Forget 'toes in the water' - how to win a pension's full 100%

Most hedge funds are delighted to announce 5%-10% pension allocations. Schroders, on the other hand, won Highway Insurance's full pension pot. They explain how, while Liability Solutions' Phil Irvine explains how hedge funds need to change to follow suit

A year ago, Phil Irvine, head of advisory at London pension fund consultants Liability Solutions went in search of a solution to offer to the firm's client Highway Insurance's pension fund. He found a city divided. Quite neatly divided, in fact.

In Mayfair, west of London's West End theatre district, sat the brass plaques of London's boutique hedge fund community, the UK's version of Connecticut. A long history was vested among this community of hedge funds and, perhaps latterly, a slowly emerging presence of long-only, absolute-return funds.

Mayfair's finest

The best of such a community, so the theory would go, would be ideal to provide an alpha 'kicker' for Highway Insurance's pension fund.

Ross Dunlop, chairman of Highway Insurance and trustee of the pension scheme had, unusually for many UK corporations, been publicly positive on the contribution that a flexible mandate (including hedge funds) for their insurance funds could bring, an allocation with which Liability Solutions had also helped the company.

In Highway Insurance's 2006 Report and Accounts, Ross commented that "Highway once again enjoyed strong returns.

"Given our propensity for overall portfolio risk being no greater than that of short bonds...shareholders should be more than satisfied."

Highway Insurance's pension fund was in some respects a more complex matter, bringing not only income from the policyholders' payments, but also the moveable feast that is future liabilities, subject to inflation and interest rate risks as well as imponderables such as mortality rates.

A hedge fund manager could provide useful alpha. But to match a liability as closely as possible required expertise in swaps and collateral management.

Canary Wharf lies east of Mayfair, and of London's centre (London's 5th Avenue, if you like), a labyrinth of skyscrapers which house the large global investment banks, in short, those with the most extensive swaps expertise. However, Canary Wharf's expertise in funds of hedge funds (FoHFs), and absolute-return expertise outside its prop desks, was relatively limited, with track records on many of the funds of hedge funds they ran stretching in the main to a matter of months, not years.

Traditionally, Canary Wharf and Mayfair would more likely meet when the former's prime-broking and cap-intro teams meet to raise money or provide services to the latter's hedge funds, not to provide solutions to pension funds in partnership.

(This is, however, not to say the two are not co-operating to work for pension funds, as a recent link between Mayfair fund of hedge funds manager Key Asset Management and Canary Wharf's Barclays Capital demonstrates).

The best of both worlds?

Enter then the City, the Square Mile that houses few investment banks, few pure hedge fund operators, but most of London's long-only asset managers that have run pension fund assets for decades. And, more specifically, in Highway Insurance's case, enter Schroder Asset Management, chosen by Highway Insurance from a shortlist of four assembled by Liability Solutions.

"The initial brief of Highway Insurance's pension fund was to evaluate a multi-asset, absolute-return approach combined with a liability swap," says Irvine. "The thinking was: the company wished to implement a strategy to address the scheme's future funding-level volatility. However, they were also aware that interest rates were historically at a very low level, and that the decision of when to hedge their liabilities was clearly going to be an important part of the process.

"Some groups had a focus on absolute return and blending hedge funds with other asset classes, but there were not that many who allocate between them, could run a swaps portfolio alongside, and had experience in explaining the key issues with trustees," Irvine explains.

"Generally speaking, the West End has a lot of experience in the absolute-returns side, but less so blending it with long-only assets and even less so with swaps portfolio management, and derivatives. They may have used them to cover their FX positions but, in the main, they were dealing for HNWIs, and even though the industry has been moving towards institutions, Mayfair had little reason to develop these particular skills because they were aiming for x pounds per annum.

"The City has a long history of managing pension funds in a long-only manner, and has of late been moving towards absolute-return strategies," Irvine explains. "Those who went through to the shortlist in this case had sat down and thought about the potential for packaging their different skills together to satisfy the Libor-plus mandate."

It is this combination, Irvine says, that could define 'institutionalisation' of hedge funds and the industry, at least partly.

Having an appropriate suite of portfolios will undoubtedly play its part as will robust infrastructure, perhaps registration and excellent reporting. But, Irvine adds, the hedge fund groups with only this may only win the typical 3%-5% allocation from European (possibly more from US) pension funds. Asset managers who can demonstrate absolute-return capabilities added to swaps and derivatives expertise with the ability to create bespoke solutions could find themselves with far larger proportional pension mandates. In Highway Insurance's case, the absolute figure may have been relatively small, but it was 100% of the pension pot.

Schroders has had experience allocating between long-only and absolute-return, taking what Irvine describes as the "classic Yale approach" and more recently in swaps for interest rate and inflation hedging, for its own £480m employee-pension scheme, says David Lomas, head of insurance asset management at Schroders. (Due to Schroders' fortunes being weighted quite heavily to the equity markets, Lomas adds, the in-house pension scheme now has a more diversifying range of asset classes in order to reducerange of asset classes in order to reduce risk.) Lomas himself brings extensive experience of helping insurance firms, both in their premium portfolios and modelling of expected future liabilities and the returns needed to meet those, and also with their pension funds - as was the case most recently with Highway Insurance.

Highway Insurance's money, once moved from its present managers, will begin at Schroders allocated 60% into a diversified growth pool and 40% in a liability-focused pool.

However, of course, Gareth Henry, associate director, Strategic Solutions at Schroders, emphasises this will change over time as opportunities and needs arise.

Henry does not see Schroders' discussions with trustees as one-way traffic - as pension trustees select from the menu of services Schroders offers, Henry says: "It's often about asking the client why they want their investment in a certain form. It lets us have a good understanding of where we will fit in to give them the right kind of management."

Schroders' strategic solutions teams - now of which there are now four in the UK - are able to draw upon the various fields of expertise across the whole firm. The group aims to develop a full understanding of client issues and then use the resources of Schroders to solve client problems.

Its discussions with pension funds may be robust, but also are mutually beneficial for their frankness. "There were issues around understanding what Highway was trying to achieve - specifically around risk tolerance and different measures of risk, and the amount of return required to move them toward where they wanted to be," says Henry, "and make sure these two were consistent, and placing all of that in a liability context so it's not about delivering a specific number, but more about moving the funding in a positive direction, roughly 2.5% YoY."

On the liability-driven investment (LDI) front Schroders will establish a bespoke swaps portfolio hedging inflation and interest-rate risk embedded in the liabilities. 30% of the pension fund will be hedged at outset, and up to 100% over time. Highway will benefit from a bespoke approach to active asset management, combined with a portfolio of swaps. To decide when to increase the hedging ratio, Schroders will take views on the value in bond and swap markets.

The solution proposes to reduce Highway Insurance's current portfolio's expected volatility of 13.5% pa by around a third, while targeting outperformance of the liabilities of 2.5% pa.

For hedge fund firms that link up with third-party swaps expertise to give an overall LDI product, says Irvine, "the devil is in the detail in terms of the moving of collateral between the two. It's the use of collateral moving backwards and forwards as interest rates move up and down - which a pension fund is neutral on, because if interest rates move up, the discount value of the liabilities goes down, so their deficit goes down too." Where the ALM solution requires the collateral, the crucial question is around the effective use of that collateral.

Henry says placing the pension fund's liabilities in the middle of the asset manager's thinking on developing a solution was important.

"The key was putting the liabilities at the centre and working in a liability context, while being aware that the future payments to beneficiaries can only be estimated, and that the further into the future you look, the cloudier it becomes.

"It's very easy when you get into the detail to get hung up on the exact expected cash flows and matching them to a high degree, which would be a spurious approach. By having all these kinds of discussions and bringing these points to the fore, everyone gets comfortable with the position of the client."

well diversified

In Highway Insurance's case, the allocation of assets will be largely to a wide range of asset classes and active management strategies, managed as a whole - "not to be pulled back into the old world of looking at each element compared to a benchmark, which creates a short-term focus on relative returns," says Lomas, "and which can be a hindrance on some of the larger allocation moves."

Lomas adds, true to Schroders' non-benchmark-bound philosophy, the firm's discussions with Highway Insurance on risk "went beyond the idea that asset classes necessarily have normal distributions." In terms of the managers employed, most will be Schroders' own, although, at the outset, elements of property, private equity, absolute-return and emerging-markets debt will be externally managed to ensure a fully diversified portfolio. Henry says co-orindating the management of a whole pension fund's assets allows more elegant insight into "how the parts work together," and, in one sense, takes some pressure off the trustees.

"Splitting things up between different mandates and managers places the onus for the total view on the trustees.

"This is a major role and the total position may not be looked at as often as it should. It is possible to drift back to a very benchmark-driven, siloed mentality, getting away from the total assets and liabilities view.

"In the last decade, the pension fund industry became very benchmark-focused and forgot to manage risk and return between total assets and liabilities, leading to a massive concentration of risk in equity exposure, subsequent deficits and scheme closures."

The search and shortlist selection also clearly changed the nature of the consultants' task, from "saying we will find you the best equity manager, and the best fund of funds manager, to finding people who could work on all the issues the pension fund faced, which in this case was not just the asset allocation," Irvine explains.

Herein lies arguably the second way the Highway Insurance pension fund deal was new. "The brief was to give ownership of the problem to the manager, not just asset allocation, not just a percentage of the assets, and, in this way, it was similar to Highway Insurance's previous mandate," Irvine explains..

"The manager has to constantly consider the liabilities and manage them, and reassess them actively along the way," Irvine says.

Schroders, he adds, had considered the asset allocation, adding value with the way they proposed to manage the swaps portfolio "and was a large enough organisation to give comfort to trustees. You can find people who say their fund of hedge funds is uncorrelated, and while that may be important for trustees, it's not solving the pension fund's critical issues."

Winning the 100% mandates will also require open-minded trustees. "Highway," says Irvine, "looked at their overall problem and decided to allow the manager to solve it, rather than be prescriptive. And they gave the manager the full set of clubs to play the course."

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