Institutional investors need to alter their thinking when it comes to investment management in the lower-for-longer interest rate and returns environment.
Delegates at the Pensions and Lifetime Savings Association's annual investment conference, held in Edinburgh March 8-10, were challenged by academics, politicians, money management and pension fund executives, to check and amend their existing assumptions about the industry if they are to continue to meet the outcomes needed by their plans' participants and clients.
“Often the unexpected happens, but if you can get on top of that and prepare for it, that is better,” said Ed Balls, former shadow Chancellor of the Exchequer and chief economic adviser to the U.K. Treasury, opening the conference. “But of course, you can only do that if you have gone through the process of asking yourself: What are the assumptions which are actually underpinning our decision-making so that we can challenge them.”
While the official theme running through the conference was diversity, a key takeaway was the urgency to challenge assumptions. Mr. Balls said there are a number of reasons things go wrong in politics and government — and that might also resonate with conference delegates.
Some mistakes, he said, will be “right there in front of you, but you just didn't see it … The worst mistakes are the ones you see, but you do it anyway,” citing the abolition of a 10-pence tax category in the U.K. “It was there, and you could see the distribution of consequence,” but it was done anyway.
Then there are the mistakes where the forecast is wrong. “If we had known in 2004 there would be migration from East European countries on the scale that we subsequently saw,” there would have been transitional controls on European Union migration in place, Mr. Balls said. “But we just didn't see it. The forecast was wrong, nobody saw it, inside or outside of government.
“And there's also mistakes which you make despite your very best efforts.”
On the investment side, Saker Nusseibeh, CEO at the £28.5 billion ($35 billion) Hermes Investment Management, used his time speaking on a panel focused on “Facing the Headwinds: Investors and the Economic Outlook” to step back from what's happening today, and challenge the assumptions behind investing for a pension fund over a 30- to 40-year horizon.
“The key is … most of the ways in which, as pension schemes and pension plans, we invest have at the root an acceptance of the way the economics of the world, and particularly the markets and asset classes of the world, work. That is at the basis of what we do. So there is an assumption that there is a natural rate we can get over the long term. There are dips in cycles and there are peaks — but over the long term we can expect to make a return of a certain number,” in the region of 6% to 8% per year.
However, he said, people are considering the current period as a dip in the cycle. “We look at the markets … and we think it's going to get better. What if it isn't? Why should it be? Because the fact is, we are still suffering from the results of the '08 crash – that is the reality.” The economic slowdown and “mountain of debt” have resulted in “incredibly low monetary policy,” leading to asset returns correlating with yields. “Is this last eight years an anomaly, or actually have we had a step change where we are, for the foreseeable future, in a permanently low interest rate environment?” Mr. Nusseibeh asked.
He cited analysis showing returns from any mix of asset classes will not yield more than 2%, at best 3%.
Importance of fees
With a change in assumption on returns will come the need for a rethink on the importance of fees. “Because fees become a larger proportion of wasted return the lower the long-term returns are. When you have returns of 10%, having fees of 40 basis points is small. But when you have returns of 2%, having fees of 40 basis points is huge. So you have the rethink the relationship between you and the asset managers, because fees become very important vs. what you can get, and think very hard about what it is you are buying,” said Mr. Nusseibeh.
He also talked about the need to recognize that those aged 55 and younger have lived “in a remarkably stable world. By and large as far as our investment is concerned, it has been stable.”
But the takeaway from the U.K.'s vote to leave the EU, the election of Donald Trump as president of the U.S., “and from what might happen in France” as right-wing candidate in the elections Marine Le Pen looks evermore popular in the polls, “is that this age of stability is over. And if this age of stability is over and you have 2% to 3% returns no matter how you mix your asset class allocation, then how do you get a better return over the long term?” asked Mr. Nusseibeh.
Speaking on the same panel, Ciaran Barr, London-based investment director at RPMI Railpen, which runs the assets of the £25 billion Railways Pension Scheme, London, had the task of outlining a number of investment options for asset owners once they have accepted they are in a lower-for-longer environment.
“What do you do? The first thing is panic, because your business is predicated on really good real returns. But after that, you have to think long and hard about what levers do I have? I can't control what the equity market beta is going to be.”
However, Mr. Barr said investors can try to get better beta from the market — so-called smart beta, a phrase executives at RPMI won't use because it “implies there is dumb beta out there, and you don't know for 10 years which one you've got.” Mr. Barr instead said “alternative risk premia” do present opportunities, but only as part of the solution.
Identifying and buying companies that “are going to be sustainable and well governed in the long run” is another option to “sweeten what the market gives you,” because well-governed companies “do better on average” than the universe, he said.
Maxing out the liquidity budget is something Mr. Barr thinks investors should do, “if you believe in the illiquidity risk premium,” but warned that does not mean investors should throw money at private equity and other asset classes.
Improving internal governance is important.
“You need a really flexible governance structure because what you don't want is to be in a situation where the markets offer you very good returns, because markets have fallen so assets are cheap, and you can't do anything,” he said, because an investment committee meeting is not due for months or consultants need to be in the room. “So you need to ex ante times like this when things are good, overhaul your governance structure so that it's flexible, so you can lean against the wind when markets are doing well, and take opportunities when things aren't doing well,” said Mr. Barr.
He reiterated Mr. Nusseibeh's point on fees, and said: “Costs in the investment industry are simply too high, full stop. They have been far too high forever; they are still far too high. Things are improving but at a glacial pace,” and “people are rewarded for market beta and not skill.” Mr. Barr said an obsession remains for the “Keynesian beauty parade,” although genuine skill should be recognized and paid for.
Mr. Barr's made two points. First, get contributions high early on — “particularly as we move into a world away from DB and into DC, getting those contribution rates as high as possible is vital,” he said, adding there is more to be done through government action, by the PLSA itself and through financial education. Second, he challenged investors to “move away from the orthodoxy — you don't have to go and buy lots and lots of bonds at a negative real interest rate just because that's what's always been done,” he said. “You do have flexibility over how you fund pension funds.”
At the end of the day, he said, quoting economist John Kenneth Galbraith, “In economics, the majority is always wrong.”
Paulina Pielichata contributed to this story.