Every Investment adviser, whether it be to individuals, Pensions Funds or other institutions, preaches the mantra that diversification is a good thing - don’t put all your investment eggs in one basket. The cynic might say that by arguing for spreading the risk the adviser is covering himself – especially if there is a counterbalancing component to the asset classes he recommends! As a Trustee I am expected to exercise due diligence in my legal responsibility of overseeing the appropriate investment of the Fund’s assets. This includes ensuring that there is an appropriate spread of risk so that the Fund is as protected, as much as possible, from the vicissitudes of today’s pyretic world.
However unlike most other investments where bigger is always better a Defined Benefit Pension Fund has no underlying imperative to grow - and its legal construct is also very different from that of a PLC or a Limited Company. For me and I suspect many other Trustees with a past or present business career an early lesson that needs to be learned is that we are not actually running a business at all. True there are superficial similarities to, say, the operation of a company offering investment products to consumers. But the core objective of a Pension Fund is different, which brings us back to diversification.
As an individual or a corporate investor I probably want to grow my assets and at the same time protect them. “How much risk do you want to take” is the often asked but always unanswerable question that advisers love to pose. It is unanswerable because risk is an abstract concept - until after the event that is! If the advice leads to my becoming much richer then, with hindsight of course, it was good advice – even if along the way the risks were large. If the advice leads to the diminution of my net worth then it was bad advice, even though the recommended portfolio was seemingly wise, diversified and comparatively risk free.
In normal times (remember them?) we minimise risk by being diversified and for a Pension Fund that usually means achieving a suitable balance between Liability hedging and Return-seeking assets. But what is a suitable balance – conventionally that is determined largely by the Funding ratio.
If a schemes Funding Ratio is strongly positive – say in excess of 125% - today’s imperative for many funds is likely to be to “derisk” – that is to say to switch substantially, possible even completely, from return seeking Assets into those that hedge against future Liabilities. In a way this is a bit counter-intuitive. If your Asset management policy has successfully got you into a healthy position then why not do more of the same?
The answer, of course, comes from the fact that a Pension Fund’s objective is not to make as much money as possible but to make sufficient to meet its liabilities – with some margin for error. It is arguable that mature funds which are closed to new entrants should do this as soon as they can. The fact that the Fund is closed means that no provision for new employees needs to be taken account of in the Liability calculation – this estimate can be predicated completely on the present and future demands placed on it by existing members.
But what if a Fund’s Funding Ratio is negative and the sponsor cannot or will not make up the shortfall sufficiently to allow a switch to Liability hedging investments? Here the conventional wisdom is that far more of the Fund’s assets should be placed in return seeking assets like Equities. For me there is a feel of the Roulette table about this! Presumably the main reason that a fund has got in trouble is because it has been too heavily committed to highly volatile stocks and shares rather than largely risk free Bonds and Gilts.
Is more of the same the correct medicine in these circumstances on the grounds that it must all come right eventually? I’m not so sure that it is.
One option might be to try and come up with an income generating investment portfolio which gives sufficient inward cash flows to cover annual pension payment obligations and not worry over much in the short and medium term about the value growth performance of the asset itself. Better a stable blue chip with good dividends than one that might (or might not) grow ahead of the market. It would be these challenges I would be throwing at my investment advisers at the moment.
Paddy Briggs is a Member Nominated Trustee of the Shell Contributory Pension Fund. He writes in a personal capacity.
“Pensions Age” January 2012