CIO commentary on the DBD portfolio

UniSuper’s Chief Investment Officer, John Pearce, provides a snapshot on how the Defined Benefit Division (DBD) investment strategy operates, and a comparison of DBD performance and a typical Balanced Fund.

The DBD investment objective

The central objective of the DBD investment strategy is to maximise the probability of generating sufficient returns to meet its future commitments.

To achieve a sufficient rate of return, the DBD has to have exposure to growth assets (such as equities), and cannot invest solely in defensive assets (such as cash).

To achieve this objective the optimal mix of assets may change based on a number of point-in-time factors. Some of these include expected returns on the various asset classes, changes to salary inflation rates and mortality.

Important definitions
Vested Benefits Index (VBI): the ratio of assets to benefits payable should all members withdraw from the DBD immediately.

Accrued Benefits Index (ABI): the ratio of assets to liabilities, taking into account the most reasonable estimate of the expected rate at which members withdraw, die or retire from the Fund and the benefits they would receive at the time.

In this section we will use the term ‘funding ratios’ to refer to the ABI and VBI.

Refer to the more detailed definitions of these terms in Monitoring the DBD.

Given that benefits are defined and relatively stable compared to asset prices, the required return could be expected to increase as the Fund moves into a technical deficit position (VBI < 100), and reduce as the Fund moves into a surplus position.

DBD asset allocations

This pie chart shows the general asset allocation of the DBD portfolio at 30 April 2017. The following sections summarise some of the current characteristics and strategies pertaining to each asset class. The asset allocations and the specific holdings change over time.

Text outlining chart is below.

Australian Shares

Approximately 54% of the DBD assets are held in Australian listed equities – the vast majority are held in Australian shares within the ASX 100. The portfolio is therefore dominated by “blue chip” companies such as our large miners, major banks, retailers, and Telstra. Other large holdings of significance are three of Australia’s high quality retail property trusts (Colonial Retail, GPT, and Westfield Retail) and two well established listed infrastructure companies (Transurban and Sydney Airport). Given Australia’s underlying fundamentals are positive for at least the medium term, we expect our shareholdings to deliver solid returns, combined with attractive yields and high levels of franking credits.

International Shares

International shares constitute about 10% of the portfolio and are heavily skewed toward established companies with a record of stable earnings. Examples of holdings include global listed infrastructure and quality household names such as Colgate-Palmolive, Nestle and Johnson & Johnson.

Infrastructure Portfolio

The infrastructure portfolio is spread across a number of assets which are expected to deliver reliable income streams with potential for capital growth. The DBD infrastructure portfolio includes a stake in Adelaide Airport. In total the Fund owns 49% of Adelaide airport – a prized asset which is simply beyond the direct reach of most other funds in the country.

Property

Direct investments in property are concentrated in the very resilient retail sector, although it is also diversified across office and industrial assets. A feature of the DBD’s property allocation is a share in the Fund’s 100% ownership of “Karrinyup”, which is arguably Perth’s premier shopping centre. The Fund also has a 100% ownership of 7 Macquarie Place, which is an office building at an attractive location in Sydney’s CBD. These represent further examples of investments which most other funds cannot directly access, in their own right, due to lack of scale.

Dynamic Asset Allocation

Generally speaking, DB plans (and Balanced Funds generally) have adopted a relatively static approach to asset allocation. A static approach simply means an allocation to “growth” and “defensive” assets which remain relatively stable over time. The problem with a static approach is that there can be a tendency to take on too much risk when the market is expensive, and vice versa. A dynamic approach involves a gradual rebalancing of the portfolio at different market levels.

At UniSuper, the funding ratios are a more useful measure than market levels to guide us in setting asset allocation, as they directly relate to our commitments. Therefore, our asset allocation framework is structured by reference to different levels in our funding ratios. In simple terms, at high VBI/ABI levels, we will generally rebalance to a more defensive asset allocation, while at lower VBI/ABI levels we will generally rebalance to more growth assets. The process is somewhat intuitive when you consider that high funding ratios would typically coincide with high (or “expensive”) market level.

While the terms “growth” and “defensive” are conventional labels used by the market, they are also simplistic. At UniSuper we prefer to allocate assets to three risk categories being high risk, moderate risk, and low risk.

A typical example of a high risk asset is a listed equity, while cash and investment grade bonds constitute the bulk of low risk assets. A quality, conservatively geared property would be considered moderate risk as it has the growth characteristics of an equity and the income characteristics of a bond. Our dynamic asset allocation process sets target allocations for the three risk categories, for different levels of VBI/ABI. At the current time actual asset allocation is 47% in high risk assets, 38% in moderate risk and 15% in low risk. Actual allocations deviate from the target allocations within permitted ranges. This compares to a typical Balanced Fund which simply has a 70% growth / 30% defensive asset allocation.

Performance of the DBD portfolio

The performance of the DBD is best captured in measures such as the VBI and ABI, and not by reference to the actual portfolio returns. 

Defined Benefit Division - ABI and VBI

A line graph showing the quarterly values of the ABI and the VBI of the DBD between 1992 and 2017.  During this period, the values of both the ABI and the VBI fluctuated well above and below 100%, reflecting movements in investment markets as well as benefit changes or improvements of the DBD.  Noticeably, the VBI has fallen below 100% during financial crises such as the ‘dot com’ dip and the GFC but has recovered to a healthy position on every occasion. As at 31 March 2017, the ABI and the VBI are over 120% and 110% respectively.

As shown in the above graph the VBI and ABI are now over 110 and 120 respectively as at 31 March 2017. Points worth noting are:

  • The latest dip in the VBI below 100 was not the first time it has happened. In fact, since the inception of the DBD, the VBI has fallen below 100 on at least four occasions and has recovered to a healthy position on every occasion. 
  • The fact that we see gyrations in the VBI and ABI over time should not come as a surprise when taking into account the way in which assets and liabilities accrue and are accounted for over time. The liabilities of the DBD are the commitments made to members which, by their very nature, gradually increase over time. Assets on the other hand are far more volatile and subject to the vagaries of the market on a daily basis. Furthermore, the accounting rules provide that assets need to be re-valued on a “marked-to-market” basis. In other words the assets need to be valued as if they were theoretically being sold at prevailing market prices. 
  • While the dynamic asset allocation process governing the portfolio management of the DBD is aimed at smoothing out the volatility of the VBI and ABI, we are unable to entirely eliminate this risk due to the nature in which assets and liabilities are accounted for, as described above. 
  • The dynamic asset allocation process has ensured that the portfolio was suitably positioned to benefit from the strong returns experienced in equity markets over the past 18 months. 

The future course of the VBI and ABI is of course impossible to predict as they are subject to market forces. However, the design of the DBD has largely enabled it to stand the test of time and, given normal market conditions which include the occasional bouts of volatility, there is no reason to suspect that the long-term future will be any different. Members will be aware that the Board made a decision under Clause 34 to change the way members’ future benefits will accrue from 1 January 2015. This decision and the normalisation of markets have also enhanced the long term viability of the DBD, which is obviously something worth striving for given the DBD’s position as a core differentiator in UniSuper’s product suite.