Last year was a bad year in Kenyan pension scheme investment. Their portfolios concentrated in two- thirds or more in domestic fixed income showed negative returns. There is a phrase in investment circles for this risky behaviour: picking up nickels in front of a steamroller. In 2022 the economic environment changed; trustees need to react. The status quo is not an option.
The problem was exacerbated by the reliance by pension schemes on balanced mandates. Such mandates fell out of favour many years ago around the world as they incentivise peer group benchmarking by asset managers. The peer group benchmarking created a dynamic whereby alternative investing, and in particular offshore (the most mainstream of alternatives) was squeezed out of portfolios.
The replacement is the use of specialist mandates where the trustees set an asset allocation by reference to their liabilities and implement with mandates that focus on a particular asset class. How specialist mandates allow trustees to regain control of the strategic asset allocation is explored further in this article: https://starcapmgt.com/balanced-but-not-balanced/
The status quo is not an option, and switching to specialist mandates is part of the solution. The solution also encapsulates implementing much more diversification into the portfolios of pension schemes. This is achieved with the use of alternative assets, that is asset classes other than the mainstream domestic cash, domestic fixed income and domestic equity. Diversification has been described as the one free lunch in investment. Through the use of modern portfolio theory, an investor can reduce risk and enhance returns. For a pension scheme, that means pay bigger pensions.
The alternative asset class where Kenyan pension schemes will see the biggest bang for their buck on the diversification front is by allocation to offshore. A report1 by the World Bank calculated that Kenyan investors should have 100% offshore allocation. Trustees may have difficulty stomaching that asset allocation, but analysis summarised below shows it is around 50% offshore, substantially higher than the 15% limit imposed by RBA.
Investing offshore makes sense for any investor as it brings diversification. But for pension schemes there is an additional pertinent reason. Pensions are deferred pay. An individual cannot diversify their salary from the local economy but they can diversify their deferred salary from the local economy. And the fiduciary duty under which pension assets are managed dictates there should be such diversification. With partial global risk pooling of deferred salary everyone benefits, that is gets bigger pensions. It is the concentration of immediate and deferred salary in the local economy that is risky. Trustees are fulfilling their fiduciary duty rather than being unfaithful when they embrace offshore investment.
The graph below shows the results from modern portfolio analysis. As portfolio risk increases from left to right, the optimal asset allocation blends from domestic cash though domestic fixed income and domestic equity to offshore fixed income and offshore equity. This result is driven purely by the historical risks of each asset class and the correlation between them. No return premium was assumed to international asset classes to deliberately favour them in the analysis.
Kenyan pension schemes currently have on average around two-thirds allocated to domestic fixed income. This is a portfolio risk level that trustees are comfortable with, and is shown on the graph. The corresponding asset allocation for that risk level – so no increase in risk – is shown: it has 54% offshore split 24% international fixed income and 29% international equity.
The world changed in the first quarter of 2022. The 14 year period of quantitative easing came to an end. Interest rates started to rise and further rises still are still talked about. Inflation is high and sustained. The global economy flirts with recession. During 2022 the US Dollar was strong: all currencies depreciated, and the Kenyan Shilling was no exception. Where the Kenyan Shilling was an exception is that its depreciation continued even when the US Dollar gave up its strength in the fourth quarter of 2022. At its peak the Kenyan Shilling was depreciating at 3% per month.
Allocating to offshore in a meaningful manner – bringing diversification from Kenya and is itself well internationally diversified globally and by asset class – provides a solution which ticks all these boxes. It picks up the return from Kenyan Shilling depreciation. It provides diversification, which will mitigate recessionary influences. Diversification allows a portfolio to allocate more to equity without changing risk levels. Greater equity means greater long-term return. Greater equity provides the inflation protection that fixed income does not. It is real, that is above inflation, long-term returns which pay pensions.
