Joseph Mariathasan: Pension fund trustees' top five mistakes
Pension funds consistently make five mistakes. So argued Justin Arter and Andrew Stephens at BlackRock in a recent seminar.
Mistake number one: Trustees focus too much on the micro rather than the macro. They spend de minimus on asset allocation, which arguably is the most important decision that pension funds can make. Of the 20 hours a year a trustee typically spends on work for the corporate pension scheme, most of it is spent on compliance and other micro issues. Indeed, Arter and Stephens argued that there was a reverse order of importance on the amount of time spent on any task. Manager selection, in this context, the pair saw as not a particularly good use of a trustee’s scarce time.
The second mistake: There is not enough recalibration of assumptions in the context of the market environment. For example, while asset values have increased tremendously, so have liabilities. The returns for growth assets are likely to be much lower than the historical experience. BlackRock said it expected 3.4% a year for equity returns for the world ex-UK.
That leaves four options for pension funds. Firstly, do nothing – and indeed, some pension funds believe they should not change asset allocations as they can weather the storm. Secondly, pension funds could access different betas by changing asset allocation, moving to new asset classes such as emerging markets. Thirdly, they could get a return kicker from active management: if beta returns are only 3.4% a year, 1% alpha on top is a huge proportion of total returns. Fourthly, pension funds could move into illiquid asset classes. These may tie up capital but typically generate higher long-term returns.
Mistake number three for pension funds is a misuse of time horizons. Around 80% of BlackRock’s clients can liquidate 90% of their portfolios within 30 days. But, as Arter and Stephens asked, why would they ever need to do that? Their time horizons span 20 to 30 years or more.
The issue is: what does it cost them to be able to liquidate portfolios within 30 days? The illiquidity premium on something like infrastructure is 1% a year, which again, compared to expected annual returns of 3.4%, is a hefty premium.
Yet if there is one competitive advantage that pension funds have over other investors it is that they are long-term investors. What appears to be preventing greater use of illiquid assets are issues such as governance; access for smaller pension funds who may only be able to invest in pooled investment vehicles; diversification for small schemes; and risk modelling of illiquid assets. As Arter and Stephens argued, these issues can be overcome.
Mistake number four, the pair said, is that pension funds are not efficient at managing the total risk of their portfolios. They underestimate the risks on the liability side such as the impact of inflation. As Arter and Stephens pointed out, 75% of pension schemes in the UK are now cashflow negative. Gilt yields would have to go up by 2%-3% across the yield curve for this to change.
Finally, Arter and Stephens argued that pension funds should undertake a more critical assessment of the advice they actually receive. Manager selection can be assessed ex-post. Strategic asset allocation, however, is an area that is not enough attention in terms of both obtaining advice and assessing the quality of that advice.
While not everyone would agree with Arter and Stephens’ list of the top five pension fund mistakes, they certainly can’t be ignored.