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In the past the majority of pension funds invested their assets in traditional balanced portfolios. Such portfolios have allocations to a number of asset classes such as equities, bonds and cash. The asset allocation policy, which stipulates the proportion of the portfolio to be invested in each asset class, is devised by the investment manager rather than the pension fund’s trustees. The investment manager has no knowledge of the individual characteristics and circumstances of the fund, so it does not take them into account when determining the asset allocation policy. Instead the decision is mostly driven by historic practices and peer group allocations.

In addition, balanced portfolio performance is usually benchmarked against other investment manager’s returns in traditional peer group surveys, often over short time periods. Fearful of underperforming their peers, investment managers tend to target short-term returns rather than following farsighted strategies that are likely to produce better returns in the long term.

Another downside to this peer group focus is the reluctance of investment managers to ‘break ranks’ and embrace new ideas or invest in nontraditional asset classes. Academic research has shown that asset allocation policy is the primary driver of investment performance. Therefore, it is important for trustees to take control of their asset allocation policy and implement a strategy that refl ects the specifi c needs of their fund.

Recent years have seen pension funds moving away from balanced portfolios and instead adopting a strategic asset allocation policy. This involves specifying the proportion of the fund to be allocated to each asset class and appointing specialist investment managers to manage each allocation.

The investment managers’ performance is benchmarked against market indices appropriate to the asset class. For pension funds wishing to follow this approach, the first step is to carry out an in-depth review of the fund, considering issues such as the maturity of liabilities, whether the liabilities are inflationlinked, and whether the fund is over- or underfunded. This allows the trustees to determine the level of risk that they are willing or able to take. Having decided how much risk to take in total, the next question is how to best ‘spend’ this risk, or in other words, how much should be allocated to each asset class. It is important that risk is taken where it is likely to be best rewarded, i.e. where expected return is highest. It is also important to ensure that the fund has adequate diversification.

As well as having different expected returns and risk profi les, asset class movements are not perfectly correlated, i.e. they do not necessarily move in the same direction at the same time – one asset class may perform well when another is performing poorly. Diversification is the strategy of investing in a variety of asset classes to take advantage of this feature, with the effect of lowering the overall risk of the fund.

Alternative asset classes outside the traditional equity, bonds and cash, such as hedge funds and private equity, have grown in popularity over the past few years. Increasingly easy access to such asset classes has provided trustees with much greater opportunity to achieve real diversification in their funds.

Unfortunately, there are some barriers to putting in place a strategic asset allocation policy. Key issues are the time that trustees need to spend on investment matters and the investment skills necessary for decision making. The requirements are obviously much more onerous for a fund utilising a strategic asset allocation policy than for one investing in a balanced portfolio, where many of the decisions are delegated to the investment manager.

Fortunately there are solutions to this problem, such as to:
• Delegate to an investment sub-committee that undertakes most of the work and brings appropriate proposals/recommendations to the main trustee group for ratification; and
• Engage the services of investment advisers to assist with the process. With appropriate assistance where necessary, the goal of implementing a strategic asset allocation policy reflective of their fund’s requirements should be attainable by the vast majority of pension funds.

(Ashlin Noonan, Head of Asset Liability Modeling
and Strategy Formulation at Novare Actuaries
and Consultants; www.novare.co.za.)

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