An alternative approach to funding pensions?

4 March 2019

[This article was originally published in Professional Pensions on 28 February 2019]

Financial markets have been analogous to Spain’s world famous Pamplona bull run over most of the past decade, with equities leading the charge.

Born out of the financial crisis, quantitative easing and the search for real returns have engendered an asset price boom.

The final quarter of 2018 represented an inevitable market correction after sometimes eerily smooth market progress. But there are also grounds to expect lower investment returns in future, driven in part by high asset valuations built on historically low interest rates and bond yields.

After the negative returns from world stock markets in 2018 and with negative real yields available from risk-free government bonds, DB pension promises that are funded by any of these asset classes have become more expensive.

In this environment, UK pension schemes have sought efficient ways to build portfolios with greater certainty of returns and cash flows.

At face value, the publication of an All Party Parliamentary Group report at the start of this month – focused on the potential benefits of Alternative Investments to pension funds – therefore seems a timely intervention.

The report – UK Pension Schemes and Alternative Investments – begins by setting out how an aging population, fewer workers and lower prospective returns are giving rise to “a very real worry…that the UK will be left with the choice of smaller pensions, later pensions or higher contributions”.

It identifies that encouraging pension schemes to “better diversify their investments and improve returns” could mitigate some of these challenges and, in turn, presents a case for the role of alternative assets.

These assets, however, can present complex challenges and risk profiles that need to be assessed for their suitability and that need to be diligently managed.

A healthy degree of caution is advisable.

At USS, we have developed a significant presence in Alternative investing. Our ‘private markets’ investment programme now exceeds £18bn, over a quarter of the USS DB fund’s assets.

Our considerable size (as the largest private UK pension fund by way of assets), the scale of our internal investment team, and our commitment to building Alternative Investment capabilities over the past 12 years has allowed us to move beyond investing in only in third-party private equity funds and UK property.

The majority of our private investments are now conducted directly and include infrastructure, private debt and equity, with ownership of or lending to assets as diverse as airports, utility companies, shipping ports, motorway service stations, shopping centres, nurseries, crematoria, and renewable energies.

This has been the headline move in a gradual diversification of the scheme’s DB fund over the past decade – begun prior to and continued since the global financial crisis, to broaden beyond the often binary world of bonds and equities.

It has been beneficial in terms of securing strong, long-term risk-adjusted returns – and our ability to manage a large part of this programme in-house has substantially reduced the associated agency costs.

But, from our experience and to achieve the best potential outcomes, a fund must have a combination of sufficient size, scale of resource, and time horizon to be able to make the associated substantial commitments over years and decades.

At USS, we have benefitted from economies of scale and a long-term and relatively early commitment to put in place the conditions, capabilities and governance to support a successful alternative investment programme.

If necessity be the mother of invention, the market landscape after a stellar decade may encourage greater efforts and investment flows seeking more diverse and innovative sources of returns.

But there is no panacea to the significant challenges facing the industry, and Alternatives are not a one-size-fits-all solution.

How will an allocation to Alternatives sit alongside the other assets in different pension funds: what areas of alternative investing are suitable, in what proportions, and how accessed and managed? Are the risks understood and time-horizons aligned?

These are critical considerations for DB funds – but also for the rapidly growing world of DC funds.

Roger Gray Roger Gray

Chief Investment Officer