Information overload and pension increases: leading to sub-optimal outcomes?

How LDI strategies help trustees convert data into knowledge

By Johan Kriek, Head of LDI at Sanlam Investments

Valuing a defined benefit pension fund is a complex endeavour.  It is a world 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 always going to be wrong.  And it is in this context that lay-trustees are expected to make judgements about what level of pension increase pensioners should receive.  They are expected to consider the complex interaction of often competing objectives, primarily between the well-being of their 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 intergenerational equity.

Fortunately the Pension Fund Act comes to the rescue with Section 14B requiring that each fund establish a pension increase policy.  Furthermore it states that pension increases should be a percentage of the Consumer Price Index (or an equivalent measure of price inflation) and asking that the frequency of pension increases is specified in this policy, with a maximum increase period of three years.  These increases are subject to a number of minimums from solvency legislation, but then once again subject to the fund not becoming financially unsound and 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 and especially section 14B will clearly show that, with the best intentions, legislation unfortunately added to the complexity and amount of information that needs 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 that meets the relevant requirements.  Typically increase policies specify pension increases of 75% of CPI while targeting 100% of CPI, subject to affordability.  This, to some extent, explains the proliferation of LDI-solutions delivering inflationary increases with Trustees resting assured that they have delivered on their fiduciary duties by ensuring that the increases specified in the pension increase policy is delivered.

But is this doing enough? Have trustees really met their obligations to pensioners and should they rest so easily? Could they, with the right tools distilling the myriad of 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, like pension funds, would be better served (in terms of reducing pension costs to the sponsor and higher-than-expected pension increases to pensioners) to have a significant exposure to these riskier asset classes.  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 very 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 DB pension fund effectively and efficiently.  And, with trustees not being trained or well equipped with handling 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 to effectively manage the financial well-being of the fund.  Would this not empower Trustees to truly fulfill their fiduciary duty and do what is best for pensioners and members?  And this in a context where the impact on the fund’s funding level and sponsor’s 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 is complicated, but this is not really what implementing these solutions is about.  One doesn’t have to fully understand how your smart phone 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.

Where dynamic hedging offers a great solution is 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.  We truly believe that dynamic hedging solutions empower trustees to make decisions that are in the best interests of pensioners and members while fully considering the financial impact on the sponsor and ensuring intergenerational equity