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Asset liability modeling crucial for pension fund trustees Back  
One of the principal duties of the trustees is to operate the trust fund in accordance with the pension scheme rules using ‘the same degree of care as a prudent man of business would in the operation of his own affairs’.
Trustees have a duty under trust law to ensure that they do not profit from office, that they do not discriminate, that they act conscientiously and honestly. They also have a duty to seek professional advice - this includes advice on the selection and appointment of fund managers and they then must supervise delegated functions.

Typically trustees will delegate certain specific tasks to third party individuals such as the administration (record keeping of the scheme) and the investment scheme assets.

It is important to remember that the delegation of specific tasks to third parties does not diminish the trustees ultimate responsibility of conducting the business of the scheme - they can delegate the task but not the responsibility. Trustees remain liable for their actions and the actions of those acting on their behalf.

Trustees are governed by the following laws and regulations
• The pension scheme’s rules - specific to each scheme
• Trust law
• The Family Law
• European Law
• Case Law
• Revenue legislation

The main duty of a trustee is to act with the beneficiaries’ best interest in mind at all times - this usually means financial interest. Bearing in mind the above, the principal responsibilities of a pension scheme trustee is investing the assets of the scheme in a prudent manner. The criteria they should apply in choosing a fund manager will depend on whether the scheme is established on a defined benefit or defined contribution basis.

Defined benefit schemes
A defined benefit scheme typically provides the scheme members with a benefit promise. The benefit at retirement is usually calculated to provide equal to 1/60th of their final salary for each year of service with that employer.

Generally speaking the performance of a fund manager should not necessarily concern members of a defined benefit arrangement except to the extent that where the performance is so bad or funding so poor that the scheme can not meet its liabilities and must be wound up.

The trustees in choosing a fund manger to invest the assets of a defined benefit arrangement must take a number of factors into consideration. Obviously the ability of a fund manager to produce consistent returns is important however it is more important to ensure that the fund is invested in the correct asset categories.

For instance if a pension scheme has a high percentage of older lives as members and is paying pensioners from the fund then the fund needs to match its liabilities. Conversely where the age profile of the members is young, then a more aggressive or dynamic approach can be adopted.
Asset/liability modeling is extremely important and is perhaps one area which is most frequently overlooked by scheme trustees.

Taking extreme examples trustees could invest the scheme assets exclusively in equities - equities have in the long term out performed other asset categories, however due to their volatile nature it is likely that the funding rate calculated by the scheme actuaries could vary greatly from year to year. Conversely by investing in more conservative funds for instance fixed interest/gilts it is possible to have a very stable long term funding rate, however this may not necessarily impress the sponsoring employer as the long term cost is likely to be far greater due to lower returns achieved by fixed interest investments.

Defined contribution scheme
Deciding on an investment strategy for schemes established on a defined contribution basis or AVC funds is no less complicated a matter however the trustees must apply a different set of criteria.

In selecting a fund manager for this type of scheme trustees should be able to demonstrate that they have undertaken due process, otherwise they may be open to action by scheme members - they could be sued.

To ensure that trustees discharge their duties in a compliant manner they should:
• Take proper independent advice
• Decide upon the criteria for selection
• Decide upon an investment mandate
• Determine whether the member should be given a choice of fund manager
• Determine whether members should be given investment choice
• Monitor the performance of the selected fund manager

In deciding upon the criteria for selecting a fund manager trustees should consider the following:
• The investment team
• Their management style: top-down, bottom up or passive
• The fund options available
• In deciding upon an investment mandate or setting an investment policy trustees should consider whether the scheme funds are invested on an active or passive basis or both.
• Trustees should consider whether members are given a choice of fund manager

The issue as to whether a choice of fund manager or indeed choice of funds is made available to a member can be summarised as follows:

No choice
If the trustees only offer one fund manager they must ensure that the selected fund manager performs in line with the benchmarks or achieves the investment objectives that have been set. For instance, the investment policy set out by the trustees might be to require the appointed fund manager to consistently achieve top quartile results. If the selected fund manager does not perform and the trustees take no action then members may take action against trustees for imprudently investing the scheme’s assets. In offering one fund manager and not offering a choice of investment profile i.e. a range of funds ranging from conservative to aggressive, it could be the case that scheme members’ assets are inappropriately invested. For instance it could happen that a member nearing retirement age could have their funds exclusively in a managed fund which typically has an exposure of 60 - 80 per cent in equities. If a stock market correction occurred it is possible that a significant loss of funds could be experienced in the weeks or months immediately proceeding retirement and a corresponding reduction in pension would occur.

In such circumstances the scheme member may have a case against the trustees in so far as they have not provided a fund that could have consolidated the members’ funds.

It is important to remember that under a defined contribution arrangement it is the members who would take on investment risk not the sponsoring employer. The sponsoring employer typically agrees to pay a contribution usually based as a percentage of salary and this is the limit of their exposure. The pension available to scheme members will be determined by:
• The level of contribution paid in
• The investment return achieved on contributions
• Expenses deducted from the members account
• Annuity rates available on retirement

Giving choice
Giving members a choice of fund manager and a range of funds from which to select also has its down side but is usually a more prudent course of action. Where choice is given communication regarding the range of funds offered and the investment risk associated with each fund is crucial.

Using an extreme example a member nearing retirement age could have elected to invest their entire fund in a specific sectoral fund such as high tech stocks or Japanese equities. This type of investment is extremely high risk and generally not suitable for the individual who requires to purchase a pension on retirement. Where the member has not been properly informed about the risks involved it is possible that they could bring a case against the scheme’s trustees for either allowing such an investment or not properly advising on the risks involved.

Monitoring fund performance
It is important that trustees of pension schemes whether they are defined benefit or defined contribution continue to monitor the performance of the fund manager and ensure that the investment objectives that have been set are actually achieved. Where a fund manager under performs in a particular year this is not a reason to switch fund manager. However where the selected fund manager consistently under performs then action should be taken.

In a defined benefit arrangement where a significant portion of the funds could be invested in fixed interest assets to match the scheme’s liabilities it is not appropriate to compare the performance of this particular fund to a typical managed fund as the amount invested in various asset classifications i.e. equity, gilt, property, cash is unlikely to be consistent.

From a defined benefit contribution perspective it is inappropriate to consistently change fund managers and follow the best performing fund manager. Usually this approach ultimately results in under performance as you are moving funds from an under-performing fund manager - at a low price and buying funds with the top performing fund manager at a high price. This is contradictory to the most fundamental investment strategy - buy low and sell high. Indeed it could be argued that a more prudent investment strategy would be to change fund manager if your fund manager has been the best performing fund manager and in turn switch funds to a fund manager who has performed poorly but whose current investment strategy is likely to achieve good returns.

The performance of most fund managers is cyclical. The most difficult if not impossible task faced by a trustee is to appoint a fund manager who will consistently achieve to quartile returns.

Research has shown that this in the long term is not usually possible. The number of fund managers out performing the various stock market indices within which they operate is very low, hence the significant movement towards investing scheme assets on a passive basis - index tracking or consensus.

Current investment trends
In Ireland we have seen a significant move towards index tracking over the past five years. Trustees like to be able to demonstrate that they have achieved at least average returns and in the context of a defined contribution scheme having a passive fund option available is perhaps a good thing.

On a defined benefit basis it allows for a core/satellite approach to be adopted whereby schemes’ liabilities could be matched by a mix between fixed interest and passively managed funds and the balance invested on a more stock specific basis.

The most recent trend in fund management has been the introduction of funds with exposure to a small limited number of stocks. The first such fund was Setanta Asset Managers Focus 15 which has only 15 different stocks contained within the fund. Other fund managers such as Bank of Ireland Asset Management, Eagle Star and KBC Asset Management have recently introduced similar investment vehicles. These types of funds are not for the faint of heart or risk adverse however the stocks contained within these types of funds are usually the fund managers preferred stocks or ‘best bets’ and where an individual or scheme Trustee is trying to achieve out-performance these types of funds will probably achieve this but at a greater degree of risk than a typical managed fund.

Peter Griffin is a pension consultant at PricewaterhouseCoopers.

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