Ex U.K. Pension Chief Says Negative Yields Will Make You Cry

(Bloomberg Markets) -- Until his retirement at the end of September, Roger Gray led investment management at the U.K.’s largest private pension, Universities Superannuation Scheme, which runs a fund on behalf of 420,000 current and former employees at higher-education institutions throughout the country. During his decade in charge, USS’s assets rose to £73 billion from £26 billion ($90 billion from $32 billion), with an annualized return averaging 10.5%. But his final years were controversial, as a pension deficit and demands for higher contributions triggered the largest industrial action ever seen at U.K. universities. Strikes and protests have erupted at about a fifth of the more than 350 member institutions. In an interview in early September at his London office near the Bank of England, Gray, 62, talked about what he could have done differently and his fears for defined benefit schemes if negative interest rates persist.

Bloomberg Markets: How did USS’s investment approach change under your tenure?

Roger Gray: Before I arrived, USS’s fund was mostly externally managed, even though external managers hadn’t outperformed internal ones. We grew investment team headcount to 150 from 65, increased the amount of management done in-house, and created a professional board to oversee the investment side of USS. Allocation-wise, we’ve focused very heavily in private markets. We added to global emerging-markets equities and fixed income in nongovernment credit. We’ve never been impeded from doing something because we didn’t have the hands or legs to make it work. Now I say to people interviewing here, if you walk through our office, you won’t find people of dubious competence.

BM: Explain the shift into private markets that accounts for more than 25% of the fund’s portfolio.

RG: When I arrived, about 8% of USS’s portfolio was in private equity, infrastructure funds, and property. We were then in the foothills of moving toward a Canadian-style pension manager model. Private markets offer very significant cost advantages if you are a direct investor, as [fees are] quite big. In our case, carried interest would have been hundreds of millions of pounds.

BM: Your direct investment portfolio includes a 10% stake in FGP Topco Ltd., the holding company that owns Heathrow. What is the case for your direct investments?

RG: We always looked for diversity, and U.K. infrastructure is very attractive to us, as it has the same inflation characteristics as our liabilities and is part of a legal and regulatory framework that has operated with a fair amount of stability. Heathrow is a core piece of the U.K.’s infrastructure. It’s capacity-limited, which actually gives it pricing power. With the [planned] third runway, we will defer receipt of cash flow for quite a while, as cash flow will be diverted into building the asset. In all, around 2% of deals we look at turn into a transaction, and we lose most deals we pursue competitively because somebody is always willing to pay more. We tend to find interesting opportunities between the cracks. One example: We acquired [highway service station company] Moto Hospitality Ltd. and syndicated 40% to CVC Capital Partners. It was a transaction that had some infrastructure qualities, it had some property qualities. It was a retailing business as well, but it wasn’t an obvious target for infrastructure or property funds.

BM: Let’s talk about performance.

RG: Our goal is to achieve 55 basis points per year of outperformance after costs. We have assets with U.K. inflation exposure, like infrastructure, and inflation-linked gilts [U.K. government bonds]. Ten years ago the standard portfolio would have been no leverage, 10% government bonds, 10% property, 80% equities. How have we actually done? If you look at three, five, seven, 10 years, we’ve outperformed 100% of gilts, we’ve outperformed pretty much anything except 100% of U.S. equities. For the five years through Dec. 31, 2018, we were in the top quartile in terms of investment returns, according to a third-party analysis [by Mercer].

BM: Yet by comparison, another U.K. university pension plan, the Superannuation Arrangements of the University of London, has outperformed you in recent years. Why is that?

RG: That’s true; we underperformed compared to them. Obviously, it’s not true every year. They have a very different asset allocation. From their annual report, they have about 35% in return-seeking assets, 25% in equities, 10% in alternatives, and the balance in fixed income. There is quite a large chunk, 35%, in liability-driven investment, and I don’t know what amount of leverage is embedded in that. I guess it could be a reasonable amount, perhaps two times leverage. They will have had the benefit of significantly higher leverage. It just so happens that index-linked gilts have outperformed just about any other asset class, particularly last year.

BM: On index-linked gilts, looking at USS’s portfolio, it looks like you missed an opportunity to profit from their price gains.

RG: If we had known that index-linked gilt yields would go to –2.25% in inflation-adjusted terms, we could have designed a strategy that would have produced high returns. In that environment, leveraged liability hedging is a superb strategy. Cash rates have been low and government bonds have had extraordinary returns. So funds that have had a high degree of liability-driven investment have had a huge tailwind to their performance. We have had some tailwinds. We’ve had favorable markets and have taken quite a return-seeking approach to assets. The best of all would have been to have done both at the same time—take a return-seeking approach to assets and have a lot of leveraged hedging. We could have done more, but we couldn’t have radically done more. One matter is size. We’re not a £2 billion fund where you can move 10% into liability hedging. Things move slower here. We are a prudently steered supertanker looking to the long term. Another matter is price. We were put off by the price of inflation-linked gilts relative to other assets.

BM: How long do you see this era of low- and negative-yielding bonds persisting?

RG: My expectation is that not very long from now, we will look back and say, what was that about? Giving the German government your money for 30 years at –0.3% annual nominal return is an extraordinary thing to do. I suppose it might make sense if we have a complete financial collapse, we have war, huge aggravated uncertainty. And I think that if there’s one point of the current position of defined benefit pension funds that I would want to impress on you today, it is the nub of the pension crisis. At a time when long-dated risk-free assets are paying –2% in real inflation-adjusted terms, the pricing of a new pension promise is extremely high. It has never been seen at this level in history. Mercifully, we have 30 basis points added to gilt yields in September, but August took these gilts down to numbers never recorded previously.

BM: Can you explain why your fund’s deficit calculations vary?

RG: At one extreme you can take USS Investment Management’s best estimates of asset returns over the next 10 to 30 years, and on best estimates we don’t have a deficit. The trustee has to have a measure of prudence when it projects future returns and their deficit number is higher. The most expensive is the buyout method where you take all USS liabilities and ask an insurance company to price it for a guarantee and hold the capital against that guarantee. I don’t know what that deficit is, but it will be a hugely scary number.

BM: If gilts remain low or even negative for a prolonged period that will have to impact your plan’s deficit calculations. What will this mean for defined benefit schemes like USS’s? Already, USS members have gone on strike over increases in contribution rates.

RG: I will cry as I say this. If long-term risk-free assets remain as they are today, just do the math: You may have to pay 50% of salary. It’s a huge strain on affordability. The cost now is huge in order to generate returns while being prudent for schemes with guaranteed benefits.

BM: What do you plan to do after USS?

RG: I would like to do something that is good for the world. I also want to spend time playing the oboe, which once upon a time I considered doing professionally. Music, as is so much of life, is the imagination. Having a sense of destination or orientation is important.

Robertson and Waite are asset management reporters at Bloomberg News in London.

To contact the editor responsible for this story: Siobhan Wagner at swagner33@bloomberg.net

©2019 Bloomberg L.P.