In the harsh and variable climate that is the Karoo, plants have had to adapt in many wonderful ways in order to survive. They seem to be constantly under siege by extreme heat, extreme cold, severe drought, floods, poor soil types, brackish water, mankind and not least of all, grazing animals, both wild and domesticated.
Among the arsenal of weaponry which they have evolved are highly specialised root systems, thorns, an ability to re-root from broken branches and an ability to absorb and store water.
Okay, so what does this have to do with pensions? At the moment. quite a lot. Dying may not be quite the right word but if pension funds don’t learn to adapt to changing circumstances then their future is far from assured, let alone rosy.
Do a quick search on Google for the expression “adapt or die” and after its use in looking at the survival of plants in South African deserts, you will find yourself looking at architecture, internet technology, business technology, jazz, homeland security, telecom companies, textile exporters, supply chains and of course endangered species. And that is just the first 10 results.

While pension funds may not yet be described as an endangered species, one has to wonder what they will look like in even as little as
10 years’ time. I suspect the typical benefit structure will be less generous and we may have to wait longer before we can draw a pension but hopefully it will be more secure.
Pension fund investment strategy certainly has to change. I am sure that over the next few years virtually all investment plans will be liability-management driven. Pension managers have to know how their assets will react to changes in economic circumstances. If funds don’t know what will happen to their assets if long-term
or short-term interest rates rise or fall, if mortality rates change, salaries and wages increase at a higher rate than assumed, or various other economic or demographic circumstances change how can those funds possibly
survive?

So liability management is important but it is not an exact science, nor indeed is it possible or desirable for all pension funds to manage all of their assets in this way. However, knowledge of a fund’s position is vital. Trustees should know exactly where their fund will be if medium-term interest rates rise, if long-term interest rates decrease, if the yield curve rises steeply, if credit spreads widen. Are funds safe if volatility increases, for example?
Most funds would benefit from decent scenario planning. Possibly the simplest calculation that most funds could do relatively easily is to work out what effect a 1% change in long-term interest rates would have on both their assets and their scheme’s liabilities.
Calculations are very easy when it comes to calculating the effect of a change in interest rates on a fund’s bond portfolio but schemes really should be able to work out the effect on the rest of their assets whether they are equities, property or whatever. If you don’t know the answer should you be investing in that asset class in the first place?
When you see the answer then you can decide whether to put interest/inflation swap overlays in place. Another challenge for pension funds is the fact the circumstance change all the time. Scenario planning is not the sort of thing that can be done only every three years and then forgotten about. The whole investment world is simply too dynamic for anyone to sit around doing nothing. I hesitate to recommend the right timescale but with tight annual reporting deadlines, I guess reviewing where you stand is often likely to be a continuous process for most really large schemes.
I remember reading somewhere that liability-matched portfolios were the end game in this industry. I am not so sure. Of course, one can create a portfolio of bonds and swap assets that precisely matches the profile of the
liabilities at any point in
time.
I am equally sure that no matter how carefully it is designed it will not be a matching portfolio for that scheme almost any time later. Pension schemes, unless closed to future accrual and membership, are simply too dynamic and even closed schemes, unless 100% insured, can have unexpected mortality and longevity changes.

And so, to come back to our analogy with the Karoo, funds may not be under siege by extreme heat, extreme cold, severe drought or floods but low interest rates, the recent experience of stockmarket crashes, regulatory changes and new accounting standards, do make many pension fund manager wonder just what might happen next.
I am delighted to see that so many funds do take this seriously and now do risk manage their pension schemes. I just wonder if we are really going far enough to avoid getting hit by the next unanticipated crisis?