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The problem, as I see it, is that such a group of professionals does not exist today.
Actuaries and pension consultants have, in the past, carried out this role, but it is clear from the historical record that they have been unable to carry it out properly. The advice they have given has led to massive pension deficits, not just in individual cases but generally. It has also become increasingly questioned, correctly in my view, whether they do not have two major obstacles to overcome before the advice that they give can be recognised as authoritative. First, they must be in a position to give advice to the trustees which is objective and without conflicts of interest. Second, they must be properly trained, which at present they are not.
There is a clear conflict of interest between the interests of a company’s management and those of the beneficiaries of final salary schemes which the company sponsors. The beneficiaries want the contributions to the fund to be large and the investment policy to be cautious. The management wants the opposite.
In recent years it is clear that the score has been management ten, beneficiaries zero. This is a situation that trustees cannot allow to continue. This must be true on moral grounds and it seems to be becoming a legal obligation as well.
To ensure that there are no conflicts of interest, the advice on contributions and asset allocation must be given to the trustees by people whom they appoint and pay, but who receive no benefits which depend on the good will of the company’s management.
This is not the current situation and, if trustees insist on it, it could give rise to legitimate dispute with the company’s management, who may feel that the contribution rate is unnecessarily onerous and that the investment policy is overly cautious.
These are, however, problems that should be capable of resolution. With regard to the contribution rate, there are a number of unknowns, but the largest is likely to be the assumed rate of return on the pension fund’s assets. At present, it is the habit of many pension consultants to assume that if funds are invested in equities rather than bonds, then a higher return will be achieved on the fund’s assets and that, in consequence, a lower contribution rate will be adequate.
This is not a justifiable assumption. There are two reasons for this. One applies generally, the other applies intermittently. The general reason is that while risky assets, such as equities, will usually give higher returns than bonds, they will also carry higher risks. The correct funding level for a fund should take into account both the risks being run and the expected return. No investment policy is likely to produce higher returns without involving higher risks. The contribution rate should not therefore depend on the investment policy.
This point can be readily demonstrated by reduction ad absurdum – i.e. by taking the opposite view to its logical extreme. If it is assumed that equities will give a higher return than bonds, then investing in leveraged equities will give an even higher return than equities. On this set of assumptions, any level of contributions can be shown to be adequate, if risk is ignored.
While in general, therefore, the contribution rate should be independent of the investment policy, there is an additional reason for trustees to demand that this should be particularly true today. This is because the return on equities is not stable over time and the fluctuations are broadly predictable. It has been well established among financial economists, for about the past 30 years or so, that after prolonged periods of above average
returns, equity returns will be poor. (Technically this is known as exhibiting negative serial correlation)
We have been in a period of markedly above average returns for the past 30 years and equity investors must now expect to suffer very bad returns for a prolonged period. (The poor returns of the past 5 years are not nearly enough to bring the average back to normal.)
As the Myners’ Report pointed out, trustees need to be able to understand the risks which are involved when asset allocation decisions are made. It is particularly important that trustees should have an understanding of the key issues, in terms of financial economics, which should provide the basis on which such decisions are made.
Unfortunately, at least in my experience, actuaries and pension consultants do not generally have a proper training in financial economics. I have seen several reports from actuaries and pension consultants. Not one of these has been in my view professional, as the authors did not seem to have an understanding of financial economics. This was shown in the absence of any reference to the negative serial correlation of equity returns and by the assumptions about the future growth of dividends, which were totally unjustified either in theory or from past experience.
I attribute this failure to inadequate training. In writing this I am only being slightly blunter than the words in the Interim Assessment of the Morris Review of the Actuarial Profession, which expressed concern that: “…the profession has been too insular, with insufficient contact with other professions and too narrow a professional training, and has been slow to adopt new approaches and techniques. This has resulted in useful inputs from the disciplines of economics, statistics and demography, to name only a few, having less impact than they should.”
The current situation, as I see it, is that trustees have moral and presumably legal obligations to obtain sound and dispassionate advice on the level of contributions that should be made to their funds and the way in which the assets should be invested. Unfortunately, it is not clear where they can obtain this, as the traditional sources seem to have conflicts of interest and inadequate training for the role.
At the very least therefore, trustees need legal advice on what they should do. I also believe that trustees need more information and greater education and training so that they are able to bring greater knowledge and understanding to judging the advice that they receive.
Andrew Smithers
Chairman
Smithers & Co Ltd
020 7283 3344
info@smithers.co.uk
www.smithers.co.uk
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