The bond weighting of the pension funds in our global asset allocation survey climbed from 39% to 45% in 2008. In contrast, the average allocation to equities tumbled from 42% to 34%. The drop in equity valuations had a profound impact on actual asset allocations for most funds. Calpers reports their alternative allocation moved 4.3% above its admissible policy range, a reflection of the sharp decline in the value of its equity holdings.

Overall, the surveyed funds held their allocation to alternatives at a steady 7%, about 1% below the prior year. Investors withdrew a record $152bn from hedge funds in the fourth quarter alone, according to Hedge Fund Research (HFR). Yet Peter Moon, CIO of the €24bn Universities Superannuation Scheme (USS), plans to double his allocation to alternatives in the medium-term from 11% to 20%. “We see opportunity in absolute return and alternative beta strategies for long-term investors,” he says.  USS, which invests the savings of more than 200,000 UK academic and university staff, saw its asset value plummet by €7.6bn last year or a loss of 25%, largely due to write-downs in its public equity portfolio. Performance of UK pension schemes, as measured by State Street’s WM All Funds Universe, was down 16.5%. Returns for the 133 defined benefit plans in the index may have been helped by sterling weakness as UK pension funds have relatively large allocations to global equities.

Our global pension fund monitor measures the asset allocation and performance results of 16 large pension funds in 12 countries. The largest is APG (formerly ABP) with €173bn in AUM while the smallest is VBV Pensionkasse with €4.3bn in AUM. Pension fund returns are reported in local currency terms. Funds in the UK, US, Ireland and Sweden have a stronger equity bias and account for €268.8bn in AUM. Together, the five pension funds in these four countries have a minimum 50% allocation to equities each, with USS at the high end at 67%.

The remaining 11 funds, with less than 50% exposure to equities, have €473bn in AUM. France’s national reserve fund is 49% invested in equities, while COREM and Japan’s Government Pension Investment Fund, have just 13% and 16% invested. Recognising the geographic variance of the funds and differences in plan design, regulation and valuation methodology among buffer, national reserve, corporate, life insurance and public pension funds, helps explain the divergence in returns. They range from a loss of 29.5% for Ireland’s NPRF and a gain of 2.7% for COREM. Among the hardest hit on the asset side are USS, Calpers and FRR, each reporting a loss of 25%. Yet last year, gave little solace even to funds with large bond holdings as lower government yields, often used in combination with other rates, translated into larger liabilities.

The average loss of 17.3% is optimistic and partly skewed by the fact that two pension funds in our sample universe adhere to a fiscal rather than calendar year. We have made an adjustment to one (USS) so that the loss is reported on a calendar year basis. The full extent of the damage to Harvard’s portfolio, however, will not be known until June 30, 2009. The university is already working on the assumption that the portfolio will be down 30% or €8.3bn for the fiscal year, according to Forbes. The positive return into last June partly reflects former CIO Mohamed El-Erian’s decision to bet, via credit default swaps, that companies could struggle to pay their debts. Part of this insurance was taken off when El-Erian left for Pimco in early 2008, leaving the endowment vulnerable when markets plunged this fall. Yet during his tenure, the endowment upped Harvard Management Company’s exposure to emerging market stocks which have fallen about 50% since July, more than US stocks, according to the MSCI Emerging Markets Index.

One of the poorest performers in Canada is Caisse de Dépot, which unlike some of the big losers cited above had only 20% in equities, a relatively low weighting compared to peers. Its loss of 25% was the worst in the fund’s 43-year history which exceeded by more than a factor of 2.5 the loss of 9% it suffered in 2002. The Caisse became a major investor in asset-backed commercial paper in 2008. Even before the year ended, Philippe Ithurbide, who heads Rates, Credit and Currencies at the Caisse, wrote a letter from Quebec in our last dossier outlining the dangers of easy access to bank credit, the high levels of leverage present in financial products, the poor appreciation of risk and the deficiencies among rating agencies in assigning ratings. “The S&L collapse and the technology bubble were insufficient in their magnitude… in order for the current weaknesses to surface we had to wait for the arrival of the sub-prime crisis.” The Caisse has 45% invested in bonds and 13% in property. This last asset class saw a modest increase in our select universe of large global funds. Once again, we caution that this is likely the result of the dislocations caused by a drop in the value of more traditional asset classes. Canadian pension funds suffered the steepest decline on record with an average loss of 15.9%, according to RBC Dexia Universe. For un-hedged Canadian investors, the drop in the Canadian dollar also provided help. The Caisse de Dépot, however, did not benefit from this as it had adopted a currency hedging strategy.

Last year’s rout spared few Scandinavian funds. Finland’s Local Government Pension Fund saw its equity allocation reduced by 11% compared to 2007. Only fixed-income investments and real estate yielded positive returns, reducing the fund’s cumulative real return since its inception in 1988 to 2% per year. Returns of equity investments were a loss of 41.9% and were mitigated by a 2.7% gain in fixed-income. “The downward spiral has continued despite the extraordinary measures taken by governments and central banks,” says deputy CEO, Timo Viherkenttä. “Beginning in the autumn of 2008, investment markets have also been weighed down by a rapidly deteriorating outlook for the real economy. We still do not see any clear indications of sustainable market recovery.”

Coverage ratios drop prompting policy responses

Sweden’s buffer funds with high allocations to equities and Eastern Europe also fared poorly as did the Netherland’s APG, which saw its coverage ratio (assets divided by liabilities) drop from 118% in September to 90% at the end of the year. Deteriorating coverage ratios has been a central theme, prompting regulatory authorities and pension funds to introduce a combination of responses. In the case of APG, which is required by law to hold a minimum ratio of 105%, a temporary 1% increase in the contribution of employers and employees has been announced effective July 2009 as part of a five-year plan to restore its coverage ratio. The contribution rate will increase again by 2% between January 2010 and 2014. The fund, the largest in our survey, also plans a reduction in the risk profile of the investment portfolio.

The regulatory response in Sweden and Denmark has been to introduce new accounting measures to discount liabilities. Introduced last autumn by the country’s supervisory authorities, it gives industry-wide pension schemes and life insurers the option to use an average of the long-bond rate and covered bond rate to determine what discount rate to use in calculating liabilities. Prior to the change, Swedish and Danish pension schemes used an average of the government bond and swap rates, resulting in a lower discount rate and consequently larger liabilities and lower coverage ratios. We note that this initiative does not apply to corporate pension schemes or Sweden’s AP buffer funds.

Coverage ratios in the UK also reached historic lows last year, sparking debate on how liabilities should be discounted. The coverage ratio of the vast majority of 7,800 private sector defined benefit UK schemes dropped to 84% in November during a period of unprecedented market stress, according to the Pension Protection Fund. (The ratio was at historic low in February 2009 at 76%). This dismal funding landscape has prompted policy experts to consider the merits and limits of different valuation approaches. High among the questions asked by pension funds is: how much is my pension deficit? Gilt yields which drive funding valuations remain low; a switch to corporate bond yields carries event risk. Looking ahead, the change in credit yield and discount rate assumptions will not only impact how pension schemes calculate their coverage ratios, but will likely become a significant issue for M&A transactions where there could be a transfer of liabilities from one company to another.

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