Schemes often look at total investment returns when assessing success. However, a recent paper says other factors should also be taken into account. Helen Morrissey reports
The success of a defined benefit (DB) pension scheme is often measured in terms of the investment returns that it achieves over the life of the fund.
However, a recent paper published by the 300 Club - a group of leading global investment professionals - suggests that a different focus should be adopted.
In Using wealth, not returns, to set objectives and measure success it is suggested that using total returns in isolation is no longer sufficient. Instead, asset owners such as pension funds should also look at the level of absolute wealth needed to achieve the scheme's objective as well as the impact different paths of return may have on this wealth during both the accumulation and decumulation phases of the fund.
The paper uses the following example. "Consider a closed DB pension fund with assets of £1bn that needs to pay its expected pensions over the next 10 years. It needs an average real required rate of return of 2% a year to do so. Assuming the fund has the same annual outflow over the next 10 years, there will be exactly the right amount of money to meet all its payments. Poor performance early on may result in the fund not being able to make the pension payments towards the end of its expected life as the strong performance years will be working on a smaller pot of assets. Strong returns early on may, by contrast, result in the fund having more money than it needed."
The message is the ability to meet an overall wealth target should be considered a key measure for success, not just the investment returns.
While such issues have been discussed over the years, now might be the right time for schemes to take another look at this approach, says report author Stefan Dunatov, chief investment officer at Coal Pension Trustees.
"This is an issue that has been discussed over the years but we are at a real tipping point right now in that we are seeing more DB schemes start to shift from an accumulation to decumulation phase," he says. "As more DB schemes are closed then issues like this start to bubble to the top."
Cardano client director Tony Baily agrees that this is an issue that needs more focus: "We are at a point where more schemes are becoming cashflow negative. When we work with clients we would encourage them to look at whether their funding level is improving over time rather than focusing on total returns. If a scheme has had poor returns early on then having good returns at a later stage might not be enough to get them where they need to be. That is why we encourage clients to place more emphasis on funding level and then ask themselves whether what they are doing is adding or detracting from this."
Punter Southall head of investment consulting Danny Vassiliades says that all schemes should have a focus on their liabilities when assessing the success of investment strategy.
"If a trustee board hasn't realised by now that they need to look at how their liabilities are behaving as well as investment returns then that is a failure of governance," he says. "All trustees should be on board with that."
However, while he agrees a focus on the sequencing of investment returns would be beneficial, he says trustees have many competing demands on their time.
"The path of returns is important and you can certainly cause some damage if you get it wrong - there is certainly a need for more certainty," he says. "However, trustees have a list of investment issues as long as their arms that they need to deal with right now and the path of investment returns probably isn't currently that high on the list. It is something they may come to if they have the time."
Baily agrees that such an approach is yet to be widely adopted by trustee boards. He believes this is because there is a lack of accountability within the industry that needs to be addressed.
"If we look at the last decade then UK DB schemes have actually lost somewhere around £400bn," he says. "We have to ask who is to blame for this and there is a lot of finger pointing going on. Consultants blame trustees, trustees blame markets and so it goes on. Schemes may have beaten their benchmarks but when they look at their funding levels they have gone down so we are focusing on the wrong things. It is not just about assets - it is also about the liabilities and we need someone to take accountability for this."
He continues: "As we see more trustees in the position of having good levels of net returns yet growing deficits, I think it might prove to be a bit of a lightbulb moment for them to change behaviours and focus on different things. It is something consultants need to be pushing harder to raise awareness of also."
Dunatov says that the use of total returns will always be an important measurement tool for schemes. However, he believes such measures should not be used in isolation and that the inclusion of factors such as absolute wealth will help schemes have a better overall picture of how to achieve their objectives.
He says: "It is easy to focus on total return numbers as they are easier to measure and compare across periods and adding in a different factor such as absolute wealth will certainly complicate matters. However, I am not advocating that schemes move away from having a total return focus - it is more a case of schemes adding to their information armoury by considering other measures as well. It makes sense that schemes take a closer look at their objectives and assess their success using a variety of measures."
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