Publications

What has this got to do with pension funds or trustees?  

Pension funds are the largest single group of shareholders in British industry. Although they may be small individually, in aggregate they represent about a third of all shares quoted on the London Stock Exchange and although they delegate the management of those assets to professional investment managers, the Trustees remain responsible.  

The Inquiry findings consider the position of pension schemes as investors and identifies two priorities: for investors and those who advise them to concentrate the minds of company leaders on future prospects rather than simply on immediate performance, and for financial institutions to adopt an inclusive approach to their relationships with investee companies.  

Trustees have a fiduciary responsibility to ensure that the funds under their control are properly managed. Good short term performance is important, but not at the cost of poor long term performance. Adversarial relationships between investors (through their investment managers) and investee companies can be disruptive and counterproductive; they should be replaced with a climate of increased trust and deeper understanding.  

Investors should ensure that their investment objectives are properly articulated to companies and companies should recognise the importance of communicating to investors their longer term vision and corporate objectives, as well as shorter term financial matters.

Barings

Following the collapse of Barings many trustees have been reviewing their managers' use of derivatives. As we reported last year in Bulletin 7, about half of large and medium sized funds currently permit their managers to use derivatives, about a quarter have not thought about it and about a quarter decided against their use.  

We urged trustees contemplating allowing their managers to use derivatives to make sure that scheme documentation permits their use and to ensure that investment management agreements contain appropriate guidelines and restrictions on their use.  

Although the headline story on Barings was the mis-use of derivatives the real issues for pension trustees were different ones, the security of assets, the investment of cash and the risk of securities in the process of settlement.  

Funds managed by Barings generally used the bank as their custodian. The assets were held separately from those of the bank itself and were recognised as being separate by the administrators. The custody system survived and appears to have been sufficiently robust, although it was never properly tested.  

The merits of separate designation of securities - often thought to be overkill -particularly came into its own and provides food for thought.  

Cash was held on deposit with the bank and was on risk, indeed it appeared for the first few days that some losses would be sustained on cash deposits. In the event deposits were paid in full.  

Transactions in the process of being settled were frozen pending clarification of the company's position.  

The lessons to be learned from Barings are that custody is important. Poor investment might lose 5% of scheme assets in a year. A poor custodian might lose all of them!  

Custodial agreements may be dry and boring documents. They are also important, for on them hinges the security of scheme assets. Just as trustees should not simply accept investment management agreements presented by the manager, but should take advice and ensure they are appropriate from the scheme standpoint, so trustees should ensure that the custody agreement provides proper protection.  

Cash is not just a residual, something left aver from investments, it is an asset in its awn right and should be properly managed as such. In particular it should be diversified across a number of quality borrowers lust as an equity portfolio contains a diversified spread of investments.  

To the extent that cash is the one form of investment where it is almost impossible to identify separate deposits or to designate separately, it is prudent to take extra care in diversifying holdings.  

Transactions caught in the settlement process can be at risk in the event of failure by one of the counter-parties. This is not an argument for never dealing, but it is a hidden and little appreciated potential cost of high turnover.  

The next Barings type problem won't be the same, but at least some lessons have been learned.  

New Gilt Investments for Pension Funds

The Inland Revenue has issued a consultative document on the taxation of Gilt Edged Securities in which it is proposed that the tax treatment of gilts and other bonds be changed. All profits would be treated as income and all losses chargeable against income. At present different investors face different tax treatments.  

The result, according to the Revenue, would be to remove over 100 pages of legislation and to provide a more consistent tax treatment between different kinds of investors and different types of bonds.  

The significance to pension funds is that the proposed changes enable the introduction of a new variety of bonds. The Bank of England has itself issued a consultative document on "Gilt Strips" which allows a stock to trade in two additional forms, as a capital stock carrying no income entitlement and as an income stock with no residual capital.  

Gilt Strips may have a number of advantages for maturing pension funds, not least of which is the ability to match liabilities and cash flows more appropriately. These proposals are important for pension funds as investors, they should be carefully examined and discussed with investment advisers.

Next »