What The Term ‘Pension De-Risking’ Really Means

By HighView Financial on March 26, 2012

KNOW YOUR CLIENT:

One of the basic tenets of individuals & firms who are registered with Canadian securities firms, such as broker-dealers and portfolio managers, is what is referred to as “Know Your Client“.

KYC, as it’s commonly known, requires securities registrants to ensure that investment recommendations are ‘suitable’ for each client given key client attributes such as their investment objectives, risk tolerances and other factors that can affect suitability such as time horizon of investing.

WHO IS REQUIRED TO FOLLOW KYC:

KYC is a key element that all compliance departments of registered securities firms monitor extremely closely as violations of clients’ KYC profiles can result in client litigation and regulatory penalties.  The classic KYC Horror Show is a scenario in which an investor whose KYC is focused on the preservation of capital and they are placed into a portfolio of aggressive growth investments that decline materially in value and create serious losses for the client.  Although the reality in Canada is that KYC requirements are a very basic set of standards for registered securities firms (such as broker-dealers and portfolio managers) to ascertain, these rules don’t apply to firms and individuals that are not captured by securities legislation such as asset consultants & investment manager search firms.

Specifically, in Canada, in order to be captured by securities regulations, firms and individuals must generally be involved in one of two activities related to individual securities (ie: stocks, bonds, mutual funds, etc.):

1. Advice of individual securities

2. Trading in indivdual securities

Advice related to the search, selection, due diligence & recommendations of money managers and asset allocation is currently not considered a ‘securities registerable activity’.  As a result, unlike securities registrants (ie: broker-dealers, portfolio managers) who are required by law to meet stringent educational and experience standards, no such standards exist for asset consultants and investment manager search firms.  For this reason, they are not held accountable – at least according to securities law – to KYC requirements.

WHAT DOES PENSION DE-RISKING REALLY MEAN?

This unfortunate reality of KYC rules not being applicable for non-registered roles such as asset consultants & money manager search firms is fully evident given the current term ‘Pension De-Risking’.  Having been in the investment management business for over twenty-years in registered capacities with both broker-dealers and portfolio managers, I view this term as ‘Consultant Speak for a KYC Breach’. Or, another way to define Pension De-Risking is:

“We screwed-up!  I know the advice that we provided to you for the past twenty years was more aggressive than what you could really tolerate, so we now need to De-Risk your portfolio and bring it back to where it should have been in the first place.”

Given that asset consultants and manager search firms are generally not registered with securities regulators, they are not held accountable – at least under securities law – for such KYC breaches.  Clearly, not a good deal for pension sponsors & their members.

WHAT CAUSED THIS MESS?

As we described in a recent HighView article, for the past thirty years, consultants to the pension industry have been advocating equity-biased portfolio structures — also know as the standard ‘60/40 Portfolio Structure‘ — ie: 60% Equity/40% Fixed Income.  In our view, it’s a ‘Cookie-Cutter’ standard that was adopted based upon some set of mathematical theories that looked great on paper but in reality had nothing to do with an individual Plan’s needs and tolerances for risk.

As a result, this simplistically, misguided view during this time period also held that a pension plan and its sponsor have an infinite time horizon and thus could accept short term fluctuations in equity returns in exchange for a long-term equity risk premium.  As a result, pension plans have generally been provided with the wrong portfolio advice for twenty+ years as they’ve been provided with portfolio structures that were far more aggressive than what they should have ideally had.

A recent article in Benefits Canada highlights the facts that in the UK – where pension de-risking has been happening for over ten+ years – the average equity asset allocation has become materially more conservative, having declined from 70% in 1999 to 42% as of 2011.

SO WHERE DO WE GO FROM HERE?

I believe that there are two broad implications (call them predictions) for the pension & institutional client segment (including foundations & endowments) given the investment chaos of the past decade:

1. Consultants Will Continue To Cover-Up Their Mistakes With Investment Jargon:

It’s often said that there is ‘nothing new under the sun’ — the same applies to portfolio management. Fancy terms like De-Risking will continue to emerge, as well as the allegedly new concept of LDI – Liability Driven Investing – which is another Consultant Speak term for the way portfolios of many clients with large pools of capital used to be managed 40 years ago before the global investment community became obsessed with chasing relative returns;  it’s called, ‘Goals-Based Investing’….or…..managing your assets to match your liabilities.  Our view is that had plans been following these basic principles over the past twenty+ years, there would be far fewer pension casualties in today’s marketplace.

2. Canadian Securities Regulators Will Begin To Examine The Advice Activities of Consultants:

In a portfolio of diversified securities, the impact of policy decisions – such as asset allocation (ie: stocks vs bonds) and investment manager selection – are FAR GREATER than the contribution of any one security to a client portfolio.  As a result, the notion that securities registration should only apply at the individual security level is incredibly outdated and in dire need of change by securities regulators.  In my view, advice related to all levels of client portfolios (ie: asset allocation –> manager selection –> security selection) should be registerable activities under securities law.  This would ‘level the playing field’ amongst all portfolio advice providers, raise the standards for those providing asset allocation & investment manager search services and increase their accountability and legal liabilities to their clients.

As I’ve learned over the past twenty years in the investment business….nothing sharpens your attention to providing the right client advice and attention to the details as when you and your firm have real regulatory liability!