©Copyright 2001 Rogers Media. The following article first appeared in the December 2001 edition of BENEFITS CANADA magazine.

The hands-on approach

At the time, a significant number of sponsors, employees, consultants as well as investment experts believed that active managers could not reliably outperform the major market indexes. Some active managers even seemed to throw in the towel by making their portfolios more reflective of an index.

With this belief, it was only natural to question whether active managers were worth the investment. After all, managers who stuck to an index had far lower management fees, and they were performing better too.

An opportunity to lower plan expenses and improve results at the same time must have seemed too good to be true for plan trustees and fiduciaries. In fact, it was. It now appears that both aspects of the indexing decision are questionable.

Active managers, especially those who do not emulate the indexes, now show performance over both short- and long-term periods that is well ahead of the indexes. More importantly, this holds true over rolling time periods as well as those that ended recently. On a rolling 10-year basis, a number of managers have repeatedly outperformed the Toronto Stock Exchange 300 Total Return Index, after fees, and by margins as wide as 3.25% per annum or more.

The realization that active managers can indeed beat the indexes in a cost-effective manner is not good news for defined benefit (DB) plan sponsors that expected to reduce their expenses by indexing. By avoiding active investment decisions, these sponsors have let the market--bad investments as well as good ones--drive their returns lower than actuarial funding requirements (see "A cautionary tale," page 49).

For example, an indexed billion-dollar DB plan that had a comfortable $150-million surplus three years ago at the time of its last actuarial valuation is now facing an experience deficiency of $32 million. Amortizing this deficiency will cost the plan sponsor $8 million of corporate earnings or equity per year for the next five years.

The additional funding expense of $8 million a year dwarfs the $2 million reduction in investment management fees the plan sponsor achieved by indexing. As well, the $8 million has to be paid out of corporate earnings each year. There is no option to pay it out of the pension fund, as there was with management fees.

FIDUCIARY ISSUES
Corporate executives who sit on their companies' pension committees have multiple fiduciary responsibilities. As committee members, they must ensure the prudent operation of the pension fund. As corporate officers, they also owe a duty to their shareholders or owners. If a decision to index the pension fund adversely affects shareholders or owners to a significant degree, it is reasonable for these parties to question whether their interests were taken into account when executives chose to index.

It could also be argued that indexing was a speculative as opposed to prudent investment decision. There may well have been a rationale proposed for indexing. But in the end, plan fiduciaries have made a decision to invest in securities that have not passed any screens for suitability or prudence. Investments in the defunct mining company Bre-X are a good example.

The purpose of the pension fund is to meet the plan's liabilities. These are generally long term in nature. As we have seen, evidence that active managers can outperform the indexes over longer time periods--much shorter than the liabilities, to be sure--does exist. It has for some time. Consequently, we must ask if a decision to index took proper notice of the nature of the plan's liabilities, and whether the pension committee met its fiduciary obligations to the plan.

The answer to this question depends on the process by which the committee reached its decision to index. If the committee chose to index because its members did not want to miss out on the high returns that the indexes were offering, or for political reasons within the company, this would likely not have been a prudent decision.

On the other hand, if the committee decided to index after an extensive asset/liability study and careful consideration of the risks involved relative to the plan's risk tolerance, it probably did meet its fiduciary obligations. Prudent fiduciary conduct and making the best decisions are not necessarily the same thing.

LESSONS LEARNED
Here are four lessons that we can learn from the index bubble over the past few years.

1. Remember liabilities. The purpose of a pension fund is not to match the indexes--it is to cover the plan's liabilities so that pension benefits can be paid. The objectives for the fund should relate to the plan's needs, not the market's.

2. Models aren't reality. Many plan sponsors have attempted to take liabilities into account by conducting detailed asset/liability modeling. It is difficult to do this using actual investment managers on the asset side of the equation, so the models use indexes instead. Unfortunately, this can result in a desire to emulate the indexes in order to fit the model.

3. Use appropriate time frames. Does anyone remember day traders? In today's fast-paced world, it can be difficult to think about time frames as long as a year, let alone those over which pension liabilities evolve. Periods of 10 years or more are actually more appropriate for pension investment issues. Yet, how many pension committees use them? And how many will make mistakes by focusing on two- or three-year periods?

4. Don't let fees drive investment decisions. Fees should be reasonable. In fact, the numerous Pension Benefits Acts across Canada require this. Competition among investment managers is fierce, and fee schedules are available to all plan sponsors and consultants. Any manager whose fees are excessive will lose business.

At the same time, if someone offers you a better product at a lower price, be sure the product really is better at meeting your needs before being swayed by the lower price. This is as true for pension investment as it is for refrigerators. If investment decisions are driven by a desire to lower fees, the sponsor may prove to be penny wise but pound foolish. BC

Simon Segall is vice-president, marketing with Foyston, Gordon & Payne Inc. in Toronto. ssegall@foyston.com.