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You cannot comply unless you know what the regulator means

27 August 2012 Gareth Stokes
Gareth Stokes, FAnews Online Editor

Gareth Stokes, FAnews Online Editor

Regulation 28 requires that pension fund administrators and Trustees match their pension fund assets to fund liabilities. This requirement presents challenges in the defined contribution space, because the fund liability is the sum of individual member li

If you ask a pension fund Trustee how to match assets to liabilities within a fund they might suggest a “balanced investment view” or “inflation plus targeted” strategy. But neither of these responses is correct. An inflation plus targeted strategy places pressure on pension fund Trustees to go out and find a manager that not only promises returns of inflation plus five or seven, but actually delivers on this promise. “Therein is one of the greatest sources of value destruction in the pension fund industry,” says Cabot-Allethauser. “The active versus passive debate has nothing to do with whether active managers achieve their benchmark after costs, but rather with the risk to fund members of pursuing inappropriate strategies over the short-term”.

A cycle of value destruction...

A 2008 study conducted on the Australian superannuation fund industry estimates that pension funds lose as much as 3% per annum to poorly applied investment strategies. Cabot-Allethauser believes that the industry’s failure to understand the Regulation 28 assets to liabilities matching requirement is a major contributor to such losses domestically. By way of example she considers a pension fund applying a CPI plus 7% targeted strategy. If the asset manager underperforms against this target the pension fund Trustees fire it. “We panic, close shop on the manager and lock in any losses the manager has incurred,” she says.

To make matters worse the Trustees then source a new asset manager that meets their confirmation bias by topping the performance tables on a one, three and five year view. They back a manager that has consistently outperformed at the exact moment this performance begins tapering off! “We fire an underperforming manager, lock in the loss, employ a new manager at the top of their game, and watch the performance slide – and there are costs to make each of these changes,” says Cabot-Allethauser. The 3% value destruction stems from conflicted service providers, chopping and changing from one asset manager to the next and instructing fund managers to perform against benchmarks on an annual basis. Such instruction contributes to value destruction in the short-term.

In order to minimise value destruction Trustees must realise that retirement saving is not simply an issue of getting the highest risk adjusted net return for members. Performance is the most important issue, but it must relate to what the member has to achieve.

The regulator’s point of view

When asked what it means that assets be appropriately matched to liabilities in a defined contribution environment the Financial Services Board (FSB) offers the following definition: “Members should have a reasonable expectation of being able to purchase an income stream on retirement that can at least replace a considerable portion of their current salary”. The definition is simple enough, but Cabot-Allethauser warns that the individual member should consider the varying cost of the annuity to provide this income stream rather than obsessing over how much cash he or she accumulates over time.

This warning is particularly important given the “lower for longer” developed world interest rate scenario coupled with “new normal” returns across asset classes exhibiting today. “Lower bond yields drive up the price of annuities and signal lower returns going forward,” she says. Pension funds must watch both assets and liabilities, because a plan put in place during the heydays of stock market returns (between 2002 and 2007 for example) will not cut the mustard given current return expectations.

Achieving a CPI plus 5% return over long periods of time does not guarantee the expected replacement ratio either, because there are too many factors eroding the value of the accumulated assets. “Savers have to consider that the cost of purchasing an annuity, the impact of mortality and longevity, varying investment returns as well as preservation, contribution rates and salary progression have a huge impact on the long-term savings outcome,” says Cabot-Allethauser. “The hard truth is that saving a fixed amount of salary and meeting your return objective over time is not enough”.

Trustees can make a difference

Stakeholders in the pension fund environment need to consider long-term savings outcomes from a liabilities perspective. A great way for asset managers to tackle this issue is to create default solutions that target specific net replacement ratios. In doing so they can manage the bulk of pension fund members towards their desired replacement ratio (the liability side of the equation). Trustees can then spend more time assessing why certain members are not achieving this ratio. They can also make meaningful assessments about whether problems with individual members stem from the asset management side (for failing to meet return objectives) or due to member behaviours.

“Picking the right fund manager matters about 3%,” concludes Cabot-Allethauser. “And there is no answer to the question: What is the right fund manager?” She believes the only real benefit of a multi manager is that it insulates Trustees from behavioural reflexes of buying high and selling low, thereby preventing value decimation. The person who has the greatest responsibility for the retirement outcome is the liability manager – or the pension fund consultant.

Going forward Trustees need to monitor savings outcomes at the individual level, engage with the employer and consider how assets are matching liabilities rather than obsessing over whether the fund is getting the highest possible return.

Editor’s thoughts: One of the easiest ways to decimate long-term investment return is to make frequent changes to your portfolio. Each time you sell out of one position, and buy into another, you incur additional costs. You also risk selling out of an underperforming investment before it rebounds, or buying a leading fund before a correction. Has the retirement industry, through its obsession with higher returns, lost sight of the retirement savings objective? Add your comment below, or send it to

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