October 2010
For professional investors and advisers only
Best practice for pension
fund investment
Neil Walton, Head of Global Strategic Solutions, Schroders
and Jonathan Smith, Strategic Solutions Analyst, Schroders
In this short paper we discuss how to construct an appropriate governance framework in order to maximise the
effectiveness of a pension scheme’s investment strategy. We will also discuss some high level principles that may be
applied to designing a successful investment strategy.
Building a successful strategy – overview
High quality governance lies at the heart of an effective investment strategy. Trustees and sponsors should look to:
1.
Maximise the pension scheme’s governance budget subject to the external resources that have been made
available to the scheme
2.
Tailor the scheme’s investment strategy to the scheme’s governance
We discuss both of these steps in turn in this paper.
Governance can be broadly defined as the resources applied to investment decision-making. The amount of
governance available to a pension scheme is often referred to as the “governance budget”.
1. Effective investment governance
It is perhaps not surprising that the best governed funds tend to perform better than less well governed funds.
While quantitative data on the precise size of the advantage is relatively scarce some research¹ suggests a
strong governance framework could be worth as much as 1–2% of additional return per annum. Pension
schemes should therefore look to maximise their governance budget subject to the resources that have been
made available to the scheme.
A pension scheme’s governance budget comprises of three pillars:

The time available to make investment decisions

The expertise of the decision makers

The organisational effectiveness of the decision-making body
The first of these pillars is largely outside the control of the scheme, however we will discuss a number of steps that
schemes can take to maximise the second and third.
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“How much is good governance worth?” The Ambachtsheer Letter, June 2006
October 2010
For professional investors and advisers only
Effective delegation
Potentially the most important step is effective delegation. In practice, this often means separating governance
into a governing function (for example the wider pension scheme trustee board), which sets the framework,
monitors, and controls, and an executive function (for example an investment-sub committee), which makes
investment decisions within the given framework and implements the investment strategy.
Best practice funds adopt a clear separation of governing and executive functions, with a strong culture of
accountability. Furthermore, the executive function should have a high level of investment expertise, enabling
the pension scheme to access more complex investment strategies.
Ideally, the executive function should be led by a strong Chief Investment Officer (CIO) (appointed by the
governing function) with a very high degree of investment expertise. For schemes lacking the internal
resources to set up a separate executive function, an alternative is to delegate certain, clearly defined,
investment decisions externally, e.g. to an investment consultant or fund manager. In this case, accountability
and alignment of interests (e.g. via appropriate remuneration structures) is particularly important.
Clear objectives and commitment from all stakeholders to these objectives
This is particularly important if schemes are to minimise agency conflicts within their governance structure.
One area of potential agency conflict is between the interests and incentives of the executive and those of the
scheme as a whole. Clearly stating objectives in a policy document that all parties have agreed to (and had a
stake in formulating), helps to minimise such agency conflicts. In practice, this could mean basing the
remuneration of the CIO, fund mangers or consultants on the achievement of the scheme’s objectives, thus
helping to align the interests of all the stakeholders involved in running the scheme.
Clear beliefs
An investment belief might be characterised as a high level assumption about how to view investment markets
or regarding what works best for a particular scheme.
Clearly stating investment beliefs should help to improve the quality of decisions taken. A clear list of
investment beliefs can act as a benchmark by which to judge the suitability or otherwise of a particular
investment decision, as well as encouraging the critical examination of these beliefs.
A risk budgeting framework
Risk budgeting injects discipline into the investment process by forcing the scheme’s trustees to think about rewarded
and unrewarded risks and balancing risk and return on each investment choice.
Asset allocation is determined by allocating a proportion of the sponsor’s/trustees’ overall risk tolerance to each part of
the investment strategy. This involves breaking down the various components of risk and developing a cascading
series of targets or budgets.
An example is given in figure 1. The process begins by establishing an overall risk budget, framed as some measure
of downside risk (one such measure is Value at Risk (VaR95) – defined such that the funding level should only fall by
more than the VaR95 one year in twenty). This will largely be determined by the risk tolerance of the sponsor/trustees
and the return objectives of the scheme. The risk budget is then apportioned in stages, with the most important
decisions taken earliest on in the cascade.
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October 2010
For professional investors and advisers only
Figure 1: Illustrative risk budgeting process
Scheme sponsor
risk tolerance
Return Objectives
Assumptions
Funding level* risk
budget = 4%
Growth portfolio
assets (e.g.
equities) = 6%
Active
management risk
budget (“alpha”) =
2%
Liability matching
assets (e.g. bonds)
= 2%
Market related risk
budget (“beta”) =
5%
Property
Skill element
in active
equities
Hedge funds
Bonds
Swaps +
cash
collateral
Credit
High yield
debt
Equity market
returns
*Ratio of assets to liabilities
** Note that at each level sum of parts may exceed total risk budget
due to diversification benefits
Source: Schroders, for illustration only
2. Tailoring a scheme’s investment strategy to its governance budget
It is important that schemes align their investment strategy to their governance budget. Failure to do so can mean
introducing too much complexity for the scheme’s governance to cope with, which in turn can lead to expensive or
ineffective investment strategies. The following principles can help schemes map an effective investment strategy onto
their governance budget.

The most important investment decision is likely to be the high level allocation to growth/liability matching
assets. Therefore governance resources should be allocated to this first and foremost.

Schemes with a very limited governance budget should primarily look to adopt low cost /low complexity
investment strategies. In practice this may mean investing in “mainstream” asset classes only, such as
equities and bonds.

Schemes with limited governance budgets might wish to consider accessing more sophisticated strategies via
pooled instruments such as “diversified growth funds”.

Generally speaking, it requires less governance to add value via diversification, than via “alpha” (or “active
skill”) strategies. So, for example, schemes might wish to look to diversify their market exposure beyond
traditional equity investments before looking to selecting a large number of actively managed equity funds.
Further principles for pension scheme investment
The pensions investment landscape is constantly evolving, however in recent years the following principles have
become widely accepted as being “best practice”:

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The ultimate aim of pension scheme investing is to pay the scheme’s liabilities. Schemes should therefore
look to manage their investments accordingly. This is commonly referred to as “liability driven investment”
(LDI). In practice this can mean:

Adopting an overall liability based benchmark (e.g. outperform the liability discount rate by x%) rather
than, say, a peer group benchmark.

Focus on managing funding level risk rather than just asset risk. This may mean, for example, tailoring
a scheme’s bond portfolio so that it matches the nature of the liabilities, even if in isolation such a
portfolio would be more volatile than a poorly matched one.
October 2010
For professional investors and advisers only

Schemes should look to only take investment risk when they expect to be rewarded for doing so. An example
of a rewarded risk is equity risk. Unrewarded risks include interest rate risk and inflation risk in the liabilities not
hedged by the assets.

Schemes should look to diversify their assets where possible. However to be successful diversification
strategies should be “dynamic”, reacting to changes in the economic environment.

Pension schemes are very long-term investors. They should therefore look to exploit this by investing in
assets with time based premiums such as the illiquidity premium (i.e. receiving a premium for locking up
capital for a period of time).

As long-term investors pension schemes should avoid focusing on short term performance excessively.
Excessive short-termism destroys value by the cost of excessive trading and by draining a scheme’s
governance budget.

As investors with large amounts of available capital, pension funds with significant governance budgets may
be able to exploit an “early adapter” advantage when moving into new markets that other investors cannot.
Summary
Figure 2 brings together the themes discussed in this paper.
Figure 2: Pulling it all together - building an investment strategy
High level objectives & governance structure
– Investment objectives; who does what and how is it
done?
Performance monitoring
– What’s the performance?
– Where has it come from?
Mission and
governance
Performance
monitoring
Strategic
Focus
Implementation
– Investment managers
– Manager flexibility
Risk
budget
Strategic
asset
allocation
Implementation
Benchmarks
Benchmark design
– Market benchmarks?
– Outcome driven benchmarks?
Risk budget
– How much risk?
– Where should it
be allocated?
Strategic asset
allocation
– How much in bonds,
equities, alternative
assets?
Source: Schroders
Pension schemes can enhance their investment strategy by increasing their governance budget and then tailoring
their investment strategy accordingly. They should be wary of overstretching their governance capabilities with over
complex/high cost investment strategies.
Successful delegation, possibly separating the governing and executive governance functions is an important step.
Schemes should also set clear objectives, articulate and critically examine their investment beliefs and consider
adopting a risk budgeting framework.
Further principles for successful pension scheme investing include: putting the funding level at the heart of the
investment strategy, using dynamic diversification strategies, taking a long term view and exploiting competitive
advantages.
If you would like to discuss any of the issues discussed in this paper further, please get in touch by emailing us at
UKPensions@schroders.com.
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October 2010
For professional investors and advisers only
References
Clark, E. and Urwin, R. “Best-Practice Investment Management: Lessons for Asset Owners from the Oxford – Watson
Wyatt Project on Governance”
Gautham, R. “A Holistic Approach to Risk Budgeting”
Koedijk, K., Slager, A. and Bauer, R. “Investment Beliefs that Matter: New insights into the value drivers of pension
funds”
Urwin, R. “Best Practice in Investment Governance for Pension Funds”
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