Strategic asset allocation for pension funds.

2nd AFIR Colloquium 1991, 3: 33-49

Strategic

AssetAllocation

forPensionFunds

Philip

G. Scott

NorwichUnionInsurance

Group,PO Box 4,Surrey

Street,

NorwichNR1 3NG, United

Kingdom

Summary

Strategic

AssetAllocation

isthemostimportant

decision

foranypension

fund. It remains,

however?

theleast

understood.

Thereisno right

orwrongway ofdetermining

theStrategic

Asset

Allocation

and in the end

itisa question

of finding

thebestsolution

to a setof constraints,

some implicit

(fund

structure)

andsome explicit

(legislation).

Thissolution

willalsobe heavily

influenced

by

thepersonal

philosophies

of the investor.

An agreed

Strategic

Asset

Allocation

Benchmark

isthevital

way inwhichthechoice

that

has

Onlyinthis

way cantheinvestment

process

beenmadecanbe communicated

toall

parties.

be understood

andtheresults

measured

toensure

thefundachieves

its

ultimate

objective

of

providing

benefits

toits

members.

Thispaperiswritten

by an investment

manager

(whoisalso

anActuary)

andittries

totakea

practical

approach

tothedevelopment

ofStrategic

Asset

Allocation

structures.

R¨¦sum¨¦

R¨¦partition

Strat¨¦gique

desActifs

pour les Fonds de Retraite

La r¨¦partition

strat¨¦gique

desactifs

estlad¨¦cision

laplusimportante

pourtoutfondsde

retraite.

Elle

reste

cependant

laplusm¨¦connue.

Il

n¡¯ya pasde bonneou de mauvaise

fa?on

ded¨¦terminer

uner¨¦partition

strat¨¦gique

d¡¯actifs

eten finde compte,

celase r¨¦sume ¨¤trouver

la meilleure

solutionun¨¤ ensemble

de

contraintes,

certaines

implicites

(structure

du fonds)

d¡¯autres

explicites

(l¨¦gislation).

Cette

solution

sera ¨¦galement

fortement

influenc¨¦e

par les philosophies

personnelles

de

l¡¯investisseur.

Un rep¨¨re

convenu

de r¨¦partition

strat¨¦gique

d¡¯actifs

estlafa?on

essentielle

de communiquer

lechoixeffectu¨¦toutes

¨¤

lesparties.

Ce n¡¯est

que de cette

fa?on que le processus

d¡¯investissement

peut¨ºtre

compris

etlesr¨¦sultats

mesur¨¦s

pourgarantir

quelefonds

atteigne

sonobjectif

ultime

quiestde fournir

desallocations

ses membres.

¨¤

Cetarticle

est¨¦crit

parun gestionnaire

de placement

(quiest¨¦galement

actuaire)

et tente

d¡¯adopter

une approche

pratique

au d¨¦veloppement

desstructures

de r¨¦partition

strat¨¦gique

d¡¯actifs.

33

1

Introduction

1.1

The averageage of the populationin most countries

continues

to increaseat a time of improving healthcare,

with today¡¯s

workers looking forward to a greater number of retirement

years.This is happening at a time when Governments are

unable to fund the aspirations

of thisgrowing populationof

pensioners.

1.2

The establishmentof investment funds from which benefits

can be drawn isa vitalway of ensuringthatpensionerscan

achievea betterqualityof life.

Itis thereforesurprising

that

both individuals and corporate bodies have limited

understanding

of how to investsuch funds.

1.3

A basicprinciple

of investmentisthatenough funds shouldbe

available

to fulfil

the liabilities

when they arise and within this

requirement to seek the maximum accumulation. The

challengeprovidedby pension funds is in understandingthe

natureof the liabilities

and the mix of assetsthatbest enable

them to be met.

1.4

There are two principaltypes of pension fund. There are

those thatprovide ¡°Defined Benefits¡±ie where the benefits

payable are calculatedfrom a pre-determined formula.

funds where

Alternatively,

there are ¡°Defined Contribution¡±

each member effectively

has theirown fund and from which

they receivethe total

accumulation.

1.5

Whilst in Defined Benefit funds the liabilities

are more

precisely

known because of actuarial

techniques,in essence

both typesof funds are seekingto satisfy

the same need: that

is to provide benefitswhich will be payable in real (ie

inflation

adjusted)

terms at some time in the future.

1.6

The principal

subject of this paper is how those responsible

for pension funds should choose between the many asset

typesavailable:

eg.Equities,

Bonds, RealEstateand Cash.

34

1.7

The assetstructure

of any long-term fund, like a pension fund,

needs to be decidedusinglong-termtime horizons.

This longterm target for the fund is generally known as the Strategic

Asset Allocationstructure.

It should take account of the

liabilities

of the fund and actuarial

skills

have an important

part to play in determining the StrategicAsset Allocation

structure.

1.8

Equitieshold a clearadvantage in matching the attributes

of

long-terminflation

linkedliabilities.

It is thereforeaccepted

wisdom in the UK thatthe naturalposition

fora pension fund

is to be heavilyinvestedin equities.

However, short-term

returns from equitiesare highly volatileand thereforea

proportionof otherassetsshould be held to diversify

this risk

and ensurethatliabilities

can be met.

1.9

This leadsto the crucial

question for all investors:

¡°How much of the fund should be in equities?¡±

There isno simple answer to thisquestionand views willbe

held by both the investmentmanager who ¡°looksafter¡±the

assetsand the actuarywho ¡°looksafter¡±the liabilities.

This

paper is writtenby an investmentmanager (who is also an

Actuary) and ittriesto take a practicalapproach to the

development of the Strategic

AssetAllocation

structure.

1.10 Deviationsfrom the long-termassetstructure

can oftenbe

considereddesirable

because of short-term

expectations

about

the returnfrom the different

assettypes.ThisisTactical

Asset

Allocation,

which isnot a subject

forthispaper and should

normallybe delegatedto the day to day investmentmanager

of the funds.

35

2

Asset

Structures

2.1 The actual asset structures of pension funds differ significantly

between one country and another. For example:

Table 1

Break down of pension fund assets by type - 1989

UK

%

Netherlands

Germany France

%

%

%

Japan

USA

%

%

Equities

78

38

15

26

27

47

Real Estate

10

16

10

-

1

4

Bonds & Cash

12

46

75

74

72

49

Source : Various

2.2

Care needs to be exercised in comparing the data, not least

because of very different valuation methods in different

countries. However, the differences are sufficiently large for us

to try and find out why they exist when the funds are seeking

to achieve the same aim.

2.3

UK Pension Funds

UK pension funds have traditionally had higher weightings in

equities than pension funds in any other country. The

importance of equity investment has existed for many years as

can be seen from the following table.

36

Table 2

Asset Distribution - UK Pension Funds

%

1980

%

1970

1965

%

1990

%

UK Equities

50

56

44

53

OverseasEquities

-

-

6

21

RealEstate

5

10

22

10

42

32

23

10

3

2

5

6

Bonds

Cash

Source : Central Statistical Office

2.4 One of the main reasons for this equity bias is the inflationary

expectations in the economy. The UK has had a high rate of

inflation relative to many other countries and real assets, such

as equities, have been important in achieving real (ie inflation

adjusted) returns. Bonds on the other hand tend to fare badly

in times of high inflation. See below :

Table 3

Period

UKAssets- RealRatesof Return

Equities

Bonds

%

%

AverageRate

of Inflation

%

1950 to 1959

-2.5

+13.8

+4.1

1960 to 1969

-1.9

+4.2

+3.8

1970 to 1979

-4.9

+1.8

+13.3

1980 to 1989

+6.9

+15.3

Source : BZW Equity-Gilt Study

37

+6.8

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