Fundsmith Equity manager Terry Smith has urged pension funds to ditch gilts for equities, saying that their habit of marking their assets and liabilities to market on an annual basis has led to a focus on short-term thinking that is of benefit to no one.
Writing in the FT about the recent liquidity crisis in UK pension funds’ liability-driven investment (LDI) strategies, the manager recalled his own experience of working with these institutions.
He described one moment early in his career when he sat through a meeting where an actuary reviewed his bank’s pension fund.
“He would provide a range of forecasts for the longevity of its members, inflation and the long-term returns on its assets, which resulted in an estimate of the fund’s surplus – or deficit – of assets over future liabilities,” said Smith (pictured).
“I wondered then why the actuary was coming up with these estimates of future returns when he could simply look up the current price for the stocks and bonds.
“Some years later I felt like the young man who had thought his father was an idiot, but as he reached middle age discovered that his father seemed to have become smarter.”
Smith realised the actuary was looking at the fund as a long-term investment vehicle, as he should have been. However, he pointed out the accounting profession later decided that instead of relying solely on actuarial valuations, company pension funds should provide a “fair value” for their assets, estimating a deficit or surplus in their annual accounts.
“What could be more conservative than annually marking to market [adjusting the value of an asset based on current market conditions] your assets? Well, it depends why the assets are held,” the manager explained.
“Pension fund assets are there to fund payments over long periods, often decades into the future.
“The problem with showing an annual mark-to-market of assets and liabilities is that it brings short-term price volatility into the reckoning and may lead to poor decisions. Companies and pension fund trustees became obsessed with minimising this volatility.”
Smith said this was when investment consultants who advise pension funds “cooked up” the LDI concept, which involves estimating the future liability to pay out pensions by buying bonds or gilts to match those liabilities at maturity.
The manager described this approach as “flawed”, asking why anyone would invest in low-return assets such as gilts over the long term rather than those that should produce a higher return, such as equities.
“The answer lies in the willingness to swap a probably-better-but-uncertain outcome from equities for the certainty of the redemption yield of government bonds and a desire to avoid annual mark-to-market swings,” he said.
“There can be quite sharp adverse swings in equity prices, just as we have seen in bonds, as interest rates rise. Yet bonds at least have a redemption value many years hence when the pensions are due for payment.”
Smith said that, to compound this mistake, consultants advised the funds to add some leverage to achieve the liability matching if the fund had a deficit — which most had.
For example, if you had a fund with assets that were two-thirds of its estimated liabilities, say £64 for £100 of liabilities, then it didn’t have enough money to buy gilts to match its liabilities.
“However, it could do so with leverage, using the £64 to buy gilts as collateral to get a bank to buy another £36 to hold for it,” he explained. “Of course, this wasn’t called leverage but a derivative contract, which had the same effect.
“The addition of derivatives was the detonator for this explosive mixture of inappropriate accounting and a misguided investment strategy. As gilt prices fell last week, pension funds were faced with margin calls against those derivative contracts which could only be satisfied by selling some of their gilts. The price fell further, triggering more margin calls.”
While every wrong decision is easy to criticise with the benefit of hindsight, Smith pointed out he has experience of taking over a pension fund with a deficit and leaving it with a surplus.
The manager was chief executive of Collins Stewart in 2003 when it acquired what was then Tullett Liberty, now TP-ICAP. The interdealer broker came with a pension fund that had about £64 of assets for every £100 of estimated liabilities.
Smith said that he also faced the “siren call” of investment advisers who suggested liability-matching investments in bonds. Instead, the pension fund trustees fired the investment adviser and moved to a strategy of investing in just 20 high-quality equities.
“The adviser said it was ‘the most dangerous investment strategy he had ever seen a pension fund adopt’,” Smith recalled.
“The chair of the trustees memorably retorted: ‘In contrast to the strategy you are recommending, it is in danger of making money.’”
By the time Smith left Tullett Liberty a decade later, the pension fund had £132 of assets for every £100 of estimated liabilities.
He said this wasn’t just down to timing – he took over at the bottom of the 2003 bear market – but also because the fund took the right approach to volatility. For example, he pointed out equities fell sharply in the 2008 to 2009 financial crisis, and the trustees reacted “in exactly the right fashion – by ignoring it”.
Smith said the moral of the story is that any long-term investor – as any pension fund should be – that tries to eliminate price volatility from their portfolio will not only fail, but more importantly will end up focused on the wrong risk.
“Pension funds should get back to investing in assets with the likely greatest return over the long term – equities,” he said.
“Any annual deficit should be regarded as a contingent liability and trustees should regard consultants the same way that Tullett Prebon’s trustees did.”