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The Actuary The magazine of the Institute & Faculty of Actuaries

Haunted by black holes?

he recent publicity over the Kvaerner pension scheme has highlighted diverging views among actuaries and other investment professionals as to the most suitable strategy to be adopted by pension fund trustees. It also raises a number of questions:
– should trustees and advising actuaries ‘play it safe’ with liability-driven investments (LDIs) or should they seek to make good pension fund deficits with more aggressive investment strategies?
– what are the risks of doing so, if things go wrong?
– can trustees and advisers be sure of their legal position?

‘Safe strategies’
Gilts are perhaps the best known and most commonly used LDIs. Many schemes have moved away from an emphasis on equities towards an entire portfolio of gilts or a mixture of gilts and corporate bonds. This cautious trend can be traced back to the announcement by Boots, in October 2001, that it was adopting a gilts-matching policy and had moved all its pension fund assets into that asset class. Other trustees and schemes followed suit over the following three or four years. In fact, gilts-matching has become such standard practice in some quarters that we have seen claims against actuaries alleging that, in certain circumstances, it was negligent not to have recommended a gilts-matching policy in the period from 2000 to 2003, and that doing so would have prevented further increases in fund deficits.

Dangers of safe strategies
That said, it might be wrong to characterise a gilts-matching investment policy as being safe, and one that will automatically insulate actuaries from potential claims in the future.
First, a gilts-matching investment strategy locks in any deficit, whereas equities have a better chance of producing growth for the fund and reducing any deficit. Second, a cautious investment strategy cannot guarantee that the deficit will not increase, because it may not adequately (with the benefit of hindsight) factor in changes in, say, mortality and salary inflation. Finally, many schemes switched into a gilts-matching policy, and the increase in demand has meant that prices have risen rapidly and yields have fallen. The result is that these investments are now less attractive, particularly in comparison to equities, which have increased in value since March 2003.
The combination of the above factors has led some commentators to criticise the ‘lemming-like rush’ into gilts or long-term bonds, and the most vocal of these is Dr Ros Altmann (adviser to the Kvaerner scheme), who advocates that funds seeking to address a deficit should diversify their range of assets to include hedge funds, commodities, currencies, real estate, venture capital, and even infrastructure projects. Given the current number and extent of ‘black holes’, there is increasing comment that it is insufficient for asset management strategies simply to move in line with liabilities without reducing the deficit, with the result that a shift back towards equities is now discernable, as well as towards the more novel approach of multi-asset investment. Even Boots made a U-turn from its 100% gilts-matching strategy, only about three years after its original decision.
In this climate, we now expect to see criticism of those schemes that pursue and maintain overly defensive investment strategies. Therefore, while we are currently seeing claims against actuaries arising from an overexposure to equities following the dotcom crash, we expect to see claims in the future alleging the opposite, namely that for the last three years, actuaries have been negligent if they have been advising schemes to be under-exposed to equities.
Nevertheless, it would be wrong to describe this as a ‘damned if you do/damned if you don’t’ scenario. Although our increasingly litigious culture suggests an increase in claims to be inevitable, it is not all bad news for actuaries and we provide some observations below on the legal test for liability and some mechanisms by which actuaries can manage the risk.

The legal framework
In providing advice to the trustees, the actuaries must act with reasonable skill and care. An actuary will be found in breach of this duty if the trustees can show that no reasonably competent adviser could have given that advice. This does not mean, however, that actuaries will be immune from claims if they simply follow the herd. While the advice provided by actuaries to other similar schemes will be a relevant factor in determining the issue of negligence, it will not be determinative, because the court will look at the specific circumstances of the scheme in question. Indeed, as we mention above, the lemming-like rush into gilts and long-term bonds could in fact precipitate claims, notwithstanding that it has been a popular investment strategy.
Pension scheme funding should not be seen in simplistic terms as a choice between a cautious or aggressive investment strategy, but involves looking at a whole range of investments and, if thought appropriate, creating a multi-asset allocation. Actuaries who recommend a strategy at an extreme end of the spectrum of choices are more likely to be exposed to claims, and to be found negligent, in the event that the strategy does not achieve its goals. Sadly, this is merely a reflection of modern society professionals will rarely be thanked for sticking their neck out when it all goes right, but will be a clear litigation target should it all go wrong.
On the assumption that actuaries avoid extreme positions, we consider that the threshold test for liability, outlined above, is high, and indeed there have been few successful claims against actuaries to date. The threshold may have risen further as a result of the Pensions Act 2004, since trustees are now required to have a full understanding of their schemes, investment and funding principles. Therefore, while they are entitled to rely upon advice, they are not entitled to do so blindly, and this could possibly reduce the number of successful claims yet further in the future.
However, downplaying the merits of these claims could have disastrous consequences. There may be a temptation for actuaries to attempt to deal with these claims in-house, hoping that a few well drafted letters will see an end to the matter, without involving their professional indemnity insurers, and thereby without affecting future years’ premiums. However, temptation must be resisted at all costs, because the insurers may then be entitled to treat the insurance policy as if it never existed, or refuse to indemnify the claim in question, leaving you exposed at the time when you need support the most.
In providing advice to trustees, the actuary must have knowledge of both the employer and the fund, and should consider the interests of all the stakeholders in the scheme. Indeed, Mr. Norgrove, the chairman of the Pensions Regulator, has recently commented that ‘prudence can be reckless’, stating that it would be rare for the Regulator to support trustees who were pressing for a level of funding that could put the employer at risk. However, taking into account the interests of all stakeholders is not the same as acting on their behalf, since they clearly have conflicting interests. Therefore, another temptation that must be avoided is the otherwise laudable intention to try to keep both the employer and the trustees happy at the same time, as this will simply be storing up problems for the future.
It is worth noting that while the Pension Protection Fund (PPF) may provide a safety net for failing pensions, this will not in itself prevent claims being made, since the PPF acquires the rights of scheme trustees and can in theory pursue any claim against the advisers that would have been available to the former trustees.

Advice to actuaries
Finally, the best advice we can give to actuaries to manage the risk is to delimit the scope of their retainer in their contracts, including the agreement of a liability cap, and further, with regard to third parties, they should publish a disclaimer on each of their reports and substantial advices.
The gilts-matching versus equities debate will continue. Recent claims have criticised the ‘cult of the equity’, but future claims may well take the opposite tack and focus on the lemming-like rush into gilts-matching or other cautious investment policies. In any event, we believe an increase in claims against actuaries in the future is inevitable, although as we demonstrate above, it is not all bad news for actuaries since the threshold test for liability is high and there are a number of measures actuaries can take to manage the risk.