I read an interesting comment piece by Peter Smith in the ever-reliable FTfm section of yesterday’s Financial Times. It concerned a possible upcoming change in the investment strategy of the Bank of England’s own defined benefit pension scheme.
So, what have they been doing and what might be next?
Around 2007, the fund switched investment strategy from one with a mix of gilts and equities to a “portfolio exclusively focussed on index linked-gilts”. Having checked the most recent fund report and accounts (as at 28 February 2017), the actual split is around 60% index-linked gilts, 30% index-linked corporate debt (issued by the likes of Network Rail) and 10% fixed-interest gilts. The point being is that the scheme has been wholly invested in debt-based securities for over ten years. This has served the scheme very well over many years, with the funding level now reported to be 101%, an improvement from 96% in 2011. I would take issue with the contention from Marc Ostwald of ADM investors who rather uncharitably suggested that the scheme has “been an OK performer more through luck than judgement”. Many schemes will look back and wish they had achieved the same “luck” over the last ten years.
The really interesting bit is what might come next.
According to recent meeting minutes, the Scheme’s Chair of Trustees (John Footman) has stated that the Scheme was considering “alternative approaches” and “taking more investment risk”. This is being taken as a sign that gilts are “relatively less attractive” and that “defined benefit pensions are not necessarily best served by gilts”.
Gilts may not be hugely attractive, but they remain an important tool (perhaps the most important tool) in a trustee’s armoury for tackling the biggest pension scheme risks of interest rates and inflation. While many of our clients are rightly seeking higher yield where they can get it (through multi-asset credit, illiquid assets and other growth assets), gilts (and instruments such as Liability Driven Investments) will remain core to a scheme’s investment strategy.
In my view, this potential change in tack may actually be more about dampening the expected cost of future benefits than managing the risk of benefits built up to date. With ongoing accrual costs at an eye-watering 50%+ of pensionable salary, perhaps it has been decided that more investment growth is needed to mitigate this (broadly speaking, the more investment growth that is assumed, the lower level of contributions are expected to be needed to pay for future benefits).
There is no suggestion that wholesale change is on the horizon. I would expect the vast majority of the £4 billion plus fund to remain invested along current lines.
So, what can we learn from the Scheme’s approach:
- It is important to regularly review your Scheme’s investment strategy – a strategy that is right today won’t be right forever;
- Diversification (and here I agree with Mr Ostwald) should be an important consideration for scheme trustees –even the smallest of funds should be considering how different asset classes can add to overall performance and reduce risk;
- The nature of defined benefit pensions means that the ongoing build up of benefits is hugely expensive if the investment strategy is wholly gilt based. To sustain benefit accrual (where the risk can be sustained), growth-seeking assets are likely to be a necessary part of the portfolio; and
- The search for yield in the current environment may point towards alternatives to government bonds.
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