We are all told early on in pensions investment theory that you can’t invest without incurring risk and that, indeed, you have to accept risk to achieve reward.
Now, after years of investing in the equity market, apparently without risk, as returns rolled in without having to worry , it has all so suddenly gone wrong.
Of course, as the market steamed ahead we all expected to see a correction but the extent of this correction has taken almost everyone by surprise. It is now quite clear that very few funds really had properly analysed their risk exposure. Very little scenario planning had taken place, and as a result, all too many funds had been left dangerously exposed to market falls. We had forgotten about the basic truths of investment that markets don’t go up forever. Of course, one can roll out all the old sayings but especially true, even in investment terms, is that there is no such thing as a free lunch.
It is, nevertheless, still quite a shock to see the impact of these market falls on pension funds. In the US, car maker Ford has, for example, just revealed that its pension fund deficit has doubled to $6.5bn. The company’s pension assets have lost 15% of their value this year. Many funds have lost more than this but the absolute value of Ford’s deficit is quite difficult to take in. Admittedly Ford’s pension assets are currently valued at around $34bn, but the fund, as for so many other funds, will probably take many years to recover.
The question many fund trustees face just now is what to do. In theory, with equity markets having fallen so far, the upside potential is greater than the downside risk but can funds afford to stay in the equity market with their existing managers?
For many funds the problem is how much risk they can afford to take from here. Although funds are being told that the asset class which best meets their liabilities is bonds, not many trustees or their sponsoring companies want to switch and lock in deficits. Most pension funds are funded on the basis of a 2% or so real rate of return, so that switching more of the fund from equities into bonds simply reduces the chance of earning a positive rate of return whilst crystallising the present deficit. Not a very attractive prospect.
Nevertheless, to gauge the potential impact of further market falls, funds really should risk budget and review their funds much more strictly. As many funds have now realised in ‘down’ markets, underperformance has proved harder to accept. Efficiency and out-performance have become relatively more important.
In the bear markets of the last three years, pension funds have found themselves less willing to put up with underperformance. If markets are going down then you certainly do not want your manager to underperform an already negative return. As a result we have seen more pressure on returns versus both benchmark and cash. When markets went up managers outperformed cash and general price increases without effort. As a result many funds took their eye off the ball.
We have begun to realise our funds need greater asset allocation flexibility and more diversification. The penny has dropped that not only is asset allocation more important than manager selection, it is actually now crucial to the survival of the pension funds. Having moved from peer-group benchmarks to index benchmarks, a few consultants (after the Paul Myners Report) are now realising that the most appropriate benchmark of all for a pension fund is a liability driven one.
But what exactly is a liability-driven benchmark? According to Paul Myners, in his now famous report, it is an objective that is necessary to meet the fund’s liabilities taking account of risk, and is not expressed relative to other pension funds or a market index.
According to Martin Kraus at Hewitt Bacon & Woodrow, liability-driven investment will help trustees and plan sponsors manage the level of risk in their pension plans; measure key risks so that they can be compared and put in context, and provide innovative solutions for implementing risk-managing investment strategies.
It is perhaps a pity that more pension funds were not encouraged to think along these lines before the market crash. Ah, but it is so easy to be wise after the event, but is it really too late? I really hope not.
Funds really must focus on the total risk they incur. For too long pension funds, encouraged by many consultants and all the Index tracking firms have focussed too much attention on matters such as the somewhat spurious Benchmark Tracking Error. Asset allocation has often been thought as too difficult to do and whilst its importance realised, far too much attention was paid to minor tracking differences. For too long we thought of a pension fund as effectively a manager of managers rather than an entity in its own right. I don’t think this is the way we will view funds for much longer.
Pension liabilities are longer-dated than is often realised, let us hope we can find the right assets to match those liabilities.