For pension funds with a large roster of external managers, balancing the integration of top-down strategy with managers’ bottom-up implementation is one of the most challenging tasks for CIOs.
The key, says Mark Walker, CIO of Coal Pension Trustees Services Limited (CPT), which oversees around £21 billion in assets on behalf of beneficiaries in two schemes from the UK’s legacy coal industry, is to ensure external managers truly understand the strategic reasons and goals for the allocation. It’s a process that is more complex, and goes much deeper, than a mandate’s label or just trying to beat a performance benchmark.
Four years ago, CPT introduced short duration, higher yield, external bond mandates for one of its two pension schemes. Working in combination with other assets, the idea was that if the pension fund needed to meet future cash flows three or four years down the line, it could run off those mandates. The managers wouldn’t buy any more bonds and when they got to maturity, the proceeds would be collected and used to pay benefits.
In a classic, top-down strategy, the allocation was crafted to meet cash flows at the pension fund where up to 10 per cent of assets under management may need to be sold to pay benefits in a given year, explains Walker. It was only on closer examination of the portfolio he noticed that one of mandates had a bond with a maturity of 2054.
“This clearly didn’t link to our top-down strategy – it wasn’t going to mature for another 30-odd years!” he says.
Recalling initial discussions with managers around structuring the higher yield bond mandate, Walker cited conversations around timing cashflows out, diversification and manager flexibility around adjusting the duration or managing credit risk. Yet behind these discussions, it was also key that the manager understood the strategic, top-down resonance of the portfolio in the context of the pension scheme’s cash-flow priorities and that not implementing it correctly, held consequences for strategy. Even so, a rouge bond slipped into the portfolio.
Aligning top-down strategy and bottom-up implementation can only be achieved if external managers truly understand asset owners key purpose, Walker continues. For CPT’s two pension funds, that purpose is paying pensions against the backdrop of a huge pay-out ratio (no new money has come into the schemes for the last 30 years) pegged to RPI, meaning that if inflation is much higher than expected, the schemes must generate more returns.
It’s a cash flow focus that means every external manager must understand the importance to the pension schemes of selling an asset well (divesting is just as important as investing) alongside growing the assets to generate returns given that the more income the schemes can collect, the less they have to sell.
“Our starting point with managers has to be about ensuring they understand the liability characteristics of the schemes and the importance of making payments out of the scheme – our purpose is to provide benefits to members, and our payments are much higher than most.”
Property and ships
Top down, bottom-up alignment is a particular headache in the UK property allocation. The schemes’ property managers don’t just need to understand the importance of controlling fees and costs given the impact on vital rental income coming into the pension funds. Other factors are coming into play like the rise in capital expenditure to repurpose UK buildings in line with new environmental and energy efficiency rules, and the impact on cash flows ahead.
“You could argue this kind of expenditure is a bottom-up issue,” reflects Walker. “But it really makes us evaluate the place of property in our portfolio and the value from spending money on a property versus selling the property and committing capital elsewhere. Blending top down and bottom up in a segregated property mandate involves so many different factors. You think you’ve connected the two, and then you discover you haven’t.”
Similar themes have guided the rationale to sell ships, despite ownership of 50-odd ocean-faring vessels across both schemes earning double digit IRRs over the years and comprising one of the best-performing allocations last year alongside private debt and macro hedge funds.
“It has been a good time to sell some of our ships, not least because of increasing costs around environmental standards. Fitting sulphur filters to some of our ships was costly, and more environmental regulation is coming,” he says.
Successful alignment also requires the schemes’ external managers feed-up and share any information that supports top-down strategy. Witness another anecdote from the front line. When flicking through a report from one of the schemes’ global equity managers, Walker noticed the average dividend yield for the stocks in their portfolio was 1.4 per cent – but share buybacks had been at the level of 2.5 per cent over the year.
Since every ounce of income is collected and used to pay benefits, the fact not all the cash flows from companies in the portfolio was being paid out in dividends, but being used, instead, to buy back shares, would have hit the schemes’ all important cash flows.
“It was a facet of the stocks the mandate was invested in, but it impacted the income we received,” he says. “It was a useful piece of market information. Things might happen at a market or stock level that we will then need to think about at on a mandate, cash flow or strategy level.”
Manager shake-up
The quest for alignment with third party managers has resulted in a shake-up of the manager roster in recent years as Walker seeks to buid relationships with a smaller number of bigger names. Many managers have fallen away naturally, like long-term private equity or special situations managers where the investment is realised. Elsewhere, mandates have been consolidated or changes in the value of the asset class has led to fewer managers required.
However, Walker has also reduced the number of manager relationships by asking 25-odd existing managers and some potential new names to come up with ways to work more closely with the schemes, emphasizing their particular needs around high cash flow requirements and high returns, as well as key investment themes like climate and technology. Walker was looking for managers prepared to leverage their resources and help the pension schemes form macro views, access liquid growth opportunities, better structure the equity portfolio or manage climate risk without losing returns.
As a consequence CPT, on behalf of the schemes, now has four strategic providers and around 15 core managers (plus a further 10-15 core private equity managers).
“We are not completely closed to new managers, but the bar for others is higher now because we generally look to our core and strategic managers first if we want to do something new.”
Assets have also flowed to these managers. “Over the last 12-18 months, our percentage of assets with these managers has gone up. We’ve seen our number of legacy managers go down, and the value of assets go up with strategic managers.”
China
Now both pension funds are also revaluating their approach to China. The schemes first invested in Chinese private equity around ten years ago; an active, onshore public equity allocation followed, and together with a small exposure to Chinese fixed income and stocks held by global managers, onshore and offshore exposure to China is around 6 per cent in one of the pension funds.
“We’ve had some great investments, but the risks are increasing,” says Walker.
For example, some of the China portfolios increasingly drag on the Trustees’ climate and wider ESG metrics, and the geopolitics have got more complicated.
“In the past we’ve been relatively bullish on China, but the risk and complexity are increasing, and although we are not exiting, we are reviewing our exposure and I expect it will come down.” For now, he has no short-term plans to put new money into private equity and is likely to re-evaluate positions in public equity too. Still, he’s mindful of the potential short-term benefits to Chinese equities as China opens up after COVID.
The allocation to China sits in a wider equity allocation, divided three ways between Europe, US and Asia. Allocations include small cap and climate and healthcare allocations. Although he is positive on equities in the long run, he expects more downside in the short-term.
“The key issue for us is if they fall we don’t sell them because this is a permanent capital loss,” he says.
Outlook
With no LDI strategy, very few gilts or typical rebalancing requirements, the pension schemes escaped the worst of UK bond market volatility last year. However, the secondary impact from forced sellers as UK pension funds sold assets to meet margin calls did buffet the portfolios, impacting prices of assets the schemes had planned to sell and the balance between buyers and sellers at the time.
“Whilst we still have high return targets, much of our strategy is actually about what we have to sell. We have around 50 per cent of the portfolio in illiquid assets, and don’t want to or need to be a forced seller,” says Walker, who adds that sterling’s weakness has actually helped the pension funds. Many of the two funds overseas assets are unhedged and have seen their value go up. However this has increased illiquidity given the unhedged US private equity allocation went up in value, but the hedged public equity allocation fell.
Looking out on the best income-generating assets ahead, rising bond yields bode well.
“It’s easier to get income now – bonds are paying higher income, much more than they were 12-18 months ago.” However, he’s already feeling some impact from lower distributions in private equity and expects worse ahead.
“We still received hundreds of million in distributions from private equity and special situations debt last year. In private equity alone, we saw around £400 million in distributions last year but that was still less than expected.”
Price discovery in the illiquid allocation is also difficult.
“Private equity has not revalued down as quickly as public equity so understanding the value and a true price, rather than just a latest valuation, is a challenge.”
