Using growth assets to generate investment returns relative to the scheme liabilities.
Issued: March 2017
Last updated: September 2019
19 September 2019
The latest updates to this guidance reflect a number of regulatory changes introduced in 2018 and 2019, including The Pension Protection Fund (Pensionable Service) and Occupational Pension Schemes (Investment and Disclosure) (Amendment and Modification) Regulations 2018, and The Occupational Pension Schemes (Investment and Disclosure) (Amendment) Regulations 2019.
The update has involved significant rewriting of various sections throughout the Investment Governance and Investing to Fund DB Schemes portions of the guidance; you may, therefore, find it useful to re-acquaint yourself with the guidance as a whole.
Updated information on investment decisions and your statement of investment principles, stewardship, reporting, sustainability and financial and non-financial factors may be of particular relevance.
1 August 2019
We have made some small updates to this guide to reflect the fact that an industry led body: The Cost Transparency Initiative, has produced standardised templates which we encourage trustees to use to obtain information about costs and charges from their provider.
Other minor changes have been made including minor editorial changes.
30 March 2017
First published.
What you need to do
- Understand the risks your growth assets are taking to seek return, including those in multi-asset funds.
- Put in place appropriate methods, such as diversification and hedging, and appropriate governance arrangements to manage those risks.
Understanding growth assets
Pension schemes hold growth assets, also known as ‘return seeking investments’, because they want a positive return over time to grow the scheme assets.
Investment in growth assets involves taking risks to target the desired return. Many different types of growth asset are available to pension schemes and involve taking different types of risk to seek that return.
You need to understand how your growth assets are expected to generate return and the principal risks involved. Your investment manager(s) or investment adviser should be able to explain this to you and provide relevant training.
You may find it helpful to consider whether the return is essentially:
- contractual (such as bond investment), where a legal agreement gives you the right to a specified level of return but you take the risk that the other party (eg the bond issuer) may default, or
- non-contractual (such as equity investment), where you are entitled to a share in the profits from a venture, but you take the risk that these profits may not be achieved
You may wish to use a framework that considers the underlying drivers of return of the growth assets and reconcile these with your investment beliefs, if you have developed them, eg:
- credit risks
- equity market risks
- real estate risks
- insurance risks
- interest rate risks
- inflation risks
- currency risks
- liquidity risk
- political risk
- non-macroeconomic / behavioural factors
- investment manager skill
- environmental risks including climate change
- governance and stewardship risks
A framework like this can help you understand how your growth assets may perform across a range of different economic and market environments. It can also help you critically assess proposals to invest in new or different types of growth asset.
As well as the risks from the investments themselves, you need to consider the risks arising from how those investments are accessed, particularly where pooled fund structures are used.
Diversification
As described in the matching assets section, it is a legal requirement for scheme assets to be properly diversified[16]. Diversification may provide greater stability of investment returns and reduce risk.
For growth assets, you may, for example, wish to consider diversification in terms of:
- asset classes
- geography
- asset managers
- sector risks
- underlying securities
Schemes generally seek diversification by investing across different asset classes. However, the returns from different asset classes may be driven by the same underlying risk factors. Consideration of these underlying factors should enable more effective diversification to be embedded in your scheme’s investment portfolio.
You should also consider how diversified your scheme’s assets are from the scheme’s employer. If the same factors significantly affect the employer covenant and the scheme assets, it increases the overall risk in the scheme.
Even pension schemes with well-diversified investment strategies may experience periods where diversification offers little protection. This happened in the global financial crisis of 2007/8, when many asset classes performed badly at the same time. You may therefore wish to consider other types of risk mitigation techniques, eg reducing your scheme’s exposure to significant market falls by using suitable tail risk hedging strategies.
See an example of assessing employer risk in our IRM guidance.
Governance
You need to have appropriate investment governance arrangements in place for your scheme’s growth assets so the risks are properly managed.
A portfolio of growth assets that is well-diversified across different risk factors can involve different managers and asset classes and may require increased governance and monitoring.
Multi-asset funds
Multi-asset funds are a popular way to access a diversified portfolio of return-seeking investments, with the aim of reducing scheme risk while maintaining scheme return. While these funds may offer benefits to schemes in terms of risk and return, they cover a wide range of investment asset classes and investment and risk management strategies. Fund performance over different times and market cycles can vary significantly between funds. You need to check the selected fund is consistent with your investment objectives.
Adopting this approach outsources the selection of assets and governance of that portfolio to the fund provider. If you’re considering investment in a multi-asset fund, you need to complete sufficient due diligence before investing to ensure you properly understand the main drivers of the expected return and how risks are managed and mitigated. Assessing historical fund performance under different market and economic conditions can help with this.
If you decide to invest in a multi-asset fund following an investment modelling exercise, you should satisfy yourself that the chosen fund fits with the modelling assumptions used, revisiting the modelling with more appropriate assumptions if necessary.
Things to consider: diversified growth funds (DGFs) and other multi-asset funds
The range of approaches adopted by DGFs and other multi-asset strategies can vary significantly between funds and strategies. Examples of areas to understand are:
- the range of asset classes the fund may invest in
- the degree of investment flexibility within the mandate, eg the equity allocation in a DGF might be able to range between 15% and 85%
- the extent to which derivatives, the ability to short stocks, structured products and other complex instruments are used
- how the manager expects to generate the return objective, including the amount of return generated by active management of the underlying assets (alpha), general market movements (beta), by tactical asset allocation (market timing) and by other components, such as currency, sector and sub-asset class investment decisions
- how past performance (and risk control) has been delivered and the extent to which that was influenced by market conditions
- how volatility within the portfolio will be controlled
- how performance can vary over different time periods - many DGFs are designed to target equity-like returns with less volatility over the long-term, but short-term performance can be materially different from this
- which parameters to use for the fund when doing investment modelling, eg those for expected return, volatility and correlation with other asset classes
Trustee toolkit online learning
The module 'An introduction to investment' contains tutorials called 'Types of asset: Common assets', 'Types of asset: Alternative assets', and 'Capital markets and economic cycles'. The module 'Investment in a DB scheme' contains a tutorial called 'Changing the asset allocation strategy'. You must log in or sign up to use the Trustee toolkit.
Footnotes for this section
- [15] Regulation 4(7) of the Investment Regulations.