Trustee Guide Part III - How Performance Is Calculated
This is the third in a series of short notes that explain how the IC Select Fiduciary Performance Management (FM) Standard works and how trustees can benefit from the information. This note explains why return relative to liabilities was chosen as the performance basis for the fiduciary manager performance standard.
It was essential that the performance measurement methodology used for the standard had two key attributes. Firstly, it had to measure performance according to what is most important to trustees and, secondly, the results for each fund had to be capable of being combined together into groups of funds, to give an overall impression of how the fiduciary manager was doing, and to avoid cherry picking by managers of the best track record.
All trustees will have as the primary objective paying the pensions of the members. Of course, many things will contribute to this including contributions and liability management exercises. However, in investment terms, the key element will come from the extent to which the assets, net of all costs out-perform the liabilities. If the assets out-perform the liabilities, then this will contribute positively to the funding position and vice-versa.
Whilst performance relative to liabilities net of all costs met the first criteria, it was initially unclear how this measure could be used to group funds together. As the liabilities are different for every pension scheme, with some having longer durations and others comparatively short time horizons, the relative returns of the assets to the liabilities will be impacted by the maturity of the scheme.
For example, consider two pension schemes both with 80% of the liabilities hedged and the assets invested in an identical manner, one scheme has a long liability duration, of say 20 years, and the other a shorter liability duration of 10 years. When interest rates fall, causing the value of liabilities to increase, the scheme with the longer duration will see its liability value increase by more than the scheme with shorter duration liabilities. Consequently, even though both schemes have identical investments, the relative performance of the scheme with shorter duration would be better. In the event of interest rates rising, the longer duration scheme would outperform.
With every pension scheme having a different duration for liabilities this appeared to make it impossible to combine schemes together as, irrespective of the skill of the fiduciary manager, track records would be dependent on the liabilities of the scheme and not just the decisions of the fiduciary manager.
The solution lay in the investment tools available to fiduciary managers. As a fiduciary manager with full discretion can, if they choose, hedge 100% of the interest rate and inflation risk, this effectively converts the liability benchmark to cash. Any decision then by the fiduciary manager to hedge less than 100% of the liabilities can be viewed as an active decision by the fiduciary manager, in other words to deliberately expose the scheme to interest rate risk to exploit an interest rate view. The only difference then between the relative performance of schemes where the fiduciary manager has full discretion will be the return objective the trustees have asked the fiduciary manager to achieve.
Consequently, if the fiduciary manager has full discretion, then schemes can be grouped together in composites with each composite comprised of funds with similar return objectives, for example liabilities plus 2%. The average performance of each composite would then reflect the fiduciary managers historic track record for that return objective. This avoids cherry picking performance track records by the fiduciary manager when presenting their performance to prospective clients.