Funds Europe held a pensions roundtable discussion with three senior UK defined benefit figures recently as they themselves reached retirement. Their views about the state of occupational pensions and investment are their own. Chaired by Nick Fitzpatrick.
Roy Gillson (former chief executive Aerion Fund Management, in-house investment team for the National Grid UK Pension Scheme)
Peter Dunscombe (former head of pensions investments, BBC Pensions Trust)
David Brief (former CIO, BAE Systems Pension Schemes)
Funds Europe: Are UK occupational pension funds still the success story they once were, particularly in terms of risk and value?
Roy Gillson, Aerion: For those who have been in employment with a company defined benefit [DB] scheme over the last 30 or 40 years, pensions have been a wonderful thing. The UK system used to be a shining example to the world and certainly to Europe, but if you were now looking for a role model, the UK would not be a good example.
Peter Dunscombe, BBC: There has been an inevitability about the demise of final salary schemes. The cost of them, with increased longevity, appears to be too great for companies to contemplate.
David Brief, BAE Systems: I think the final salary schemes committed suicide. Longevity has become an issue as well, together with ten years of poor returns and changes in actuarial evaluation, which have increased the deficits.
Gillson: I think one thing we’ve seen under a variety of governments is a tendency to reduce risk without any concern for the value for money effect on the pension. The result was that regulation became tougher and pension funds went from being investment funds with a promise to being insurance companies without excess reserves. That has been a steady process under governments of all types.
Funds Europe: Who do you think is most responsible for the reduced status of UK pension funds?
Dunscombe: As more regulation has been applied, it has been inevitable. I don’t think you can blame the Government for wanting to have more regulation. We were a most wonderfully unregulated area of the world, and yet we were effectively insurance companies with no reserves. Also, there was more flexibility on the actuarial side. It is totally understandable that they have tightened up the way they do things, but you can’t blame them for it.
Gillson: To take the simplest mathematics, I always say: ‘When we started pensions, you started work aged 20 and, if you were a man, you worked until you turned 65 and expected to live perhaps five years after that. So you gathered contributions over 45 years and you paid out for five. People now don’t start working until they are 25 and they expect to retire at 60. So that is collecting for 35 years and then paying out for 20.’ These mathematics meant that the finances had to change.
Brief: The UK was late in moving to the prudential system of the Danish or the Dutch. So when they moved, pension funds were not 100% funded and they were struggling to regain solvency. It’s a lot easier to maintain solvency than to regain it. The actuarial consultancy profession has failed pensioners. Who were the people technically valuing these schemes and every three years signing off a valuation for a schedule of contributions that would guarantee that the pension promise would be met? It’s the actuaries. Who do the trustees and the companies talk to? The actuaries. What did the actuaries do? I don’t know.
Funds Europe: In your definition of actuaries and what they do, do you include their role as an investment adviser as well as a market forecaster?
Brief: Yes. They were the people to lead that debate. Our job as chief investment officers is to interpret and help the trustees understand what the actuaries are saying to them and put it into practice. It’s not my job to stand up and say, ‘The fund’s insolvent, you need to do something about it.’
Gillson: Investment consultants are the new guys on the block. It is in the last ten years that there has been an identifiable actuarial business and investment consultancy business.
Dunscombe: It was another source of revenue.
Brief: They don’t make much money out of actuarial consultancy. Investment consultancy is where they make money and, funnily enough, the most profitable part of investment consultancy is risk management. They make a fortune out of full risk management programmes for pension schemes.
Funds Europe: Is investment consulting more of a UK phenomenon rather than a European one?
Dunscombe: In the UK we have a trustee structure defined by elected groups with responsibility for the whole pension scheme and they are not expected to be professionals in any area. They are representatives, so legislation requires them to take formal advice from experts. If we take the Netherlands as an example, there is a different management structure without that legal need, and you can appoint experts.
Gillson: The large European schemes are resourced in a different way from those in the UK. If you look at the big schemes, they employ hundreds of people internally, which is quite rare in the UK, so I think there’s a resourcing issue.
Brief: The Dutch pensions are dominated by industry-wide pension schemes.
Gillson: The Dutch pension scheme is like an industry-wide insurance company with appropriate resourcing and professional staff to do all the jobs required. We are not; I had a staff of 30 on the investment side and about 20 on the administration, plus several in outsourcing.
Brief: BAE were the same on investment. There are about 15 internal pensions professionals; we have three in-house actuaries to reduce the actuarial cost, which is unusual but is what the company wanted.
Dunscombe: But they’re presumably advising the sponsor and not the trustees.
Brief: They’re advising the sponsor, yes, and doing a lot of M&A [mergers and acquisitions] work.
Dunscombe: One issue which I think is really significant is that the attention that the plan sponsor paid to the pension fund 20 years ago was zero; it was there, it was looked over by somebody; the pension fund executive probably didn’t even make a presentation to the main board of the sponsor.
Gillson: If there was one.
Dunscombe: Now we have a proper dialogue with the sponsor. It is a much more commercial relationship than has ever existed before.
Gillson: They now understand that their balance sheet and the shareholders’ balance sheet is the reserve of the insurance company, which is the pension scheme.
Funds Europe: Are defined benefit (DB) schemes unsupportable for the UK plc?
Gillson: There could have been a much better scheme design linked to career average and not final salary, with limited inflation and risk cover.
Dunscombe: He’s right. Defined benefit will wither; it will be seen as too expensive.
Funds Europe: How successful has Whitehall been at creating a sustainable private pensions industry?
Brief: It hasn’t even created a sustainable private pensions minister. On the investment side I think government policy has tended to be fixated on the pool of private pensions and its ability to fund various initiatives. Pensions policy towards provision has been driven by government worries about angry pensioners being photographed walking up Whitehall brandishing placards.
That has had a major impact for investment as people are talking more about risk and the liabilities. Whether that has made DB pensions more sustainable is debatable – they have not decided on a replacement while what has been done in terms of trying to recover the situation has made them less acceptable to sponsors.
Dunscombe: I think it’s probably worse than that. I don’t think they have created a sustainable DB environment but they have tried to create an environment where there is a sustainable pensions industry. However, I think there are a number of problems in the DC [defined contribution] arena, namely fees in the segregated area.
Funds Europe: Yes, for instance, with some schemes all the tax benefit accrued to members’ pension funds goes to investment management fees over the period of their contributions.
Gillson: The ISA [individual savings account] industry has been accused of the same thing, that the extra charges on ISAs wipe out any tax benefit you might have had through investing in an ISA compared to a taxable form of investment. One of the things that governments are guilty of is changing the rules too often.
Dunscombe: There should be some government encouragement to having larger groupings of DC schemes so that they can get the economies of scale.
Brief: You only have to look at Europe, there should be a sustained effort to create industry-wide pension schemes.
Gillson: Yes, and 1.5% would be a typical set of fees per annum for DC schemes, and that’s far too high because it’s a retail product and it shouldn’t be in this environment.
Dunscombe: The government has to address public sector final salary pensions.
Gillson: One of the good things has been the Pension Protection Fund. That was a necessary move. It’s a structure which seems to be working, it’s a professional organisation which seems to be well managed, organising on behalf of all of us as taxpayers the underwriting of those pension schemes which weren’t sufficiently well organised and, therefore, not sufficiently well financed, and maintaining reasonable levels of pensions for those who had contributed. However, if there was a problem, it will need a national solution, but we keep pretending that a levy on the 20 largest pension schemes is a suitable allocation.
Brief: It’s a great example of the big society.
Funds Europe: Has the UK come into a harsher world with a changed reality in terms of pensions?
Brief: Absolutely. For the majority of people, Tier 1 pensions are going to be their largest single pension pot. DC contributions, for cost reasons and because most people start them too late, will give people nil chance of having a comfortable retirement. So in 30 or 40 years’ time, there is going to be the most amazing political issue.
Gillson: I think our children will understand that. I don’t think anybody starting work today believes that they will be doing anything other than working all their lives until they are physically not capable.
It’s a terrible backwards step that we have to say we’ve participated in, in some way. Expectations were raised to a level where they couldn’t be met, and now there’s no chance of meeting them.
Funds Europe: Considering regulation, was the idea of building up internal professionalism one of the good things to come about as a result of the Myners Report ?
Brief: That is right; however, it has become a Myners industry, which I disapprove of. But there are one or two things in the Myners principles which make a lot of sense.
Gillson: They represent a strong positive in improving the education and understanding of trustees outside the large schemes. The fact that it was compulsory made a lot of trustees sit up and do something.
Dunscombe: The real winners from Myners were investment consultants. Most of the non-top 30 schemes said, ‘Ooh, we need to get a lot more professional advice. Where can we get it?’ The natural home for that was the investment consultants.
Funds Europe: As scheme managers, what are your experiences with consultants? How well do they serve the scheme and how much value for money do trustees get out of them? To what extent is the model conflicted?
Gillson: Over the past decade, actuarial consultants have developed into investment consultants with others coming aboard, so it’s an interesting business model. But they inherently have conflicts of interest they don’t declare, in the sense that they can be advising different clients on whether a particular fund manager is good, bad or indifferent.
It’s impossible to manage all those things in-house without having some severe conflicts of interest. For instance, if you find a very good small manager and you’d like to employ them, if you’re one of us we can do it very easily, without any conflict of interest. They might have more limited capacity than we want as an individual client, but if you’re a consultant and you’ve got very limited capacity on offer, who gets that capacity? Is it your in-house sub-multi manager system? Is it your advice to other people? There is a conflict of interest and as fund managers we’re so used to dealing with these things and we have rules.
Brief: They’ve got round them by auctioning the capacity, which is a new development, and saying: ‘Our fee is going to be two and a half times the norm because it’s such an exciting opportunity.’
Gillson: Or it’s going to be a dedicated product that you can only access through us.
Dunscombe: And we’ll charge you a fund management fee and not an investment consultant fee. Which is a very clear conflict.
Brief: Absolutely. At BAE there is no retained investment consultant. We have an actuarial consultant and we have an investment consultant; Aon [the reinsurance intermediary] do the asset liability modelling and that sort of advice. We will use consultants for consultancy but commission them on a one-off basis. Once you retain a consultant, they very quickly own the investment process and it can be tough getting it back.
Dunscombe: I agree with everything that’s been said. As an industry we have to start fighting back. One of the ways we are starting to see the investment consultancy industry move is away from what investment consultants used to call 15 years ago ‘balanced management’ towards a more boutique-based model.
Gillson: I’m delighted to see occasions when a smaller fund – which isn’t capable of having its own in-house resources – delegates authority to an implemented consultant which is paid on success or judged by results. That implemented consultant then has no conflict of interest with the rest of the business. It’s that latter one which is hard. Take the example of Russell Investments, I knew Russell in the US when it was as conflicted as the current crop of UK consultants.
Today, it is a non-conflicted implemented consultancy business because that’s the most profitable part, it’s the most sensible part. They’ve eliminated those conflicts of interest. I hope that the UK consulting actuaries go down that route and end up with coherent implemented consulting businesses for medium-sized clients.
Brief: I think that’s an interesting business model because I wonder whether trustees’ willingness to tolerate underperformance for an implemented consultant would be any different from a fund manager’s.
It will be interesting to see if they’ve actually created a more profitable but far less stable business. Consultancy is a bit outrageous and they make a huge amount of money from running asset-liability swap overlays.
Dunscombe: As do investment banks.
Brief: I agree, but I’m not certain consultants are doing anything except ringing the investment bank swap departments and asking them to do the modelling.
Dunscombe: Or, indeed, thinking about the counterparty risk issues.
Brief: Correct. So I have grave doubts about that but it is the single most profitable activity in investment consulting, by a country mile.
Gillson: It’s usually a good rule that if it’s the most profitable product for your provider you should internalise it if you’ve got the size.
Brief: I think any corporate that has a decent treasurer should be capable of doing it, even if they don’t have an in-house investment department.
Dunscombe: It does also come back to us as clients to deal with consultants. I am aggressive, I speak my mind and argue over fees, and I think more people are doing that. I think as an industry we have been easy prey and too easily cajoled by counterparties who say, ‘No, this is the price, take it or leave it’, when in fact if more people said no, there would be more negotiation. We need to engender more negotiation with investment consultants and fund managers.
Gillson: We were talking earlier about how trustees should spend their time. We can agree that the last thing they should be doing is spending their time listening to salesmen from investment management houses, consulting actuaries or investment banks trying to persuade them to buy products.
Funds Europe: Can you explain more about the conflicts between implemented consulting and just consulting?
Gillson: It would be like a commercial fund manager allocating a new issue where there’s expected to be a reasonable profit to its favourite clients. There are rules against doing that, so we give fairness to all our client groups, there are no equivalents in the consulting market.
Dunscombe: But I think it is really interesting that they are effectively going against what they would have regarded as their target market, that is to say larger pension schemes, and it’s because implemented consulting fees are higher.
Gillson: It’s an understandable business decision, but it’s a clear conflict of interest that they should not have in their business. And they don’t declare it either.
Brief: In the middle part of this decade, actuarial consulting partners suddenly decided that they should be paid as well as investment managers. They got incredibly greedy and aggressive about fees, which I think is quite understandable. But they come up against a client base that is very sceptical of their added value, so I think it is a difficult ongoing relationship. Even apart from the conflict of interest, it is an uncomfortable one.
Funds Europe: What alternatives are there, particularly for medium-size and smaller schemes that cannot necessarily hire internal consultants?
Brief: If the trends that we are talking about continue, then the relationship between a pension fund and the consultancy industry will be the same as the relationship between an investment manager and investment bank.
Gillson: I agree. What I’d like to see in contrast is a good consultancy business operating independently, which is then offered and actively used by small and medium-sized pension schemes that can’t afford to have their own resources. This, to me, seems an intelligent and aligned relationship between investment consultants and clients.
Funds Europe: Can you say to what extent investment manager fees have impacted on the decision to move towards passive management?
Dunscombe: Deciding when to change strategy because of funding ratios is a current issue. My standard advice to any individual who comes to me and says, ‘Which fund managers do you recommend?’ is, ‘Do you think you have time and knowledge to be able to select fund managers who are going to provide above-average performance after their fees?’ And they look at me blankly because they have no idea that that’s the question. So my standard answer for a retail-type individual is, ‘Go passive if you can get low fees’, because a typical retail individual doesn’t have the skill to select top quartile managers.
If you can’t select top quartile managers at commercial fees, then there’s no point paying retail fees. The lower the costs of fund management the more sense it makes to be active.
So if you have an in-house team that costs you three or six basis points, that’s much the same as passive. But if you’re paying 50 to 70 basis points as an institutional fund manager or 150 to 200 basis points as a retail individual, it’s crazy. In general, we know that the after-cost performance of the top quartile fund manager is in the order of 50 to 100 basis points above the benchmark in the good times.
Brief: I always tell trustees that the institutional fund management business is designed purposefully to disappoint them because of the power of these numbers. If you look at a fund manager in the UK, it’s reasonable to expect, when you look at long-term performance, that a really good fund manager will do something like 70 basis points above the index. If you’re charging 50 basis point fees, who is going to employ you? So you have this conspiracy of people saying, “We will do at least 2% above the index, our process is designed to do it. And look! Over the last slightly dodgy period we’ve done it.’
The problem is a) the performance is very unlikely to persist and b) the only reason they’re saying 2% at all is because their fees make what they’re actually likely to achieve utterly unappealing to trustees. So immediately trustees are all sexed up to expect 2% and if they are blessed and get a perfectly respectable 0.75% they are monstrously disappointed at the result. There’s a sort of mad mindset in investment management where the managers are making claims they can’t deliver solely to charge fees that they cannot really justify.
Dunscombe: As we said earlier, if you look at the UK industry stats for pension schemes, the top decile outperformed by 0.5% per annum before costs.
Gillson: And the top decile costs will be more than 0.5%?
Brief: Yes, so you’re talking about an industry where performance targets are being driven by fiction. This is quite apart from whether you have the skills to identify managers. I know that it’s the thing I loathe most about this job, judging fund managers. They do irritating things – like you appoint them and they all leave, or you appoint them and after 20 years of fantastically consistent results, they underperform. Why bother? I’ve actually said this to trustees.
Dunscombe: Even for a fully active scheme in terms of the total investment risk, less than 20% of that risk will be active fund management and the other 80% is assets relative to liability. The danger is that trustees are spending 80% of their time on active management. So one of the risks of active fund management and selection is there is insufficient delegation by trustees and, therefore, they spend too much time on something that actually represents 20% of their fund.
Brief: With our low costs and the portfolios we’ve run in-house at fairly low risk, I think over the years we’ve added enough value for it to be worth it. We’ve become disillusioned that people can actually add sufficient value to justify the fees. There’s this strange dichotomy in some funds which have 40% index exposure, which is a statement that they don’t believe in manager skills, but then hold 10% in hedge funds. I question this asset allocation; you either believe in management skills or you don’t.
Gillson: Someone said that if a manager had a good track record they would become a hedge fund manager. I think that one of the problems in the long-only space is that the really talented managers now operate in the hedge fund space.
Brief: That is probably fair.
Gillson: We all believe in hedge funds as an opportunity set and it’s an even more difficult selection. In hedge funds you have two and a half thousand managers to choose from and the process of selection, whether you do it in-house or externally, is going to be expensive. So this level of expense versus benefit, they both go up.
Brief: I’ll give another example of that. We used to do our private equity through funds of hedge funds. It was building up and I was looking at the costs. I found it’s cheaper for us to have one person in-house doing some due diligence and working with a dedicated consultant who puts up the hedge funds. It’s a seven-figure saving.
Funds Europe: Which direction is your fund going and what are the challenges it faces?
Brief: Our fund is going to be around for another 70 years plus, we’re not going to see net cash outflows well into the 2020s. We have a long time to go, so I can only hope that the company continues to recognise the importance of investment and that we continue to have the good relationship with our investment committee that I’ve enjoyed. My advice for my successor is that you have one client and you must be dedicated to client service. The uniqueness of having worked as an in-house pension fund manager is your intimate relationship with the scheme, and through it with the 240,000 beneficiaries who depend on what we do.
Dunscombe: I’d just reiterate the point about dedicated resource to serve the trustee board. Every scheme should have an appropriate level of resource, which is theirs and theirs alone. It doesn’t need to be 80 people full-time, it could be part of one person. Also important is to keep focusing on low-cost effective solutions for pension schemes, the answer to which depends on the size of your scheme and the complication that you wish to be involved with. But simple, cheap solutions are often the right answer.
Gillson: I think the only thing I would do is endorse exactly what was said. I think it’s interesting that we focused these final comments on in-house resources because I spent 24 years in-house so that’s where my culture is. I’d endorse one additional point, about smaller funds being able to afford an internal resource. I think, culturally, we need to get that message across; it isn’t only the big funds that need that internal resource, you can justify it with a £300m scheme.
©2011 funds europe