UK Pension Funds

Why have UK pension funds not invested heavily in hedge funds?

Ros Altmann
Originally published in the August 2005 issue

Hedge fund managers have expressed frustration that UK pension funds have been slow to diversify into alternative assets. There are many reasons for this. The actuarial investment consultants who dominate trustee investment thinking have always believed long-only equity investment is the best way to maximise long-term returns. They have not spent enough time trying to understand what hedge funds can do, having been deterred by the perception of hedge funds as high-risk, high-fee, highly geared, unregulated vehicles which are too complex.

But the hedge fund industry itself is probably partly to blame too. It has failed to explain clearly that hedge funds are not all the same, how they can reduce portfolio risk, that many hedge fund styles are not highly geared, nor the benefits of downside risk control in helping trustees reliably meet liabilities in mature pension funds. Trustees are often unsophisticated investors and need to be educated to better understand the complex concepts of hedge fund investing. If hedge fund presentations are not pitched at a level which the intelligent layman can understand, then the trustee audience will be lost in the first few minutes and may simply switch off, thus losing the value of the presentation and failing to appreciate the benefits of diversification into alternative assets.

History of UK pension fund asset allocation – over-reliance on long-only equities

UK occupational pension funds are in deep trouble. Final salary schemes have become too expensive for many employers, and companies are struggling to finance enormous deficits. There are many reasons why this situation has arisen, but inappropriate investment allocations have played a significant role. For far too long, UK employers were relying on equity investments to deliver long-term growth and meet pension liabilities, and this ideology appeared to be validated by exceptionally strong equity returns until 1999.

At that time, pension fund asset allocation was around 80% in long-only equities and the rest in bonds. Trustees believed that, because pension investing time horizons are so long, they should try to maximise long-term returns, by 'taking' plenty of risk, with the best asset for delivering higher returns being equities. Actuarial models assumed unsustainably high rates of equity returns, well into the future, which suggested that less money needed to be invested today, in order to provide tomorrow's pensions. Indeed, the more the fund invested in equities, the lower the apparent cost of providing the pensions would be!

UK pension fund investors failed to recognise developments in asset management and investment banking over the last 10-15 years. Traditional thinking ignored three vital points.

  1. Pension funds are supposed to deliver pensions, not to 'maximise returns at minimum risk'
  2. There is scant evidence that equities can reliably match the liabilities and risks faced by pension funds (inflation, duration and longevity)
  3. A pronounced equity bear market could have severe negative effects on the ability to deliver pensions, especially if accompanied by falling inflation and interest rates.

Alternative investment approaches can help address all three of these areas, but UK pension funds have been slow in adopting more modern methods of money management. Pension fund asset allocation and asset/liability modelling failed to properly consider assets other than equities and bonds.

Since 2000 – deficits

In 2000, the UK Government set up the Myners Review, to investigate institutional investment behaviour, examining why pension fund asset allocation was so standardised and had not diversified into other asset classes. When asked why they had not invested in hedge funds, trustees responded that this was because their actuarial investment consultants had not recommended them. So theReview team then asked the actuarial firms why they had not recommended hedge funds and were told that this was because the trustees had not shown any interest in them!

In truth, both trustees and the actuarial firms were caught up in the ideology of long-only equity investing, and seemed to truly believe that the best long-term returns would be delivered by just staying with equity managers and riding out any downturns, on the expectation that all would be fine in the longer term. Most pension funds have learned, to their great cost, that this is far too simplistic. Trustees and their advisers failed to take into account the risks of sharp market falls, coupled with falling interest rates and rising longevity, which have resulted in enormous increases in liabilities at the same time as asset prices were falling. The resultant deficits now urgently need to be addressed. Additional company contributions can help reduce deficits to some degree, but new investment approaches are also required.

Switching to bonds – misguided

Most pension fund investors are looking for ways of reducing their equity exposure, in order to reduce portfolio 'risk'. Having recognised that relying totally on equity market beta and perhaps additional long-only alpha to deliver the required returns over time was wrong, there is now a strong school of thought, led by some in the actuarial profession, that switching equity exposure into bonds is the answer. They suggest that pension liabilities are 'bond-like' and, therefore, that investing in bonds is the best way to match these liabilities. They are recommending the simplistic solution that trustees should switch their equity exposure into bonds, perhaps using corporate bonds to add some extra yield over gilts.

This strategy is, in my view, dangerously misguided, because although pension liabilities are 'bond-like', they are not properly matched by bonds at all. If pension liabilities are rising by at least 5% each year (being discounted by a bond discount rate) then returns above 5% are required, to encompass the residual risks of pension liabilities. These relate to salary inflation, to which pension liabilities are linked before retirement, limited price inflation, to which the liabilities are linked after retirement, duration – since pension liabilities stretch for many decades into the future, and longevity – with mortality estimates continually being revised upwards.

Even inflation-linked bonds will not match pension liabilities properly. And with schemes significantly in deficit, trustees must try to outperform their liabilities. It will not be enough just to match them. This means that switching to bonds is not a realistic answer. It may reduce the volatility of the portfolio, but will be achieved at the cost of maximum loss of expected return. In addition, of course, if aiming to use corporate debt to provide some yield pick-up over gilts, there is still default downside risk in the investment, without much upside potential to offset this risk. If the reason to switch from equities to bonds is to 'reduce risk' there are better ways to do this.

Alternative asset allocation approaches – diversification

The equity risk premium cannot be relied upon to deliver sufficient, consistent returns to match or outperform pension liabilities. If returns required from pension fund investments are greater than bond yields, then it is essential to hold non-bond assets. Alternative assets are not highly correlated with equities or bonds, so adding them to a pension fund portfolio will be beneficial. Nowadays, there are many more ways to add value and new sources of return, which can be harnessed to improve the asset/liability profile. Investors can benefit from new sources of beta and alpha rather than just long -only equity or bond management. Swaps can be used to offer closer liability matching, meeting cash flow, limited price indexation, and longer duration requirements better. The costs of such swaps may be worth paying, in order to avoid further downside risks, but swaps alone will not be enough to generate higher long-term returns to outperform liabilities – hedge funds are an important additional investment to consider.

Downside protection – don't take risk, control it

The other vital element of pension investing, which has been so neglected in the past, is downside protection. The traditional thinking is that long-term investors must 'take' risk in order to make the best returns (i.e. investors willingly accept risk in the expectation of superior returns). However, 'expected' returns are not always achieved. Having suffered sharp equity falls, many pension funds are in the position that they cannot afford further significant losses. Their risk/return profile is skewed, with a greater value being placed on downside protection than seeking upside potential. This suggests that a more diversified, absolute return focus is required going forward, and it is this kind of profile which alternative investments in general and many hedge fund strategies in particular, are often designed to deliver.

It is also vital that trustees understand the need to 'control' risk, rather than just 'take' risk, using active risk management, rather than passively accepting downside potential. Reduction of risk should be achieved for the lowest reduction of expected return, and this means that alternative assets and hedge fund styles of management, which target absolute returns, rather than merely trying to perform well relative to particular indices, should deliver improved portfolio efficiency and more reliable investment returns. Ultimately, if portfolios do not suffer the sharp downturns of equity bear markets, returns will not need to be so high each year to provide superior long-term returns. Risk control, which still allows good upside potential (not just switching into bonds, which removes most of the upside), should deliver safer, more reliable returns for pension investors and allow trustees to meet their pension liabilities more securely over time.

Pension fund investing in future – what should hedge fund managers do?

The challenge for hedge fund managers – particularly multi-managers – is to help pension fund trustees understand how to use alternative investments to reduce the risk levels of their portfolios. This education process requires skills in making the concepts of hedge fund portfolios accessible to trustee levels of knowledge and understanding. Many hedge fund presentations are too complex and confusing for trustees to understand. If they do not understand, they are less likely to invest. The hedge fund industry has not taken this task seriously enough. Managers have been too focussed on explaining the products and strategies which can be offered, rather than trying to understanding trustees' needs and then explaining how certain types of hedge fund can help to meet those needs. Differentiating between hedge funds is also important. Helping trustees realise that not all hedge funds are the same and that this is really an investment management style, rather than an asset class per se, can help trustees to better understand how to use hedge funds.

Trustees need help to understand that there are no easy answers and that future asset allocation should encompass far more than just long-only equities and bonds. Many medium-sized pension funds are still frightened of alternative investments, and could benefit enormously from an education process about the need for diversification. The majority of trustees are not sophisticated investors, even though they are looking after huge amounts of money and they need much more hand-holding than hedge fund managers have previously offered.


Using hedge funds and other alternative assets should be a mainstream part of pension fund asset allocation in future. The sooner trustees and their investment advisers wake up to the opportunities of the modern financial marketplace, the better. Hedge funds need to adapt their offerings and their marketing to suit the trustee audience. Focussing on the problems of switching to bonds, benefits of diversification, downside protection and absolute return investing are the most important messages, but try to make sure the potential clients understand the messages.

Ros Altmann is non-executive director and governor of the London School of Economics, member of the Lord Chancellor's Strategic Investment Board, and an independent policy adviser on pensions and investment policy. She has had a long career in the City, running Chase's international equity operation in London, and was a Director of Rothschilds and NatWest, responsible for global equity investment.