On the money

Housing associations have tended to provide final salary pension schemes to their employees but new accounting rules and stock market turmoil have begun to change this.

In a bid to find schemes less likely to leave them with huge liabilities and deficits, some associations have turned to money purchase schemes, where pension payouts are based on an employee’s contributions rather than their salary. But instead of closing their final salary schemes, associations can change the type of investments they use for their fund in order to reduce the risk of losses.

One option is structured investment arrangements, which are finding favour with some trustee boards of large and medium-sized pension schemes. The broad approach of these arrangements is to follow an investment strategy that provides only limited exposure to the volatility of equities. Traditionally, investment managers advising trustees suggested greater exposure to equities. However, when markets were difficult, there was a corresponding exposure to losses.

In contrast, today’s structured arrangements gain much of the upside, but limit the potential downside. To do this, roughly 80% of the fund is invested in AA-rated bonds, with the rest exposed to call options on the total return of, say, the FTSE-100 index. Such arrangements follow a pre-agreed approach, tailored to the needs of a particular scheme, and typically span 10 years – which should be sufficient to allow a scheme that has been in deficit to recover. Moreover, running costs typically fall, largely because the need for active investment management is reduced.

Bonds are essentially loans made by investors to governments or companies in return generally for a fixed rate of interest over a fixed period. They are usually tradable.

Call options are the purchase of shares at a pre-determined price. A trader who buys call options believes share prices on which he has bought the options will rise. For example, he agrees to pay 100 pence for a share that he believes will be trading at a higher price at a pre-determined date in the future.

As a result of this structure, the value of the fund at any time is a combination of the call option that has matured, the discounted value of the future option, plus the fixed-interest bonds and their accrued income. This product has been modelled over the past 20 years (10-year periods) and it will often underperform an 80% equity/20% bond portfolio, but outperform a 20% equity/80% bond portfolio, which it closely resembles from a volatility point of view. The whole point is that the client chooses a required return and the model optimises the amount in synthetic AA-rated bonds and equity call options.

This arrangement is far less volatile than direct equity investment, essentially because there is less exposure to the future, which is unknown. For added security, an arrangement of this type should be backed by a highly rated bank or similar. But trustees with no concerns about high short-term volatility should not invest in this product. Instead, simply invest in 100% equity funds, which should produce better results over the long term.