Trustees’ guide to investment strategy – Spring 2003: Juggling flexibility with market returns

The stock market’s current dire performance has concentrated the minds of many trustees on the risks they and their funds may run. Ultimately, it is their responsibility to decide how to mitigate these investment risks, without missing out too much on the upturn – whenever it may come. No-one should ever have thought that being a pension scheme trustee was easy. The current investment climate, though, is probably making things more difficult than at any time since the calamitous falls in the stock market of 1974. However, the bounce-back in 1975 was extremely quick. On top of that the legal and accounting constraints were very different from those today. Now, few would gamble on the chances of a swift return to the valuation figures of 2000. There is much advice available from investment consultants, but what it is will depend on who you ask. And risk has different meanings for trustees compared with their investment managers. For investment managers, risk can often mean the possibility of their chosen investments performing worse than the relevant stock market index, whether that is going up or down. Whereas trustees face a starker dilemma: Can they pull themselves out of the position where they risk not being able to deliver on the benefit promises, while at the same time avoiding the risk of being unable to take advantage of the upturn? Squaring this entirely is probably impossible. As investment experts Keith Ambatscheer and Don Ezra put it in their book Pension Fund Excellence: “Safety and opportunity for high returns should not simultaneously characterise a single investment. Suppose that aninvestment is ‘safe’ (meaning that there is little chance of its price declining) and it has a very high expected return. In an efficient market investors would flock to such an investment. They would bid its price up as they fight to buy it. At the higher price, its expected return becomes lower, and it is no longer as safe. It would still be desirable, and its price would keep being bid up, until its combination of relative opportunities and risk are in rough equilibrium with other available investments.” Some investment managers are currently offering absolute return products, designed to provide perhaps 3% or 5% above the rise in the Retail Price Index. “They remove one of the biggest risks trustees worry about, the risk of capital loss,” says Alan Grant, head of investment consulting at consultants Jardine Lloyd Thompson. “But there are still opportunity costs. You may be able to buy a product that gives 5-6% return, but there may be a period where we see a recovery in the market, perhaps of 20%.” Nor, he points out, are these products (or any others) offering an absolute guarantee. “There is still a risk associated with them. There is really no asset class without that risk except cash. One misconception by trustees is that they are being led to believe equities are the risky investment, and bonds are the thing for security – but there are risks in bonds also. It is important that trustees understand this.” How much risk any group of trustees should take with their investments depends on a whole host of issues; size of fund, maturity, whether or not they are open to new entrants, whether they are defined benefit. Running a DC scheme raises particular issues, for while the member may be given a choice of investments, it is the trustees who provide the shortlist from which that choice is made. So trustees must take care about their selection, both of the type of funds and of the managers of those funds, and keep an eye on them as conditions change. Most DC schemes in the UK provide a lifestyling arrangement, either as the only choice or as the default. In these, the member’s account is moved from equity-type investments into bonds and cash funds in a series of switches phased to coincide with the member’s run-up to retirement. In effect, this turns the ‘timing’ issue, which experts themselves are finding difficult at present (see box: The devil is in the timing) into a mechanistic formula. Inflexibility here could give trustees a litigation risk in future; at the least, they should allow members to vary their chosen retirement age, as their working patterns become clearer. In today’s volatile markets, administration also impacts on the member’s investment risk. Contributions should transfer into the members’ funds as fast as possible, not sit around in the trustees’ or the managers’ accounts for days or even weeks as sometimes happens. Investment consultancies and commentators are currently giving very different advice about overall strategy. On the one side are people such as John Ralfe, former finance director of Boots who has now set up his own investment consultancy, and actuary John Shuttleworth of PricewaterhouseCoopers, who see no role for equities in a pension fund’s portfolio. On the other side are those, such as Alistair Ross-Goobey, formerly of Hermes, who believe that the flow of dividends means that equities should always have an important place in the portfolios. “Capital volatility is not critical,” he wrote recently, “unless you have to realise assets at an inconvenient time.” There is, though, a general tendency to advise trustees to do more asset-liability matching – linking pensioner liabilities to bonds, and current members’ liabilities to equities. However, many trustees remain unconfident about their ability to deal with these advisers. So though many more trustees have been trained since the Myners Report, a pre-requisite for mitigating your scheme’s risk may be more of the same, to ensure you do understand the advice you are given. So trustees must ask and ask again, use their investment advisers and question both them and the managers alike. The devil is in the timing Trustees’ biggest dilemma today is when to make the move to a new strategy they believe is right in the long run. Simon Jagger, director and actuary of consultants Jagger & Associates, says that trustees should ask for an analysis of their schemes’ time horizons. “When do major changes come through?” he asks, “If you know that, you know how much longer you have got during which you can reasonably take investment risks. One of my clients is going through a phased switching, treating everyone 10 years or more from retirement as a global equities liability, and transferring them across to bonds as they get closer. Another is going in for a wholesale switch, which is proving wise because one-third of the workforce are now likely to take early retirement or redundancy within a year.” However in the short-term, as Alan Grant, head of investment consulting at Jardine Lloyd Thompson puts it, “It’s very difficult to get anyone to commit themselves on the timing of a switch – investment managers, consultants, or trustees. Often, they give the manager instructions to drip-feed the change, over perhaps six months, with a pound-cost averaging approach over a period. There’s a feeling that this leaves trustees less exposed to criticism at a later stage.” Trustees highlight own gaps The results of a Watson Wyatt self-assessment questionnaire to 300 individual trustees in funds totalling ¬£165bn, found: • Trustees believed they had a significant training need, in terms of strategic asset allocation and investment manager selection. • They doubted their ability to question external advisers, particularly among funds below ¬£250m. • Trustees across the whole fund size spectrum believed that their understanding of different approaches to investing (e.g. passive, value, hedge funds, absolute return) was weak. • They also realised that the understanding of their investment managers’ performance weighed against risk was important. Closed schemes and stochastic valuations One of the reasons that trustees and employers have put themselves in such an exposed position is that they have focused on the single figure result in their actuarial valuations – actually, just the end-product of a whole series of calculations based on different assumptions. The actuarial profession is bringing in new guidance for sensitivity analysis in their valuations, demonstrating to trustees what the effects on their scheme will be if the assumptions, for instance on investment returns, are varied up or down. A stochastic valuation is being developed by actuary David Jones, partner at Lane Clark & Peacock. “Effectively it’s a probability valuation, giving an idea of the range of outcomes, and the distribution of probabilities,” he explains. It’s especially important for trustees of schemes which are closed to new entrants to understand these, he says, because their room for manoeuvre is so much less. “Once a scheme closes, you are going from a long open tube into a cone, with a point at the end which is the end-point of the scheme.” Identical closed schemes can carry very different implications for the company’s potential contributions in future years, depending on how they are invested. Specific manager risks The focus on getting asset allocation right does not take away the need to check individual managers’ activities. Alan Grant, head of investment consulting at Jardine Lloyd Thompson highlights two specific issues; style drift and – perhaps surprisingly – outperformance. “Style drift is the possibility that the trustees have appointed a particular manager because they have adopted a certain investment style, but they then drift towards adopting a different style. The consultant must alert trustees to this, and personnel changes.” As for outperformance, he says, “If you see a good performance compared with the benchmark, you may sit back without realising that a manager has been taking risks he should not have been.” Another possible risk, especially for the smaller scheme that invests in pooled funds, is that trustees may not pay enough attention to those funds’ exact asset mix. “In the past, some mixed managed funds were arguably misclassified,” says Simon Jagger, director and actuary of Jagger & Associates.