In the period of 2003 to mid-2007, the investment world was relatively benign. Aside from investigations on backdating of options and a few minor scandals, we did not see the types of egregious behavior that tainted boardrooms and executive suites in 2001 and 2002. Certainly some credit is due to the legislative actions and increased scrutiny by both management and directors. However, some credit is also due to the strong performance of the Federal Reserve in managing growth and inflation, and availability of plentiful liquidity from investors. There just hadn’t been the high profile bankruptcies or major market disruptions that cause markets to re-price risk. Until late 2007, the sharp rise in commodity prices, excesses in the sub-prime mortgage markets and the war in Iraq didn’t bother the investment markets. At the same time, there were record sums of money committed to private equity, hedge funds and mortgage borrowers, along with increased reliance on a variety of complex, derivative-based transactions. Risk was added to portfolios right and left, all in search of continued high returns. In late 2007, risk came home! Where does this leave the typical director?
Directors of institutions and those who have responsibility for the oversight of their company’s pension plans – be they Defined Benefit or Defined Contribution – have been faced with an interesting dilemma. Financial markets have performed remarkably well, achieving an unusual feat in 2006 where virtually every market finished the year with gains. No doubt most directors were looking at rosy performance reports and feeling very good about the returns of their company’s portfolios. But, what types of issues were waiting to emerge in this environment? What were the right questions to ask to anticipate heavier seas? Where does one turn for direction? These are the issues we will touch on in this article.
1. Review Investment Policy
Key concerns may come from a variety of factors, the majority of which were not widely anticipated. These may include currency dislocations, commodity shortages and price inflation, reductions in demand that put companies or industries into liquidity crisis, and the list goes on. The best way to protect against any of these disruptions is with a well-constructed investment policy, which clearly looks beyond the current market environment and considers the long-term risks and opportunities from many asset classes. The investment policy should also address the appropriate objectives of the entity, define risk and establish risk targets or a risk budget and deal with diversification of nonsystematic risk. Those include diversification by asset type, industry, and credit level exposure. This policy is within the purview of the board and should be reviewed – although not necessarily changed - at least annually. A well-constructed investment policy will specify frequency and minimum content of investment reporting, including performance relative to appropriate benchmarks, compliance with policy and identification of any violations. A few additional questions you should be asking might include the following:
- What are the biggest risks in the portfolios and how do they affect the achievement of the objective?
- Are asset class target allocations and “normal ranges” still appropriate in light of future financial market return and risk expectations and recent changes to our liabilities?
Many of the issues within the investment policy are technical in nature and are probably best dealt within a committee of the board. Typically the investment, finance or audit committee will be most appropriate, wherever risk is reviewed at the board level. It is in these committees where the expertise is typically resident to ask the tough questions about past performance and risk profiles. [Note: Most large companies have a risk committee staffed by management that looks at a wide variety of business risks, assessing each in the proper business context. In some other companies, it is the pension committee that looks at these risks in an asset/liability context.] This is an essential activity that requires specific knowledge and background in a number of areas, including accounting, finance and investment. Reliance on outside experts can also be an important part of managing these issues, not just in the vacuum of a particular company, but to gain perspective of an industry or even a broader market context.
2. Assess Return Assumptions and Diversification Adequacy in Pensions
A few short years ago, the nation’s corporate pension plans were in a tight spot. Funding ratios were under 90 percent, return assumptions were being challenged as too high and concerns of rising contributions into DB plans presented increased risk to earnings. On the Defined Contribution side, many plans seemed to offer limited choice to employees or an overwhelming number of options that overlapped.
After several years of robust economic growth and financial markets, funding ratios have improved and are thought to exceed 100 percent currently. Earnings have maintained double-digit growth but show signs of slowing, held back by several years of rising interest rates, oil prices, and shocks in some sectors of the US economy such as housing.
Possibly slowing earnings after strong market performance should lead directors to reassess certain key assumptions underlying their pension plans and a nearly fully funded plan is the easiest time in which to ask some of these questions:
- Are the discount rates used in pension plans still appropriate given financial market developments?
- How is your investment team revising financial market return, risk and asset correlation expectations to reflect recent financial market performance and currency shifts?
- Do you feel that the asset class choices provided to your Defined Contribution investors gives them the full range of return, risk and diversification options that they are likely to seek, are understandable to employees and appropriately diversifies their risk?
Recommendations from management and staff are the appropriate first step in engaging in this discussion. Having said that, it is important to understand how other organizations of similar size, experience and complexity are dealing with the same issues. The board, or the appropriate committee may decide it will best meet its fiduciary duty by seeking an additional, independent insight or expertise not resident within the board or elsewhere at the firm for a view that is uniquely responsible to the board or the relevant committee.