British DC plans use liability-driven investing

LONDON — U.K.-based consultants and money managers are applying liability-driven investing principles to defined contribution plans.

If successful, this approach could revolutionize so far humdrum DC investment strategies that have focused largely on conventional bond and equity investing through lifestyle funds.

Industry sources say liability-driven and target-return-driven investing are new concepts for defined contribution plans and could attract interest in other large markets, including the United States.

A key reason behind the move is that the number of individuals in U.K. private-sector defined contribution plans is outpacing those in defined benefit schemes. By the end of 2005 there were roughly 4.5 million members of occupational DC pension plans in the United Kingdom, according to Andy Cheseldine, a senior consultant at Hewitt Associates, London. This compares with around 3.2 million people in defined benefit plans at the same time, he said.

While the estimated £400 billion ($747.6 billion) in defined contribution assets at year-end 2005 is dwarfed by the £800 billion in defined benefit plan assets, the rising number of participants means new cash flows will increasingly be directed to defined contribution plans.

In anticipation of this broad shift, firms such as Merrill Lynch Investment Managers, London; Hewitt Associates; Watson Wyatt Worldwide, Reigate, England; and Schroders PLC, London, are seeking ways for defined contribution plan executives to make more efficient use of participant contributions.

Their proposals include using:

• a wider range of asset classes, including alternatives, in which DC participants may invest;

• dynamic asset allocation to meet a targeted investment return; and

• protection strategies to lock in returns.

Merrill Lynch has been applying a liability-driven investment approach to its DC products and has attracted interest from a number of clients, according to Andrew Dyson, MLIM's head of institutional business for Europe, Middle East and Africa. He would not identify the clients. The firm manages £2 billion in DC assets.

"The more people depend on DC, the more important it is to get it right. Our conclusion is that the traditional approach, the lifestyle approach, looks outdated when applied to modern thinking," he said.

With its target-return-driven funds, MLIM first attempts to calculate the investment return necessary to achieve the income the individual member requires on retirement. This target return acts as a reference point for dynamic asset allocation, said Mr. Dyson.

Asset allocation could be done "mechanistically," where investment returns above a certain level are banked and invested in less risky assets such as bonds. "This ‘banking' approach has a higher median outcome and a lower risk level … but you don't have the blow-out upside. If equities do well, the additional return is banked and that money is taken off the table," said Mr. Dyson.

Alternatively, asset allocation can be done "judgmentally," where the firm manages the asset allocation according to the target investment return it is trying to reach. Depending on the level of liquidity needed in the fund, this approach invests in a much wider range of assets than DC funds have done in the past, said Mr. Dyson.

He would not give more details.

Similarly, consultant Hewitt Associates is working on offering its DC clients a dynamic asset allocation approach, said Gillian Warwick-Thompson, principal consultant.

"We have thought about an individual DC member as a one-person DB plan with defined liabilities. Once you know your target, you can then work back to see what you can do about it and come up with ways of investing to meet that target," she said.

Part of Hewitt's dynamic asset allocation strategy would also involve protecting and banking excess returns by moving them from a high risk to a lower risk investment.

So far, the targeted investing strategies the firm has done with clients have involved a fairly conventional mix of equity, bonds and some property, she said. There was no reason alternatives like hedge funds and private equity couldn't be included in the mix, but in practice, these assets posed liquidity problems that could be tricky for plans needing cash flow, Ms. Warwick-Thompson added.

"We have not come up with anything using options as this tends to be expensive over the long term. Further work needs to be done to price this at a sensible level," she said.

Watson Wyatt Worldwide's new approach to DC investing includes a far lower allocation to equity and the use of a wider range of alternative assets than has been the case to date. It also recommends dynamic switching of investment strategy depending on the individual's financial circumstances and downside protection against investment losses.

At this stage the model is a "prototype for discussion" and is not yet in practice by any of the firm's clients, said Roger Urwin, global head of investment consulting.

In Watson Wyatt's model, DC funds would invest up to 30% of total assets in domestic and global equities with the balance of the assets invested in a range of other strategies including property; emerging market and high-yield debt; hedge funds of funds; global tactical asset allocation funds; private equity; infrastructure; and index-linked bonds and commodity futures.

"DC is not working like this at the moment, but I'm sure many plan sponsors would like it to work like this in the future," he said.

Typically, U.K.-based DC plans invest 80% in global and domestic equities with the balance invested in bonds, cash and property.

A well-diversified asset mix such as that proposed in the new model could have the same expected return but with up to a third less investment risk as a typical DC plan with a high proportion in equity, said Mr. Urwin.

"We are not necessarily advocating the use of all these asset classes for everybody, but the point is that you want a lot more diversity in investment in the DC strategy," said Mr. Urwin.

Alan Brown, head of investment at Schroders, is seeking ways to create a deferred, inflation-protected annuity that DC plan members close to retirement could buy.

"Just before retirement, when the DC plan member has to carefully manage investment risk, there is often very little room to take much initiative," he said.

He proposes that about 10 years before retirement, the participant starts to switch out of equities and, rather than investing in conventional bonds, invest in funds designed to guarantee an inflation-protected income after retirement. These strategies would be structured using long-dated swaps, which are commonly used by defined benefit plans when trying to manage their liabilities through liability-driven investing.

But the high cost of swaps combined with the low level of long bond yields means it is very expensive now to create this type of strategy for a DC plan, he said.

Mr. Brown hopes to be able to find an inexpensive way to create this essentially passive strategy when, and if, real yields on long bonds move closer to 2% from just less than 1% now.

Mr. Brown has had talks with the government's Debt Management Office about the possibility of launching a long-dated government bond that would provide no income for the first 10 years and then offer an inflation-protected return for a set number of years.