All
risk and no reward?
Peter Davy asks
what schemes can be doing to minimise their risk
If the last
few years in the pensions market have shown anything it is that
the risks involved are ultimately borne by beneficiaries.
After all, it is their retirement at stake, and even defined benefit
schemes are only as strong as their sponsoring employer in cases
of serious underfunding.
The difference with DB schemes, of course, is that the beneficiaries
are entitled to expect those running the fund to manage that risk
on their behalf. Unfortunately, pension funds’ record of doing
so is – at best – mixed.
Much of the blame for this can be spread. For instance, Dr Ros Altman,
independent pensions consultant and economist, points out that trustees
were no more wrong footed by the stockmarket slump and increased
longevity than the investment advisers and actuaries on whom they
relied for advice.
“Trustees were really just doing what everyone else was doing,”
she argues.
Similarly, government policy hasn’t helped. LPI, the tax on
surpluses, the removal of ACT relief and revaluation all worsened
the position of many funds, while often sending entirely the wrong
signals to trustees. For instance, Altman suggests it was unrealistic
to expect trustees to understand that their scheme could be fully
funded according to the MFR while being completely inadequate to
actually pay the pension.
Others have been less sympathetic, though. Harry Kat at Cass Business
School, a professor of risk management, argues that even allowing
for the difficulties involved, the record of most pension funds
was poor. “Faced with a highly complex task, most pension
funds appear to be seriously mismanaged,” he writes.
“Very substantial amounts of money are wasted every year while
at the same time obvious risk management opportunities are systematically
ignored.” He goes on to criticise “the lemming-like
behaviour” that saw most funds retain similar investment policies
despite massive collective losses. “[I]n pension fund investment
management it is generally preferred to fail conventionally than
to succeed unconventionally,” he observes.
Where there is general agreement is that for too long trustees have
focussed only on returns and ignored their obligations. “Instead
of actually asking what their liabilities were going to be, there
was an unwritten assumption that the secret was just to rely on
the equity risk premium to do all the work for you,” says
Altman.
“In fact, in a way trustees were actually encouraged to welcome
risk, because the more risk they were willing to take, the more
they were told they should expected to be rewarded for it.”
Looking
forward
Still, the important question is whether the lessons have now been
learnt, and in some ways the evidence is encouraging.
Certainly, the evidence anecdotally is that trustees are taking
the issue increasingly seriously. The current profile of liability
driven investment and focus on trustee knowledge and understanding
reflects this.
And in some areas, there have been real gains. Longevity risks are
a good example. Companies such as BAE, which recently agreed to
inject £1.1 billion into its scheme, partly to cover a £800
million shortfall identified by a review of its mortality assumptions,
have helped highlight the problem, and others seem to have taken
note.
According to a recent survey by Mercer Human Resource Consulting
and the Association of Corporate Treasurers (ACT), more than half
of pension funds have reviewed their mortality assumptions in the
last year. Of the rest, about half again intended to review theirs
in 2006.
More generally, according to worldwide partner at Mercer, Tim Keogh,
schemes have also learnt to stop looking at their pension fund in
a silo, without reference to the sponsoring company.
“One of the things that’s interesting about a lot of
the discussions we’ve been having this year for the first
valuation under the new regime is how much of the dialogue is about
the company, rather than the pension fund,” he says.
Considering the pension in the context of the sponsoring company
can only help in establishing a realistic measure of the risks involved.
With regard to investment risk, though, this survey was less encouraging.
One of the surprises, for instance, was the low take-up of derivatives
– only about five per cent of respondents had used interest
rate or inflation hedging instruments, with another ten per cent
using other derivatives.
While it is true that such instruments won’t be suitable for
every fund, the danger is that too many are failing to even consider
them. Instead, the only lesson some seem to have drawn from the
last few years is that if they had too much in equities in recent
years, the answer must be to switch to bonds.
Another report this year, by Jardine Lloyd Thompson, supports this.
Its survey of both DB and DC schemes found that, of those making
changes to their investment policy in the previous year, 65 per
cent had increased the proportion of gilts in their portfolio, with
almost the same proportion cutting their equity exposure.
This is despite the fact that such an approach is unlikely to be
suitable for many schemes. As the report’s authors noted,
“[It] may reduce risk going forward, but…will require
considerable capital to generate the small (but near-certain) returns
from a fixed interest portfolio. This ‘flight to safety’
is likely to exacerbate the problem, in the future, with healthy
stock market gains being missed out upon, perhaps understandably,
in the name of caution.”
For those schemes already in deficit or with weak sponsors, such
an approach is likely only to entrench the problems.
It is worth noting, for instance, that Boots – widely held
as a trailblazer for moving its pension scheme into bonds a few
years ago – ended this financial year with a £56 million
deficit, despite injecting £85 million into the scheme over
the past 12 months. For Boots the deficit is affordable; for others
it may not be.
A more
complex world
The answer for many funds is likely to be a more diversified portfolio,
more closely matched to their precise requirements and taking in
a greater range of asset classes. However, this has yet to be widely
implemented.
There are a number of reasons why trustees may be reluctant. One
is simply a lingering herd mentality among pension funds: trustees
are still likely to be more comfortable following their peers than
leading.
Related to this is a suspicion of the complexity of the approaches,
as well as the technological modelling tools often that underpin
them.
As ACT technical officer Martin O’Donovan puts it: “I
don’t think trustees are convinced this is an exact science
and they are therefore a little sceptical of some of the more complex
strategies.” Given that most trustees are not investment experts,
they are also cautious about using instruments they don’t
fully understand.
In many cases, such an approach is understandable. Dr Susan Mangiero,
a US-based consultant and author of Risk Management for Pensions,
Endowments, and Foundations, points out that if the renewed emphasis
on risk management means anything, it is that fiduciaries must be
able to justify their investment decisions.
“Basically, process is everything,” she explains. “The
important thing is how fiduciaries have arrived at their decision
as to how to invest.” Real transparency concerns with some
hedge funds that makes valuation problematic, as well as more general
ignorance on the part of trustees about such instruments, means
that they may be right to be cautious.
On the other hand, rejecting such instruments out of hand is little
better. Mangiero notes that the question of whether there is a fiduciary
duty to hedge has already come up in other contexts in the States,
and it easy to see how such an
argument could be applied to pensions.
“If you look at something like a plain vanilla interest rate
swap, you could hardly call that exotic, so if a pension plan is
not even looking at that, is that a good thing?” asks Mangiero.
In fact, this is already beginning to change. Keogh says that although
the take-up remains limited, there has been a marked increase in
interest in derivatives to address risk.
“The use so far is limited, but that’s in the process
of changing,” he says, arguing that the industry is in a “transitional
period” as such arrangements move from being rare to fairly
routine, if not exactly common.
However, completing this transition will require a step change in
trustees’ understanding of the issues involved. Mangiero says
there is “an urgent need for clear and comprehensive fiduciary
education”, without which trustees stand little chance of
identifying and managing the risk as
they consider issues such as alternative investments, derivatives
and portable alpha.
Or, as Altman would have it: “Trustees can’t just think
they’re going to get by knowing what equity and bonds are
and meeting an hour every quarter to discuss their investments.
The world just isn’t that simple anymore.”
Peter
Davy is a freelance journalist
-
Pensions Age August 2006
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