Pass the hat to whom it fits best
The impact on pension funds of long-term funding issues means that actuaries will have to be particularly vigilant when it comes to managing conflicts of interest, says Gerry O’Carroll
Wearing two hats can be uncomfortable and in times of changing conditions it can also be hazardous.
While Irish pension funds need a raft of advisers, at the centre stands the actuary. On a daily basis it is normal to find the same actuary involved as adviser to the sponsoring company, the trustees and individual fund members. In addition, the actuary may assist in appointing an investment manager and formulating investment strategy.
The actuary’s employer could also be carrying out separate work for the government or for another corporate entity that might be, for example, in the process of taking over a sponsoring company for which it acts.
In such a context, therefore, potential and actual conflicts of interest are nothing new. However, the frequency and degree of the conflict has increased in Ireland in recent years as a result of the growth in size of pension funds relative to the capital value of their sponsor.
The risk of losing the confidence of one stakeholder due to a potential conflict must be recognised and addressed at an early stage.
Consider the case where an actuary that advises a number of Irish PLCs is also asked to advise on investment strategy. He could simply decline the assignment. Alternatively, he could advise his client on the benefit of diversification.
Given the recent stock market volatility and the relatively greater decline in Irish equities, we know that risk control and diversification must be beneficial in the long term. By adopting models such as global market capitalisation weightings, clients can be guided out of the dangers of local subjectivity.
However, in Ireland the move towards indexation, which has been extremely strong over the last decade, was coupled with local manager views on asset distribution. Given that asset distribution is by far the critical long-term decision it is now difficult to understand why it was left to be determined by local views. It was inevitable that the consensus local view would be heavily biased in favour of local equities when compared with a strategy based on world capitalisation weightings.
As far as long-term strategy is concerned, world weightings are the most appropriate, although there is no reason why this cannot be overlaid by separate tactical asset decisions to over or underweight the world index. This tactical issue should be a separate decision.
The recent increase in stock market volatility had a more pronounced adverse impact for holders in Irish equities, which brings this issue into focus. Irish funds will inevitably feel the full impact of trying to meet the local statutory funding standard. In due course any move at European level to impose a more onerous funding standard along the lines of Solvency II will create even greater anxiety for trustees and sponsors of defined benefit funds.
One possible solution to square the circle between employer and trustee needs is the use of contingent assets. Funding standard requirements and market volatility do not sit comfortably alongside each other and normally force a debate on reducing equities in favour of bonds.
An alternative is for the fund to have access to a ‘buffer’ portfolio, either within or outside the pension portfolio in the form of a contingent asset. While trustees will welcome a ‘within’ the portfolio asset, the company will resist this due to lack of access or control of this asset.
The contingent asset, properly structured, can help to bridge the gap between the parties. Whether it is in the area of advising in the area of the correct allocation to Irish equities or the use of ‘local’ contingent assets, any actuary advising employer and trustees enters inevitably into conflict of interest territory.
The actuary could, of course, decline to advise on the use of contingent assets or any other investment strategy issue, particularly where they form part of a sponsoring company’s business. However, they could use their particular risk measurement skills to assess the lesser ‘actuarial value’ of such an asset as opposed to its market value in a liquidation scenario.
Similarly, for companies with pension funds having a large exposure to Irish equities, the impact of the statutory funding standard could be hugely adverse.
The contingent asset approach may, therefore, grow in appeal. But such assets represent an even larger exposure to the Irish market place. Is this acceptable? While we cannot serve more than one master at any one time, we can master the services we provide all of the time and not be a slave to those services.
If the hat fits comfortably then wear it, if not then pass it to him whom it fits best.
Gerry O’Carroll is senior actuary at Watson Wyatt in Dublin