Investment Guidelines Made Simple The IAPF recently published a set of guidelines to help trustees manage pension scheme investments more effectively. In this article we explain why the guidelines were issued, what they say and how trustees can use them. In subsequent articles we will look at: understanding pension liabilities investment risk and return bonds equities alternative investments Why guidelines? As a trustee, you face a long list of tasks to ensure that your pension scheme runs smoothly. It is easy to forget that your main job is managing the scheme s investments: for a typical scheme most of the benefits are paid for by investment returns, not contributions themselves most of these returns come from your investment policy (how much is invested in equities, bonds and alternatives) rather than the investment managers selected to do the investing for you Many trustees do not spend enough of their time on investment issues and do not have a carefully thought out policy or management structure to implement this policy. This could put members benefits at risk, or lead to higher than necessary costs for the employer. What guidelines? The IAPF guidelines are a set of simple principles which you can follow to address these issues. Trustees of defined benefit (DB) schemes face some different issues to trustees of defined contribution (DC) schemes, but the key principles are the same: make sure you are obeying all the relevant laws discuss investment matters regularly take expert advice unless you are an expert yourself review your investment policy regularly delegate, delegate, delegate The last point cannot be overemphasised. Your job as a trustee is to manage the investment process, not do it. Even if you wanted to, successful investment requires frequent decisions which you simply cannot make at yearly or even quarterly meetings. The buck stops with you, but you are serving your members better by recognising where you can and can t add value.
The additional principles for DB schemes are: consider risk as well as return, and measure risk against your liabilities, not against other schemes balance risk to members against cost to the employer safe strategies might cost the employer more than they can afford. The additional principles for DC schemes are: consider the needs of members when designing the fund choices being offered explain the fund choices clearly to members offer a suitable default fund for members who can t or won t decide for themselves. Simple, yes, and obvious, perhaps, but these principles require discipline and effort to implement successfully. The principles in full can be downloaded from the IAPF website at: http://www.iapf.ie/informationlibrary/guidelines/pubtitle,1626,en.html What next? The first thing you should do is to have a good hard look at your trustee board to see how well you are following these principles at the moment. It is often easier to see this by asking someone else to do the looking. This could be one of your advisers, or a trustee sub-committee. With this clear view, you can agree an action plan to ensure that you are following the guidelines in future. It might take you some time to get there, but at least you will have started the journey.
Pension Liabilities Made Simple The first article in this series looked at the new IAPF investment guidelines. These explain how pension scheme trustees can make sure that they are looking after their investments properly. In this second article we look at the liabilities the benefits paid to the scheme members. Trustees need to understand these liabilities so that they can decide how much to invest and what sort of investments to make. Valuing Pension Liabilities A pension is a series of regular payments made over a person s lifetime after retirement. The cost of providing a pension will depend on: how long the person lives for the rate of interest which can be earned on money set aside to provide the pension what increases are made to the pension to protect it from inflation Pensions are a bit like houses: both are large investments that are hard to value you can t just look them up in the paper like you can with any shares that you own. The only real way of finding out how much your house is worth is by putting it on the market. If you don t want to actually sell your house, you can get a good estimate of its value by asking an estate agent. The estate agent will use his knowledge of the prices at which other similar properties have changed hands recently to come up with a value for your house. If trustees want to know the value of their liabilities, they ask an actuary. The actuary can: use his/her knowledge of mortality rates to work out how long the pensions are going to be paid for refer to financial markets for objective expectations as to what level interest rates will average out at over the long term (the yield on a long-dated bond is the reference point in this regard we will explain bonds in more detail in a later article) refer again to financial markets for their long-term expectations for inflation (again, bond markets are the reference point in this regard)
The important investment point here is that pension liabilities behave like bonds - both are heavily influenced by long-term interest rate expectations. If the price of bonds goes up, so does the value of pensions. If bonds go down, so do pension values. So bonds are the safest type of investment for a pension scheme. If trustees had unlimited funds available, they would probably invest completely in bonds. But funds are usually limited, so most trustees need to invest a large part of their assets in riskier assets (equities, and other alternatives which we will discuss in later articles), which offer potentially higher but less certain returns than bonds. What types of pension? There are two different types of pension scheme, and knowing the cost of providing pensions has slightly different uses according to the type of scheme. A defined benefit scheme provides benefits which are specified by a formula (e.g. a pension of two-thirds salary after a full career). Trustees need to know how much these benefits are worth so that they can work out how much money needs to be paid into the scheme. They also need to know more about those liabilities so that they know what sort of assets are the safest to invest in. A defined contribution scheme specifies the amounts which are paid in (for instance, both the member and the company might contribute 5% of monthly salary). The benefits provided will depend on how much is paid in and how well the investments do. Trustees need to know the cost of buying a pension so that they can tell members how much pension they are likely to get. Members can then decide if they need to pay extra contributions or if they want to change their mix of investments to alter the amount of risk they are taking.
Bonds Made Simple Bonds have a number of characteristics that are very useful for individuals and companies who are providing for pensions at some point in the future. In this article we will firstly define what we mean by a bond and then review the characteristics that interest us as investors of pension fund money. What is a bond? A bond is a loan - the lender is usually known as the investor and the borrower is known as the issuer. Just like a car loan interest is paid at regular intervals but in contrast to a car loan absolutely no principal is re-paid until the final date (the maturity date) of the loan. The characteristics that appeal to pension investors include: 1. They are less volatile than equities 2. They are available in a range of maturity dates 3. They pay income and this income is known in advance 4. Their values move in tandem with defined benefit pension liabilities 5. They are often issued by the government and so are quite secure 6. The principle is fully repaid at maturity Let s look at each of these in turn. Bonds are less volatile than equities In our diversified portfolio of pension assets we typically look to equities and property to be the growth assets that provide us with a real return in excess of salary inflation. On the other hand we usually look to bonds to provide stability in the portfolio due to their less volatile nature. The lower our tolerance to volatility or risk the more bonds we would allocate to our portfolio at the expense of equities and property. Not all bonds are the same however so we need to pick carefully among the bond universe. Bonds are available in a range of maturity dates You can buy a bond that matures in 30 years or 6 months depending on your needs. If you were on the investment sub-committee of a defined benefit pension scheme with a young workforce then you might buy some 30-year bonds to match the liabilities that you will have to pay when the employees retire in 30 years time. If your time horizon was only 6 months then you might seek out a bond with a much shorter maturity date. It is worth noting that the volatility of 30-year bonds is a multiple of that of 6-month bonds and this should be borne in mind in your investment decision. Bonds pay income which is known in advance Bonds pay pre-determined dividends on an annual or semi-annual basis and that interest could be used by investors to pay pensions or expenses. Often however, where
investors are invested in a bond fund rather than an individual bond, the income is reinvested and so it cannot be accessed without selling units in the fund. Bond values move in tandem with defined benefit pension liabilities The liabilities of a defined benefit pension scheme are essentially a loan and they tend to be impacted by many of the same factors that impact a bond. Therefore the Trustees of a defined benefit pension scheme can chose to invest some or all of the pension scheme s assets in appropriate bonds in order to achieve a good match for future pension payments. Unfortunately equities offer a higher return than bonds over the longer term and so a better match may be achieved at the expense of higher returns from equities. Bonds are often issued by the government and so are quite secure Governments issue bonds to raise money for major capital programmes such as building roads and ports. Public and private companies can also issue bonds to raise capital. As prudent pension investors we are comfortable to lend our money to the Irish government. We would be less comfortable to lend to an emerging market country or to an individual company where our investment is higher risk. In return for the higher risk however we are likely to earn a higher return and this may sufficiently ease our discomfort to make it worthwhile. The principal is fully repaid at maturity As with the coupon payments, the principal repayment and the date upon which it is paid are known in advance. As a pension fund investor we have greater certainty than we would have with the equity market where we will not know in advance how much we will receive until we actually sell our investment. Conclusion Bonds play a key role in the world of pension fund investing from both an individual and an institutional viewpoint. Their unique characteristics provide investors with the option to manage risk and return more effectively and to provide for the future with a greater degree of certainty.
Risk and Return Made Simple The contribution rates to most pension schemes are set assuming that a certain level of investment return will be achieved. If the required level of return is greater than you can earn by investing in safer assets such as cash or bonds, you will have to take some risks to achieve it. But be careful whilst you have to take risk to earn extra returns, that doesn t mean that all risks are worth taking. You should avoid poor risks if you can this means that you can take more of the good ones. Let us explain, read on Diversification The golden rule of investment is diversification never invest too much in single company, industry, country, currency or type of asset. Concentrated investment positions can produce spectacular returns if they go well or disastrous ones if they go badly. If you diversify, the peaks and troughs are smoothed out, hopefully without reducing your long term return. Most trustees are aware of this principle when it comes to picking stocks, but many forget that it applies at other levels as well. For example, Irish pension schemes often have higher levels of investment in the Irish stock market than good practice suggests is appropriate. This has produced strong returns for many years, but the last year has shown that the downside can be very painful. You should try to diversify your equities as widely as possible. Stock markets across the world show a tendency to move in tandem, so you can reduce your risk still further by investing in other types of assets (such as property, commodities, hedge funds etc which will look at in more detail in a later article) which offer similar levels of return but show less correlation with equities. Active management So far we have talked about investing in line with stock markets. Many investment managers seek to provide higher returns by investing in stocks that the market has (in their view) mispriced this is called active management. Active managers charge more for their services than passive managers who simply track the market. Active management is attractive because it offers potential extra returns around the margins, and these extra marginal returns may not depend on whether stock markets themselves are going down or up so they offer an additional source of diversification. Of course, this is fine if you only pick the winners, but this is very hard to do. As with markets, past performance is no guide to the future the best manager last year may be
the worst this year. And remember that the average active manager must underperform the market after his fees are taken into account. Hedging Hedging means eliminating risks that you don t think are worth taking. One of the reasons often given for not investing in global equity markets is the risk of currency fluctuations. These can indeed have a big effect on returns over short periods. Some investment managers will try to make money out of currency markets. If you believe them, you could hire an active currency manager. If you don t, you can eliminate the currency risk using derivatives called futures or forwards. Most schemes hold bonds of much shorter term than the liabilities. This means that when interest rates change, the bonds and the liabilities do not move in tandem. As with currencies, there are investment managers who believe that you can make money out of interest rate changes. If you don t believe them, you can simply buy longer dated bonds or use derivatives called swaps to reduce this mismatch risk.
Equities Made Simple In this article we look at equities (also known as stocks or shares). Share in the company s future profits To raise money to run and expand their business, companies can either issue debt to be paid back over a fixed period (i.e. borrow the money), or alternatively grant investors a share in the future profits of the business (i.e. issue shares or equity). Because these future profits are uncertain, investors demand a higher expected return from equities than from bonds. And over the long term, these higher returns have generally been delivered. If pension schemes only invested in low-risk assets such as bonds and cash, then the potential for higher future returns would evaporate and contributions into the scheme today would have to increase significantly to compensate. Short-term volatility illusion or reality? Equally however, the value of the stock at any given time reflects the average investor s view on prospects for the company s future profits. Every time these expectations for the future change (and that happens every day, every minute even), there are buyers and sellers and the stock price adjusts accordingly. It s easy to think that the dramatic fluctuation in stock markets over 2008 has been simply barmy and that it does not reflect reality. But it does the ups and downs reflect the nervousness and uncertainty that investors all over the world feel about economic growth, recessions, impact of bad debts on banks future profits, lack of access to credit etc. How to invest diversify, diversify The single most important word for any savvy investor is diversification. If you believe that future global growth will allow stocks world-wide to increase in value, then don t confine your portfolio to any one particular company or indeed one particular type of company invest in a global basket of stocks. The most convenient way of doing this is through a pooled fund where your money is pooled with that of hundreds of other investors the fund manager can therefore purchase a wide portfolio of stocks and everybody gets a slice (or a number of units) of the overall percentage return. Most pension schemes invest their assets in one or more pooled funds of this form. Remember however, it is the type of investment (e.g. global equities, Irish equities,
Eurozone bonds), that will largely determine your returns the choice of fund management firm to provide this fund is generally of much less significance. What types of equity funds? Companies can be categorised into different groups, and sometimes fund managers will package their pooled funds along these lines. Generally, the more specialist the description, the more volatile the fund will be. For example: Group by regions an Irish equity fund will contain a basket of Irish stocks only and will generally be less diversified, and more volatile, than, say, a global equity fund. Group by industrial sector for example, a basket of US financials companies, or European technology companies, or companies in the energy sector. Companies within the same sector can show quite a similarity in returns, while different sectors (e.g. energy vs financials) can deviate markedly. This again illustrates that a diversified mix of sectors (e.g. a broad global equity index) offers a valuable safety catch. Group by size of company in large markets such as the US or the UK there are recognised baskets of small cap stocks representing smaller companies. Generally speaking, small cap stocks can be expected to provide higher volatility but also (in compensation for this) higher long-term returns Emerging markets vs developed markets stock markets like Brazil, Russia, China etc offer higher potential return in return for what will be a rocky ride along the way! All of the above sectors will have their ups and downs, and all will be influenced by the general fortunes of stock markets worldwide. Our advice is simply to never ignore the virtues of diversification, seek as broad a mix as possible and then also seek further diversification from other asset classes apart from equities. Alternative asset classes is the subject of our next article.
Alternatives Made Simple What is an alternative asset? For the purposes of this article we are assuming that the following assets are mainstream : Equities or listed company shares Bonds loans to governments or companies Property bricks and mortar Cash bank deposits and similar liquid instruments The term alternative therefore relates to invests that are different to the above list. There are a multitude of potential investment opportunities, in the interests of brevity we will concentrate on some of the more popular alternative assets, specifically: Private equity Hedge funds Commodities Currency funds Infrastructure The rationale for investing in alternative assets is that they provide a good long term investment return and importantly diversification away for the mainstream investments. Diversification means not having all your eggs in one basket and so when looking to add alternative investments into a pension fund portfolio the Trustees and their advisors are usually looking for assets that, when combined with the assets in the current fund, will lower the overall risk of the fund. Private Equity This term refers to investments in companies that are not listed on stock exchanges. Pension funds typically access this market by investing in private equity companies or private equity fund of funds. There is a wide range of types of strategies within this area ranging from investing in start-up operations (also known as Venture Capital) to management buyouts of long term established businesses. Readers may remember that the Jefferson Smurfit Group was bought by private equity company Madison Dearborn Partners in September 2002. Following much restructuring they subsequently listed again on the Irish stock market in 2007 as Kappa Smurfit plc. Investors in Madison Dearborn Partners would have benefited from the higher value that was placed on the business at the time it refloated on the Irish stock exchange.
Investment in Private Equity is a long term investment as you cannot typically get your money back for a number of years. This long term investment time horizon is what differentiates private equity from listed equity. Hedge Funds The term hedge fund usually refers to a fund that uses non traditional or mainstream assets to target a higher rate of return. The range of investment approaches within hedge funds is extremely wide. Given the diverse nature of hedge funds and the risk of adopting just one strategy, many pension funds that invest in hedge funds do so through a Fund of Funds arrangement. The Fund of Funds manager would select what they believe to be the best hedge funds around the world and invest a proportion of their fund in these strategies. Commodities Investments in raw material such as oil, gold, wheat, steel etc. Actual exposure to these assets is usually through the futures market as opposed to physical investment. Infrastructure Investments in roads, hospitals, schools, bridges, airports etc. These are long term capital intensive projects that would be expected to give a positive real rate of return over a long time frame. Given this time scale investment in infrastructure would offer diversification away from equities and bonds whose daily prices are more influenced by short term drivers. Currency funds These funds buy and sell different currencies (e.g. US Dollar, Brazilian Real, euro, Thai Bhat) in order to make a profit. The investment rationale is that these markets are often not fairly priced as other buyers of currency tend to be doing so as a bi-product of their actual investment decision (e.g. a decision to buy shares in Microsoft for an Irish investor means selling euro and buying US dollar) and not because they believe there is an investment opportunity in the currency market. Therefore there is an opportunity for a manager that is purely trading currency to make money.