19/06/06
Strategic Decision-Making
The world would be a boring place if we all agreed with each other all the time. But when it comes to operating effective governance structures, and being accountable for areas of responsibility, it helps if the parties involved are in agreement about who is responsible for what. For pension funds there are many areas where there is increasing agreement, but the identity of the rightful owner of the responsibility for making strategic investment decisions remains a debatable point.
Over the last few years those in the pension fund industry appear to have reached a consensus that the primary objective for a pension fund investment strategy is to enable the fund to meet its liabilities, both in the short and the long term. Similarly, there appears little debate that strategic investment decision-making, by which we mean the allocation of funds to assets in order to meet a liability-based objective, is one of the primary contributors to enabling a pension fund to do this. There is no corresponding consensus about who should be responsible for strategic investment decision-making. We believe that this responsibility should lie with those who have the appropriate skills and expertise to make these decisions on a regular and ongoing basis - the investment managers.
The investment manager cannot, however, fulfil this task in isolation. As a first step, a fund must decide whether it wishes to take any investment risk, and if so how much. The Trustees and sponsors of the pension fund must be clear about the fund objectives and how much risk can be taken in the investment strategy. For the sponsors this entails being comfortable with any potential additional contributions if investment risk is not rewarded as expected, or being comfortable with any additional contributions required if no significant investment risk is to be taken. For the Trustees this entails being fully aware of the possible implications of investment risk being taken within the fund and what courses of action are open to them if investment risk is not rewarded as expected.
Providing assistance to the Trustees and the sponsors in being comfortable with these areas and deciding on an appropriate liability benchmark and risk budget is a key role for the investment consultants. Based on these decisions, it then falls to the investment consultant to help the Trustees decide what sort of overall investment strategy to pursue and which investment manager to appoint. For instance, if the fund is only taking a small amount of investment risk and is well funded, the investment consultant might discuss with them the suitability of a 'bond and swap' investment strategy. The investment consultant would also explore whether a pooled or segregated solution might be most appropriate for the fund. Following on from that, the investment consultant would select a short-list of investment managers specialising in the appropriate areas from which the Trustees could select their preferred manager.
Where the fund has decided to take investment risk, it is sensible for responsibility for taking that investment risk to sit with those who are best placed to understand and manage it. This means someone who is an investment expert and is responsible for making investment decisions on a daily basis. Investment decisions are best made by those with a mindset that enables them to make decisions quickly and sometimes on the basis of incomplete information. Waiting for too much confirmation of an investment stance can mean that the opportunity has evaporated by the time the decision to invest is taken. These qualities lend themselves well for making investment decisions, but not for other key roles such as deciding on or advising on the appropriate risk budget. It makes sense to separate the roles that require different skills and allocate them to those parties with the necessary skills.
Holding investment managers accountable for strategic investment risk squarely aligns their interests with those of the pension fund. The single largest business risk run by the investment manager is that his investment decisions fail to meet the objectives of his clients and it therefore clearly serves the investment manager's purposes to construct a strategy that best meets the objectives. However, the fear of losing the mandate can be softened by designing a highly tailored investment portfolio which would prove costly to unwind or transfer to another investment manager. For this reason funds should ensure that managers to whom they are delegating strategic investment decision-making make use of liquid, cost-effective instruments to implement these decisions. This is a further area of investigation in which the investment consultants can be of help to the Trustees.
Successful strategic investment decision-making is a critical part of enabling a pension fund to meet its liabilities. Investment managers are best suited for that role. But this is only one piece of the jigsaw. The success of the investment strategy in meeting the fund objectives is equally reliant on the clear expression of those objectives as on the actual investment decisions made.
Sarah Smart, Investment Director Strategic Solutions, Standard Life Investments
First published in European Pension & Investment News on 19 June 2006
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
The Standard Life Investments group includes Standard Life Investments (Mutual Funds) Limited, SLTM Limited, Standard Life Investments (Corporate Funds) Limited and SL Capital Partners LLP. Standard Life Investments Limited acts as Investment Manager for Standard Life Assurance Limited and Standard Life Pension Funds Limited.
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