Setting the Course
The content of this post was adapted from the Talk, “Setting the Course,” authored and narrated by Jon Lukomnik.
One of the most critical responsibilities of a pension fund trustee is to oversee the investment program. Most pension trustees are not experts and find themselves suddenly thrust into an unfamiliar, complex, uncertain, and chaotic environment. At the same time, they are entrusted with making investment decisions for huge amounts of money on behalf of beneficiaries whose financial futures could depend on those decisions.
To navigate a constantly shifting landscape of potential obstacles, trustees need to remember their one purpose, which is offsetting current and future pension obligations. To do that, they can employ three key tools: a statement of investment beliefs; an asset allocation study, or, even better, an asset liability study; and an investment policy statement.
Statement of Investment Beliefs
An investment belief statement helps trustees define and document what they collectively believe creates value and what creates risk. This document helps guide investment choices, helps trustees work through practical decisions, and helps trustees choose between different recommended courses of action. The statement serves as a North Star when risk, fleeting opportunities, conflicting time frames, the public environment and even differing opinions of experts can create complexity and uncertainty.
Asset Allocation Study
An asset allocation study is a report that determines an appropriate investment strategy in terms of what types of investments to make – how much in stocks, how much in bonds, etc. -- to balance an entity’s willingness to accept risk versus reward by adjusting the investment portfolio according to the investor’s risk tolerance, goals, liquidity needs, and investment timeframe. There are three important asset allocation assumptions to consider as part of an asset allocation study:
Expected return by asset class
Expected volatility by asset class
Expected correlations between asset classes
These underlying assumptions, which should be forward looking and calculated in excess of the risk-free rate of return, help inform the available investment choices. But, trustees can’t just accept the results of the study as if they were foreordained; trustees should understand and agree with those capital market assumptions, as well as grasp the methodology, and evaluate the efficacy of the study. And, perhaps the most important thing for trustees to remember is that, in the end, the goal is to pay pension benefits, not outperform other funds or benchmarks.
Asset Liability Study
It is crucial to appreciate the relationship between assets and liabilities. An asset liability study models how future payments move in relation to assets as well as how funding levels adjust under different circumstances. Some important considerations include whether interest rates are rising or falling; what if the economy goes into a period of inflation or deflation; projected changes in the number of beneficiaries and members, and other factors – all of which should sum up to a projection of what will be paid out in benefits and how much will come in through contributions.
Investment Policy Statement
An investment policy statement (IPS) describes how a system plans to run its investment program. A complete IPS should include policies and procedures, such as an overall fund return target, risk preferences, a rebalancing policy, manager selection guidelines, and brokerage guidelines. The IPS serves as a summary of these policies and procedures, which should each be fully outlined in separate documents.
The overall goal of a pension fund is to pay benefits to participants. To achieve this goal, trustees are expected to develop an investment strategy designed to achieve a long-term return. The role of the trustee also includes establishing policies and procedures, ensuring execution by management and investment professionals, providing staff with the tools they need, and confirming that reports from management are independently verified. It is not an easy job, and trustees come from a variety of backgrounds and levels of expertise. A successful trustee exhibits many important qualities, but perhaps the most critical attributes are the courage to ask questions and the tenacity to get answers.
The full Talk and the supplemental materials are available as part of the Asset Management Series of the Board Smart governance e-learning system. Click here to review the full curriculum. For more information about Board Smart subscriptions, please visit www.boardsmart.com or contact info@boardsmart.com to schedule a demo.