Deficit and underfunding at the £6.7-billion ($10.4-billion) pension fund for employees of United Kingdom retailer Marks and Spencer had long weighed down one of the high street’s best known names. But a sustained, conservative investment strategy characterised by a “keen focus on risk management” and “an understanding of the scheme’s liabilities” has helped to turn the M&S scheme around. The fund’s decision to shrink its equity allocation and boost its fixed income portfolio has helped cut the deficit from $2 billion in 2009 to $450 million in March 2012. It has made strategy at the closed defined benefit scheme with around 125,000 members, of which just 14,000 are active, a template for other funds in de-risking mode.
Mixing and matching
In an interview from M&S’s Paddington Basin headquarters in London, Brian Kilpatrick, the head of Marks and Spencer Pension Trust Investments, explains the fund’s liability matching strategy. M&S has portioned 70 per cent of assets to a diversified fixed income allocation that includes investment in global sovereign exposure, a global credit portfolio, a material exposure to gilts as part of its growing liability-driven investment (LDI) strategy and emerging market debt. Here, Kilpatrick is encouraged by the “relative strength” of emerging-economies’ sovereign balance sheets compared with those in the developed world during the financial crisis. In the last year the fund’s best performing mandates have been benchmark-agnostic fixed-income absolute-return strategies.
Kilpatrick explains why not all of the fixed income portfolio is purely matching and the strategy the fund uses to counter this. “Some investments within the allocation have very high matching characteristics like gilts, but other allocations, like sterling corporates, aren’t purely matching because they include a credit-risk premium. When we construct an LDI hedge, we look at the different duration exposures within the fixed income portfolio and then use swaps to plug any gaps, relative to the liability duration at any point across the curve so we get the shape of the hedge where we want it.” Sterling corporate bonds are a good example of this strategy at work, he explains. Their short duration doesn’t match the longer term liabilities of the scheme so the fund uses swaps to “move duration along the curve”.
So far the scheme has hedged the majority of its interest rate and inflation exposure and the LDI strategy will evolve as the scheme continues to de-risk. “We will be opportunistic in our de-risking, de-risking when we are ahead of our journey plan and adding to our gilt portfolio when the trustee considers yields as being attractive,” he says. Explaining the rational behind the strategy, Kilpatrick says, “We have seen some schemes negatively impacted by interest rates falling over the last year or so; the consequent funding level risks can be material. Because we are uncomfortable being exposed to a rewarded risk of this magnitude, we have evolved our LDI portfolio as conditions permitted risk to be reduced.”
De-risking framework
The remainder of the scheme’s assets are portioned to growth investments comprising a 12-per-cent equity allocation, down from 40 per cent in 2006 when Kilpatrick fist joined M&S from the National Association of Pension Funds, where he was investment advisor. The rest is in infrastructure, private equity, hedge funds, property and bespoke opportunistic allocations that were born out of the financial crisis. Exposure to equity markets is largely indexed and the scheme has a dynamic de-risking framework in place, based on agreed funding level de-risking triggers, monitored frequently by the trustee. De-risking trades will be executed when these triggers are hit, but the composition of those trades will depend on respective market conditions when funding-level triggers are reached, Kilpatrick explains.
He says that the scheme’s infrastructure allocation is a mix of low-risk public-finance initiative assets, sought after for their liability-matching and inflation-linkage characteristics, plus more opportunistic allocations in the US. However, it doesn’t include any emerging market infrastructure. Hedge fund exposure includes allocations to two multi-strategy funds of funds and a number of single strategy funds. This includes some “more rewarding” specialised strategies that have focused on picking up distressed assets during the financial crisis and have earned “significant investment returns for the scheme”. Going forward, Kilpatrick says the fund plans to increase its alternatives allocation in private equity and infrastructure. It invests in private equity only via “traditional vehicles”.
Kilpatrick describes the funding level as “integral” to asset allocation at the scheme and the deficit has certainly driven some of the pension fund’s most innovative strategies – none more so than the decision to draw income from a $1.5-billion portion of the company’s property portfolio. Under a property partnership set up in 2007, M&S retains control over the selected properties, however the pension scheme is entitled to receive an annual profit distribution earned through leasing the properties back to M&S. As a result, the M&S Pension Scheme was able to recognize the fair value of these future income streams as an asset in its accounts, leading to an improvement in its funding position.
Marks and Spencer’s large diversified fixed income portfolio contrasts with other UK corporate pension schemes, which still tend to have big equity allocations. For Kilpatrick, it’s the safest strategy to steadily de-risk. “We know the return above gilts we need to meet our glide path,” he says.
