The ACT is just one of many professional bodies in the investment and finance area, but it sets particularly high standards in its efforts to educate its members.
This booklet (fewer than 100 sides of A5, plus a bibliography and glossary) is the latest in their series; it brings together 25 short pieces by practitioners in the pensions arena. The coverage, arranged into eight chapters, is highly topical and reflects current concerns among corporate sponsors - FRS17, DC vs. DB, governance, hedge funds and private equity, active vs. passive – they are all here. For multi-nationals, the last chapter, by Georg Inderst, one of six contributors from the Law Debenture Corporation, provides a useful review of the current state of play in European pension fund provision, taxation, and regulation. Pan-European pension arrangements anybody? Not yet; Georg spells out the complexities. Clearly such projects are not on anybody’s front burner.
Much more likely to be on the front burner is the topic covered by John Ralfe, head of corporate finance at Boots plc and by Charles Amos of ICI’s pension fund, who both look at the risks arising from investment strategies. Both writers superficially have the same message for corporate treasurers – beware the risk in equities. But go back and take another look and a peculiarly modern paradox emerges: Amos explains that because of the relative maturity of the ICI scheme, the company and the trustees decided to reduce equities to 50% in 1997. (It is not clear where the proportion is now, but one assumes it is lower.) Boots with in all probability a younger workforce and therefore longer liabilities decided to reduce equities to …0%. Both writers claim their organisations reached their conclusions by arguing from first principles. So, how many sets of first principles are there, and who should adopt which?
The answer is a whole number greater than one. The questions in front of trustees arise because of the complex interplay between the interests of several sets of stakeholders. It is not simply the shareholders on the one side and scheme members on the other. On both sides of that fence, there are sub- groups, with potentially conflicting interests. Younger members of the Boots scheme may feel that their interests are not best served by (partially indexed) fixed income securities, even if the sleep patterns of incumbent management are improved. Older members are more conscious of what Keynes said about the long term. Meanwhile on the other side of this stakeholder divide, some Boots shareholders may be interested in minimising the long term pension cost, and could be forgiven for believing that if capital markets are efficient, it is a perfectly reasonable expectation that equities will beat bonds over the long term. As John Coombe of Glaxo SmithKline forewarns in his introduction, “if UK management allows itself to make economic decisions on the basis of accounting practice, then the cart is firmly in front of the horse and calamity lies ahead.”
Is John Ralfe just early, or is his company going to be the exception? The management of Boots seems to be saying that whatever the other stakeholders may feel, he who pays the piper calls the tune. Companies bear the risk – they, or management as their representatives, decide the asset allocation. However, we are not even sure what the liabilities represent, and that is the second confusion. The old consensus that pension liabilities – at least those of active members with more that 10 years before retirement – are equity-like is breaking down. The accountants seem to have mounted an attack on that consensus and appear to be winning, although the government and actuarial practice still seem to insist that pension liabilities are not like AA corporates, as FRS17 insists.
Confirmation that the accountants are winning comes from a typically intelligent and insightful contribution to the book from Roger Urwin of Watson Wyatt. He acknowledges that FRS17 “represents the key interests of the sponsoring employers”. He also approves of it because it is not vague and judgmental like so much existing actuarial practice. It can be modelled. But he is not a 100% fixed income man. He explains clearly that notwithstanding the nature of the liabilities, some mismatch may be appropriate. It depends on three things: the financial strength of the employer, the term of the liabilities, and the size of the current surplus of assets over liabilities.
The seemingly inexhaustible supply of new regulations, the confusion over what the liabilities are really like, the volatility of financial markets, all are encouraging the closure of the defined benefit schemes. But off-loading £700bn of liabilities is no easy or short-term matter. Bulk annuities can help, and they too are covered in the book, by Robert Thomas of Law Debenture. But the replacement is no bed of roses. Defined contribution schemes are still trustee-based, unlike stakeholder, so the trustees’ governance responsibilities remain, as Peter Thompson of Mercer’s explains. Indeed, we should remember that the investment risk has not disappeared, it is simply on different shoulders. And those are not particularly educated shoulders.
In the US, where the shift has taken place to a greater extent, and earlier, the human resource departments have undertaken major educational and advisory services.
A short book, especially with 29 contributors, cannot cover such complicated topics in depth. I would have liked to see a chapter on the US experience, and another on model risk – how to cope with the risk that the assumptions used in a quantitative model turn out to be unjustified. Finally, there is the topic of how best to agree on a realistic set of objectives for the investment managers and a mandate for which both trustee and manager share a clear understanding. But that’s another book; in the meantime I commend this one to your readers.