Asset Allocation Policy

Arnott, Fabozzi, Lovell & Rice [1990, p. 24] suggested, however, that pension funds confront powerful forces driving them towards conservatism, which tend to shorten the investment horizons of fund managers. A pension fund is an asset pool dedicated to discharge a long-term obligation. Over long periods of time, returns on risky assets dominate those of less risky assets. Thus, efforts to constrain volatility in assets, funding ratios or expenses will predictably cut investment returns and increase the real cost of pension plans. Conservatism will therefore particularly affect those funds with low funding ratios.

In the US, pressure to constrain volatility can be found in the following legislation:

• as a consequence of the Financial Accounting Standard Board (“FASB”) Statement Number 87, pension expenses are sensitive to funding ratios and will climb as the funding ratio declines, thereby depressing earnings as well as placing it as a liability on the balance sheet;

• under the Omnibus Budget Reconciliation Act of 1987 (“OBRA”), any unfunded liability must be amortised over five years instead of the 15 to 30 year amortization schedule that previously prevailed; and

• under OBRA, Pension Benefit Guarantee Corporation (“PBGC”) insurance premia rise sharply for severely under-funded plans. This increase is triggered when the plan drops below (approximately) a 125% accumulated benefit obligation (“ABO”) funding ratio, directly affecting cash flow.

Most of the consequences of FASB 87 and OBRA are based on the ratio of assets to the ABO.2 The ABO considers only current employees, years of service and salaries, and does not allow for future growth in the real wages of employees. Thus it systematically underestimates true pension liabilities. However, this often has a minor impact unless the plan covers a youthful workforce.

In the UK, the recent introduction of a minimum funding requirement3 (“MFR”) for pension funds has increased the importance of maintaining fund solvency. It also places increased emphasis on the short-term volatility of pension funds. Under the new regulations, liabilities and assets have to be valued annually using a prescribed valuation basis. If the ratio of liabilities to assets is less than 100%, additional contributions or other action will be required to bring the fund into solvency over a reasonable time period. For funds with solvency ratios of 90% or less, corrective action must be taken more quickly.

Trustees are therefore encouraged to seek portfolios that are less volatile in the short term. Thus, Booth, Matysiak McCausland [1995] suggest that as a result of the imposition of a MFR, real estate investment is likely to appear less attractive. However, they concluded that as a result of most funds being solvent,4 the degree of disinvestment (if any) is likely to be small. Notwithstanding this, negative pressure on the level of real estate investment remains.

Arnott & Bernstein [1988] argued that the risk component of pension liabilities maybe broadly characterised as:

• interest rate risk, since the liability is the net present value of future obligations;

• productivity growth, which tends to be reflected in the real wages of employees; and

• inflation, which increases terminal earnings.

Therefore, a strategy to minimise risk will incorporate sensitivity to interest rate movements inflation and real economic growth, in the proportions by which a fund is exposed to these factors. Thus, as younger employees carry liabilities that are sensitive to the real economy, funds with a youthful membership should hold more equities and real estate, which would participate pari passu as the growth of that economy. In contrast, mature funds with a high proportion of retired employees, and most liabilities nominally defined, can best cover their pension risk with bonds.

Failure to understand real pension liabilities leads funds to seek to ensure pension surpluses, which in turn increases their true risk (Amba [1987]). For example, a fund adopting a contingent immunisation strategy, with the duration of bonds matched to liabilities, might seem to protect the trustee from any legal recourse as long as actuarially determined pension contributions are made. Certainly, wage-related contributions on salaries increasing at more than the rate of inflation would enhance this protection.

A problem may occur, however, if economic strength or unexpected inflation forces wage increases above actuarial assumptions. The pension fund may become modestly under-funded and subject to the cash flow and balance sheet consequences previously outlined. However, since both real economic growth and inflation demonstrate meaningful serial correlation - see section 2.4.6 -it is likely that this could affect the pension fund for consecutive years. The effect of conservatism remains modest today, with most pension funds comfortably funded; see table 2.4. However, Arnott & Bernstein believed that these pressures will grow, with investment horizons shortening and long-term returns falling.

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2Under FASB 87 and OBRA, accountants value real estate and venture capital projects on an appraisal basis, thereby understating their true volatility.

3For a detailed analysis of the effects of the Pensions Act 1995 on real estate investment, see Booth, Matysiak & McCausland [1995] and Booth, Lizieri & Matysiak [1996].

41n the survey conducted, 79% of schemes had a solvency level of 100% or greater at the last actuarial valuation. These schemes are likely to be solvent to an even greater extent under the MLR basis.