Judgement by your peers
Now 60% of UK pension funds have a customised benchmark, with the incidence even stronger among the larger funds. This is reminiscent of the position in the early 1970s, when funds generally had their own benchmark. Some funds were consistently outperforming their customised benchmarks but clearly underperforming their peers. When our company started providing universes which allowed meaningful comparison there was a strong demand for our information.
Will history repeat itself with a move back from customised benchmarks towards universes? To answer this question one has to understand what has driven the move towards customised benchmarks. One of the most important of these is the increasing importance of asset/liability studies which is one of the initial steps in computing a customised benchmark.
These studies look at the liabilities of the fund both now and in the future and compare it with the fund’s assets. The average fund has only 50% of its members active, with the balance either drawing pensions or entitled to deferred benefits. One view would imply that funds should only have 50% of their funds in equities, whereas the figure is currently at 70% – leaving funds with a risk described as mismatch.
Will these asset/liability studies lead to a massive shift away from equities as benchmarks are recast to take funds’ increasing maturity into account? I would advise caution. Although asset/ liabilities studies are promoted as being precise mathematical models they depend on a number of estimates. These include predictions of the equity risk premium and estimates of the level of inflation in coming years.
The consultant community has not agreed a standard approach and there are different methods in use. It is a solution, but not necessarily the Holy Grail. I am concerned that the move towards customised benchmarks brings with it certain inflexibility. Customised benchmarks tend to be fixed and as such do not reflect an environment which is fluid. Universes reflect the dynamics of a real world which is subject to constant change.
Taking the long view, I think that it is sensible to look at the way in which funds are now structured and to find appropriate methods of measuring them. What is becoming clear is there are two main attributes – maturity and levels of funding. Divide each attribute into three levels, high, low or medium and there are nine combinations. Each of these nine combinations should have a benchmark which allows people to make meaningful comparisons – and that is a universe. It is reasonable for stakeholders, whether trustees or sponsoring companies, to ask why one fund has performed better/worse in comparison to one which shares its key attributes. This type of measurement is a key element of transparency.
The measurement of consultants is another key issue. Now that consultants are drawing up short lists of managers, it is important that the effects of their decisions are presented and verified in a way allows people to make meaningful judgements. A leading firm of consultants has recently announced that they are subjecting their figures to independent verification. But it is disappointing that there seems to be a continuing resistance in the consultant community to the concept of measurement. Transparency requires an independent view on the manager selection process
In the NAPF Guide to the Myners Principles for Trustees, it is stated that “trustees should arrange for measurement of the performance of the fund and make formal assessment of their own procedures and decisions as trustees.”
I still hold to the view that the management of pension funds is an activity which is competitive and as such peer group measurement has a vital part to play. Looking to the future, I think that universes and customised benchmarks will co-exist. Customised benchmarks are clearly in vogue, but they cannot address the whole picture. It is natural for people to ask: “How is our fund performing compared to its peers?” and “What is the cost/benefit of adopting different asset allocation and stock selection decisions?”. These are not questions which will go away. Nor should they. A rising tide lifts all boats and it is essential to compare funds with a universe to differentiate skill from tidal movements.
Peter Warrington is an executive director of the performance measurer WM Company in London