Where one size dows not fit all
It was with great hesitation when we were writing the ‘Rebuilding Pensions’ Report that we formulated a recommendation for what has now become the Statement of investment principles (SIP). We were, however, encouraged by the overwhelmingly positive support for this which we received from all over Europe from the responses to our questionnaire.
I kept thinking that this should not be another piece of paper, another layer of bureaucracy which is required and then nothing is done with it.
It is a fact that trustees and members of boards of directors of pension funds/trustees are, in majority, not specialists; that they are (or were) overwhelmingly conservative and that therefore they need to be motivated, activated, made responsible and accountable for the very important task they have. Only then will there be a move towards a more dynamic strategic asset allocation (SAA) with tactical active or passive re-balancing (TAA) which is needed in view of the volatility of markets and currencies. What is good long term, in a concept where fund specific asset-liability management plays its role and where therefore there is insight in what can and cannot be done with the assets in view of the outstanding liabilities, may not be appropriate to the full extent over the shorter term.
We can safely say that the average trustee of a pension fund is a prudent person, maybe a too prudent one, who was often too happy to operate in a restricted environment where the regulation specified what can be done and what cannot be done. It is even safer to say that the supervisors, with notable exceptions, also preferred such a regulated environment where the asset allocation can be checked against the rulebook.
One size, unfortunately, does not fit all; worse, it doesn’t fit anybody and the damage it has done in terms of lost opportunities and sub-optimal performance is considerable and has been evidenced once more in the explanation accompanying the Proposal for a Directive on Institutions for Retirment Provision (IORP) adopted by the European Commission in October.
The advantage of pension funds over individual provision-and there is much to say for appropriate individual choice related to investments-is that there is risk sharing that is that the group can -but does not have to-take more risk on average than the individual. We therefore thought that the SIP should be named ‘Statement of investment and risk principles’ (SIRP).
Risk is as important as return, if not more important and so is risk adjusted return. Academics and practicians have devoted a lot of time and thought to the question of performance attribution. Has an investment approach been rewarding considering the risk involved? Where does performance come from? If they believe in a top down approach, the answer should be essentially from the construction of the allocation between asset classes, regions/countries and increasingly from sector allocation. For those who believe in a bottom up approach, the answer should be from securities selection.
Finally, for those preferring a passive approach, it should come from their ability to replicate the benchmark with the least possible deviation at the lowest possible cost, unless-of course- they search for (active) tilting away from the benchmark with the objective of adding some value. These approaches are not inconsistent; they all aim at achieving return relative to an objective or, to a reference index and at controlling risk both relative risk vis-à-vis a benchmark and, more importantly, absolute shortfall/downside risk i.e. the risk of capital losses/negative return.
The trustees when liberated from the cosy world of the regulation and investment restrictions imposed by the rulebook are on their own. They need to write down their strategic asset allocation and their risk profile, how they measure risk and how they control/manage it.
The European Commission wants to make this mandatory: ‘Member states shall ensure that every three years, as well as without delay after any significant change in the investment policy, all institutions located in their territories disclose their investment policies to the competent authority of the home member state. This will be done by sending a statement of investment policy principles containing the risk measurement methods and risk management processes implemented and the strategic asset allocation with respect to the nature and duration of pension liabilities’ (art.9 of the Proposal).
This requirement is absolute for DB as well as for DC type plans, for all small and all large plans. The SIP is a high level statement of responsibilities, beliefs and objectives which sets the framework against which the more detailed investment guidelines are drafted.
It provides the basis of accountability for all parties concerned.
It provides a clear audit trail which can also be communicated to members and beneficiaries as well as the reasoning behind the asset allocation, the risk profile, the asset-liability profile of the fund and the implementation issues involved.
The experience demonstrates that the obligation to write a SIP framework has obliged board of directors/trustees to focus on the essential objectives of any fund for which they are responsible and that it has considerably raised their professionalism, alertness and understanding. It has also shifted the (strategic) asset allocation and the risk tolerance in the right direction, that is to precisely where they should be for each fund specifically (‘Rebuilding Pensions’ Report, page 24).
In our recommendations with reference to the SIP (recommendations 5 and 41, pages 45 and 51), we go beyond what the European Commission is requiring in art.9 of the proposed directive. The latter nevertheless contains the essential requirements of a SIP.
We think a SIP can and must be an instrument that allows for greater clarity and understanding and that is indispensable if one moves to a ‘prudent man concept’ which is essential to get away from restrictions imposed by regulation.
Whether it will work to its full potential depends on the practical application, that is whether it becomes a tool to improve the investment strategy and the risk control and whether the parties involved namely the board of directors/trustees, the asset and liability managers and the fund’s management as well as supervisory authorities use it for that purpose.
We think it will reprogramme the minds of those involved where useful or necessary and lead to better strategic asset allocation and to better risk control because it offers greater understanding and allows for greater-and importantly-fund specific co-operation along the process.
The fear of moving to a prudent person standard is great for those unfamiliar with it, but it is time to replace the illusion of security of the rulebook by the reality of security, efficiency and affordability which must be gained day after day in the markets.
It is time also to get rid of rigidity in the liability side and to replace the static approach of technical reserves which must be funded at all times by the reality of the going concern approach which allows for a Dynamic Minimum Funding Requirement (DMFR). A DMFR takes into account the surplus status, the buffer, when existing which allows for greater risk taking, as well as the status of shortfall or insufficient reserves which need to be addressed either quickly or over a larger time period if the age profile of the fund members permits this.
It is also time to distinguish between fluctuations of the assets due to short term market movements which need not to be addressed in the short term unless one would accept to have to change the contribution rate all the time, and structural shortfalls which need to be corrected quickly for the purpose of security.
Security is a matter of reality, but also of perception. The SIP is a policy document which lays down the general investment and risk principles but these may need to be changed if the circumstances change. All can change: the group, the sponsor and the markets, for example.
If we take the markets: until recently it seemed that equities were the to be preferred asset class-they always are over the long term because there is a risk premium one can take advantage of over so-called ‘risk free assets’.
But it could be that we are heading to a recession and that equities are all of a sudden, no longer so desirable comparatively speaking. That may, or may not, trigger a change of the ideal SAA, the risk profile of a given fund, but it will for certain change the shorter term TAA. In 1999, with hindsight a 100% allocation to equities, particularly to growth stocks and within these to TMT was no doubt most rewarding globally, but also highly risky. Look at 2000, the picture has completely changed!
Is the 1999 SIP set out for, say three years, still valid?
Is the risk profile still the same and what about the risk tolerance?
No doubt a lot has changed if one looks at sectors.
Taking the broadest and most widely used benchmark which is the MSCI World, one sees IT up nearly 100% in 1999 and down by 30% as at 30, September 2000 for 2000; telecoms up 48% in 1999 and down 32% in 2000. Consumer discretionary or luxury goods up 32% in 1999 and down 19% in 2000. Conversely, health care down 8% in 1999 and up 23% in 2000; utilities down 10% in 1999 and up 21% in 2000 always as at 30, September 2000
Are the UK funds sufficiently diversified when they almost invariably invest 50% of their assets in UK stocks and 25% in international stocks? Probably not, if one realises that the UK market represents 9.43% of MSCI World equities.
Are EMU-based pension funds well diversified if they invest 40% of total assets in the Euro-zone equities knowing that this represents only 16.55% of the MSCI World index or are they enough internationally diversified if they invest only 3% to 7% of total assets outside their home markets for the equity portion (like those from Germany, France and Finland)?
Do they realise that TMT risk is not limited to NASDAQ but that US TMT (Software, Hardware and Telecom) is good for 18.2% of the MSCI World index which is a larger chunk than the whole of MSCI-EMU equities which, as said, are 16.55% thereof, and this after a major correction of these US (and other) TMT stocks?
Utilities and energy stocks are now safe heavens but these are, taken together, only 9.18% of MSCI World, that is less than half of TMT.
One would need to overweight these and underweight the other group considerably to have a meaningful effect and what about the tracking deviation in that case? Does one’s risk tolerance permit this?
Forget about stocks and go to the safe haven of bonds? Bad luck: they have not performed well lately either. To real estate? No, not a performer either. Or to money market instruments? Not an alternative either except one that allows to avoid downside risk in extreme and rare circumstances. Beyond these short term considerations given as an example, the SIP must stand the test of time and be a beacon in rough seas.
The SIP will allow for a reference framework which combines all the tools at hand: the SAA, the ALM, the risk principles and the risk management tools, and will therefore, if properly used, be a framework in which prudence/risk can be adapted and fine tuned.
Prudence is the freedom to take calculated risk. Freedom to take risk in the sense of opportunity risk brings the potential of higher return. Take TMT again as an example: after the ‘irrational exuberance’ of the TMT bubble and the rough markets this has caused, we are heading to new price equilibria from which point pension funds as long term investors ‘par excellence’, can benefit. TMT is not going to disappear after all.
Freedom of investment is not only a right, it is duty laid down in prudential principles of which the most important ones are security, profitability, diversification, quality and liquidity which must come in any combination optimal for each fund: that is what the SIP is all about, in day-to-day practice. Freedom, when we are in charge of managing money for others, particularly pensions money, implies responsibility and accountability-making sure that all checks and balances are in place- which are two cornerstones of the fiduciary duty we have in managing a pension fund. It implies adequate supervision-adequate in the sense of fund specific-which is the third leg of making the prudent man concept applicable in practice.
Therefore, responsibility, accountability and adequate supervision form the basis of good pension fund governance. In practice, a true ‘prudent man’ is a person that excels in the duty of information and in transparency rather than in the application of restrictions which do not fit all and therefore are an illusion of false security and a potential source of additional risk.
The European directive will set a standard for a move to a generalised ‘prudent man’ approach (art.13 of the Proposal). The SIP will be a tool to support and verify this. It is to be hoped that all those in charge of pension funds will make use of this unique possibility and that they will do this actively and prudently.
Koen De Ryck runs Pragma Consulting in Brussels. He is the author of Rebuilding Pensions