Reconciling different shareholders' views
There are essentially four major players in the provision of and management of pensions. An understanding of the objectives of each can be very illuminating when considering how they should and how they actually do interact with each other. This ‘Game Theory’ formulation has a clear, explicit macro objective, namely, that individuals at the end of their working careers can look forward to an “adequate” retirement income that equates to an ideal of 75% of the final salary.
The fund management viewpoint
The majority of fund management firms, particularly the subsidiaries of large listed companies, are run as businesses that seek to maximise profits to shareholders and seek to control business risk as far as possible to ensure greater stability of earnings. Managers seek to differentiate themselves from each other to seek competitive advantage. They also judge themselves against each other or, more significantly, against an index which is a proxy for the rest of a universe of other fund managers. Underperformance against an index or against a peer group when figures are available represents a very significant business risk for a firm. It can be the driver behind rapid growth or indeed rapid decline over time periods of a few years.
History shows that balanced fund managers during the equity boom years of the 1980s and 1990s, ended up taking slightly more risk without straying too far from the pack by increasing their equity holding at the expense of bonds. This led to a gradual creeping up of the equity percentages to figures approaching 60% or more. Specialist equity managers took huge business risks by straying too far from the index. Avoidance of bottom 4th quarter performance against the peer group and hence against the index proxy, was always a more important criterion than trying to achieve top quarter performance on a regular basis. Indeed, achieving upper quartile performance over one year periods on a consistent basis would give the highly desired characteristic of top quartile performance over a five year period.
Managers have been, for the most part, reluctant and remiss in not looking at liability driven benchmarks despite more recent urgings from investment consultants.
The trustee viewpoint
Trustees are facing an increasingly complex environment with, in many cases, an ill-defined set of objectives. In the case of a final salary scheme for example, in theory the investment performance should not be important. If the company stood by the guarantee of the pension scheme it would be forced to step in if the fund had a shortfall leaving the trustees with little to worry about regarding investment performance. However, the ambiguity in ownership of pension assets has led to surpluses being shared out between beneficiaries and shortfalls being made up by the company. Trustees are therefore sometimes under pressure to maximise a surplus to be able to increase benefits. This would be at the expense of the company’s shareholders since the distribution of surplus would reduce the scope for the company to take a pensions holiday when the scheme is over funded. There has, therefore, been a general view that trustees should look to maximise returns whilst keeping risk at reasonable levels.
The company’s viewpoint
Companies are faced with an asymmetric risk position in that surpluses in a pension fund may have to be shared with beneficiaries whilst they are liable to make up shortfalls in final salary schemes.
Even before the recent market falls, a move towards a strict snapshot market valuation under FRS17 led to the change in some valuations from having surpluses to gaping deficits.
The fact that life expectancy has increased very significantly, retirement ages are lower - often mid-50s, and the recent large scale spate of mergers, means that the liabilities of pension schemes have increased. This, combined with an outlook for equity markets that looks like single digit returns for the next decade means the cost of a final salary pension provision has therefore risen dramatically over the last few decades.
The solution for many company directors has been to abolish the final salary scheme and move to a defined contribution or money purchase scheme.
Companies are typically trying to reduce the overall costs of pension contributions as well as trying to shift risk off their balance sheet. As a result, total contributions to employees’ pensions have been cut, often by many percentage points.
Faced with lower returns available to build up a lump sum and lower yields available to turn that lump sum into an annuity, the future looks a lot gloomier for those depending now on a defined contribution (DC) pension scheme.
The tragedy of the move to DC schemes is that companies have moved from schemes based on final salaries (with large expenses and inherent risks for the company through the guarantee of covering shortfalls), to the opposite extreme of much less generously funded schemes (with all the investment risk shifted to individuals who are not best placed to take it), without considering any of the possible alternatives in-between.
Alternatives to a precipitous shift from the safety of final salary schemes to defined contribution include the idea of pensions dependent on average salaries throughout a working career rather than final salaries. This is far more predictable and more closely linked to actual contributions than shifting some of the shortfall risk onto beneficiaries, eg a minimum figure for pensions together with an explicit ownership of surplus for example.
The government’s viewpoint
Governments, unfortunately, often have a short-term horizon geared to a five- year election cycle rather than the thirty or more years required to adequately deal with the issue of how to ensure the retired population in future years has an acceptable standard of living. Governments should adopt a strategy for pensions that will not have a detrimental effect in the eventual size of cake. Deciding how to divide it between the retired and the wage earning sections of society is a political problem rather than an economic one with many levers available to find a compromise.
Pensions, of whatever form, represent a transfer of wealth from those who are producing income and wealth, to those consuming it. The state can alter the distribution of earnings between workers and pensioners in any number of ways through, for example, increasing taxation and increasing the state pension at the same time.
It can be argued that the longer-term goal for governments should, however, concentrate on ensuring that current legislation for pension schemes does not detract from long-term wealth maximisation. The redistribution of wealth between pensioners and wage earners can be easily adjusted through a mixture of taxation and state pensions.
The ideal behaviour of the government should, therefore, be to ensure that the regulatory regime encourages market forces to allocate resources most efficiently whilst clearly taking pragmatic steps to cope with the inevitable distortions that do occur.
The whole debate of risk has to be defined in terms of the four major stakeholders in the debate and the completely different objectives and hence risks of each one clearly understood.
Fund managers need to move away from reliance on index benchmarks which merely reduce and control their own business risk but have little relevance to the other stakeholders in the pension debate. Corporate structures of fund management firms also need to be looked at carefully. Investment is a long-term game and needs a long-term perspective that, in turn, requires stability in the fund management process. The last few years of rapid mergers, name changes and staff movements have not been helpful in this regard. Big Bang in 1986 signalled the end of the partnership model in the City driven, in part, by the risks of unlimited liability partnerships. The advent of effective limited liability partnerships or similar corporate structures may mark the renaissance of a business model that does have the great advantage of promoting stability and long-term horizons.
Trustees may need to seek compromise with company management over ideas that whilst not as beneficial for scheme holders as the final salary schemes, offer better risk/return trade-offs than defined contribution.
Company managements need to slow down the rush to abandoning final salary schemes. The argument that everyone benefits by aiding job-hopping through moving to defined contributions schemes is grossly over-rated. It assumes that there is no better alternative viewpoint and that corporations are benefiting by encouraging a perpetual state of insecurity. While portability may be seen as absolutely critical when cradle-to-grave employment is a thing of the past, the question arises as to how true this is. It can be argued that after a moderate degree of employment promiscuity in their 20s to early 30s, most people change jobs now no more frequently than they did 30 years ago.
Governments need to be more honest and clearer in their aims for pensions legislation. Ultimately, legislation that seriously detracts from wealth creation will reduce the size of the cake that can eventually be redistributed amongst workers and the retired. Given the growing evidence from the 401(k) experience that retirees in the US will have precious little to retire on despite a 20 year bull market when decision making was easy, perhaps it is time to re-visit defined benefit schemes and try to rescue what was good from them.
Can the human mind construct a retirement vehicle with (a) some sort of floor (b) substantial upside (c) portability in the early years (d) some choice (to allow for life-cycles and total asset/liability assessment) (e) managers who are best able to access and use market information (f) managers who are best able to hedge and manage risk rather than those least able to.
The actuarial profession, the high priesthood of the life insurance and pensions industry, has a clear opportunity to fulfil its vocation. It is well placed to take on the most critical role in this game of providing for both life and death, that of Games Master. To align the interest of the players to generate collaborative behaviour. The actuarial profession needs to rise to the challenge or else face the threat of becoming an irrelevance in the field that gave rise to its creation.
Joseph Mariathasan is director of business development at GMO Woolley, the UK affiliate of Grantham, Mayo, Van Otterloo & Co