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The trm Report - June 2006 The unintended consequences of introducing a marked to market accounting standard for pensions has been that market volatility has sometimes blurred long term investment decisions. The sharp fall in equity prices in 2000 and the ensuing bear market caused real concern for all investors – and particularly for pension funds. A greater focus on liability driven investment, as opposed to investment return, slowly appeared. The balancing of pension assets and liabilities has, in effect, been transformed into a ‘business’ of managing accounting surpluses or shortfalls. Switching from equities to bonds certainly helps balance the books, but the decision carries the risk of being too prescriptive and not considering the financial markets and their alignment with economic fundamentals. Balancing the books at today’s long dated yields crystallises accounting shortfalls in terms of burdensome costs for sponsoring employers and an almost inevitable reduction of pension benefits for employees. But, in doing so, trustees should be mindful of the global interest rate environment and the level of credit markets. The global economy over the past two years has registered its strongest growth for decades and it looks like it will continue this strength into 2006. Yet long term interest rates in the major bond markets have remained relatively low in both nominal and real terms. The US Federal Reserve has been raising interest rates for two years but long term interest rates are still low by historical standards. The increase in US short term interest rates should have increased risk in the form of higher volatility but levels remain low and credit spreads remain tight. At present the excess liquidity is most obvious in global bond prices because this is the major asset holding of governments. Other asset prices, such as property and equity, benefit as investors with broader portfolios shift out of expensive bonds into assets that are perceived to be less expensive. History shows that the end of liquidity fuelled asset price inflation is not caused either by a tightening of monetary policy or by a substantial loss in the financial system such as occurred in the Long Term Capital Management episode in the United States. Identifying this trigger is an important determinant of investment strategy in 2006. The bigger risk in 2006 to global liquidity is turbulence in the financial markets caused by an unexpected event in the credit markets. The reason is that the combination of low borrowing costs and low volatility induces investors to take on additional and excessive risk, knowingly or not, in order to try and boost investment returns in a low return environment. An understanding of the cause of the surge in liquidity and the likely trigger for its contraction is therefore very important and should not be underestimated by trustees when rebalancing the allocation of pension assets. The liability matching characteristics of bonds certainly provide a very compelling reason to switch out of equities, but should not be done so purely for accounting reasons. In exercising their powers of investment, trustees are increasingly required to perform in accordance with a seemingly endless steam of new management directives and policy guidelines. The consequent risk is that boards might be distracted from investment decisions at a critical time in the markets. Trustees should therefore ensure that they manage the investment risk by forging a closer working arrangement between board, consultant and investment manager. Oliver Boyle
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