Byline: Alistair Graham
Soul searching and asset reallocation is expected to continue among UK pension funds this year after 2003 saw them finally gain some breathing space.At the start of last year a lot of pension schemes were in a bad way following three miserable years. By the end, through luck rather than design, markets had moved in their favour as funds took the opportunity to try and shore up their positions and close huge deficits.
The rally in 2003 also gave schemes time to consider the devastating effects of the bear market and question their investment policies. Funds have in the past relied on equities to generate high returns. For a long time it worked, enabling companies to enjoy long holidays from making contributions to their pension funds.
The onset of the bear market in 2000 changed all that. The dramatic plunge in equity values left pension funds nursing huge losses.
Mike O'Brien, managing director at Barclays Global Investors, said: "Funds haven't been adequately diversified during the bear market and are now questioning the whole idea of equity-dominated investment policies. It's no good being invested in 20 markets if they are all going the same way."
Consultants have been recommending that schemes move more of their assets into bonds. These offer a more predictable source of income from which funds can meet their regular pension payments. But some schemes are still resisting a significant switch to bonds in the hope that high equity returns will help them reduce their funding shortfalls.
John Ball, partner at Watson Wyatt, a consultancy which advises the pension funds of more than half the FTSE 100 companies, said: "Schemes with poor funding levels still feel that they need to gamble on a continued upturn in the equity market in order to restore the scheme's funding to a satisfactory level." The gamble is paying off so far, but pension funds know they need to diversify away from equities over the long term. Funding shortfalls have exposed schemes' flawed strategy of trying to outperform at all costs. In doing so, funds have taken too much risk and too little account of the returns they need to pay their pensioners.
In the past, pension funds have compared their performance against other funds. However, peer-group benchmarks ignore the widely varying pension liabilities each company is facing.
Now funds are building benchmarks tailored to their liabilities. This will lead to portfolios becoming more diversified, but funds still have a long way to go. For example, UK funds are overexposed to domestic equities and are dragging their feet on investing more overseas.
The average UK scheme has almost 60% of its assets in domestic shares, according to WM Company, the performance consultancy. The UK equity weighting in the FTSE World index is only 10%.
Perhaps predictably, pension consultants claim there is a shortage of quality overseas equity managers to recommend. Nevertheless, consultants have started to come under fire for their part in funds' disastrously high equity weightings and lack of regional diversification.
The cost of …