How giants lost £25bn

Pension funds had a bad year in 1994.
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Last year was one Britain's pension funds would dearly like to forget. It was only the second time in recent memory that they ended worse off than when they started, with the average fund down 5 per cent, according to figures produced by Caps, a leading firm of performance measurement consultants.

Only once before in the past 10 years has the funds' investment return - income and capital gain combined - been negative. The last occasion was in 1990. As Britain's pension funds have an estimated £500bn of assets, the loss of value last year amounts to about £25bn.

The poor performance reflected the fact that last year was one in which equities and gilts, the two main types of asset in which pension funds invest, both lost money. British equities produced a negative return of 5.6 per cent while the return on UK gilts was minus 8.7 per cent

The only bright spot in an otherwise unprecedentedly difficult investment climate was that UK property produced a return of 14 per cent after several years of dismal performance. Yet this was only minor consolation as pension funds on average have progressively reduced their exposure to property from 12.2 per cent of total assets in 1985 to 4.2 per cent last year.

More unusual still was that the loss of value was shared more equally than ever before among different pension funds. The gap between the best and worst performers was narrower than in previous years. Whereas the spread between the first quartile and third quartile performing fund is typically 4-5 per cent, last year the spread was just 2.4 per cent. In other words, all pension funds have suffered almost equally from one of the worst years for investment returns in living memory.

The main culprit was the Federal Reserve's decision last February to raise American interest rates after three years of accommodating monetary policy. That unexpected decision caused a sharp sell-off in both equity and bond markets around the world. Few investment managers proved able to take effective corrective measures. It turned out that there were virtually no more profitable holes for fund managers to run to.

In retrospect, the best place pension funds could have invested employees' money last year was in the Japanese stock market. That produced a positive total return (income and capital gain) of 15.6 per cent. Most other large markets were down, with the sharpest fall in the ever volatile Hong Kong stock market which generated a total return of minus 14.9 per cent. Index- linked gilts, a traditonal alternative to gilts and equities, also produced a negative return of minus 8 per cent.

The dismal performance will have come as a shock to many pension fund trustees, John Clamp, chief executive of Caps, said yesterday. Trustees have become accustomed to handsome returns over the past decade. The typical pension fund has produced a median return of 13 per cent a year over the past 10 years, compared with inflation of 4.9 per cent and an increase in average earnings of about 7 per cent.

The poor performance figures will not prevent pension fund trustees from seeking to set unrealistic targets for their company pension funds. According to Caps, most funds continue to be set the task of doing better than either other pension funds or the stock market as a whole.

Yet statistical analysis shows that these targets are virtually impossible to meet over the medium to long term. No pension fund has consistently been in the top half of performance for seven years in a row. Even using rolling five-year averages to smooth out the impact of exceptional years, only one in seven does consistently better than its peer group over10 years.

Despite widespread academic evidence that consistent outperformance by pension funds is a rarity, the process of concentration within the fund management industry continues. The big four pension fund managers - Mercury Asset Management, PDFM, Gartmore and Schroders - manage an estimated 40 per cent of all pension funds. Measured by value rather than number of funds, the proportion is higher still.

After an indifferent year in 1993, the big four as a group again outperformed their peers last year, Caps said . This however concealed signficant differences in in individual performance. PDFM (formerly stockbroker Phillips & Drew) was the star performer: it managed to avoid significant losses despite the market downturn. By contrast, Gartmore, the publicly-quoted fund management company, had one of its worst years for a long time and finished among the bottom quartile of pension fund managers.

Caps says the market share of the big four pension fund managers continues to grow, although there is increasing competition from second-tier managers. Of these, the two most successful in the past few years have been Morgan Grenfell Asset Management and Barings Asset Management.

Pension funds continue to change the shape and balance of their portfolios. In 1985, a typical fund would have had 51 per cent of its assets in UK equities and 14 per cent in overseas stock markets. The balance would have been made up of UK gilts (15.5 per cent), property (12.2 per cent), cash (4.4 per cent) and other assets.

At the end of last year the comparable proportions were: UK equities 55 per cent, overseas equities 23 per cent, UK gilts 5.5 per cent, index- linked 4.9 per cent, property 4.2 per cent, overseas bonds 4.1 per cent and cash 3.6 per cent. In other words, funds have increased exposure to equities at the expense of gilts and property. It remains a matter of debate whether they have taken on increased risk in the continuing search for improved performance.