Pension funds should ditch alpha and cut fees

If anyone has reason to pray that the current equity rally holds, it is the world’s active fund managers who need investors to return to the folly of betting on outperforming the markets rather than the uninspiring but reliable business of cutting costs.

Pension funds, particularly those where the employer bears most of the risk of making good on promised payouts, are hurting after more than a decade of poor market returns.

In Britain, for example, pension funds which promise to pay a fixed percentage of workers’ final salaries are woefully underfunded. If you use a more conservative government bond yield to value the funds, the top 200 firms in Britain needed a whopping £120bn to be considered fully funded, according to consultants Aon Corporation. This is not the result of some unforeseeable economic storm but instead the fruit of two related delusions; that a prudently managed portfolio can expect to get a return of eight percent a year or so over the long run, and that individual funds can maximise their returns by choosing the right active fund manager who will outperform even that optimistic benchmark.

And as is so often the case when we are kidding ourselves, these assumptions allowed employers and savers to avoid doing something unpleasant; in this case putting away the cash required to actually fund retirements. Workers felt as if they were “earning” more because their take home pay was larger than it would have been if they were saving sufficiently and businesses could often take contribution holidays or avoid chucking in extra to make good the shortfalls. Win-win, right?

Well, actually no. It was more lose-lose-win, with the two losers being the savers and employers, and the sole winner the financial services industry.

Now it is essentially impossible to know what rate of return capital in aggregate can demand over a long period, but given the way debt goosed the economy and asset markets, and given the way a long, and for investors benign, period of disinflation in the past 25 years affected returns, I’d be willing to bet that the eight percent benchmark will prove too high.

So that leaves the question of how pension funds and other retirement savers should best invest and on one point there seems little doubt: paying the extra for active fund management is not a good bet.

Active funds create drag on returns in a number of ways; the managers themselves must be paid, as must the investment banks and brokers who advise them and executive the trades they make in order to try to beat the market.

While it is always possible that market returns will more than make up for this, there is no doubt however about who bears whatever costs are generated.

Lots of data, little outperformance
Andrew Clare, Keith Cuthbertson and Dirt Nitzsche of London’s Cass Business School have published an analysis of decades of performance data for 734 British pooled pension funds with more than £400bn under management. As about 40 percent of UK institutional money is in pooled funds and there is data going back more than 20 years, this is a pretty fair sample.

The result, according to the authors, is that there is “little evidence” of positive performance persistence, i.e. that managers can outperform over time. Further, there is “virtually no evidence” that active fund mangers can time the market. For example, over a 20 year period ending in 2004, only three of 42 pooled funds showed statistically significant outperformance, while two showed statistically significant underperformance. All 42 did, however, charge statistically significant fees.

“With increasing numbers of UK fund mangers purporting to be able to provide ‘high alpha’ products to the UK’s beleaguered pensions industry, our results do not give us great confidence that the solution to the widespread deficits lies in the hands of the UK’s active institutional investment managers,” the authors wrote.

About 20 percent of the UK’s institutional money is now in passive strategies, with most of the growth happening in the past 10 years. The response of the fund management industry to this has been to offer ever more complex fund structures, often with more freedom to short stocks or employ leverage and almost always at a higher cost to the ultimate consumer.

Who knows, perhaps some of these will work. Perhaps all that was wrong with the old fashioned funds was that they couldn’t bet against things, or use borrowed money to amplify returns.

My guess however, is that the best solution is a simple one: go passive and cut fees. It is money in the bank, as it were, from day one.

Employers and employees have a common cause here and should not let an evanescent rally blind them to the steady bleed that fees represent.

Survey launched to shed light on responsible investment policies:
UKSIF, the sustainable investment and finance association, launched the 2009 “Responsible Business: Sustainable Pension” survey to help leading corporate pension funds learn more about best practice in Responsible Investment (RI) and so respond to today’s investment challenges. Pension funds are being invited to participate based on their plan sponsor’s reputation as a corporate responsibility leader.

The survey is being sent to the pensions managers of all UK listed companies in the prestigious FTSE4Good and Carbon Disclosure Leadership Indexes. Sponsored by leading investment managers Hermes Fund Managers and KBC Asset Management, this is the second bi-annual survey of the pension funds of companies highly regarded for their corporate responsibility. The survey was developed by independent pension fund industry leaders to give an RI framework specifically tailored to the needs of this group. The inaugural survey in 2007 found that nearly two thirds of funds gave “great” or “some” significance to alignment with their plan sponsor’s corporate social responsibility (CSR) and/or sustainability policy.

The 2009 results, to be published later in the year, will give a picture of developments since then. At that point, participants will be offered confidential feedback comparing their approach with the group as a whole. Michael Deakin, Chair of the UKSIF Sustainable Pensions Advisory Board said:

“We have designed this survey to provide trustees with a better understanding of Responsible Investment (RI) policies. This will offer the opportunity to address the challenges of long-term sustainability that many funds are facing.”

Steve Falci, Vice President – Sustainable Investment, KBC Asset Management Ltd said: “We are delighted to be involved with the UKSIF survey ‘Responsible Business: Sustainable Pensions’. Pension fund trustees are realising that ignoring sustainable development is not an option, a trend which is leading to growing interest in responsible investment. Also the link between sustainable investing and long term investment returns cannot be denied, these are strong sectors supported by strong long term drivers of secular growth.”

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Email James Saft at jsaft@reuters.com and find more columns at reuters.com/news/globalcoverage/columns