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Asset Management For Professional Clients onlyPension Fund Indicators 2012 A long-term perspective on pension fund investment... Pension Fund Indicators 2012 Production editor and enqui

Asset Management For Professional Clients only

Pension Fund Indicators 2012

A long-term perspective

on pension fund investment.

Pension Fund Indicators 2012

Production editor and enquiries

Ben Lloyd, telephone 020 7901 6263

Media enquiries

Telephone 020 7568 9982

Contributors

Agnes Bartha (Performance measurement and data)

Ben Lloyd (UK pension assets, Asset allocation and Alternative sources of return)

Bernard Hunter (Bonds)

Bronte Somes (Infrastructure and Private Equity)

Dan Edelman (Hedge Funds)

David Roberts (Real Estate)

Ian Barnes (Current thinking in UK pensions)

Ian Howard (Performance measurement and data)

James Collyer (Equities)

Kevin Barker (Equities)

Liz Troni (Real Estate)

Mark Deans (Risk measurement and Derivatives)

Matt Bance (Global tactical asset allocation and Currency)

Neil Olympio (Asset allocation in the presence of liabilities)

Paul Moy (Infrastructure and Private Equity)

Stephan Schnuerer (Infrastructure and Private Equity)

Uta Fehm (Bonds)

© UBS 2012 The key symbol and UBS are among the registered and unregistered trademarks of UBS

All rights reserved July 2012

Crown copyright material (sourced as “National Statistics”) is reproduced under the terms of the Open Government Licence from HMSO/National Archives

While every care has been taken in the compilation of the data in this book, neither UBS Global Asset Management (UK) Ltd nor any of the other data sources quoted will be liable for any consequences arising from the inclusion of inaccurate data

Pension Fund Indicators 2012

Foreword

Our aim with Pension Fund Indicators is to deliver to our readership an objective and educational source of investment data and practical explanations, covering the range of investments available to pension funds and the various techniques for combining them

In this Olympic and Diamond Jubilee year, it is with great pleasure that we celebrate a milestone of our own: the latest edition of Pension Fund Indicators, now in its 40th year The first edition, released in 1973, focussed solely on UK equity and gilt markets Today we cover the broad spectrum of asset classes utilised by occupational self-administered pension schemes which, we estimate have total assets in excess of GBP 1 trillion (see figure A.5)

Whilst somewhat clichéd, it is true to say that change is the only constant Over the years, the publication has sought to draw in new topics: 1978 saw overseas investment and property merit their own chapters for the first time At one point, alternatives only commanded one page and it wasn’t until 2000 that this chapter was significantly expanded Today, alternatives are covered extensively in Chapter 6

In this edition, we have maintained our topical chapter, ‘Current thinking in UK pensions’ (Chapter 1) This looks at some

of the recent trends and news in the UK pensions industry and sets them in their longer term context

Turning to global markets, 2011 saw a return of some of the volatility experienced during the extreme financial events of

2008 and 2009 This came after the somewhat relative calm of 2010 The key driver of equity markets was macro news flow and the ensuing gyration between ‘risk on’ and ‘risk off’ behaviour The eurozone sovereign debt crisis dominated headlines while investors shunned ‘risk’ assets, such as equities, in favour of perceived safe havens In this extremely volatile environment, world equity markets returned -6.2% (as measured by the MSCI AC World Index in Sterling terms) despite a strong finish to the year

Recession, coupled with the sovereign debt crisis, means that market uncertainty – and thus volatility – looks set to linger This volatility is borne out in the figures showing the aggregate funding position of corporate pension schemes in the UK Based on the PPF-7800 Index, the aggregate position went from a surplus of GBP 21.7 billion to end the year with a deficit

of GBP 255.2 billion during 2011

2012 and beyond brings with it many challenges for pension schemes There is no doubt that many schemes will continue

to look at diversification, as well as seeking out new sources of alpha and improved risk management

2012 also heralds the ‘go-live’ of auto-enrolment Set against the backdrop of just 19% of Defined Benefit schemes in the

UK remaining open to new members in 2011, compared from 23% in 2009, alternative arrangements for individuals saving for retirement are even more pressing

During these challenging times, we hope that this publication provides you with some informative facts and valuable insights, which you are able to draw upon when thinking about your pension fund investment strategy

Ian Barnes

Head of UK & Ireland

UBS Global Asset Management

July 2012

1 Current thinking in UK pensions 5

2 Asset allocation in the presence of liabilities 11

The focus on liabilities

2011 - a challenging year for maintaining funding ratios

The implications for sponsors and trustees

A failure of asset allocation?

A failure of risk management

A new metric

Structuring investment policy

Asset liability investment solutions

Liability hedging strategies

Return generating strategies

Dynamic risk management

Reducing/eliminating longevity risk

Implementation considerations

When to hedge liabilities?

Return generation – the role of derivatives

Looking ahead

Introduction

Equity characteristics

What is an equity?

Uncertain long-term returns

Volatility

Diversification

Sensitivity to interest rates and inflation

Equity valuation

Equity markets

The global equity market

Emerging market equities

Equity management

Approaches

Active management

Style

Value

Growth

Momentum

Small company equity

Unconstrained equity investment

Short extension or 130/30 funds

Active quantitative techniques

Passive equity

Corporate governance and socially responsible investment

How suitable are equities for pension funds?

What is a bond?

Who issues bonds?

Credit risk and the growing importance of non-government bonds

The global bond market

Some important bond terminology

Pension fund allocation to bonds

Emerging market bonds

Pension Fund Indicators 2012

What is real estate?

Gaining exposure to real estate

Real estate derivatives

Key benefits and challenges of investing in real estate

Global real estate investment

The UK and European real estate markets

Market performance

Differences in market practices

Commercial real estate sectors

The US real estate market

Market performance

Commercial real estate sectors

The Asia Pacific real estate market

Market performance

Within-region diversification benefits

Growth of Asia Pacific real estate markets

6 Alternative sources of return 67

What are suitable alternative investments?

Hedge funds

Hedge fund strategies

Performance

Private equity

Private equity as an asset class

Private equity investment characteristics

Increasing investor interest

The private equity industry in 2011

The private equity market in 2012

Infrastructure

A defensive component in portfolios can enhance long-term overall returns

Defining infrastructure assets

Infrastructure as an asset class

How does infrastructure compare with other asset classes?

Risks

Investing in infrastructure

Key attributes of best-in-class infrastructure managers

Key issues in 2012 and beyond

Global tactical asset allocation

Currency

How does currency affect returns?

Equilibrium risk and return

Currency effects in non-equilibrium conditions

The case for dynamic management

Separation of currency investment decision

Gold

Commodities

Art

A - UK pension assets 92

B - Asset allocation - the historical perspective 95

C - Risk measurement 106

D - Derivatives 112

E - Performance measurement 117

F - List of tables and graphs 121

Current

thinking in

UK pensions

Over the past 39 years that we have been publishing Pension

Fund Indicators, the various authors of this chapter have

commented on the many trends and challenges that the

UK pension market has faced Sometimes the tone has

been upbeat and optimistic, other times more sombre and

introspective Unfortunately, the subject of this chapter

for this edition is possibly the most challenging that UK

pension schemes have ever had to face, as it deals with the

breakdown of a fundamental relationship between asset

returns and inflation Whilst this topic may be dry (unlike the

start of summer 2012), it is no less important than the other

topics that have been featured in previous editions

Preaching to the converted?

Pension funds the world over have become converts of

the asset-liability study, the process by which the expected

returns from the mix of assets held is linked to the expected

growth of a pension scheme’s liabilities Key to these studies

is the data input on the expected returns of different asset

classes To be consistent with certain truisms about capital

markets (such as “over the long-term the return on capital

must exceed the cost of capital”), these expected returns

are usually built up from an assumed risk-free rate of return

(or cash) plus a risk premium which varies from asset class to

asset class So, the higher the perceived risk of the asset, the

higher the size of the risk premium to act as compensation

Looking at a real world example, equities are deemed more

risky than bonds, and so the equity risk premium is higher

than the bond risk premium

For pension funds, managing interest rate and inflation

exposures remains a core objective Therefore, the goal of the

asset-liability study is to find a mix of asset classes where the

combined risk premia from these assets will exceed inflation

by a certain margin in order to keep the cost of meeting those

liabilities relatively manageable The cash coming in must

match the cash going out A typical pension fund will aim to

beat inflation by about 3%

Under normal market conditions, the risk-free rate is

expected to exceed the prevailing rate of inflation by a

modest amount Usually the size of the risk premium

required to achieve inflation plus 3% will be somewhere

between the risk premium for equities and the risk premium

for bonds, hence most pension funds have a mix of these

two basic asset classes

The importance of these two main asset classes for pension

funds over a 49 year period is shown in Figure 1.1 It is

interesting to see how the asset allocation of the average

pension fund has changed over this time period Exposure to

bonds and equities still dominate, yet there are a number of

interesting themes:

• Reduction in exposure to UK equities, with a larger

exposure to global equities

• Fixed income exposure hit a low in the 90’s and whilst bigger now, a significant portion is in Index-Linked Gilts

• The exposure to alternatives, non-existent in the 1960’s, 70’s, 80’s and most of the 90’s has seen a general increase from 2005 on

Despite these changing asset mixes, the overall inflation-beating objective still remains

So far, so good Well, much like the unpredictable nature

of the weather, when markets do not behave like they are meant to, what happens then? Surely the return differential between the cash rate and inflation is relatively stable? Actually, no, and this is the root of the significant challenge facing UK pension schemes in 2012 and for the foreseeable future

The real rate challenge

One of the biggest investment problems that pension funds face in the current climate is the magnitude of negative real short rates In other words, the short-term interest rate is too low and is actually below the prevailing rate

of inflation

By drawing in data from across our investment teams, our analysis indicates that the risk premium for equities should be about 3.75%, and for government bonds about 1% Whilst the current risk-free rate yields only 0.5%, an expectation for the total return to equities is about 4.25% Clearly then, it is difficult to exceed an inflation rate of around 3% (at the time of writing) by any significant margin, and certainly a return of inflation plus 3% is very difficult

to achieve

A government can shrink its fiscal deficit by allowing inflation to erode the debt away Although not an explicit policy objective of the Bank of England’s Monetary Policy Committee, the inflation and interest data over the last few years would appear to suggest that such a plan is being followed This means that it is possible that negative real rates could persist for some time to come Indeed the index-linked bond market is forecasting that real short rates will remain negative for the next seven years To put this into perspective, in ‘normal’ circumstances we would expect the short-term interest rate to be some 2.4% higher than the inflation rate

What about timing issues?

Of course it is possible that a better outcome than this expected return might be achieved in equity markets This could come to pass if equities start from an undervalued position Regrettably, by our measures at least, global equities are not particularly cheap at the current time (with the exception of European equities, and we all know why this is the case)

1 Current thinking in UK pensions

Pension Fund Indicators 2012

Furthermore, there would appear to be many reasons why

UK equity prices may suffer downward pressure in the

coming years:

• Solvency II in the insurance world is likely to make

insurance companies sellers of equities

• Defined Benefit pension schemes will continue to close

and mature, with an associated shift out of equities into

matching assets

• The Retail Distribution Review (RDR) in the UK and other

similar reviews elsewhere in Europe will ban the payment

of commission to financial advisors Retail investors

who want advice will now have to pay up-front fees for

• Finally, given lack-lustre equity returns over the past decade or so in many developed markets, often referred

to as the lost decade for equities, you may also see a whole generation of retail investors put off ever buying equities again

In our view these pressures are a good reason not to count on unusually high equity returns in the coming years – however they are not reasons to despair! As various countries around the world come out of recession over the next few years, this is usually the environment where equities do best These two factors are likely to balance each, leading us to predict equity returns within normal bands between now and the end of the decade

Figure 1.1 Asset allocation – average pension fund, 1962-2011

Source: National Statistics (until 1995), WM (1996 onwards) As at December 2011

1962 1969 1976 1983 1990 1997 2004 2011 0%

20%

40%

60%

80%

100%

UK equities Overseas equities UK fixed income Overseas fixed income Cash Real estate Index-linked gilts Alternatives

1 Current thinking in UK pensions

Figure 1.2 Asset allocation – average pension fund, 1962-2011 (%) So what are pension schemes doing?

As has been the case for some years, a number of existing themes for pension funds continue to play out As we spoke about earlier in this chapter, the move out of equities and in particular UK equities in favour of fixed income assets continues While pension funds’ exposure

to overseas equities is higher than that to UK equities, exposure to this asset class has also fallen, from a peak of 32% in 2005/06, to 25%, a level last seen in 2001 The focus of schemes on their liabilities remains key There

is also continued interest in absolute/total return strategies

as well as alternative asset classes As can be seen in

Figure 1.2, pension funds exposure to alternatives has

been increasing steadily Indeed, some of the alternative asset classes that pension funds have been considering would also appear to have many of the same attributes

as equities and bonds Private equity, for example, is also a claim on future cash flows derived from corporate profits The difference is that, unlike traditional equity investments, these companies are not publicly listed and

so the investment is relatively illiquid and there should be

a premium paid to the investor for this liquidity

In a low interest rate environment, the need for income is key

In the final section of this chapter, we cover the increasing demand for income from DB and DC pension assets As DB schemes increasingly mature, and as annuity rates remain challenging for those retiring who derive the bulk of their pension assets from a DC scheme, more and more people are looking at drawdown rather than annuitisation As a consequence, the demand for income generation from pension schemes is increasing

Most schemes address this income need (at least initially) by stripping the dividend flow from their equity investments This is all well and good when your expected returns are above your inflation plus target Now that returns are severely challenged, stripping such income out simply lowers the total return on these equities to

an unacceptably low level If you are not reinvesting dividends, you are not earning a return on those dividends and so your compounded return drops Figure 1.3 shows the impact on returns of the FTSE ALL-Share with income reinvested and not

Source: National Statistics (until 1995), WM (1996 onwards)

UK Eq= UK Equities

OS Eq= Overseas Equities

UK FI= UK Fixed Income

ILG= Index-linked Gilts

OS FI= Overseas Fixed Income

Cash= Cash

RE = Real Estate

Alt= Alternatives

End UK Eq OS Eq UK FI ILG OS FI Cash RE Alt

1962

1963

1964

47

45

46

51 51 50

2 2 2

2 2 1965

1966

1967

1968

47

43

47

54

1 1 1

48 49 45 36

3 2 2 3

2 5 5 6 1969

1970

1971

1972

52

50

56

57

1 2 2 4

36 34 31 25

3 4 3 5

8 10 8 9 1973

1974

1975

1976

48

34

45

44

4 4 5 5

26 27 26 28

8 16 9 7

14 19 15 16 1977

1978

1979

1980

45

45

45

46

4 5 5 8

28 28 26 25

6 6 7 4

17 16 17 17 1981

1982

1983

1984

45

44

45

49

10 12 15 14

21 22 20 17

2 3 3

3 1

4 4 4 4

18 15 13 12 1985

1986

1987

1988

51

53

54

52

14 16 13 16

17 14 14 12

3 3 3 3

1 1 1 1

3 4 5 6

11 9 10 10 1989

1990

1991

1992

52

52

55

56

20 18 20 21

8 8 7 6

3 3 3 3

2 2 3 3

6 7 4 4

9 10 8 7 1993

1994

1995

1996

57

54

55

53

24 23 22 22

4 5 6 6

3 4 5 5

3 4 3 3

4 4 4 5

5 6 5

5 1 1997

1998

1999

2000

53

51

51

48

20 20 24 23

7 9 9 10

5 6 4 6

3 4 4 4

6 4 3 3

5 5 4 5

1 1 1 1 2001

2002

2003

2004

46

39

39

37

25 25 28 29

10 13 12 13

7 9 9 9

3 4 3 3

2 2 2 1

6 7 6 7

1 1 1 1 2005

2006

2007

2008

33

32

26

21

32 32 31 28

13 12 15 17

9 9 11 13

2 3 4 4

2 2 2 3

7 7 7 7

2 3 4 7 2009

2010

2011

23

21

18

28 29 25

17 16 18

13 14 17

4 4 4

2 2 1

6 6 7

7 8 9