Investment signals from Railpen

Chris Hitchen has accumilated a huge amount of experience in his various roles in the pensions industry. As a past chairman of the NAPF, and a trustee member of NEST, he has been at the sharp end of investment ­debates when it comes to pension funds. He now serves as chairman of the board for ­Railpen, which he joined in 1998 as ­investment director.

Tell us about how you have organised the ­investment side of RPMI.
Two years ago we appointed a managing ­director, Frank ­Johnson.
He has a finance background, and is an ­extremely strong ­corporate senior ­manager and director.
His job is to make ­sure everything works – the people, process and supply chains – and he has been ­carrying out his own ­reorganisation of the way things fit together inside the ­investment business.
The actual investing side is led by Keith ­Shepherd who is now our CIO, having come in as head of investment management from Welcome Trust four ­years ago.
He reports to Frank but the idea is that Keith is free to think about investment stuff and talk to ­investment people without worrying too much about organisational ­management. This was my idea of how we could ensure that we were getting the most out of what we had. It remains a work in progress but it is ­coming together.

RPMI has successfully marketed its ­administration business out, why not do the same with your investment business?
We have not ruled that out, but it is not part of this year’s plan. The thing about investments is, the return on the asset base is much more important than any rent you can earn from someone else’s asset base.
We run, on behalf of the Rail trustee, a £17 billion pension fund. It matters much more what the return is on that £17 billion, than whether or not we can make a few extra basis points by managing another billion or two on top.
But if we are satisfied we are doing a good job, that everything is well-oiled and working well and the way we are doing it would suit some other institutions, then we may – if our sponsors agree.
The market for fiduciary management is ­developing fast and we already do fiduciary management for 100 rail employers. ­Offering the service externally would be quite close to what we do already, but we would think very carefully before we jumped in.

What is your investment philosophy?
We try to be long-term investors, and we try to invest for return, so we have growth-­oriented portfolios in general. We ­diversify risk but, because we are long-term investors and because we are investing for return, we have, and probably always will have, a lot of equity market exposure, ­because that’s ­where the returns are. We are quite lucky that many of our ­employers have relatively strong ­covenants, one way or another. That is one reason why we feel comfortable with running growth-oriented investment strategies. ­Another reason is that the Rail Scheme is a shared cost scheme, so member contributions vary, as well as employer contributions. That provides more of an incentive to ­manage overall contribution rates, to keep the scheme affordable in the long term.

What sort of returns do you factor in, per ­annum?
We set up a growth pool – which is a ­diversified beta and alpha fund – that is ­targeting RPI plus 5% per annum over the long term. Now, that feels like a pretty stiff target, but actually it is what most pension schemes are trying to achieve with their growth assets.
It is what actuaries put into their best ­estimate bases, and so is not remarkable in that sense, but it feels very real if you are ­actually charged with trying to achieve it.
We have used external investment managers since 1987 and they have been given all kinds of different benchmarks, but these are oftenmarkest indices and almost divorces the pension scheme’s ­executive and its trustees from the real ­return targets.
In the past, if the pension scheme did not achieve its actuarial rate of return over a ­funding cycle, it was ­easy to blame the i­nvestment managers. Now we do feel ­responsible for those ­returns. We are not saying, by the way, that we are ­going to ­achieve RPI plus 5% over one year, or three years, but we have to over the long-term term.

Railpen is active within the corporate governance debate. What do you gain from this?
Good governance is about raising the bar for all companies over long ­period. If you can improve corporate hygiene then there ought to be better returns ­available to investors. For me, that is the reason why we do that. We ­were pioneers in the UK amongst pension ­schemes in voting our shares and having a policy on it: this is going back 15-20 years.
And we were amongst the earliest to ­actually expand that overseas, spearheaded by our head of corporate governance, Frank Curtis. As portfolios have globalised, clearly just ­voting in the UK becomes less relevant. Now we vote in most major markets, either directly or through third parties we ask to do it for us.

Do you think it is important for you to be ­seen to be leading this issue?
You are on a good point, that we do need to act in concert with other investors. We are not doing it just to make ourselves look good.
There will be instances when we do have to work with other people. We have done a number of things, particularly with USS, but also with a number of other investors around the world and I think we will have to do that more.
There was a period, a couple of years ago, when there was a danger that pension ­schemes in the UK were going to get blamed for the financial crisis.

Like two years ago when Lord Myners ­blamed shareholders for the financial crisis at the NAPF conference?
Yes, I was chair of the NAPF at the time and I almost felt he was talking to me specifically at that point. At one time UK pension funds owned 30% of the UK stock market and the insurers ­owned another 30% – between us we did own the majority of the big UK companies.
Even then it would be a stretch to say that the shareholders were in a position to manage companies directly, I mean that is what you have ­company managements for. But now, ­pension funds own around 13% of the UK stock market. Shareholder bases have been globally diversified, and so the challenge for us is to find enough international partners – to the point ­where shareholders do have ­meaningful influence.

What are your views on liquidity?
Overall, the rail scheme is slightly cash ­negative, ­that is ­before investment income, so overall with investment income we are ­positive. But, ­nevertheless, I think we have tried not to be too much of a slave to ­liquidity. There is ­definitely a premium available for locking your money up. If you are a long-term ­investor, it is the one thing that you have got over the other guy – but you have to do it ­sensibly. We have reasonable chunks of the portfolio that could be considered ­illiquid or partly illiquid. We have some ­infrastruc-
ture, quite a lot of private equity, real estate and hedge funds which are partly liquid.
The financial crisis did teach all investors that liquidity was worth something. You ­interviewed David Swensen of Yale in your previous issue and clearly endowments had a pretty tough time.
They invested very heavily in ­illiquid ­investments and found it was hard to ­actually make the capital calls, let alone fund the ­projects that they had committed to. We ­were not in that position, but I would not pretend that there was not an issue at all. So, in the first quarter of 2009, when equities were ­near the floor, were we buying like ­there was no tomorrow? No, we were not.
Because we still had to pay pensions of £40 million a month, and equities were the most liquid asset.
Another aspect of the crisis was that ­everyone found the bonds they had been holding that yielded a bit of a premium over gilts, ­were not as liquid as they thought they were. And here I am talking about the professional bond managers, I am not talking about the pension schemes who employed them. So, the reason why equities reached their low ­valuation point was ­because they were the main thing people could sell when they ­needed to raise money.

Did that lead to any changes within Railpen?
Yes. One thing we are doing is ensuring we are very clear about each of our sections‘ needs for liquidity. Most of our sections are very cash flow ­positive, because they are very immature ­sections for railway companies which are still running trains or their ­suppliers.
But where we have more mature sections, which are cash-flow negative, that is being managed much more carefully. We have set up pools which will provide one, two or three year liquidity, for the £4bn section of the scheme which pays old British Rail pensioners and deferred pensioners. That section does not want total matching but it does want short-term cashflows matched.
We have a number of LDI vehicles ready and available for any of our employers who needs them.
The longer term ones remain largely, at ­present, empty ­boxes. The reason for that is pretty clear: you have to be extremely anxious to de-risk at current ­index-linked gilt yields.

Did the crisis change your philosophy?
It sounds glib to say no, but we have always ­invested for the long term. I think the scale of the trough has shaken a lot of people up, and we are probably realistic, some would say pessimistic, about future returns.
So, what we do internally in our allocation group is look at different scenarios. We have employed a head of strategy, Ciarán Barr. He is ex Deutsche Bank and Bank of England and a really good economist – we are ­building a team around him.
We meet on a regular basis and talk about how we feel things are moving and what we think about our scenarios and how likely they are or not. We do not know, and we would not pretend to know what will ­happen in the future, but we can have a stab at just how bad things will be if scenarios come to pass. If there is something you think has a reasonable chance of happening, say 20%, that causes really bad things to happen in your portfolio, then that is ­something to take into account when ­constructing your ­portfolio.
And it is not just about the growth assets, it is about both sides of the pension scheme balance sheet. We pay inflation-linked ­pensions that do not go down if there is ­deflation – so we think very hard about the difference between mild deflation and mild inflation, because it makes a big difference. It might not matter so much to another ­institution.

How rigid is your asset allocation?
It used to be fairly rigid and the reason for that was because of the sectionalised ­nature of the Rail Scheme, you had to go round all the stakeholders and get them to agree the strategy for their bit of the scheme. Doing that once every three years was quite a big job and it made it hard to be dynamic.
The point about running a diversified growth fund is that we are moving the way our ­stakeholders see the scheme. Away from ­rigid asset ­allocation and more towards the risk return target for each section. It is a risk budgeting approach which enables us to ­manage the scheme more dynamically.

Is that now fully enacted?
We have around £6 billion of the scheme in that growth fund. The illiquid growth assets and the private equity sit outside because you cannot manage those dynamically. You still have to commit to funds as they come up, and so you have to form a view as to what you want your allocation to be and agree that. You can shape it slightly as you go along, but there is not a lot of potential for that. So the main dynamism comes in the liquid and ­semi-liquid growth assets.

What about the active/passive debate?
If you ask what the philosophy is here, it is pretty much that you should only pay for ­active if you really think it is going to ­generate reliable returns above the passive alternative. That leads us to have around two-thirds to three-quarters of the assets managed actively – because we think we can. That is partly ­because, if you invest in alternatives, often there is not a credible passive version.

What are you looking for in a manager?
It is really hard to say there is one thing. We have such a wide variety of managers and we have a team of eight people ­whose job it is to look for them all day. They do not do it on their own, they do ­subsrcibe to databases, but they also source their own ideas. Some of the managers we appoint are very ­quantative, others not at all. It is a case of do you believe not just that their process is ­better than the next guy’s, but do you believe that the process they have got with coming up with the strategy makes sense.

What are the warning signs for you that all is no longer well at a manager?
Often it is organisational change, or just too much success. A strategy might work well at £1 billion or £2 billion and might not work quite so well at £5 billion.
When the ­manager comes back and says they used to have a ­limit on size but can now operate a ­higher ­limit you have to be pretty sceptical.

What can you tell me about the stages of ­development on the investment side at NEST?
That is still a work in progress. I happen to be the chair of the investment committee but, they have an in house executive who ­are extreemely capable, led by CEO Tim Jones. They have recruited people from asset ­management, and have managed to find people who are obviously very committed to wanting to do something worthwhile.
In terms of rolling out the investment ­offering, they are tendering for some ­investment management contracts at the moment.
Those tenders are now closed, but it is ­important to understand that they are ­really building blocks – not strategies.
We have ­been tendering for a passive ­manager and an index-linked gilts manager and gilt ­manager.
They are not necessarily fund ­options that members will see, they are ­building blocks for fund options.
The whole NEST strategy is really around helping ­people to do the ­sensible thing, with the ­likelihood that the vast majority of ­members will end up in a ­default strategy.
The default strategy will be target dated and we will try to do sensible things around risk in return.
The idea is that in the early years, ­persistence is more important than ­investment return.

Is the first rule with NEST, not to loose any money?
Exactly. A low risk start while people get used to the idea of saving, not necessarily a no risk start, but a low risk start.
A reasonable level of risk over people’s main working lifetime, there is no point in doing this if you are not actually trying to make ­some returns.
We are trying to make a real difference to people’s retirement outcomes.