Publications

Bulletin 23 Spring 2006

Welcome to the 23rd edition of BESTrustees bulletin. Since our last issue, there have been many changes in the world of pensions. The most immediate issue is the huge amount of effort being put in by Trustees, administrators and others in the final run up towards the 5 April 2006 changes in pension tax regulations.

In the commercial world, legislative and regulatory pressure continues to combine with investment uncertainty to discourage employers from commitment to final salary pension provision. Newspapers warning of speculative bubbles in the gilt market do nothing to improve confidence. We expect the trend away from DB schemes to continue as companies decide to close their schemes to new entrants and replace future final salary accruals with alternatives, such as career average and defined contribution arrangements.

Publication of the Turner Report, both unofficially and officially, once again brought pensions to the foreground of public debate – what an introduction to Christmas. The new Pensions Regulator is making its powerful presence felt, bringing terms such as ‘Clearance’ to the pensions lexicon.

The team at BESTrustees continues to expand with Ian Ferguson, Nick Fitzpatrick , Heather McGuire, Jenny Rosser and Philip Smith joining. Ian , Nick, Heather and Jenny join as Associates, whilst Philip is appointed to the role of Trustee Support Manager. This brings our pool of Independent Trustees to 17.

We would like to congratulate Miles Buckinghamshire and Peter Thompson on their appointment to the Board.

The team at BESTrustees is completed by Sharon Bingham who now celebrates over 10 years of service with us.

Last year was a successful one for BESTrustees, and this year shows every sign of being even better. We were appointed to act for a significant number of new clients’ schemes of all sizes. This possibly reflects the growing awareness of Company Directors, both executive and non-executive, of the conflicts of interest that can arise in the deliberations of those involved in the running of occupational pension schemes.

In this bulletin, we have tried to provide information that trustees, pensions managers and their advisors will find interesting and useful, without the pressure of it being time-critical. We have tried to avoid getting bogged down in the details of implementing the Pensions Act 2004, crucial though that is, as so much has been written elsewhere.

If any reader has any ideas for future articles, please let us know.

Beauty Parades

Trustees should have a natural reluctance to change investment managers without good reason; it is costly and time consuming; performance may or may not improve, but transition costs are incurred with certainty. Nevertheless change is clearly necessary from time to time, particularly as scheme objectives vary or new mandates or asset classes are introduced.

In contemplating change it is worth bearing in mind some recent research which, if the statistics are valid, demonstrates that performance over even very long periods can be attributed entirely to chance rather than skill. A model was constructed with 100 managers, each of whom had a tracking error of 6% and an outperformance (alpha in the jargon) of 3%, - a very respectable information ratio of 0.5%. This model was then subjected to 50 years of random market shocks. The resulting annualised performance of the managers ranged from 1% to 5.2%, even over a period as long as 50 years. In every year roughly one in three managers underperformed; 70% underperformed for three or more consecutive years at some stage, and one manager for as long as eight years. All this was from managers with an alpha fixed by the model at 3%.

What this shows is that we tend to measure managers’ performance over periods far too short to distinguish between skill and chance; managers also reward their staff over too short a measurement period. How many times have we sacked a manager who has missed target for a couple of years, only to see them outperform subsequently? When we look at new managers we look at historic performance and assume that it is entirely due to skill.

Try tossing 800 coins; not surprisingly, around 400 will come up heads. Of those, 200 will come up heads a second time, and half of those will do it again. Now think of them as managers, one in eight will have consistently outperformed (and a similar number consistently underperformed) in three measurement periods on the basis of luck alone.

This is why, when selecting managers, trustees should concentrate on the people and the processes and pay little heed to recent results, hard though that may be. Consultants (and to be fair some managers, though not many) encourage us to ignore performance and concentrate on the ‘soft factors’, yet I rarely see a short-listed manager who has underperformed in the recent past. Why not?

Managers like to present with pride their information ratio, a useful measure of information performance relative to benchmark adjusted for risk taken. It is just the name I object to. It suggests that the performance is entirely attributable to skill, whereas we know that an element of luck (good or bad) is involved, and luck may be the predominant (or indeed the only) factor.

Some of those 800 random coins also had a pretty good information ratio. We should remember that when sitting through beauty parades.

Pensions Legislation - a short history

As we reel under the weight of another Pensions Act with ever more regulations it becomes harder to remember that the tide has not always been one way.

There have been discernible rises and falls in legislative support for pensions over the past century, in terms of both State and private provision.

The following brief examples illustrate the point.

The State

The cycle began with the 1908 Old Age Pensions Act, which was clearly ‘pensions supportive’. In 1925, the Contributory Pension Act set up a pension of 10 shillings (50p for younger readers) a week from age 65. The National Insurance Act 1946 set up contributory state pensions. Supportive legislation continued with the 1959 National Insurance Act, which set up the Graduated Pension Scheme: a forerunner of the Social Security & Pensions Act 1975, which set up SERPS in 1978 (now replaced). Sadly the tide turned and receded with the Social Security Act 1980, which removed the link between pensions in payment & earnings. The flow continued with the pruning of SERPS and its eventual closure to new members and its replacement with the State Second Pension.

The Private Sector

Legislative support for private pension provision might be said to have commenced with the Finance Act 1921 which granted tax relief to pension schemes meeting certain criteria. However, the first of many countervailing reversals was met in 1947, with limitations being set on tax relief and lump sums. Further limitations were imposed by the ‘new code’, which became compulsory in 1973 and by the cost implications of the Social Security Act 1973 (preservation) and the Health and Social Security Act 1984 (anti-franking). Reversals continued in 1986, when taxation of standing pension fund surpluses was introduced. This was followed by the impositions of the Finance Acts in 1987 and, of course, 1989, which introduced the ‘pensions cap’. In 1995, the response to ‘Maxwell’ brought in additional regulation, compensation, registration and MFR. Possibly the most negative legislation came in 1997, when tax credits were no longer reclaimable by pension funds.

In the early and mid 20th Century, pensions legislation was primarily ‘pensions supportive’. Perhaps there was a golden age (for such private pension arrangements that existed) from the 1920s to the early 1980s, since when we have been burdened with ever more regulation.

Will the tide turn again? Perhaps so, but as yet there seems no sign of it, the bold efforts of Lord Turner notwithstanding.

It is never possible to wind back the clock. However, perhaps the trend in the removal of support for pensions provision might be reversed by a focus on what pensions are about: - the delivery of retirement and other benefits – at what price?

We have seen a cycle of support for pension provision and its evident withdrawal. Will final salary provision be revived by a more enlightened regime of regulation? Will the final salary scheme become a footnote of 20th Century history, or will such schemes survive to benefit another generation?

Gilt Yields

In February the Government issued an additional tranche of 50 year gilt edged stock on a yield of well under 4%, the lowest since 1954. This takes the outstanding issue of the 2055 gilt to £9.6billion. Almost £10,000million is an enormous amount of money, though barely 1% of UK pension scheme liabilities. Demand for long-dated gilts exceeds supply, but it is not just pension funds to blame. Insurance companies also have long-term liabilities to match, and it appears that hedge funds and others have been significant players in the market.

It is easy to rationalise this in a domestic context, but that may not be the whole story, bond yields have also been declining elsewhere. Back in the 1980s, we had a decade of resurgence in the British economy as ‘Thatcherism’ gathered pace and, with similar policies, ‘Reaganomics’ being pursued in the US . Underpinning those policies was a belief that, in simple terms, money supply was a major determinant of inflation and restricting the level of money supply was crucial to the control of inflation. It worked, or at least something did, as the high inflation era of the 1970s was banished to make way for the low inflation we have seen since. Double digit gilt yields declined to less than 4% - but will it stay that way?

Following its economic collapse at the end of the ‘80s Japan has pursued an ultra loose monetary policy with exceptionally low interest rates in an attempt to extract itself from deflation. This led to the development of the ‘yen carry trade’ whereby investors borrow in yen to buy higher returning assets elsewhere, be they equities, property, commodities or bonds. Since 9/11 the US has also pursued a very loose monetary policy, referred to as an ‘accommodative stance’ in regular statements by the Federal Reserve.

That this has not fed through to inflation is due, in significant part, to the increasing importance of China , India and others. Their ability to produce manufactured goods at ever-lower prices has kept the lid on consumer prices, only for inflation to occur elsewhere - in asset prices, residential property, commodities and now bonds including gilts.

Just because gilt yields are lower than they have been for 50 years does not mean they will rise again overnight. They won’t. Companies reducing the balance sheet volatility of their pension obligations and pension trustees keen to match their expected cashflows, will see to that. According to Watson Wyatt the number of bond mandates awarded in 2005 was more than double the previous year and this trend is likely to accelerate.

At some stage, however, the fundamentals must reassert themselves. The profligacy of excessive global liquidity will eventually feed through to inflation and to rising bond yields. At some point, not this year and possibly not this decade, gilts will revert to a more normal yield relative to other expected asset returns. In other words prices will fall, though this does not help trustees with their asset allocation in the meantime.

Gordon Brown, however, must be one of the luckiest Chancellors in history, funding his increased public spending at interest rates not seen for two generations.

Investment Benchmarks

As trustees we generally take investment benchmarks for granted and assume that measuring managers against the relevant index is quite obviously appropriate. Two events that happened last year raise questions about the assumption that a market weighted index is necessarily the best benchmark.

The corporate changes in the Royal Dutch/Shell group reawakened the excuses that the concentration of the UK equity market provides insufficient scope for managers to perform. It is suggested that this is a new phenomenon and that we should do something about it; we should redefine benchmarks, create new indices, permit managers to invest a proportion of UK equity portfolios overseas, make more work for consultants, etc. Perhaps we should redefine the benchmarks, we should certainly examine them, but not because the problem is new.

A glance at ‘The Millennium Book – A Century of Investment Returns’ (the London Business School ) will show that the UK equity market is very concentrated by international standards and always has been. Market concentration at the end of the twentieth century differed remarkably little from that at the start, only the names had changed.

The 10 largest companies accounted for 36% of the market as far back as 1900, exactly the same as a century later. At the turn of the millennium we were concerned that just three sectors, telecoms, banks, and oils, together made up almost half the market. But a century earlier railways achieved this on their own. Banks accounted for 15% of the market at the turn of the millennium, the same as a century earlier.

As the ‘tech boom’ approached its peak at the turn of the century, there were mutterings that Vodafone (then approaching 13% of the market) was too big a single stock risk. It was suggested that managers should limit any single stock to, say, 10% and that the index should be adjusted accordingly, but before this was considered further the bubble burst.

The other relevant issue is the loss of investment status by General Motors. Those pension schemes that hold corporate bonds appreciate the importance of diversification. If we are concerned about concentration in an equity portfolio, which is generally caused by a successful company growing larger, we should certainly be concerned at the concentration on a single large obligator in a bond portfolio. Yet General Motors bonds now represent almost 10% of the US non investment grade market.

Our view is that trustees should understand the role of benchmarks used for performance measurement. Trustees are not unconstrained profit maximisers - we expect our portfolios to perform, but only subject to any risk constraints or limits that we impose. Ensuring diversification by restricting portfolio concentration is a perfectly reasonable limit to consider.

Possible alternative benchmarks include equal weighted indices, asset value based weightings, capped indices, the performance of the median performing stock, or randomly generated portfolios. These are not outrageous ideas; for their overseas investment many funds already adopt fixed weightings to avoid over-concentration on the US , whilst some high yield bond investors use a constrained index in which weightings are limited to a 2% maximum.

TKU

Faced with the guidance issued by the Pensions Regulator in connection with Trustee Knowledge and Understanding (TKU) some trustees have commented that they might consider standing down and that they do not understand why anyone might wish to take their place. This is disturbing and one hopes, unnecessary.

Many in the industry think the TKU regime is too onerous and prescriptive, and that trustee board effectiveness should be judged collectively (as with company boards) and not just on individual skill sets. Nevertheless, the motives for increasing trustee competence are sound.

Trustees should not lose sight of the fact that the knowledge required under the various headings in the Scope Guidance – “the law relating to trusts”, “the law relating to pensions”, “the Scheme’s trust deed and rules” etc are primarily applicable in the context of decision making.

The Regulator cannot expect all trustees to have a comprehensive knowledge of all aspects of trust and pensions law, or of every clause of the trust deed. Trustees cannot all become pensions lawyers!

The Regulator rightly expects, however, that when trustees are taking a decision or exercising discretion they do so in the knowledge of the relevant rules of their own scheme and within the legal framework. That is reasonable and it should be deliverable.

If the Pensions Regulator expects more of trustees then he will undoubtedly be disappointed.

Look out for the trustees ‘e-learning’ modules on the Pensions regulator’s website at www.TPR.gov.uk or directly at www.trusteetoolkit.com

The BESTrustees Service

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