More from London (see yesterday’s posting for background)…

A pension plan as a financial services firm

As some pension funds begin to shift from funds of funds to single-manager hedge funds, they usually create what amounts to their own internal fund of funds.  The only difference between this fund of funds and a real fund of funds is that the pension has only one client: its own pension plan.

It turns out that this view of the hedge fund portfolio as a sort of arm’s length asset manager with only one client can also be applied to the pension fund as a whole.  That’s how one major private pension fund described it to a gathering here in London today – as a financial firm that produces pensions.

This view also has implications for liability-driven investing (LDI).  Some said that the process of liability-matching and return-enhancing should be kept separate within this financial services firm.  For example, one major pension fund here created a team focused on removing interest rate and inflation risk (via a matching portfolio designed to match the plan’s future liabilities to pensioners) and a separate team focused solely on trying to squeeze additional returns out of those assets.  In true arm’s length fashion, the return portfolio is required to literally borrow assets from the matching portfolio – creating a real economic incentive to beat the short-term rates charged on this internal loan.

More…