WHY QUICK FIXES DON’T WORK FOR PENSIONS

Optimist: “The glass is half full.”

Pessimist: “The glass is half empty.”

Engineer: “This container is too big for the amount of water it is holding.”
 

We all know that for many things in life the Goldilocks approach works pretty well. Nevertheless when confronted with a complex problem, we often seem keen to find the easiest, quickest solution.

In most cases, this simply does not work. A car engine or an airplane is a fiendishly complex thing to design and build. It took Airbus 11 years of work and estimated development costs of €12 billion (or ca. £9.5bn) before they could deliver the first A380. No quick fixes will do here. Everybody understands intuitively that building a safe, reliable plane requires brains, commitment, time and lots of effort – and that it isn’t easy.
 

Complexities inherent in managing a pension fund

Whilst pension funds do not have quite as many moving parts as an airplane (the A380 has literally millions of individual parts, from tiny screws to some so big they require specially designed ships to be transported), they rank high in terms of complexity. For example, modelling the behaviour of their liabilities to any reasonable degree of accuracy is not really possible without modern computing power.

There are many different factors driving a pension fund’s funding position: interest rates, inflation (and more obscure concepts like the expected volatility of future inflation), longevity, cash contributions, equity, commodity and corporate bond returns etc. It is necessary to understand, monitor and manage all of these factors to reach the Promised Land where the pension fund is fully funded.

This complexity is the reason why pension fund investment strategies rarely lend themselves to quick fixes. I could increase potential asset returns by putting more money into equity. But am I really going to be happy to rely on a very volatile asset class as my main driver of returns? I could significantly reduce risk by increasing the interest rate and inflation hedge ratios. But am I really in a position to shift so many of my other assets into the collateral pool needed to back these hedges?

Several factors must be balanced against each other – and, obviously, it is also important to design a strategy that all stakeholders in the pension fund can agree to.

Pension funds are therefore inherently complex. Quick fixes won’t work. This does not mean that solutions need to be so complex that trustees cannot possibly be expected to understand them. As with most other things in life, the important thing is to find the right degree.
 

Right-sizing the complexity in pensions 

In other words, investment and risk management strategies should be as complex as necessary but as simple as possible. Any complexity introduced should provide value and it should be apparent how it can help the pension fund to get to full funding, or to remain there. One of the main roles of an investment consultant is to explain why the proposed degree of complexity is adequate and required, and how it will help the pension fund to get to where it wants to be.

Once the right level of complexity has been found, it is usually quite easy to explain why it is needed and how it fits together with everything else. A pilot does not need to know how every single part of the plane works. He needs to have a good understanding of how the different key systems – engines, navigation, electronics – work together to keep the plane in the air and to allow it to go from a to b without a disaster.

This is fairly complex, but it is right-sized complexity.

Pension trustees are in a very similar position. They do not need to understand the technical details of how each asset in a pension fund portfolio is valued, or how the longevity assumptions used by the actuary are derived.

They do need to understand how asset and liabilities behave on the whole, how closely they match each other as well as the key sensitivities of the pension fund’s funding position. A reasonable degree of complexity is an inescapable (and necessary) feature of setting and monitoring an investment strategy for a pension fund.

Only when this complexity is well understood and managed effectively can trustees emulate plane pilots and reach their destinations safely.

 

Please note that all opinions expressed in this blog are the author’s own and do not constitute financial legal or investment advice. Click here for full disclaimer.


 

Author: Sebastian Schulze

Focussing on the big picture whilst being obsessed with (relevant) details, Sebastian is a Director in Redington’s Investment Consultancy team. He joined straight from university in 2010 as a graduate and supports several senior consultants in delivering Redington’s services to clients. Before joining Redington, Sebastian spent most of his time reading Politics, Philosophy and Economic at a university in the north of England (one of the “three great English universities” according to Captain Edmund Blackadder) and European Political Economy at the London School of Economics. However, he hails from a rather large country on the Continent and continues to work on improving his English accent. With a strong interest in most things historical, Sebastian is often pleasantly surprised how useful a background in history and philosophy can be for understanding financial markets and the world of pensions.