RSS feedsLiability driven investment is as much a buzzword in pensions as ‘absolute return’ is in fund management. LDI is about matching income with calls on future cash flows in a pensions deficit-ridden corporate environment.
But wasn’t it ever thus? Well, maybe not, as long as pension fund trustees were able to get by with working out their pension fund obligations by ‘present valuing’ them using gilt-related discount rates when gilts were providing better returns. But that’s all changed.
It’s much more pressured now. FRS17 requires that pension fund assets are marked to market more rigorously, that a relatively lower discount rate is used to calculate liabilities and that this more detailed information on pension fund valuations is open to public scrutiny. The demographics have moved against pension provision as life expectancy continues to rise, while interest rates and fixed income yields are low and the return from equities over, say, the past six years as a whole, has been sub-optimal. PricewaterhouseCoopers has calculated that pension fund deficits among FTSE-350 companies now amount to £70bn.
To up the ante even further, the new Pensions Regulator has just released its medium term strategy, which was critical of the competence of pension fund trustees. “Our experience is that the standard of governance of many schemes, particularly smaller ones, is poor,” it says. “Our in-house research shows clear evidence of low standards of trustee knowledge and understanding, particularly in schemes with fewer than 1,000 members… Trustee conflicts of interest are also a concern, especially in defined benefit schemes with funding difficulties.”
In addition, perceived poor governance and fund management performance now cast a long shadow of reputational risk over corporates. Ratings agency Standard & Poor’s has placed corporates on credit watch where it felt that they were at risk of defaulting on their pension fund obligations.
Valuation
So the issue of pension fund valuation is now thrown into sharp relief. Get it wrong and employ the wrong investment strategies and the result is to fall foul of all your stakeholders and the regulators.
Consultants Watson Wyatt codify valuation into three categories:
- Discontinuance valuation – based on totalling what all scheme members’ benefits would amount to if the scheme, as a whole, was terminated at the date of valuation. This establishes the full scale of a scheme including all of the variables having to do with the number and age of scheme members, their life expectancies and probable future benefits.
- Accounting valuation – apart from meeting accounting requirements, this method summarises members’ accrued benefits and future likely benefits as at year-end. It also takes a view on how future benefits will increase in light of likely future rises in salaries.
- Funding valuation – calculates future scheme contributions and how funds should be invested.
Liability driven investments
The result of Watson Wyatt’s approach, as with those of other consultants, is that it establishes the probable scope and profile of the scheme. And this, in turn, forms the basis of LDI: how liabilities define investment strategy. The reason why managers have coined the term is that, whereas previously it was enough to match liabilities’ cash flows with those from bonds, leavened with equity dividends and capital growth, neither ingredient now produces the best outcome in view of the burgeoning obligations. “The liability benchmark is the portfolio of assets that best matches the [pension fund’s liabilities’] cash flows,” says Andy Green, European director of consulting at Mercer Investment Consulting. “This will generally be defined as a combination of fixed interest and index linked assets and includes both government bonds and swaps.” However, this points directly to the issue of risk.
“You’ve got a critical decision to make once you know what your profile looks like, once you’ve decided what your investment aims are and how much risk you want to take,” says Green. “That is the implementation decision. Do you, the trustees, retain the control of the investment policy? Do you hire a specialist manager for each part of the portfolio in order to gain from their specialist skills? Or do you have one overall manager, so that you can switch between asset classes as and when necessary?” Another decision to be taken is whether a manager should be active or whether it will be sufficient and cheaper to invest via index linked funds. Indeed, should one manager be able to offer a variety of approaches and strategies? According to Mercer, “We now have an environment within which consultants, managers and investment banks are each competing to provide full solutions to trustees. Hence, more than ever, it continues to be important to separate the genuine value-enhancing strategies from those following fashion as a means to gather assets or to execute deals.”
Managing the managers
No wonder the Pension Regulator feels that many trustees need a more thorough grounding in investment management, with the best and4 brightest from the City of London and the fund managers of Edinburgh, ranged against them. Much has been made of the conflict of interest faced by company executives and particularly finance directors who also act as pension scheme trustees. But John Belgrove, a senior investment consultant at Hewitt Associates, says: “Sadly, there are fewer FDs that are able to wear the trustee hat. I accept the conflicts issue, but largely they bring a lot of strengths to the trustee board in terms of financial knowledge.” Nowhere, perhaps, is this more the case than in the context of seeking superior returns and separating the wheat from the chaff among investment managers.
For many trustees, bonds, equities and cash have failed to bridge the ever-yawning gap between a safe return on their fund and its deficit. And yet certain asset classes have performed very well – or even spectacularly (see box). These include private equity, commercial property, hedge funds, commodities, emerging market debt and equities, private finance initiative-related bonds, currency management and pure stock picking in equities. Belgrove advises that trustees need to take the view that “these options are all part of the mix and it’s all back to ‘What am I trying to achieve? What am I worried about going wrong and how quickly do I need to achieve the results I am aiming for?’”
The trustees are faced with the task of finding managers who can get the best out of these various high return markets. Belgrove and others advocate carefully managing the managers, setting them well-defined targets. Such targets are likely to be absolute return, those unconstrained by standard benchmarks such as a return over cash or in relation to gilts, FTSE or other standard indices. Another important feature of retaining managers for the specific purpose of accessing superior returns is to limit the amount of money they run for the fund.
Worryingly, there seems to be a trend among some pension funds to buy exposure to markets late in the day by which time the early adopters have already extracted the high returns and when the risks of market downturn are increasingly acute. The current flood of funds into private equity, funds of hedge funds and commodity-based exchange traded funds may be cases in point.
So while the ceaseless quest for return continues, the job of pension fund trustees gets no easier. Indeed, it becomes increasingly pressurised in direct proportion to the increasing scale of fund deficits and the degree of public scrutiny brought to bear on pension fund performance. It is not surprising that there is a relative shortage of people prepared to act as pension fund trustees although it is such a vital role in the context of the importance of occupational pensions in the lives of increasing numbers of retired former employees.
