August 2003, by David Duncan

“For Whom the Bell Tolls ”
UK Pension Funds & the Law of Unintended Consequences

Increasing regulation has caused the financial difficulties currently facing UK pension funds but there are refreshing examples of institutional investors whose strategies would have avoided these difficulties. The example of the Yale Foundation is given in the Appendix.

The frequency of events in everyday life often conforms to a bell-shaped curve. This article seeks to show that regulatory intervention in UK pension funds since 1986 has constricted the normal bellshaped curve of everyday life and led to serious unintended consequences.

A solution to these difficulties lies in the belief that portfolios managed on absolute return principles are preferable to, but not necessarily superior to, the benchmark-related portfolios favoured by most pension funds. Absolute return strategies also constrict the normal bell-shaped curve of investment life, but in doing so they help both companies and pension funds mitigate the undesirable effects of the Inland Revenue rules on over-funding, the Minimum Funding Requirement and accounting standard FRS17.

Absolute Return Strategies

Absolute return strategies permit investment managers to hold significant levels of cash and similar short-term investments when they consider securities to be over-priced. This contrasts with benchmark driven portfolios that are close to 100% invested at all times. Absolute return strategies seek to mitigate losses by holding significant levels of cash when markets fall, accepting the fact that it is difficult to predict when to re-invest that cash to profit fully from market recoveries. The result should be lower volatility than experienced by the markets, with the expectation that over a market cycle, performance will be similar to a traditional benchmarked portfolio.

Over the past 40 years the UK pension fund median return has been 10.4% a year and as shown in Chart 1 the yearly rates of return form a rough bell-shaped normal distribution:


Chart 2 below is helpful in seeing the effect of an absolute return strategy. If the negative rates of return below -10% are limited to -10% and the top rates of return above +30% are limited to +30% the UK pension fund median return would have been 10.8% a year and the distribution of yearly returns would be a truncated bell-shape as shown in Chart 2:

In other words, volatility would have been lower without affecting the long-term rate of return. Now examine the similar effects of the unintended consequences caused by regulatory intervention.

The Law of Unintended Consequences
‘Over Funding’ Led to Contribution Holidays

From 1980 to 1986 the UK pension fund median annual return exceeded 11% every year and in five of the seven years it exceeded 20%. These returns greatly exceeded the long-term investment assumptions and this growth in the value of assets led to apparent ‘over funding’. Thereafter the UK Government took steps to prevent this ‘over funding’. Through the Inland Revenue it insisted that ‘surpluses’ in pension funds above a certain size be reduced through benefit improvements, taxable refunds to employers or contribution holidays. In most cases employer contribution holidays were used. Strong investment results up to March 2000 compounded this effect. A whole generation of senior corporate management became accustomed to employer contribution holidays. It may seem to this generation that pension funds had reached a selfperpetuating state of equilibrium and cost nothing further to finance.

In graphical terms the upper end of the distribution of investment returns leads to distortions caused by the Inland Revenue’s attitude towards ‘surpluses’. If returns above 20% a year are assumed to lead to ‘over funding’ then Chart 3 shows in red these ‘excessive’ returns:


The Minimum Funding Requirement

The Minimum Funding Requirement (MFR) took effect from 1998. If asset values fall below a prescribed percentage of the value of liabilities then extra contributions must be made by the employing company. The MFR ensures asset values do not remain below various minimum values for very long. Insufficient investment returns are a major cause of the Minimum Funding level being breached. For example, the negative returns experienced during the period
2000-2002 averaged -10.5% a year. Such significant under-performance damaged those pension funds whose ‘fat’ from earlier periods of excess performance had been eliminated through contribution holidays. Suddenly, during a period of economic difficulty, employing companies have been forced to make emergency contributions.

In graphical terms the lower end of the distribution of investment returns causes distortions because of the implementation of MFR. If negative returns are assumed to lead to ‘under funding’ in breach of MFR, then Chart 4 shows in yellow these ‘inadequate’ returns:


The remaining acceptable values (in blue) have occurred too infrequently (only 18 out of 40 years) for the traditional method of investing pension fund assets to survive in the current regulatory environment. Persevering with the traditional methods will create major unintentional problems through forced dissipation of surpluses in the ‘feast’ years and forced additional contributions for MFR reasons after ‘famine’ years.

Traditional investments in equities have served pension funds well over the past fifty years. But note that all the ‘excessive’ returns above 20% were recorded before 1994 and the worst ‘inadequate’ return was in 1974. Such extreme positive and negative returns could be absorbed prior to the introduction of the Inland Revenue’s limits on ‘over funding’ and MFR. Such events were anticipated by the traditional actuarial valuation methods then in use and high exposure to equities was both troublefree and financially rewarding. Furthermore, a decade of significant wage and price inflation between 1972 and 1981 was absorbed through this high equity exposure.

By the standards of the past fifty years the last six years have NOT been volatile. 1997-1999 produced positive returns averaging +15.9% a year and none was above +20%. These were wiped out by the poor negative returns of 2000-2002, which averaged -10.5% a year and none was below -20%.


The most damaging response to this state of affairs would be the wholesale desertion of the equity markets. It is not equities per se that have caused the damage – it is the volatility in their values occurringin a regulatory environment that has become increasingly penal since 1986. That environment will become even more restrictive when the new accounting standard FRS17, or its international equivalent, is fully implemented.


FRS17 compounds the foregoing difficulties by highlighting the short-term fluctuations in the value of assets relative to liabilities. FRS17 will cause a company’s pension fund to impact positively or negatively on its profit and loss account and its balance sheet whenever the investment return differs significantly from the assumed rate. For a company with a relatively mature pension fund the value of the pension fund’s assets may be comparable to the market value of the company. Financially this means that the investment performance of the pension fund is likely to be just as important a determinant of the company’s fortunes as its trading performance. This is a radical departure from past practices and will need radical changes in thinking to cope with it.

Alternative Approaches

Why persevere with the traditional methods when the ground rules have changed? Perseverance is bound to lead to a repeat of the painful financial events of the past 12 months where (i) pension fund contributions have had to be reintroduced or increased, (ii) significant balance sheet deficits declared and (iii) immediate profit and loss account recognition given to increases in short-term liabilities. These events have occurred at a time when individual companies have been least able to withstand such financial impositions. Insult has been added to injury in those cases where a deterioration in the pension fund’s financial position has been reflected in the employing company’s accounts and then that has led to a credit rating downgrade.

As volatility of asset values is the main culprit it seems inevitable that employing companies will demand that trustees of pension funds reduce that volatility without increasing costs.

This article began by describing the return characteristics of absolute return strategies. Chart 2 shows the reduced volatility of results to be expected from such strategies. Chart 4 shows, in blue, the limited number of actual pension fund returns that would have escaped the unintended consequences of regulations. There is a striking resemblance between the two charts. In other words, following an absolute return strategy (i) limits any impact from the Inland Revenue’s rules on surpluses, (ii) reduces the occasions when the Minimum Funding Requirement is invoked and (iii) minimises the effects of FRS17 and its international successor on the employer’s financial accounts caused by its pension fund.

Absolute return strategies are available through (i) long only funds that seek to preserve capital rather than follow a benchmark like the FTSE All-Share Index and (ii) alternative strategy investment funds that often employ short sales and gearing and invest in a wider range of securities than traditional benchmarked funds. Both possibilities retain exposure to equities and hence preserve the double advantage of long-term cost savings and protection against future significant wage and price inflation.


Example – The Yale Endowment

The investment section of the Yale Endowment Annual Report, June 2002, is a clear exposition of successful institutional investment strategy. The superlative results for this $10 billion fund over a long period of time prove the point, 16.9% pa from June 1992 - June 2002. The key elements are:

  • asset allocation targets covering six asset classes are established at the heart of the investment process and are only reviewed annually
  • diversification and equity orientation underlie successful long-term investment strategies
  • structured using mean-variance analysis which estimates expected risk and return profiles of various asset allocation alternatives
  • current analysis produces an expected real (after inflation) long-term growth rate of 6.2% pa with a risk (standard deviation of returns) of 10.9%.

These seem to be widely-used concepts and noncontentional, until one examines Yale’s interpretation of asset classes.

The resulting asset allocation is:

Domestic Equity 15.0
Foreign Equity 12.5
Fixed Income 10.0
Absolute Return 25.0
Private Equity 17.5
Real Assets 20.0

TOTAL 100.0

Traditional equity exposure is only 27.5%, (15% domestic plus 12.5% foreign). Equity orientation underlies the strategy but this is mainly achieved through Absolute Return (25%) and Private Equity (17.5%) exposures. The result is a total equity exposure of up to 70%. Real Assets include property, physical commodities and currencies

The Yale Endowment concluded that merely spreading assets across an ever-increasing number of quoted equity markets does not provide adequate diversification. When quoted equity markets fall the covariance between the markets increases, in other words, they tend to fall in unison. Does 2000-2002 match this description?

David Swensen, chief investment officer of Yale University has published a book, ‘Pioneering Portfolio Management’, ISBN 0-684-86443-6, that describes the Yale investment philosophy.

About the Author

David Duncan is an actuary who has specialised in pension fund investing, experiencing the industry from three different perspectives. Initially his career took him to Washington DC where he managed the World Bank Pension Fund. Currency diversification to pay benefits in 85 different countries led to asset diversification through the appointment of a roster of international investment managers. He returned to the UK to create and then manage for 13 years what is now the Mercer Investment Consultancy. That role culminated in the introduction of some of the earliest specialist investment management briefs and alternative investment styles. Subsequently he completed the trilogy by moving into traditional fund management as an investment director at Schroders. More recently he moved into the world of alternative investment strategies.