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The Actuary The magazine of the Institute & Faculty of Actuaries
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Pensions: Investing for the future

One of the most important aspects of a pension trustee’s role is to remember the timescale on which a pension fund operates. It is easy to lose sight of this when investment performance is measured from one quarter to another. In hand with this is the principle of matching assets with liabilities. A fund with heavy cash flow requirements is clearly at risk from volatility first and foremost, while on a longer timescale the threat is from inflation. The obvious conclusion is that, in the former case, nominal assets like bonds are more appropriate, whereas in the latter the task is to secure a rising income.

This is hardly controversial; the difficulty is that, in most cases, some kind of compromise is required between the two approaches. Investment managers tend to treat asset allocation as a question of forecasting economic conditions, but we think trustees should concentrate on cash flow. The important thing is to cover the income requirements of the fund with a reasonable degree of certainty. If that foundation is in place then it becomes a lot easier to allocate money to risk assets, taking a long view on their performance.

It follows that trustees should take a close interest in the quality of income, not just the quantity. It is always a good idea to question fund managers about the cover on dividends and the asset backing for bonds; the answers should be immediately to hand. The past two years have shown how fragile these assumptions can be, so it is important to understand the justification for asset yields and whether it is warranted by the risk. The case for equities rests on the rising income that they generate and nothing undermines it like a dividend cut.

Asset allocation
The main decision in asset allocation may be the split between real and nominal assets, but many others follow. It is customary to divide an equity portfolio between different regions, with sector exposure based on each respective index. This approach has its critics, however, and some managers prefer to invest globally. Why buy a second-rate company because it happens to be in a given market, when you can buy a better one somewhere else? It is worth considering the pros and cons.

We are all familiar with globalisation — clearly, the world economy has become more integrated and in some cases geographical distinctions have long since fallen away. There is not much point looking at, say, an oil major in the context of where the head office happens to be. However, regional trends persist and it is logical to want more exposure to where growth is expected to be stronger. It is important to have a top-down view and to understand the underlying geographical exposures of the portfolio.

When splitting a fund there is a risk of duplication, as managers often follow the same themes and have a tendency to hold large index constituents by default. Both points work in favour of a single, global approach, but they raise a further question: does the manager have enough resources to provide that service? Few individuals have shown that they can ‘do the world’, so one is relying more on a process. We think the two approaches can both be made to work, but when different managers are in charge of separate pots of money, it is incumbent upon trustees to make sure that they talk to one another and take a view of the whole.

Then there is the question of active and passive management. The theory of efficient markets is under something of a cloud with all the volatility of late, which makes the aim of outperforming a benchmark all the more seductive. There has never been a year like 2008 for active managers, when holding cash was all that was needed to outperform. The challenge is to pick the good ones and, alas, there is no obvious method. Our opinion is that income growth should be the overriding theme for trustees, and it is perhaps the most significant flaw of the index-tracking approach that it does not take any account of it. The London market in particular has played host to a series of surprising newcomers, from technology stocks to Khazak mines, which do not always sit easily in a fund that requires a reliable income; nor can you overlook the historic preponderance of the financial sector. In a tracker fund, you have to put up with what you get.

Monitoring performance
You are then faced with the task of selecting and monitoring managers. In the case of passive funds this seems simple enough, as there are only two criteria — cost and security — and headline fees are easy to compare. Trustees should, though, be aware of the various indirect charges, such as stock lending and commissions on dealing. The more complicated a product, the easier these are to add on, but even the innocuous tracker fund is not immune to such practices.

The next point is security. There is a fundamental distinction between owning assets and owning rights to assets, and by extension between funds that hold shares and those that replicate their performance by means of derivative contracts, with all the contingent risks that this entails. You can easily guess which offers more scope for creative charging practices and more temptation to mask their effects by taking unseen bets. The moral is simplicity and transparency.

There is a case for diversifying and for using specialist managers, although this will be influenced by the size of the fund. Large funds are often split as a matter of course, but the decision is less straightforward for smaller ones. Trustees must consider what they are trying to achieve; there is a rationale for using specialists in different regions, or with a contrasting approach, but it does not necessarily add much diversification to have two different managers doing the same thing.

With charges, you get what you pay for. A business model that is commission-driven will do just that. The important thing is to have transparency and to be aware that incentive structures can influence decisions. Consider performance fees: as long as the relationship implies only potential gains and never losses for the manager, then their interests will not be aligned strictly with the client and capital preservation may not be at the forefront of their thoughts. On the other hand, fees simply related to the size of funds under management may breed complacency.

Trustees will want to satisfy themselves that their investments are secure. Nominee companies are independent entities and you should naturally establish that assets are held in such a structure and not at risk of contagion from a parent. Generally, cash is at greater risk than quoted investments, but it is worth enquiring about the practice of stock lending that proved disastrous for counterparties of Lehman Brothers. All firms stress their risk controls, but procedures are only effective if they are actually implemented and this has a lot to do with corporate culture. We are firm believers that the tone is set from the top and there is no substitute for actually meeting people and forming your own judgment. Institutions can have short memories: the margin calls that brought Lehman and AIG to their knees differed little to the fixed annuity rates that did for Equitable Life, or the guaranteed surrender values of the early 1970s. One should always question returns and, when conditions change, policies should change with them.

This leads to the final consideration — reporting. In recent years there have been ever-greater volumes of performance analysis, but you can have too much when the period under review is a short one. The significant figures are the annual ones and it is hard to judge performance over less than three years, a reasonable length of time for a decision to be proved right or otherwise. It does no harm to make this clear from the start if you want a manager to back their judgment.

Trustees seldom realise that their attitude towards the investment manager can make or break their performance. It is vital that the manager has confidence in the trustees, that they will not criticise every mistake, and they will back his/her judgment.

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John Harsant founded Harsant Pensions and, although retired, remains active as a pension scheme trustee. David Ravenscroft is a fellow of the Securities Institute and a member of the Smith & Williamson Asset Allocation and Model Portfolio Committees