“Torque Fill” for pension schemes

So the Formula 1 season is well underway and this season offers a glimmer of hope for fans of McLaren. McLaren have a long and successful history, but they haven’t fared so well in recent years (not unlike UK DB schemes).  Some have attributed this lack of competitiveness in recent seasons to concentrating on building more road cars, rather than focusing purely on F1.

At the pinnacle of the road car range is the P1, a £1 million car that utilises learning from Formula 1. The car combines two common features on vehicles these days; a turbo-charged petrol engine and an electric motor. Whilst these features are relatively widespread, McLaren engineers have devised a unique solution in dovetailing the two together.

Despite recent advances in electric engine technology, a performance supercar such as the P1 still needs to rely on a petrol engine to generate the necessary torque (pulling power).  Unfortunately, petrol engines only provide this power when they are running at higher speeds.  Conversely, an electric motor has the power immediately accessible, but doesn’t reach the same level of output at the petrol engine.

Therefore in the P1, the powertrain has been designed such that the electric motor fills in the gaps (“torque fill” using McLaren jargon) where the petrol engine struggles. In isolation each component is nothing special but in combination the result is a much more consistent level of propulsion.

I wrote last month on how an increasing number of pension schemes face the challenge of needing a smooth and consistent performance. So are there lessons to be learned from the P1 about combining different tools to deliver the returns required?

The first stage of this is to look at the performance engine that provides the pulling power for a strategy; typically growth is provided by equities and other growth assets. You would expect that a scheme with a strong allocation to these would comfortably (and more) meet its objective for market rallies but will underperform for flat or falling markets.

The next stage is to think about what the performance objective is.  This should be in absolute terms but should also consider the range of market conditions in which that objective needs to be achieved. For example, a scheme may need a Gilts + 2% return in as many market scenarios as possible.

The final stage is to design the “torque filling” piece to marry up the two.

Just as the challenge for a turbo-charged car is generating immediate acceleration, the challenge for pension schemes is achieving performance in slow moving markets.  Therefore this final piece will often have a very strange target (and probably one that wouldn’t be offered as a standalone investment product).  Its target may be one with incredibly strong performance for sideways and down markets and very poor, perhaps even negative, performance in rising markets. Whilst in isolation this looks strange when considered at a total portfolio level the resulting performance should be closer to the objective.

Diversification used to be the tool of choice for this, but the reliance on (essentially long-term) assumptions with diversification make it increasingly less useful for maturing schemes. Therefore, in the coming years, I expect to see in the coming years an increasing focus on strategies that are mechanically designed and dovetailed to deliver the smooth performance that schemes need.

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