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Changes &
Challenges After The Myners Review (All material on this page is subject to copyright and must not be reproduced without the author's permission.) Good Morning Everyone. How timely this conference seems to be. After all that’s happened in the pensions world and asset markets in recent months, it is certainly a good idea for pension funds to be considering whether they need to make any changes and to think about the many challenges that lie ahead. The Myners Review, which I really enjoyed being part of, was a very exciting initiative and probably marked something of a watershed for the investment industry. As they say, life will never be quite the same again. SLIDE 2 The Review was instigated by the Treasury, to look at Institutional Investment in the UK. There was a recognition of the strong international performance of our institutional funds and an appreciation of our relatively comfortable global position in terms of future funding and affordability of pensions. But the Treasury also wanted to examine whether the UK’s investment institutions were well placed to face the future. A number of issues were of concern. These included: SLIDE 3 the standardisation of institutional investment portfolios (‘herding’) whether there were factors distorting institutional investment decisions, and inhibiting efficient portfolio management whether investment decisions were being taken in an efficient and flexible manner and whether there was a lack of domestic institutional support for UK venture capital and a reluctance to invest in small and medium sized firms. The work involved in the Review and the Report produced, turned out to be much lengthier than originally envisaged. The wide-ranging inquiry was a fascinating project and has been useful in starting the debate on improving the operation of the UK institutional investment industry. Especially given the significant demographic changes around the developed world, it’s crucial to ensure that pension fund management is working well. To the extent that we can better harness the opportunities for long-term funding of pensions through the asset markets, we’ll be much better-positioned to meet the costs of an ageing population in coming years. The many topics covered by the Review included all those shown here: SLIDE 4 Depending on who you ask, you’ll get many different answers as to which were the most important ideas and recommendations! There’s something for everyone to think about. The Review was not designed to provide all the answers and the government has embraced its findings, but has consulted on the proposals. This will be an evolutionary process, rather than a radical short-term shake-up. For my talk today, I have just chosen to cover a selection of topics which I think are particularly relevant to the challenges pension funds face in the coming years. These are: SLIDE 5
A
brief word on the MFR I also couldn’t let this talk pass without a few words on two areas which I feel are crucial to address, if we want to ensure better pension provision. These are:
a
rethinking of the Concept of Retirement There will be many changes in the investment industry and we need to wake up to the challenges ahead. But I’m optimistic that UK pension funds and our investment industry will meet these challenges head on and succeed in making the changes necessary to continue to flourish in the coming years. I want to stress that the comments I make are my own personal views and are not given in any way as a representation of the Review or any official body. So, what were some of the major Myners recommendations? MFR SLIDE 6 I’ll start with one which has been almost unanimously praised - the removal of the MFR. It’s clear that schemes don’t want it, it doesn’t do what it was designed to do and the basis on which it’s calculated has led to investment distortions. Using only UK equities and gilts as the reference assets has distorted decision-making and is also thought to have distorted the gilt market. The MFR makes no allowance for the maturity or size of schemes, strength of sponsor covenant or trustee investment strategy. The standard assumptions used to calculate the level of funding could also be wrong. Of course, as the Review states, ‘providing security for members of Defined Benefit (DB) schemes is an essential objective for any responsibly run pensions system’. Such security is important, but I believe that a major problem with the MFR is that it tries to protect pensions too much. Retired members are supposed to be paid in full (including LPI increases) and others should have a ‘reasonable expectation’ of receiving their full rights. The costs of meeting these liabilities with deferred annuities, and the lack of matching assets, means that even if a scheme is fully funded on the MFR basis, it will only, in practice, meet a fraction of its liabilities (this was demonstrated well recently in the case of the failed chemical company, Blagden, which was 100% funded on the MFR basis, but could only meet about 70% of the liabilities to active and deferred members). In fact, even with the MFR, it’s possible that an insolvent scheme’s members will not receive anything at all (not even a return of their own contributions) since pensions in payment take priority. This full protection for pensioners seems rather over-generous. SLIDE 7 Why should members of DB pension schemes be offered such complete protection, when other members of society have nothing like it? The Deposit Protection Scheme, for example, only guarantees 90% of the first £20,000 if a bank fails (regardless of whether you have £1,000,000 in your account with them!) and the Investors Compensation Scheme will only pay out up to about £48,000. If members of DB schemes which fail were only entitled to certain maximum amounts too, it would be much simpler and cheaper to provide a safety net.
The Myners
Review’s recommendation for the MFR’s
replacement – the Transparency Statement - has
not been universally acclaimed. The central theme of
the proposal is that there should be a ‘long
term, scheme-specific approach, based on
transparency and disclosure, with no
centrally-dictated set of reference assets
distorting investment decisions.’ Each scheme will be expected to publish a ‘Transparency Statement’ attached to its Statement of Investment Principles (SIP) covering all the issues shown here: SLIDE 8 In practice, unfortunately, this ‘Transparency Statement’ is likely prove expensive and time-consuming to prepare. The rationale for it is that ‘judgment of assumed investment returns’ will provide the key to pensioner protection and ‘the better the trustees think through their investment strategy, the better the protection for DB scheme members’. I must confess, I can’t agree that this process will reliably provide any level of protection at all! The Review states that funds would have to make clear both their current financial position and their future plans, which would reveal if they are planning to pursue ‘inappropriately risky strategies’. But – in whose opinion?! One can always find an ‘expert’ to justify one’s investment stance, with reasonable sounding assumptions. We all know that! With the best will in the world and smartest brains in the universe, no-one can actually reliably predict the future for investment markets. Just look at what has happened in the last few weeks! Consensus forecasts are often inaccurate and experts do get things wrong, therefore, schemes would be exchanging a cumbersome and sub-optimal level of funding security (which was the MFR) for no security at all. If pensions in payment still must be met in full, active and deferred members may again end up with nothing, if the investment assumptions turn out to be wrong. Several alternative ideas for replacement of the MFR were proposed. The front-runners included:
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converting DB schemes to DC on insolvency But my number one preferred solution would be - insolvency insurance. SLIDE 9 Myners rejected insurance on several grounds, including the difficulty of finding a mutual insurer to ensure funding, the extra cost burden on DB schemes and the possible distortion of investment decisions, if the insurer scrutinises funding too frequently. But, if scheme members and pensioners were only entitled to a fixed maximum payment on insolvency, insurance should become a much more viable option. Moral hazard issues could be addressed by not insuring 100% of the liabilities and by making premiums higher for poorly funded schemes. The insurance company would probably need to quote for cover to last at least 5 or 10 years, to give some stability to the investment profile. Of course, this insurance would only be needed to top up any shortfalls in the actual fund, since all pension funds have some assets, protected in trust. Premiums should benefit from the pooling of risk (as only a tiny proportion of DB scheme sponsors become insolvent). The insurance would need to be compulsory and schemes which could not obtain or renew their insurance would have to be wound up or join with larger schemes. I do believe it’s worth revisiting the idea of insurance in a more imaginative and creative manner. A concern often mentioned about the MFR was that it would cause companies to close their Defined Benefit (DB) schemes and switch to Defined Contribution (DC) provision. The Government does not particularly want to encourage this trend, but the costs and work involved for DB schemes in preparing the Transparency Statement would be another unwelcome burden. Thus, just as with the MFR, I fear that measures which are intended to protect members of DB schemes, might actually end up radically reducing their security, by taking away the employer’s guarantee. The recommendation that trustees should be paid for their work is yet another example. SLIDE 10 I must admit, I fail to understand how paying trustees will make them better able to make investment judgments! Providing education and training might be more appropriate. Furthermore, trustees are already paid as part of their normal job and allowed time off to carry out their duties. It is even possible that paying them extra will mean firms are reluctant to allow time off from normal work for trustee duties. The trustees would then be having to fit in their meetings outside working hours and this could make them worse off than before! I do think we need to consider carefully before trustee remuneration is forced through. Let’s move on now to a really crucial area to consider when discussing pension funds in the UK. A major change that is coming in future years is likely to be the move to DC pension provision. I believe this move to DC is unstoppable. The only question is how fast it will happen. DB vs DC Given this view, it’s imperative that we address the issues of DC pension provision as soon as possible. There are significant challenges ahead here. SLIDE 11 DC in the UK is still in its early stages, with only about a third of our schemes being DC, whereas in the US the figure is 97%. So why am I so sure that this trend is inevitable? SLIDE12 DB schemes in the UK are suffering from several negative influences. Increased longevity and earlier retirement imply a longer period of retirement and much more expensive pension provision. In addition, as they mature, many schemes have become so large that they are dwarfing the size of their sponsor companies and contribution holidays are coming to an end. Add to this the changes in the regulatory environment (LPI, taxation of surpluses, removal of ACT relief), introduction of FRS 17, problems of asset market volatility and a desire by companies to gain more certainty over their costs - and employers are bound to be attracted to DC. Why should we be concerned about this trend? Well, in DC schemes, the risk of inadequate income in retirement and investment shortfalls rests with the individual, rather than a company as in DB, but ultimately, of course, the final risk lies with the State. If occupational pensions are inadequate, the elderly will fall back on means-tested income support. So, it’s in the interest of society as a whole to ensure DC pensions turn out to be adequate. Although, in the past, DB schemes have always provided better pensions for their members than DC, this doesn’t have to be the case. There could, in fact, be potential advantages of DC provision, if it can be structured correctly, but the way it’s provided at the moment in the UK is not optimal. Much could be done to improve the pensions provided by DC arrangements. SLIDE 13 Members should, in theory, benefit from portability, more control over their investments, more flexibility over retirement age and can even have rate of return or benefit guarantees. There are also advantages to an employer of providing a DC rather than a DB scheme. Employers can benefit from
More certainty of and
control over the costs of pension provision SLIDE 14 Unfortunately, at the moment, UK schemes are not nearly as well-developed as those in the US and members of DC schemes here suffer several disadvantages, with lower employer contributions, lack of well-designed investment options and no employer to make up any investment shortfall, so there’s no certainty of income after retirement. But, from an employer’s point of view, there are not really many disadvantages of switching to DC, other than, perhaps the actual inconvenience of setting up and administering a new scheme. So what are the key issues, which we need to get right if DC pensions are not going to cause major disappointment and problems in years to come?
1. Level of
Contributions I won’t deal with annuities here, as this is a large topic and wasn’t really covered by the Myners Review. It’s certainly an area that needs urgent attention though. So far, most of the debate at the policy and investment level has focussed on the pre-retirement phase. As funds mature, as the population ages and as DC pensions become more widespread, it will become increasingly necessary for the annuity decision to be better-managed. As for contributions, SLIDE 16 the Government urgently needs to investigate the level of employer contributions. They are simply too low. As you can see here, for non-contributory schemes, only a tenth of employers contribute more than 6% of salary, compared with three-quarters in DB, and the average employer’s contribution level in contributory schemes is only 5.8% in DC, but 10.1% in DB. These contribution rates are far too low and suggest that DC will not provide adequate pensions. In fact, a study by Blake, reported in the Economic Journal 2000, estimated the contribution rates needed to provide a pension of two-thirds of final salary. SLIDE 17 These assume a male retiring at age 65, with no previous contributions into any other scheme, salary increases of 3% per annum and investment returns of 6% per annum. You can see from these results, that contribution levels of 6% are nowhere near enough. In fact, Blake’s estimates of the pension contributions needed suggest that, if starting at older ages, no-one is likely to be able to put enough into their fund to earn a two-thirds pension, because the contributions required after age 40 are higher than the maximum allowed by the current legislation. Of course, even if contributions are sufficient, it’s also essential that the monies are invested effectively. Investment performance is a major issue. SLIDE 18
In DB, investment
performance will affect the SECURITY of your
pension, but So, for occupational schemes where trustees make the investment decisions, the trustees’ investment expertise is, arguably, even more important in DC than in DB. And many schemes (including stakeholders) rely on individuals to choose their own investment allocation. If the Myners Review questioned whether pension fund trustees could adequately understand investment issues, even with the help of professional advisers, how can ordinary DC scheme members, without advice, be expected to address the investment issues properly? They need education and guidance, perhaps with the authorities issuing ‘Best Practice’ guidelines for trustees and members. A useful starting point may be to introduce measures modelled on the US ‘Safe Harbour’ guidelines. I think trustees should realise that they run the risk of being sued in a few years’ time, if they haven’t provided proper opportunities for DC schemes to optimise their investment choices. The US Safe Harbour regulations basically require a DC plan to offer the following:
at least 3 investment
alternatives As long as they meet these requirements, trustees cannot be sued for investment negligence. At the moment, though, UK schemes don’t meet these criteria. For example, many schemes offer no choice of either product or provider. SLIDE 19 The Watson Wyatt 2000 Pension Plan Design Survey showed that 23% of DC schemes had no investment choice - the trustees offer just one product -– even though it’s the member who bears the investment risk! This is inadequate. If members were offered only the Equitable Life with-profits fund by their DC scheme trustees, would the lack of choice have been appropriate? There’s an urgent need to develop a range of suitable investment products specifically for DC. These products should provide for differing risk, asset and time horizon requirements and must surely include passive as well as active options, to allow capture of the full market movement of an asset class, if desired. Alternative assets, such as venture capital and hedge funds, could also be included in the form of Investment Trusts, for example. For those members who don’t feel able to take their own decisions, there should be well-developed default options. Over 75% of DC members use their scheme’s default option, but in some schemes this is just a ‘balanced fund’, measured against the peer group benchmark of DB schemes. This isn’t really suitable. Other schemes offer ‘lifestyling’ options, whereby the fund is switched increasingly into bonds in the years before retirement age. This could well be an inappropriate investment strategy and takes no account of increased longevity, different risk preferences, other assets held by the members, or whether they are going to switch into drawdown on retirement and therefore go back from bonds to equities as soon as they retire! SLIDE 20 The Trustees also have a big responsibility in choosing which investment provider should manage the assets on behalf of members. I would suggest that their choice should depend on 3 main factors:
1. the availability
and quality of advice provided to members (risk
modellers, individual financial counselling etc) Past performance should not be an over-riding factor. And maybe, in light of the Equitable experience, more than one provider should be considered. Perhaps the investment consultants can take a lead here in recommending a better design for DC investments. It’s time they focussed closely on this issue of asset allocation for DC schemes. Which brings me to another area which I’d like to take a quick look at today. The role of consultants. CONSULTANTS Myners makes a number of comments about consultants and actuarial firms. SLIDE 21 In particular, that pension fund clients don’t pay enough for their asset allocation advice! The annual average cost of consultant advice (for a £200million pension fund) is estimated by Watson Wyatt at 1.5 basis points out of a total of 47 basis points, which is just about 3%. This compares with 57% for fund management, 32% for brokers and 6% for custody. The 1.5 basis point reward for investment advice certainly does seem low. Of course, it’s offset, to some extent, if the actuarial firm advising the fund is earning high fees on its actuarial business, and it’s certainly the case that decision makers (like fund managers) are normally paid more than advisers, but the disparity seems large. Several suggestions, with regard to consultants are made in the Review, including: SLIDE 22 a recommendation to split actuarial and investment advice, so that firms compete separately for each type of business payment of higher fees to investment consultants formal assessment of advisers’ performance and measurement of consultants’ added value on manager research and selection trustees should only take advice on an asset class from an investment consultant who has specific expertise in that asset class. SLIDE 23 The Review calls for ‘intellectual competence’ from investment advisers. It found that the major UK consultants have lagged behind their US counterparts in recommending alternative assets, such as hedge funds and venture capital, so there have not been enough specialists in these areas in the UK. I did find it amusing to hear the rationale for this. Trustees say they have not really considered investments in hedge funds or venture capital because it was not suggested for consideration by their advisers and the advisers say they have not recommended investment in them because the trustees have not shown interest in these asset classes! In many funds, there seems, perhaps, to have been an emphasis on what was traditionally perceived as the ‘low risk’ end of the equity spectrum, but markets have developed rapidly in recent years. The Review felt it necessary to go so far as to recommend that trust deeds should no longer contain investment restrictions which prohibit the use of instruments like derivatives, options and futures. The idea that such holdings only increase risk is out-dated and a recognition of their role in risk reduction is certainly overdue. There has been too little assessment or measurement of the effectiveness of investment consulting advice, either on asset allocation or manager selection and it would be helpful if we could come up with recommended criteria to use. Perhaps the increased use of multi-manager funds offers an opportunity for measurement of manager selection and asset allocation added value. If we haven’t yet designed methods of measuring advisers or trustees’ performance, we certainly have plenty of ways of measuring the performance of investment managers. PERFORMANCE BENCHMARKS SLIDE 24 This is an area which, I believe, is already changing in the UK pension fund landscape. We need to ensure the use of appropriate benchmarks for performance measurement. Peer group benchmarks are NOT appropriate for DB (and certainly not for DC). Benchmarks should be tailored to each fund’s needs and should be structured to deliver a return related to each schemes liabilities, not just to outperformance of a peer group. It’s clear that the standard approach has led to herding, just trying to outguess the competition, investment distortions and, in many cases, payment of active fees for quasi-passive management. The use of tracking errors which are too tight to allow genuine active investment decisions, the business risk of underperforming by too much and lack of reward for substantial outperformance, have created a situation where active managers all follow very similar strategies. Certainly, the use of tracking errors and risk controls needs to be looked at carefully in the context of the overall portfolio. SLIDE 25 A core-satellite approach would seem to me to make most sense for the majority of funds. A core of passively managed funds, to cheaply capture the basic index movement and then a selection of satellite funds, run by specialist managers, to try to add value above the benchmark returns. The concept of ‘risk budgeting’ where the different types of risk are aggregated into a single overall risk measure, that is consistent with the total fund’s risk tolerance, and the use of alternative assets to construct a truly well-diversified portfolio, is likely to prove to be ‘best practice’. The US is well advanced down this route of structuring the management of institutional portfolios. SLIDE 26 Last year, over 90% of US funds were using specialist managers, but less than two-thirds of UK funds were. The US is also well down the route of specialisation and better diversification as shown here. SLIDE 27 US funds have a wide range of satellite managers, around the core passive mandate and have well-diversified investment styles. The multi-manager approach is also being increasingly used, for those trustees or individuals who don’t want to choose their own managers and this will include a wider range of assets than the standard balanced mandate. SLIDE 28 As well as suggesting consideration of alternative assets, the Myners Review forecasts that fixed income will become a much more important asset class in the UK and that our fund management industry will need to develop its skill-base in this area. In the past, high UK inflation and budget deficits have made gilts rather unattractive investments relative to equities. But, on page 95, the Review predicts that the growing maturity of DB schemes, increased demand for predictable returns and concerns as to whether equities can maintain their historic outperformance, will all mean that fund management firms will need to build up their fixed income management and credit skills. They’ll require more expertise in management of corporate debt portfolios, using fixed income as a strategic, rather than just a tactical asset. The ageing demographic profile of the UK population and move to DC are said to mean that more fixed income investment will be required, to fund the annuities that will need to be purchased to support people in retirement. This leads me to two final points I would like to make – which are not specifically a central theme of the Myners Review, but which I really believe will be crucial challenges for all involved in pensions in the future. These are the debate about the concept of retirement and financial education. SLIDE 29 I’ve already mentioned the large increases in longevity which have occurred in recent years and also the trend to earlier retirement. This, coupled with the improvements in health status of those over age 50, and the pressures on funding of pensions, suggests that it must be time to re-evaluate the whole area of retirement. I know that this debate is hotting up among policy makers, both in the UK and Europe, and there is certainly much that can be done to bring policy into the 21st Century. People should be encouraged to work for longer, so they can build up more assets to support them in later life, so that we don’t waste society’s human resources and to make our pension system more affordable. Retirement should really be a ‘process’ rather than an ‘event’ (perhaps people could cut down gradually over a period of years, job-share at older ages with younger workers who are studying mid-career, for example). Cessation of work should not be tied to an arbitrary chronological age and there will need to be much more flexibility. Taking account of individual differences should be an important aim of pension policy, as people try to build up sufficient resources to support themselves later in life. The old saying that ‘middle age is half way between adolescence and obsolescence’ should be re-thought. SLIDE 30 The more years people can spend in the labour force, the more affordable any retirement support becomes. Pension and retirement policy has lagged significantly behind changes in mortality and health status and the costs of pension provision will become unsustainable. People who retire early, in their 50’s for example, can end up trying to draw out a pension for more years than they paid into it! Why wait until a financing crisis ensues, why not anticipate it and try to change social attitudes and expectations now? We need to make the whole pension system more affordable, by encouraging longer working life and focussing debate on the need for better post-retirement income provision from private, not just State sources. SLIDE31 One last point, which seemed so clear in all the Reviews work, is that the UK does not provide anywhere near a good enough standard of basic financial education for its population. So many products are too complicated (even stakeholder pensions!) and so many people do not realise the benefits of investing for the long term. Finance and investment should, in my view, be part of the core curriculum in all schools – starting in primary school, just as we teach history, geography and science. The FSA really needs to ensure better standards of financial education, information (and even advice) are received, before people make critical decisions relating to their finances. It is not just trustees who need educating more in investment matters! And, as the State tries to encourage individuals to provide for themselves, it’s essential that people are aware of why one needs to save for the long term and how to do it. Otherwise, any reform of institutional investment activity will not feed through to benefit society in the way it should. So let me just finish with what I see as some of the big challenges facing us in the future: SLIDE 32 These are:
Ensure any MFR
replacement works well |
