Up until very recently, ‘DB pension schemes’ and ‘surplus’ were not phrases often heard in the same sentence, says Morten Nilsson, chief executive of investment manager Brightwell which manages the assets of the £47 billion British Telecom Pension Scheme, BTPS, one of the largest private sector defined benefit schemes in the UK

But thanks to rising interest rates making it cheaper for these schemes to meet the costs of their pension obligations, recent figures from The Pensions Regulator (TPR) reveal that out of around 5,000 defined benefit (DB) schemes in the UK, over 3,750 are now in surplus on a low dependency basis with a further 950 schemes approaching surplus.

Writing in a recent posting on Brightwell’s website, Nilsson calls the aggregate surplus totals of £250 billion, roughly 17 per cent of total DB assets, “staggering.”

“With such eye watering figures, it’s not surprising that the government is consulting with the industry on how to put this money to use. HMRC analysis shows that just £180 million in surplus has been successfully extracted between March 2018 and March 2023. This is largely because most schemes are unable to access surplus except at ‘wind up’.”

During wind-up, employers offload their pension schemes to insurers who promise to pay employees’ retirement payments at a fixed level under so-called bulk annuity arrangements.

As schemes seek to complete a transaction with an insurer, they typically move out of riskier assets such as equities and into bonds.

But he believes the rationale of such large value transfers of returns and surplus from a pension scheme to an insurance company, when pension funds could stay in control, benefiting their sponsor, is under more scrutiny. “Many schemes are questioning whether buy-out is in fact the ‘gold standard’ or whether they risk ‘selling the family silver.’”

Nilsson continues that buyouts mean pension funds are taking money away from sponsors that could otherwise be invested in the UK economy – or wherever they operate. The new laws could allow pension funds to share the surplus subject to the “appropriate funding levels,” encouraging schemes to “invest for surplus in productive asset allocations.”

Still, barriers to any change of mindset are high, some of which are outlined in research by Mallowstreet which gathered analysis from 27 pension schemes with over £1 billion AUM. Like the fact surplus generation is not an objective for trustee boards. Schemes argue they are run to meet the promised benefits to members and protect their outcomes, not to increase the return to the sponsor.

Another challenge lies in the fact a surplus can swiftly change to deficit. Schemes could find themselves paying out surplus one year, and being underfunded the next.

“Scheme funding is only ever a snapshot in time and the recent volatility shows that some unhedged schemes can easily swing from deficit to surplus in a relatively short period of time,” he warns.

Moreover, the fact the majority of UK DB schemes are closed and mature means few want to introduce greater investment risk. They are largely adopting a cash flow matching strategy that reduces dependency on their sponsors and the DB funding regime has historically encouraged schemes to de-risk and focus on cashflow matching as they mature.

Nilsson concludes that if the government wants to increase pension scheme’s investment in “productive assets,” changing the rules around surplus is unlikely to make a difference. But he says providing more flexibility around surplus intuitively feels like a good thing.

Using the surplus to enhance DB or DC benefits, or as a volatility buffer, could be attractive. Making it easier for surplus to be returned to sponsors may be helpful in giving them greater comfort on avoiding risks of overfunding. It could also allow greater investment in their own business priorities – productive finance in a more direct way. From the trustee perspective, it could provide the ability to make discretionary one-off payments to members.

Two of the biggest pension funds in the world, the Netherlands’ €532 billion ($565 billion) APG and Japan’s ¥227 trillion ($1.5 trillion) GPIF, have joined forces to invest in large scale infrastructure deals, with APG taking the lead. The move comes as APG Asia head Thijs Aaten tells Top1000funds.com he envisages more than half of the fund’s real assets will be invested in Asia to reflect global growth and opportunities.

An infrastructure co-investment deal with Japan’s ¥227 trillion ($1.5 trillion) GPIF is the latest in a throng of relationships that Dutch pension fund APG has entered with other funds to invest in large scale infrastructure and real estate, including Korea’s largest pension fund NPS, and New Zealand Super Fund.

The €532 billion ($565 billion) APG has extensive experience investing in infrastructure and will act as lead investor in the latest collaboration, selecting projects which GPIF, relatively new to investing in infrastructure by comparison, will be invited to join.

At the end of December 2023 GPIF’s portfolio was split roughly equally between equities and fixed income, although it does have an unlisted assets cap of 5 per cent including infrastructure (which is less than 1 per cent), noting that 5 per cent of GPIF is $75 billion.

APG sees many benefits to the collaborative model with other pension funds and is open to further expanding the number of “preferred partnerships” it has with other pension funds that have a similar investment philosophy and share the same views on sustainability.

Collaborative deals with like-minded partners to date include student housing in Australia and toll roads in Portugal.

APG’s Asia chief executive, Thijs Aaten, told Top1000funds.com in an interview that in addition to increased capital to invest, investing with other pension funds has implications for the investment structures and purpose of the investments because of an alignment of interest.

“We have quite a bit of experience in private investments and even though we are a decent size we occasionally run into a situation that some of the deals are too big even for us. Deals of €1 to €2 billion is sizable for us,” Aaten said.

“The idea is we want to team up with asset owner partners who have similar investment horizons, and don’t necessarily look for an exit. We might be enthusiastic to hold on to the asset, and often GPs want to exit, but for us it could become more of a core asset with a good income or an inflation hedge. With private equity partners there is not always an alignment of interest, so we expect to see that more with asset owner partners.”

Part of what makes APG an attractive partner is its large internal teams, with nearly 100 people on the ground in Asia an example of the depth of its operations. Some funds, such as GPIF, don’t have those large internal capabilities in private assets, making APG a natural and complimentary partner.

“What we do see is that there are more like-minded partners looking for this capability in Asia,” Aaten said.

APG has about 30 per cent of its portfolio in real assets, and Aaten believes over time up to half of that will be invested in opportunities in Asia.

“That’s where I feel that if you only have 10 per cent allocated in Asia that is not in line with fundamental economic activity,” he said. “The central gravity of the world economy is shifting to Asia. I don’t think everyone sees that or is willing to acknowledge it.

“I think it is obvious, and the statistics support it – like half of global GDP is from Asia, and it is a much larger amount of global growth. The US has a stronger capital market and is still growing, but Europe is not growing much.”

APG has offices in both Hong Kong and Singapore, and the team has doubled in size in the six years Aaten, who is headquartered in Hong Kong, has been running the region. Included in the 100 people employed across the region are 20 different nationalities, which Aaten said has been key to navigating the multitude of cultural nuances in Asia and has been critical to landing deals.

He points to a real estate deal in Hong Kong where the entire negotiations were conducted in Cantonese as an example of a deal that would not have been possible from the fund’s Netherlands HQ.

“There is a long way in the run up to these deals and certain ways of doing business in Asia, so you have to talk to companies, build networks, find trustworthy partners and establish that trust with your partners and you need an understanding of the culture. That is so important,” he said.

“It’s not just about numbers but lots of other things. Some cultures appreciate the Dutch bluntness, and some don’t. It doesn’t always make sense to send me in.”

Investments in Asia make up about 10 to 15 per cent of the entire APG portfolio with the team in Hong Kong managing infrastructure, including solar farms and toll roads; natural resources, such as a Tasmanian forest; real estate, which is the biggest allocation and includes both listed and unlisted assets across the region; a small private equity allocation, although the bulk of private equity is managed from New York; and a capital markets team that covers emerging market debt, including some Chinese fixed income, developed market equities in Japan and Australia, and global emerging market equities.

The investment team at APG is run as a global team and the investors based in Asia are integrated with teams in other locations, including Europe.

APG’s pension fund clients, including the giant ABP, work to a three-year strategic asset liability modelling framework and there is no specific target to increase the allocations to Asia. Still Aaten is very bullish on Asia, a view that sometimes differs from his colleagues in Europe.

“There is no specific goal to increase a regional allocation,” he said.

“The pension funds work with a three-year strategic ALM and is still set up very traditionally with asset categories. All of these models are based on inputs and return expectations, and that’s where sometimes we might disagree on assumptions that are being used that require a deeper discussion.”

Aaten points to the large Dutch firm ASML as an example of tapping into the Asian growth story. The firm generates more than 80 per cent of revenue from Asia.

“I feel that it is easier to make money in economies that are growing,” he says. “The argument that I get often is that investments in the US and Europe would have done better than emerging markets, so why be so positive on Asia?

“There are not a lot of IPOs in Hong Kong at the moment, and there are a lot more in the US. So you might argue the US is the place to be. But when are you IPOing? When you think you’ll get a decent price, and you sell because you think you’ll get more than what it’s worth. You are not IPOing if you are not getting value. So it’s it the other way around, as investors we should buy where there are no IPOs because there is a bargain.”

 

CalSTRS has been integrating climate change into its portfolio for decades, but the strategy took a leap forward in 2021 when the pension fund adopted a 2050 net zero commitment that included an interim goal to reduce emissions from the portfolio by 50 per cent by 2030.

Kirsty Jenkinson, investment director for the sustainable investment and stewardship strategies at the pension fund, was initially sceptical of whether a net zero target would be the right approach. Two years in, she is convinced it has provided a new level of focus and anchor to climate investment at the $325.9 billion pension fund for California’s teachers.

Net zero is now one of the pension fund’s core strategic priorities, sitting alongside its 7 per cent return hurdle, benchmark investment and commitment to DEI. It has allowed the 220-person investment branch overseeing a complex, multi-asset class portfolio to align under one goal.

“Having a common shared goal, even though it is many years out, can’t be underestimated when you are a large allocator with multiple different strategies,” she says.

Measuring and reducing emissions

One of the three tenets in CalSTRS’ net zero pledge is to measure and reduce emissions. CalSTRS is in the process of allocating 20 per cent of its listed equity allocation to a low carbon index that could reduce portfolio emissions by 14 per cent. The strategy is being implemented over the cycle and allows the passive investor to reduce emissions in a way that also meets its risk parameters by limiting the level of active risk.

Following board approval in May 2023, the team extended emissions reduction to fixed income, targeting a 12 per cent reduction in emissions in corporate credit also via a bespoke index.

“Corporate credit accounts for a significant amount of our fixed income so we are focusing on the priority allocation,” says Jenkinson.

Both CalSTRS public equity and corporate credit portfolios are around 50 per cent aligned with a 2-degrees scenario, and about 20 per cent aligned with a 1.5-degrees scenario.

One of the biggest challenges is accessing emissions data and tracking emissions reduction at a company level to a total portfolio level.

“The data we get on emissions doesn’t pipe into the financial tools we use to govern the whole portfolio,” says Jenkinson. CalSTRS is working with MSCI to try and bridge the gap and measure and manage net zero public market emissions exposure and reduction efforts.

Elsewhere Jenkinson is using CalSTRS influence with external managers to try and improve emissions data and analysis coming into the fund, particularly the hedge funds in the risk mitigation portfolio.

“We have interesting partners that are helping educate us,” she says. “We can use our influence as a client to see how we can progress.”

Emissions reduction in private markets is more challenging. CalSTRS uses the GRESBY framework to track emissions in its direct and externally managed real estate allocations. In private equity and infrastructure, the team is developing an internal classification to determine the trajectory or pathway of an asset from grey to olive and green.

SISS solutions

The challenges of reducing emissions in private market is one of the reasons the pension fund is using private markets to home in on opportunities.

“It’s worked well for us to have a focus on emission reductions and climate solutions,” she says.

Investing in opportunities got a boost in 2021 when CalSTRS launched a new sustainable investment and stewardship strategies private portfolio (SISS) targeting climate investment opportunities across private equity, real estate, and inflation sensitive assets particularly.

The portfolio which has already hit $2 billion (although it’s not all fully invested) benefits from steadfast commitment from the leadership and board, despite heightened liquidity concerns at a total fund level because of the macro environment.

“The portfolio is directionally supported by our leadership and board,” she says.

Of the portfolio’s two sleeves, one involves scaling investments with existing external managers. The other allows staff to develop new investment partnerships that allows capital to flow across assets and the risk spectrum, from infrastructure to venture and into structures that sit between the risk return hurdles of the asset classes, typically a difficult fit because of underlying benchmark or other considerations.

The platform also allows investments in spun-out, first-time funds, with new players and different structures in a specific departure from CalSTRS typical investment with established partners. It is allowing the pension fund to tap into evolving, fast-moving investments and expand its expertise in the intersection between risk-adjusted returns and climate change drivers.

“We felt we needed to be open to building new structures with new players who understand the policy, technology and physics of the transition.”

Asset allocation modelling

In another development, CalSTRS is integrating climate scenarios into its asset liability modelling study, which guides asset allocation and is updated every four years. Since there is no fit-for-purpose way to pipe climate risk into the asset allocation, the process involves estimation and trial and error, she says.

“The architecture is still being built.”

Furthermore, as the team tries to understand the interplay between risk, return and emissions, they hope to build a better understanding of where the market is moving regarding emissions, physical and transition risk. From this they will be able to calibrate what risk CalSTRS is prepared to take versus the market.

“It’s a new concept, and we don’t have perfect answers.”

CalSTRS is not happy taking significant active risk, yet the team doesn’t’ know how much active risk they are taking by putting in place net zero strategies to reduce emissions and investing in climate solutions, she continues.

“I do worry about this, and because there is no visibility on how the market is pricing risk, we have to assume it may respond at the last moment, when the crisis happens.”

“We are very used to understanding where, say, inflation is going, but the market has no way to calibrate emissions. We don’t have a clear way of saying emissions are doing this and physical risk is doing this and therefore we need to be aware of this,” she says.

Jenkinson concludes that climate investment also brings considerable change management. It requires building different and enhanced skills, yet the topics are diverse and rapidly changing.

“Not everyone follows climate policy, and nor should they have to. Physics, science, and policy expertise doesn’t exist in every team. We are spending lots of time on how to work smarter – how to skill-up is really important.”

We’re witnessing a dramatic transformation of the US utility sector, driven largely by climate change and the swift advancement of technologies such as artificial intelligence (AI). Rising infrastructure costs and the push toward renewable energy are shaking up traditional investment models that depend on fossil fuels.

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A recent paper “Innovation Unleashed: The Rise of the Total Portfolio Approach” published by the Chartered Alternative Investment Association proposes a new approach to institutional investment that replaces asset class benchmarks with total portfolio outcomes. Hallmarks of the process include measuring success based on total fund returns rather than relative value in relation to benchmarks, and using factors to achieve diversification rather than asset classes.

Canada’s CPP Investments’ Derek Walker and Geoffrey Rubin, two contributing authors of the paper which includes insights from Australia’s Future Fund, New Zealand Superannuation Fund and GIC, Singapore’s sovereign wealth fund, provide specific detail of their factor approach in one section of the paper.

“We believe the factor-based approach, when implemented thoughtfully, provides greater transparency to underlying portfolio drivers and more effective tools for portfolio management,” write Walker and Rubin.

“A total portfolio approach is critical to how we at CPP Investments contribute to the sustainability of CPP,” they explain, continuing that diversification is the most important lever to control risks and influence returns, and looking at assets through a factor lens helps achieve a well-diversified portfolio.

Broad asset class labels like equities or real estate do not sufficiently capture the underlying drivers that influence the risk and return of investments, but analysing the more fundamental and more independent return-risk factors that underlie each investment strategy can. CPP Investments considers return-risk factors like economic growth, rates and credit spreads, they continue – for example, private equity is considered “high intensity” exposure to economic growth.

CPP Investments total portfolio investment framework (TPIF) reflects the full scope of investment activity at the fund. Underpinning these components is a factor view of the portfolio. At a high level, the TPIF framework consists of the following components:

Firstly, it involves setting risk targets drawn from information including the actuarial report and the investor’s own own internal risk and return expectations to estimate and express the level of market risk.

Secondly, the process involves setting exposure targets, determining the mix of factor exposures that maximises risk-adjusted return over a long horizon, robust to different macroeconomic environments.

Next the team set strategy targets. This involves modelling and mapping investment strategies onto the factor set – these representations are then consistently used through TPIF.

For example, modelling will capture different characteristics of the asset class like the fact real assets such as property and infrastructure both have exposure to economic growth and rates, while private and public investments may appear to be fundamentally similar, but their liquidity profile is materially different as are their leverage and debt levels. In this stage of the process, the team also recognise the additional expected risk and returns of active management.

The final step of the process draws together strategic allocation with day-to- day management. Using the factor lens, the team analyse how major new investments or divestments might affect the exposures of the total portfolio. “As markets and security prices change, we use our passive holdings of public market securities to rebalance our portfolios and seek to avoid unintended factor and risk exposures.”

TPIF also separates the management of foreign currency exposures from the management of the underlying assets. This permits the team to target the distinct return risk drivers of currencies.

Complexity challenges

The factor-based approach brings additional challenges above and beyond a traditional asset class-based approach. These include complexity, the risk of model error, and vulnerabilities to shifting macroeconomic relationships. Using factors to model private assets is challenging, and there are also limits on precision and robustness of the strategy, they write.

However, the duo argue that as we move to a less certain world, investors need to continue to evolve factor-based investment frameworks. Increased and more volatile inflation and emerging risks like climate change – like the need for analysis on the sensitivity of return on capital allocation choices to different climate change pathways – and geopolitical instability, are now coming to the fore.

“We believe that consideration of these types of emerging factors at the strategic allocation level and in the service of building a more resilient portfolio is important for institutional investors with diversified global portfolios.

We believe the factor-based approach when implemented thoughtfully provides greater transparency to underlying portfolio drivers and more effective tools for portfolio management.”

Listing key lessons, they write:

  • Establish a prudent and appropriate market risk appetite.
  • Determine the return/risk factors relevant to your program.
  • Map each investment strategy to your risk factor set.
  • Build and rebalance your portfolio based upon optimal factor exposures, not asset classes.
  • Consider adding new factors as the markets evolve.

Like many sustainability-focused investors, $17 billion PenSam, one of Denmark’s largest labour market pension providers, has found itself overweight US tech stocks in recent years. Not only is technology a low emitting sector, it’s also producing many of the solutions for reducing emissions by creating efficiency of production.

“We had more than 10 per cent in the IT sector,” recalls Mikael Bek, head of ESG at PenSam which introduced a climate benchmark for the equity portfolio in 2020. Over the last three years, the index successfully reduced carbon and supported positive returns in the equity allocation, but had also developed an increasing tilt to the IT sector where stocks like Amazon and Microsoft dominate the equity markets and take up a large share of the index.

“This was not the idea of the benchmark – we wanted a market portfolio with a climate tilt,” says Bek.

To resolve the problem, PenSam has just introduced a new, sector neutral climate index developed with S&P and applied to the whole $7-8 billion equity portfolio.

The index is constructed around a defined level of carbon budget linked to UN IPCC estimates on the required emission reductions to limit global warming to 1.5ºC compared to pre-industrial levels. Broadly, the benchmark has a 70 per cent reduction in emissions compared to the parent benchmark and must also further reduce carbon emissions annually by 7 per cent. If companies cannot achieve this themselves, PenSam “will make changes in the benchmark to reach its goal,” says Bek.

Alongside weighting companies in the index according to how much they cut their emissions, the bespoke index includes a higher weighting to companies having a positive climate impact. “Decarbonization is moving too slowly if we are going to reach the Paris goals. Just look out of the window! Everyone wants to continue to live the same life and emissions reduction is a very difficult task.”

The only caveat to the sector neutral approach is a large underweight to the energy sector – energy accounts for just 0.5 per cent of the index compared to 5 per cent in the underlying, broad-based benchmark. That underweight has been passed or redistributed to other sectors, he says.

“Our underweight to the energy sector is deliberate because we believe the fossil fuel sector will have problems in the long-run. We say we have a time horizon of 20-30 years ago and we need to reduce our exposure to fossil fuels,” says Bek.

In another element, the bespoke index also includes exclusions to tobacco and controversial weapon groups. Companies with poor human and labour rights are also taken out of the index.

PenSam also has a bespoke index for its corporate bond allocation that includes an exclusion on fossil fuels.  But the investor is currently exploring developing the index further, seeking a climate benchmark for the bond portfolio.

Challenges reporting on climate

Climate reporting and conforming to new regulation is one of the most challenging elements of sustainability at PenSam. In 2025/2026 the investor will report emissions in its audited, annual report for the first time. “When something goes in your annual report it is audited, that’s serious and this is a new ball game that informs our licence to operate” he says.

The EU’s Corporate Sustainability Reporting Directive, CSRD, require large and listed companies report on the social and environmental risks they face and on how their activities impact people and the environment. Pension funds have to comply with both CSDR and Sustainability Financial Disclosure Regulation, SFDR, concludes Bek.