Secrets of Success: How to put power in your pension fund

Whether you run your own pension fund, have a personal pension, or belong to a company scheme, you have an interest in how the fund is being invested.

Whether you run your own pension fund, have a personal pension, or belong to a company scheme, you have an interest in how the fund is being invested.

Only those with a defined benefit scheme, a vanishing number, can afford not to worry too much about how good a job the trustees or managers of your fund are doing with the money that will produce your retirement income.

The latest edition of the UBS Pension Fund Indicators yearbook has interesting data on how pension funds' behaviour as investors is changing. The picture it paints is one of trustees, advisers and investment managers struggling to come to terms with the new dynamics of the investment climate, driven by lower equity returns, ageing populations and potential funding shortfalls.

In 2003 the average pension fund recorded a return of 17 per cent,which was badly needed after three years of negative returns. The average 10-year return on pension funds now stands at 6.3 per cent, in a period when wages grew at 4.0 per cent per annum and retail price inflation at 2.6 per cent.

In real terms, after allowing for inflation, these figures are little different from the much longer-term data. The UBS database goes back to 1963. In the 41-year period since then, the average pension fund has returned 10.8 per cent, while wages grew at 8.6 per cent and retail prices at 6.6 per cent. Real returns have therefore fallen by just 0.5 per cent per annum, from 4.2 per cent to 3.7 per cent per annum.

At the same time, there is no doubt that pension funds are much better diversified than in the past. Forty years ago, in terms of liquid assets there was little alternative to conventional equities, gilts or cash. The last 20 years have seen the emergence of new liquid and accessible markets in the form of index-linked gilts, overseas equities and corporate bonds, together with more sophisticated options in the property market. Now we have hedge funds and private equity emerging as a potential new class of asset.

Financial theory dictates that the availability of new asset classes with different risk-and-return characteristics improves the outlook for pension fund investors. They hold out the prospect of efficient diversification, reducing risk. That this is already happening is reflected in the asset allocation decisions of pension funds.

In the mid 1960s the typical pension fund had 50 per cent of its assets in equities, 35 per cent in gilts and 10 per cent in property, with the balance in cash and smatterings of other things. Today the average pension fund has 39 per cent in UK equities, a further 28 per cent in overseas equities, 12 per cent in conventional gilts, 9 per cent in index-linked, 6 per cent in property and 3 per cent in cash and overseas bonds.

If this has reduced the risk profile, while returns are still not unreasonable, why all the fuss? In real terms, the asset backing of UK pension funds is still some 15 per cent higher than it was in 1995. The poor performance of the past four years has merely, you could say, cancelled out some of the returns of the wonder years 1980-1989, when funds returned more than 15 per cent per annum for eight years out of 10, without a single negative year.

The reasons for today's anxieties include an ageing population, which will see the ratio of those in retirement to those in work rise from 24 per cent in the year 2000 to 40 per cent in 2030; increases in life expectancy; the almost certain fall in overall rates of investment return; and the unwillingness of the state to take on responsibility for the growing liabilities that these various trends entail. You might add that human nature finds it difficult to reduce expectations: one generation always expects to do at least as well as the one before.

The issue for pension funds is: how well-equipped are they to meet the liabilities they already have and the expectations of those whose pension saving has yet to begin in earnest? Pension fund trustees are having to abandon the "steady as you go" habits of the past 20 years in favour of a more active management approach.

One increasingly popular route is to switch from a relatively simple asset allocation approach to one that explicitly seeks to match the investment policy of the fund to a specific set of liabilities. As Boots demonstrated a couple of years ago, it may be possible at times, by buying bonds with the right maturities and yields, to lock in returns sufficient to meet all your expected future liabilities.

This is an approach that private investors can also adopt. The ideal tool is index-linked gilts, which guarantee to retain their value in real terms. Unfortunately there are not enough index-linked gilts around to meet demand, with the result that yields have fallen to a point at which their potential returns are no longer as attractive, making them less efficient as liability matchers.

The big issue for pension funds still comes down to how they manage their equity market exposure. The traditional policy of having a high and permanent weighting in equities (often as much as 75 per cent) worked well for a long time during the bull market. But this policy looked more and more imprudent as equity valuations rose higher. Now all pension funds are cutting back equity market exposure.

The WH Smith and Marks & Spencer bid battles have shown how important an issue the funding of pension funds has become. This gives the fund trustees a lot of power, but power brings responsibility.

With so many competing pressures, it is going to be difficult for them to make optimal decisions, especially as the iron law of mean reversion virtually guarantees that the bumper returns of the 1980s and 1990s will not be repeated soon.

jd@intelligent-investor.co.uk