Edition: March / May 2017

Through the info overload

Strategies of liability-driven investments (LDI) help trustees convert data into knowledge, explains Sanlam Investments LDI head Johan Kriek.

Valuation of a defined-benefit pension fund is complex. It is filled with assumptions, regulations, guidance notes and best practice. In this environment, despite the best efforts of the valuator, there is only one certainty: the answer is almost certainly going to be wrong.

Yet lay trustees are expected to make judgments about what level of pension increase the fundís pensioners should receive. They are expected to consider the complex interaction of often-competing objectives, primarily between the wellbeing of the fundís pensioners and the size of the permanently-increased liability burdening the fund sponsor.

This all takes place against a background of funding levels, risk reserves, investment returns, increased life expectancy, inflation expectations and ensuring inter-generational equity.

Pension Fund Act comes to the rescue

Fortunately the Pension Fund Act comes to the rescue at s4B. It requires that each fund establishes a pension-increase policy. It also requires that pension increases should be a percentage of the consumer price index (or an equivalent measure of price inflation) and asks that the frequency of pension increases be specified in this policy. There should be a maximum increase period of three years.

These increases are subject to a number of minima from solvency legislation, but then once again subject to the fund not becoming financially unsound. The stipulations do not apply when a policy is bought from a long-term insurer in line with the rules of the fund, or where pensioners elect to have a level pension or a pension with fixed increases.

A quick read of the Act, especially at s14B, clearly shows that the well-intended legislation unfortunately adds to the complexity and amount of information that need to be taken into account when determining the level of pension increase granted.

Faced with this level of information overload, it is not surprising that the majority of trustee boards have opted for a relatively simple pension-increase policy to meet the relevant requirements. Typically, increase policies specify pension increases at 75% of cpi while targeting 100% of cpi subject to affordability.

This partially explains the proliferation of Liability-Driven Investments (LDI) solutions delivering inflationary increases. They enable trustees to rest assured that they have delivered on their fiduciary duties by ensuring that the increases specified in the pension-increase policy are delivered.

But is this sufficient? Have trustees really met their obligations to pensioners and should they rest so easily? Could they, with the right tools distilling the myriad complex factors influencing the pension-increase decision into a manageable set, do better? We at Sanlam Investments certainly believe that doing better is possible.

It is widely accepted that despite short-term volatility, riskier assets would provide higher returns over the long term. Long-term investors, such as pension funds, would be better served -- in terms of reducing pension costs to the sponsor and higher-than-expected pension increases to pensioners Ė by having a significant exposure to such riskier asset classes.

Kriek . . . consider dynamic hedging

This is contrary to the trend of de-risking and locking-in of inflation-related increases that has been the cornerstone of the vast majority of LDI solutions implemented over the recent past. There have been a number of credible reasons given for the proliferation in these LDI strategies. But, on closer inspection, most originate from not having the correct tools in place to handle the informational and data complexities involved with running a defined-benefit pension fund effectively and efficiently.

Trustees not being sufficiently trained

And, with trustees not being sufficiently trained or equipped to handle the informational complexity, the default position has been to de-risk and make sure that what is delivered is in line with the minimum criteria set out in the pension-increase policy.

But what if, by using modern financial theory, the vast amount of factors influencing pension increases could be distilled into something tangible that allows trustees to make good quality decisions easily?

Would removing the complexity still lead to a situation where trustees de-risk and settle for the increases set out in the pension-increase policy? Or would they maintain exposure to risky assets having full confidence that they are able effectively to manage the financial wellbeing of the fund?

Would this not empower trustees truly to fulfill their fiduciary duty and do whatís best for pensioners and members? And this in a context where the impact on the fundís funding level and sponsorís financial statements can be assessed on an ongoing basis, ensuring that any balance sheet and income statement risk is managed appropriately?

Sure, it could be argued that the techniques used to distil the information are complicated. But this is not really what implementing these solutions is about. One doesnít have to understand fully how your smartphone is able to tell you exactly where you are and how it guides you, using the quickest route, to the correct destination.

In the same way, it is not about completely understanding the techniques used to distill the vast quantity of data and information. It is about having access to the information in an understandable manner that guides trustees and allows high-quality, value-adding decisions to be taken.

Dynamic hedging offers a great solution in that it gives trustees better, more concise information, taking all relevant factors objectively into account. By harnessing the power of modern financial mathematical techniques, one is able to make better sense of the information overload.

Solutions which embrace dynamic hedging empower trustees to make decisions that are in the best interests of pensioners and members. At the same time, they fully consider the financial impact on the sponsor and ensure intergenerational equity.