Strategic asset allocation for pension funds.

2nd AFIR Colloquium 1991, 3: 33-49

StrategiAcssetAllocatiofnorPensionFunds

PhilGi.pScott

NorwichUnionInsuranGcreoup,PO Box4,SurreSytreeNto,rwichNR1 3NG, United Kingdom

Summary

StrategAiscsetAllocatiiosnthemostimportadnetcisifoonranypensiofnund. It remains, howevert,heleasutnderstood. Thereisnorighotrwrongway ofdeterminitnhgeStrategAiscsetAllocatiaondnin the end itisa questioonffindintghebestsolutitoona setof constrainstosm,e implic(iftund structuarned)someexplic(iltegislatiTohni)s.solutiwoinllalsobe heaviliynfluencebdy thepersonaplhilosophoifetshe investor. An agreeSdtrategAiscsetAllocatiBoennchmariksthevitawlay inwhichthechoictehahtas beenmadecanbecommunicatteodallpartieOsn.lyinthiwsay cantheinvestmepnrotcess beunderstoaonddtheresulmtesasuretdoensurtehefundachieveistsultimaotbejectiveof providibnegnefittositmsembers. Thispaperiswrittebny aninvestmemnatnager(whoisalsoanActuarya)ndittrietsotakea practicaaplproacthothedevelopmeonftStrategAiscsetAllocatistornuctures.

R?sum?

R?partitioSntrat?giqudesActifpsour les Fonds de Retraite

La r?partitsitornat?gidqeuseactifesstlad?cisiolnaplusimportanptoeurtoutfondsde retraitEel.lerestceependanltaplusm?connue. Iln'ya pasdebonneoudemauvaisfea?onded?terminuenrer?partitsitornat?gidq'aucetifs eten finde compte,celaser?sume ?trouvelrameilleurseolutionun?ensembldee contraintceesr,tainiemsplicit(esstructduurefondsd)'autrexsplici(tle?sgislationCe)t.te solutiosnera?galemenftortemenitnfluenc?pear les philosophipeesrsonnelldees l'investisseur. Un rep?rceonvenduer?partitsitornat?gidq'uaectiefsstlafa?onessentiedlelceommuniquer lechoixeffectu?to?utelsespartiesC.e n'estque de cettfea?on que le processus d'investissepmeeunt?ttrceompriestlesr?sultmaetsur?psourgarantqiurelefondsatteigne sonobjectuilftimqeuiestdefournidresallocatiosnes me?mbres. Cetarticelset?criptarun gestionnadierpelacemen(tquiest?galemenatctuaireet)tente d'adoptuenreapprochperatiquaeud?veloppemednetsstructurdesr?partitsitroant?gique d'actifs.

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1 Introduction

1.1 The averageage of thepopulationinmost countriescontinues to increaseat a time of improving healthcarew,ith 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 aspirationosf thisgrowing populationof pensioners.

1.2 The establishmentof investment funds from which benefits can be drawn isa vitalway of ensuringthatpensionerscan achievea betterqualityof lifeI.tisthereforesurprisintghat both individuals and corporate bodies have limited understandingof how to investsuch funds.

1.3 A basicprinciploef investmentisthatenough fundsshouldbe availablteo fulfitlhe liabilitwiheesn they arise and within this requirement to seek the maximum accumulation. The challengeprovidedby pension funds isin understandingthe natureof the liabilitaineds the mix of assetsthatbestenable them to be met.

1.4 There are two principaltypes of pension fund. There are those thatprovide "DefinedBenefits"ie where the benefits payable are calculatedfrom a pre-determined formula. Alternativeltyh,ereare "DefinedContribution"funds where each member effectivehlays theirown fund and from which they receivethe totalaccumulation.

1.5 Whilst in Defined Benefit funds the liabilitieasre more preciselyknown because of actuariatlechniques,in essence both typesof fundsareseekingto satisftyhe same need: that is to provide benefitswhich will be payable in real (ie inflatioandjustedt)erms at some time in the future.

1.6 The principaslubject of this paper is how those responsible for pension funds should choose between the many asset typesavailablee:g.EquitiesB,onds, RealEstateand Cash.

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1.7

The assetstructuroef any long-term fund, like a pension fund, needs to be decidedusinglong-termtimehorizons.This longterm target for the fund is generally known as the Strategic Asset Allocationstructure.It should take account of the liabilitioefsthe fund and actuariaslkillhsave an important part to play in determining the StrategicAsset Allocation structure.

1.8 Equitieshold a clearadvantagein matching the attributeosf long-terminflatiolninkedliabilitiIetsi.s thereforeaccepted wisdom inthe UK thatthe naturalpositionfora pensionfund is to be heavilyinvestedin equities.However, short-term returnsfrom equitiesare highly volatileand thereforea proportionof otherassetsshouldbe heldto diversiftyhis risk and ensurethatliabilitciaensbe met.

1.9 Thisleadsto thecruciaqluestion for all investors:

"How much of the fund should be in equities?"

There isno simpleanswer to thisquestionand views willbe held by both the investmentmanager who "looksafter"the assetsand the actuarywho "looksafter"the liabilitiTehsi.s paper iswrittenby an investmentmanager (who isalsoan Actuary) and ittriesto take a practicalapproach to the developmentof theStrategiAcssetAllocatiosntructure.

1.10 Deviationsfrom thelong-termassetstructurcean oftenbe considereddesirablbeecauseof short-teremxpectationasbout thereturnfrom thedifferenatssettypes.ThisisTacticaAlsset Allocationw,hich isnot a subjectforthispaper and should normallybe delegatedtotheday to day investmentmanager of the funds.

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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 NetherlandGsermany 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.

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Table 2 Asset Distribution - UK Pension Funds

UK Equities OverseasEquities Real Estate Bonds Cash

1965 % 50 -

5 42

3

1970 %

56 10

32 2

1980 % 44 6 22

23 5

1990 %

53 21

10

10

6

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

1950 to 1959 1960 to 1969 1970 to 1979 1980 to 1989

UKAssets- RealRatesof Return

Bonds

Equities

%

%

-2.5

+13.8

-1.9

+4.2

-4.9

+1.8

+6.9

+15.3

AverageRate of Inflation

%

+4.1

+3.8

+13.3 +6.8

Source : BZW Equity-Gilt Study

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