The above quote is often attributed to Sun Tzu of Art of War fame, though it never appears in any print translations. It is however a mantra that has been well held by UK pension schemes in designing their investment portfolios. The traditional approach of designing a fixed strategic asset allocation and then allowing discretion to apply tactical or active positions to that asset allocation was a common approach.The quote remains instructive. However, we need to remove the disaggregation of the activities. A strategy is a necessity. A fixed strategic asset allocation has passed its sell by date. the investment portfolio needs to be adaptive and far more nimble. For most schemes, there is insufficient time to set a long-term strategy and hope that the hare will fall asleep.
Changing legislation, scheme circumstances and corporate needs have rendered the set and forget strategy worthless. Similarly, schemes can ill afford the cost and distraction of reacting to every bit of noise in the markets. The answer is a plan that is applicable to multiple time horizons (the annual reporting frequency, the triennial valuation frequency, the deficit recovery period, and the life of the fund). Additionally, the plan needs to be fully adaptive to the market environment and changing scheme circumstances.
When viewed through a liability relative lense, the portfolio should not expose the scheme unnecessarily to the impact of changes in interest rates and inflation. Similarly, when analysing the portfolio for sources of return above the growth in liabilities, there should be sufficient diversification and access to complementary strategies to achieve the objectives with an acceptable level of risk relative to the liabilities.
Prior consideration should of course be given to how the portfolio might be changed in light of changing circumstances (for example improvements in the funding ratio) and these should be documented. However changes to the portfolio that are responses to market conditions or expectations of future market returns (eg equity valuations or levels of interest rates) should be managed on a continuous basis. The latter are not simply ‘tactical views’, they need to be considered across all the time horizons that are important to the scheme.
Managing any investment portfolio is all about making the right decision at the right time. Sometimes those decisions are expected to pay off over short time horizons. With these, it is easier to observe, review and alter course. Sometimes, those decisions are rewarded or otherwise over much longer periods.
In the world of DB pension investment strategies, the long term nature of some of the decisions can be compounded by inheriting other people's decisions. New trustees and finance directors inevitably inherent the decisions of their predecessors.
Many trustees and finance directors are today grappling with the challenge resulted from the unhedged interest rate and inflation exposure of their liabilities. With the benefit of hindsight, they should have closed those risks out many years ago.
Unfortunately time travel is not an option. Bemoaning a decision not to hedge (or more likely no decision to hedge) in the past is unhelpful today. Similarly pointing to the benefit that a hedge would have had doesn't help. You can't buy past performance and you can't extrapolate the past into the future either.
I was asked recently whether now was a good time to start a LDI programme given the low level of interest rates. I replied, “absolutely”. We all know rates are low and the market expects them to increase (somewhat, at some time) but they are likely to stay low for some time. There are risks that rates could fall further hitting pension scheme solvency further.
Now it may be that the hedge is introduced progressively and opportunistically, but the strategy needs to be considered and the plan developed in advance. The interest rate and inflation sensitivity of the liabilties is often the biggest single risk for a scheme. Even if you are really, really confident that rates are going to rise by more than the market is pricing in, do you want to continue to bet the farm?
Last month, we had Mark Carney, the Governor of the Bank of England designate discussing the merits of nominal GDP targeting, alongside greater inflation targeting flexibility and forward rate guidance. The text of his Guidance speech to the CFA Society Toronto is an interesting read. Despite his remarks that they did not contain any direct signals about policy in Canada or elsewhere, it’s pretty clear that it will not be more of the same at the Bank of England after he assumes the position on 1 July 2013. At a CBI dinner in Belfast on Tuesday, Mervyn King responded arguing that the Bank of England’s inflation-targeting remit may need to be fine-tuned but should not undergo fundamental change.
The inflation target and monetary policy mandate is set by the Treasury, not by the Bank of England, so the remit is not really theirs to decide. This is set each March on the day of the budget, with any change needing to come from the Chancellor.
It is interesting to trace each man’s own inflation experience. King celebrated his 18th birthday on 30 March 1966. Carney celebrated his 18th birthday on 16 March 1983.
Over their adult life, Carney has seen domestic inflation grow at a rate of 2.6% per annum. By contrast, King has experienced inflation of 6.2% per annum.
Comparison of UK and Canadian Inflation
Indices are rebased to 100 in the month of each individual’s 18th Birthday, March 1966 for King, March 1983 for Carney.
Source: Bloomberg, as at 31 December 2012.
Now of course, Carney hasn’t lived his whole life in Canada and neither individual is conditioned solely by their domestic experience but it may go some way to explaining a different attitude.
The challenge remains for policy makers to walk the tightrope of stimulating economic growth and keeping inflation in check. The expectation is for inflation to remain above target for 2013 and the challenge is set for Carney as he assumes the role in July.