As published in Pensions Age, December 2009: Over the past two years, pension fund trustees have had to deal with unprecedented volatility in investment markets. Misery enjoys company. The market turmoil in risk assets was accompanied by lower government bond yields (increasing liabilities) and a general weakening of sponsor covenants due to the economic slowdown. It has indeed been a period when, as Warren Buffet has remarked, the more regularly you examine performance, the more regularly you will be disappointed. Trustees would have suffered less angst over this period by adopting a “Rip van Winkle” approach, but this can be justified only with the benefit of hindsight. The pace and extent of the market rebound were both unexpected. So, what can we learn from the experience? Below, we examine six key lessons for trustees.
Uncertainty can lead to poor decision making – don’t over-react!
One of the biggest risks for trustees in times of market turmoil is making poor decisions at the wrong time. Investors may be panicked into selling at low market levels on concerns that the situation may get even worse. They may also sack active managers at the worst possible time. However, as history tells us, the darkest days are often the best time to buy, rather than sell.
Over the two years to end March 2009, pension fund deficits grew dramatically, but there was little evidence of panic amongst pension scheme trustees. Many schemes largely avoided the liquidity trap that banks, hedge funds and even endowment funds suffered. Generally, they did not sell equities near the bottom of the market. Was this a conscious decision or just indecision? We cannot be certain. Regardless, the message is that pension scheme trustees should continue to keep their heads – something that is not always easy to do when everyone around is losing theirs – and be clear on their tolerances for risk, both in the scheme as a whole and within each of their individual portfolios.
Illiquidity can present opportunities for true, long term investors, but threats for those with shorter time horizons
Illiquidity problems over the past two years could be regarded as positive for long term, open funds which are cash flow positive – they should be able to extract a premium for their ability to accept this illiquidity. Some long term funds have been able to address this by providing liquidity to constrained investors at an attractive price.
Nevertheless, outside the public sector, there are very few open DB pension schemes. Many schemes already have in place, or are currently building, a de-risking plan and can no longer afford to be heavily invested in illiquid assets. As yet, few DB schemes have reached a strongly negative cash flow situation – a scenario which would undoubtedly have presented a further set of challenges in the most recent crisis – but this is not far away for many. In future, trustees will have an increased focus on the liquidity of their investment portfolio and, in particular, where future cash-flow requirements will be funded from. This decision should be planned in advance and clearly documented alongside the scheme’s other plans well ahead of any future crisis.
Market turmoil can create medium term market opportunities
Historically, few trustees have been in a position to take advantage of medium term market opportunities, i.e. where markets might appear anomalously cheap (or indeed expensive) on a two to three year time-frame. Both equities and corporate bonds offered such opportunities earlier in 2009. Schemes which had sufficient flexibility in their governance structures were able to buy into these asset classes at attractive medium term levels. These schemes have already seen notable gains – indeed for many, the value which they were seeking to capture on a two to three year basis has been largely realised already.
Market turmoil can damage active management, but also creates future opportunities
In uncertain times, trustees may find it easy to throw in the towel on active management, sacking underperforming active managers and moving to passive management. However, trustees may well be crystallising losses in terms of manager underperformance at a time when the opportunity set for active management is arguably greatest. It is important to recognise that active managers tend to perform best when markets are irrationally priced.
Ensure you have an effective governance structure
Events over the past couple of years have highlighted the importance for trustees to have in place an effective governance structure and a formal plan of action which takes account of unexpected outcomes. Advance planning will take the emotional heat out of decision making if these outcomes arise. A formalised long term plan with pre-determined triggers could have allowed trustees to capture the improvements in funding levels which took place in the summer of 2007 as well as the market opportunities which arose in early 2009. Good quality governance may include effective delegation to sub-committees empowered to act in a timely fashion in specific circumstances. It is up to trustees and consultants to work together to establish the governance framework which works best for each individual scheme.
Communicate effectively
While member communication is important for DB schemes, it is even more critical for DC schemes. Some members of DC schemes will have been completely unaware of the impact of the market turmoil on their pension savings. However, headline grabbing numbers in the popular press will undoubtedly have worried many DC members. Trustees should ensure they have in place not only a suitable range of investment options (appreciating that not all members have the same risk profile), but also communicate these options in an understandable and constructive way. For members who are far from retirement, pound cost averaging copes well with volatile markets; it does no harm to remind these members regularly of this. On the other hand, for those about to enter the de-risking phase of their investments through life-styling, the message may be very different. It is important for trustees to be clear on the varied messages they need to give to each of the different categories of member.
Not just the Trustees
Consultants have also learned lessons over this period. Firstly, we have learned (or perhaps just remembered) that diversification does not always work over short periods of time. Although we believe that the longer term benefits of diversification remain firmly in place, we must make sure that trustees are aware that markets may well all move in the same direction in troubled (or indeed very good) times. Models are only as good as the input that goes into them – the interpretation of the outcomes, along with consideration of the “worst case scenario” position, remains critical to trustees.
We have also learned (or again maybe just remembered) that tracking error measures work well only in normal markets. Perversely, risk mitigation is about coping with the unexpected; this is when “what if” scenario considerations come to the fore. We should assess the opportunity for portfolio insurance, particularly when investors in aggregate are complacent about risk; curiously, it is then that the cost of insurance is likely to be at its cheapest.
Looking to the future
So have the lessons of the past two years been taken on board? Can the credit problems of 2007-8 be overcome so easily that normal service will now continue? Arguably, heavy global government support, necessary to mitigate the deepest problems of banking failures, could lead to another asset bubble in risk assets. Even if this is not a central scenario, now is the time for trustees to at least consider the possibility; they should examine how their portfolio will cope in different economic and market conditions and determine what a “bad outcome” would mean for them. Where appropriate, schemes may have to take steps (however painful) to protect against this downside risk to ensure their long term survival.
John Dickson, Head of Investment Advice