds down from 37% to 26% and other assets up from 12% to 14%. The overall weighting of equities rose in the second half of the nineties, fell in the early 2000s and recovered since. This development mirrors the movement of stock market. Yes, allocations change somewhat over time but they tend to drift with market prices. How widespread really is rebalancing?

Such highly aggregated figures may well mask more interesting developments underneath. In fact, there has been a certain convergence between Anglo-Saxon and other countries in terms of their bond-equity split. The equity content rose in the latter, particularly in the late 1990s (taking, for example, the Netherlands from 29% in 1996 to 41% in 2006, Switzerland from 16% to 38%). At the same time, the UK started to de-risk gradually, with bonds moving from 11% in 1996 to 24% in 2006.

Surely, the good old categories equities and bonds themselves are becoming less meaningful as the universes becomes much richer, for example through the increased use of corporate bonds. Furthermore, some people would even say that they are now simply raw material for sophisticated investment strategies and solutions.

The third category, ‘other assets', is still driven more by old-style cash and real estate rather than new alternative asset classes. Nonetheless, private equity, hedge funds, commodities, infrastructure, currency and GTAA overlays and so on are slowly having an impact on the aggregate figures. However, variations are massive across countries in terms of their alternative landscape. Unfortunately, the - often unreliable - figures from the various data providers rarely agree on the exact exposures.

Perhaps one way of rationalising inertia in asset allocation is the overwhelming influence of national laws and regulation on pension fund investment. The first and classic example is, of course, the existence of quantitative investment restrictions, for example, an upper limit on foreign assets or risky assets such as equities of 30%.

Most countries have removed such limitations or softened them in recent years. As a result, home bias has been reduced almost universally and the introduction of the euro was, of course, a contributing factor. Interestingly, the picture is much less pronounced in terms of the bond-equity split, where
the legacy tends to remain more influential. Other forces seem to be at work.

A second important regulatory constraint certainly is legal mini-mum return or capital guarantees, as in Switzerland, Germany and Austria. They naturally preserve a conservative investment strategy. It will be interesting to monitor the spreading of absolute return funds and other alternatives to bonds in those constituencies.

A third, and increasingly important effect of regulation on asset allocation, stems from funding and solvency rules. For example, the introduction of a traffic-light system as in Denmark and Sweden induces insurance-type of risk management with shorter time horizons. More and more countries move towards a risk-based regulation. Instead of prescribing investment allocations regulators now try to prescribe risk exposure and risk management as prominently in the Netherlands for example.

The UK has opted for a rather different, scheme-specific funding regime, supervised by a new regulator and backed by a new benefit insurance system. There, the effect on asset allocation depends very much on the strength of the sponsor's covenant.

It will be interesting to see to what extent asset allocation will continue to converge across countries. Certainly, the European pensions directive of 2003 has a certain unifying effect as has the 2004 IAS19 accounting standard. On the other hand, the reforms of national pensions regulation in recent years have taken rather different routes, and this may well have a diverging effect. Last, but not least, Solvency II may be changing the rules of the European asset allocation game again.

One should not forget that the macro-statistics mostly show averages. The picture is much more colourful at the micro-level of pension funds. For example, some mature UK pension schemes have gone (almost fully) into bonds while others have been sitting on their equities forever.

Across Europe, several pension funds have dedicated 20% and more to alternative assets while many others still have nothing. Despite or because of more restrictive regulation, there perhaps seems to be scope for innovative, plan-specific strategies.

Georg Inderst is an independent consultant based in London (georg@georginderst.com)

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