I had the idea for this post at the start of my holiday a couple of weeks ago – the week leading up to the referendum – so, given the events that unfolded following the June 23rd vote, this blog, inspired by the packing of a car, may seem a little inconsequential. However, I think there is an interesting parallel with the challenges pension schemes currently face.
Holidaying with two kids and the in-laws meant that I needed to rent a seven-seater vehicle from the car hire company on arrival at the airport (late at night with fractious kids). Once I collected the car I discovered the two extra seats were effectively in the boot of the car and therefore eliminated a large amount of boot space. Despite having packed relatively lightly I was sceptical but I set about loading the vehicle. My first attempt failed miserably – a fully loaded boot and still almost half of the luggage sitting on the pavement. So I tried again. And again. And again. To pack the car properly, I gradually discovered, required repeated trial and error because both the order in which I packed the bags, and the place I situated them, made a big difference to my success.
This got me thinking about pension schemes and the types of strategies that may be used to meet their objectives. My experience on holiday reminded me that some of these strategies have a similar “path dependency” – or, put more simply, the order of when things happen changes the outcome.
As an example, some strategies use the volatility of equities to mechanistically allocate between equities and cash, the idea being that when volatility is high the market is likely to fall and so it is better to be in cash and vice-versa. This week we are more or less at the same FTSE 100 level as we were prior to the referendum which means that a passive equity holding will have stood still over this period. The challenge with path-dependent strategies is that it is the route that the FTSE has taken that drives the performance over the period rather than simply the start and end points. So, in respect of the example strategy, it may not have come out of equities quickly enough to benefit from the shock following the referendum result, and neither gone back into equities to benefit from the subsequent market rally. Clearly this is a very short-term example (I need to get Brexit in somehow!) and the reality for pension funds is that they invest for the long-term.
Whilst there is nothing wrong with such strategies, I have written previously on how maturing pension schemes have different objectives and my colleague Jon Wilson has written on how schemes may not have the time to invest in the way they used to. To me, whilst there is inevitably a lot of merit and opportunity in path-dependent strategies, they also introduce uncertainty about a scheme’s future performance (as it is not simply the direction of the markets that matter but the path of those market movements) that some schemes simply cannot afford to take on. A mature scheme needs to be more certain of what market movements will determine whether they meet their objectives or not.
To put it another way, most schemes do not have the time to pack the boot of the car four times before finding the right solution.