The four questions pension fund managers must ask 13 September 2009 It‟s difficult for an individual to navigate the complex world of retirement savings and investment. Apart from understanding fundamental concepts such as risk and return they have to select appropriate solutions from the myriad financial products available. But the pressures involved in navigating the investment minefield multiply tenfold when the decision impacts on hundreds or thousands of other individuals. This is the challenge faced by pension fund trustees across South Africa. “How can trustees make sense of [the noise] and put it all together?” Trustees needn‟t be overwhelmed by their responsibilities. According to Craig Aitchison, head of Old Mutual Actuaries and Consultants (OMAC), there are four critical steps trustees must take to successfully oversee their funds. He discussed these steps during a recent OMAC breakfast presentation titled “Solving the puzzle.” Aitchison believes the overall fund management responsibility is similar to completing a complex puzzle such as the Rubik‟s Cube. In discharging duties as a pension fund trustee there are various aspects that need to be matched to meet the requirements of fund members. Step 1 – Where are we now? The first step recommended for trustees is to thoroughly assess the position of the fund at a given point in time. “It‟s like stepping back and starting the process afresh,” said Aitchison, warning that too many managers ignore the “big” picture. Before worrying about manager, fund or market performance, trustees should consider whether the fund risk is appropriate for its members. This requires that trustees assess member demographics, including age, gender, socio-economic grouping, geographic location and applicable replacement ratios the risk factors applicable to individual fund members should be determined too. Trustees should have a sense of time to retirement, accumulated credit, other savings and salaries of the members. “A member who is very close to retirement will have a very different ability to handle investment risk compared to a member who has just started,” said Aitchison. He said a common mistake was to assess risk in isolation. Instead the debate should take place against the backdrop of “how much investment risk you should be exposing your members to!” A single risk profile seldom applies to all members of a pension fund. It‟s also important to remember that he word „risk‟ means different things to different people. OMAC identified three measures of risk that should be considered. The first is downside risk, which looks at the exposure of a particular fund to the negative dips that occur during prevailing trends. “What we want to do is try to minimise the negative returns we have to accept along the journey,” said Aitchison. The second risk is referred to as drawdown risk. This gives you an idea for how big a loss (the worst case) you could expect on a particular investment on an historic basis. In the past pension fund managers believed 10% to 12% was the “worst case” drawdown for a typical balanced fund; but more recently they‟ve experienced drawdown of as high as 18% to 20%. The third risk is underperformance. “Once the market crashed everybody moved into cash to manage drawdown and downside risk,” said Aitchison. Movements of assets into cash and out of equity through the recent market crisis showed that attempts to manage downside and drawdown risk could actually maximise risk in all three categories! The lesson is simply this: “Market crashes affect drawdown!” and inappropriate risk-based decisions can be disastrous. The “where are we now” step also requires an intensive assessment of the existing fund manager and other service providers through quantitative and qualitative analysis. Step 2 – Where do we want to go? The second step is to define and quantify the fund‟s obligations to its members, and by extension what the fund is required to provide. Trustees need to consider the returns they should be aiming for within agreed risk constraints. Fund managers have to adopt strategies that match returns with these levels of risk while resisting the temptation to respond to market events. An example of this „mistake‟ is the fund manager that considers the timing of an investment decisions without concern for the risk appetite of the fund‟s members. If the bulk of members in a particular fund are nearing retirement then the challenge should be to limit drawdown risk through lower targeted returns and capital preservation. Active members might require growth with protection (for example CPI + 5%) while pensioners would be better served by a liability matching strategy (targeting CPI + 2%) for example. One way to tackle this requirement is to consider the returns that can be achieved within each applicable risk framework. Step 3 – How do we get there? Once you know where you want to go you have to draw up a road map to complete the journey. Answering this question will assist in determining the way forward, with the goal to achieving the fund‟s obligations. Empirical research conducted both locally and internationally suggests correct asset allocation accounts for 90% of fund returns. So the best way forward is to determine the fund‟s optimal asset allocation and then to select possible managers for the implementation. Once an optimal portfolio is proposed you should back test it for performance through extreme periods and events. There are two parts to investment performance, namely the return achieved and the effectiveness of the risk management in achieving it. These issues are essential in finding a manager with a good fit for the fund members. “The manager is there to implement your carefully crafted strategy!” said Aitchison. Question 4 – How are we doing so far? A retirement fund investment strategy requires continual evaluation and review in order to identify gaps and reduce them until you reach your ultimate goal. “In order to manage something we must keep track of it,” said Aitchison. Pension fund trustees must stay up to speed with changes at the respective fund managers, keep updated on product innovation and continually reassess the first three steps in the equation.
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