Not all brakes are the same

Many followers will be familiar with our analogy that brakes actually make you faster. The thinking goes that when you have brakes available to you then you drive faster for two reasons:

  • You have something at your disposal to slow you down if things go wrong;
  • And having this knowledge gives you the confidence to drive faster

We have been testing this with pension committee members for the last few years and we see this playing out in practice. The chart below shows an example of the average and range of lap times around Silverstone (*on a driving simulator) by some committees:

So how does this apply to pension schemes?  Protection strategies are often thought of as tools that slow you down (reduce return). However, if used properly protection strategies can actually add to performance – a simple example being that preserving capital in a falling market leads to outperformance.

I had an experience of this the other day which highlighted that it is not just about having protection; not all protection is the same – it’s the type of protection you have which really matters.

I was cycling from Paddington to the office when one of my brake cables snapped. I still had brakes, but only one of them functioning. I observed the following:

  • I cycled slower
  • I braked earlier as the brakes I did have were less effective
  • It took longer to get to work

The application to pension schemes is that not all protection strategies are the same. If you have the wrong protection strategy, your performance may suffer.

There are a couple of examples of this. Traditional “de-risking” involves the sale of equities and purchase of bonds. The challenge with this is that in the event of a market fall, whilst better than not de-risking, the scheme has probably suffered quite poor performance. For example, a scheme with 60% of assets in equity that “de-risks” 10% of that into bonds before a 20% market fall will fall 10% rather than 12% before the de-risk – the impact of what looks like a large change in asset allocation is minimal. Because of the bluntness of this tool, schemes may be more cautious than they would naturally want to be – for example, by having an even lower allocation to growth assets.

Alternatively, schemes recently have been looking at “equity protection” strategies (we call it Structured Equity). Such strategies use derivatives to provide contractual protection from market falls on equity exposure which is paid for by (for example) sacrificing returns that are not needed. This approach is far more focused than the blunt tool of moving from equities to bonds.

But the case here is the same, not all equity protection strategies are the same. Equity protection is not an off the shelf strategy. As with traditional de-risking, treating equity protection as a homogenous strategy is to use a blunt tool. The nature of this more focused approach is that it is tailored to the needs of each individual client; these change over time and with market conditions.

So, for pension schemes worrying about current market levels, putting on the brakes is an eminently sensible consideration in order to add to performance. But, not all brakes are the same – schemes should make sure that their protection strategy suits their needs and circumstances.


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