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Is Pension Reform “All About the Economy, Stupid”?

Is Pension Reform “All About the Economy, Stupid”?

Martha Quinn

“It’s the economy, stupid” is a well known slogan used by Bill Clinton in his successful 1992 presidential campaign. Can a similar thing be said about the UK pension policy?
Even when markets were at their lowest, investment by UK pension schemes represented circa 71% of GDP.  Pension scheme funds are of fundamental importance to the UK and global economy. More assets under management means more market investment fuelling economic growth.

Increased savings for retirement is an attractive end in itself.  The bigger picture however, is the economy.  What UK government, irrespective of its political persuasion, could resist creating a massive pool of assets for future investment?
Defined benefit is still important, but in a new era of defined contribution domination, the challenge for the pension industry and the government is to ensure that the investment markets deliver.

Increased Governance

With the introduction of workplace pensions has come a raft of regulatory guidance and requirements aimed at driving good quality defined contribution schemes and good member outcomes.

A number of recently published papers suggest that good governance, aimed at maximising member outcomes, may be fundamentally flawed unless it encompasses effective investment performance monitoring. Investment returns are crucial to retirement savings. In a defined contribution environment, maximising investment returns should equate to a larger savings pot for the member.

Is Chasing Alpha Really Delivering Beta?

There are essentially two basic forms of asset management: passive management (where assets are invested in funds that simply track market indexes) and active management (where managers select investments to target returns that outperform a pre-determined benchmark (or produce alpha)).

Creating alpha sounds great, but it comes with a price tag. Active management is significantly more expensive than passive management. Actively managed investments are traded more frequently, incurring higher trading charges.
Some recent papers from leading academics and respected industry figures question whether active management delivers increased returns after costs have been taken into account.

Picking Winners?

“Picking winners? Investment consultants’ recommendations of fund managers” by Tim Jenkinson, Howard Jones, and Jose Vincente Martinez looked at investment consultants’ recommendations in US active equities.

They found that despite the fund manager’s selection being one of the most highly valued and highly influential services, there was no evidence that they delivered alpha.

Opportunity Knocks

Michael Johnson pulls absolutely no punches in his paper “The Local Government Pension Scheme: Opportunity Knocks”.  Describing the fund management business as a “web of meaningless terminology, pseudo science and sales patter,” he recommends all LGPS investment management be brought in-house, a fundamental shift from active to passive management and immediate disposal of all fund-of-fund holdings.

He concludes that the dominant contributor to total returns is the asset class mix, not individual stock selection and suggests that a significant number of active managers are actually “closet trackers”.

He recognises that there are a few active managers with good records of outperformance over a sustained period, but states that identifying them ex ante is a skill beyond almost everyone.  If this is the case, in reality what hope have the trustee boards or governance committees of pension schemes really got of identifying the few effective active managers amongst the many ineffective ones?

Concealed Costs

The Pension Institute has also waded into the debate, calling for asset managers to reveal the full cost of management to investors claiming that concealed costs can account for 85% of a fund’s total transaction fees.

Despite receiving approval from the Financial Reporting Council they say that proposals from the Investment Management Association to report pounds and pence management costs don’t go far enough adding that, without fully transparent disclosure, assessing the true value added by active managers is unquantifiable.

Cass Business School conclude that “hidden costs” can materially impact investor returns particularly when active management is used.

Is Effective Investment Monitoring Achievable?

Markets have changed dramatically over the last few decades. The activities of high frequency traders and the role they appear to play in how some markets structure charges is the stuff of legend.

How market smart can trustees/governance committees possibly be in monitoring investment performance without full cost disclosure? And how much resource is it sensible to throw at this to determine whether active management really is providing alpha and underperforming when compared with passive management?

Private sector pension schemes are a good deal for the government. To make them a good deal for their members, government needs to look at the entire investment industry to ensure that it really is serving the interests of its investors, pension schemes and their members. While George Osborne’s announcement of a Treasury, Bank of England and Financial Conduct Authority review of standards in fixed income, currency and commodity markets is to be welcomed, is it enough?

If it is not, the recent news that the London Pension Fund Authority has ditched a major hedge fund over lack of transparency could be the tip of a very large iceberg.

Martha Quinn

Jennifer Chambers
Senior Associate