Automatically thinking about asset-only performance as a metric for assessing how well a scheme is doing seems fundamentally flawed, says Cardano's Emma Adair.

The overriding objective of a pension fund trustee is to make sure there are enough assets to meet the liabilities as they fall due – this is not news to anyone. If the assets are less than the liabilities the trustee needs to focus on how to close that gap. With this in mind I would argue that understanding the relationship between the progression of the assets and the liabilities is probably one of the most important parts of a trustee's job.

In every other field of business an organisation's goals help shape the key performance indicators (KPI) on which its performance is judged - but this is not how the pension fund industry seems to work. We use actuarial valuations and updates to help us understand what the picture looks like but the challenge for trustees is assessing what impact their decisions are actually having.

In the world of pensions when people think about their investments and what is working, most trustees will automatically think about asset-only performance. This seems fundamentally flawed as a metric for assessing how well a scheme is doing. It ignores the changes in value of the liabilities. The fact that for many schemes the liabilities are greater than the assets means that liability changes have a far more significant impact on the funding ratio than the assets on their own.

As an example, a one-year increase in assets of 20% might be considered good (if not very good) performance, when considered in isolation. But if liabilities went up by 25% over the same period (as they did for many schemes in 2011), then the fund is in a worse position. The overall performance is a bad result - the funding ratio has deteriorated. Conversely, an investment performance that is a loss of -5% can be good, if liabilities reduced by -10% over the same period – the funding ratio has improved.

What makes this even more relevant is that many of the factors that affect liabilities - such as inflation and interest rates - also affect the return on assets. Effective pension fund management is therefore about managing both assets and liabilities.

Using a 'liability benchmark' can be a really useful tool to help measure success or failure of decisions. By looking at the combined performance of the assets against a liability benchmark trustees can get a real sense of how the funding ratio is moving. In other words, this can help us measure whether the investment strategy is doing what we need it to do, that is help deliver a steady and stable growth in the funding ratio. Staying ahead of the liabilities by only a few percentage points each year (all other things being equal) means a steady reduction in the fund's shortfall and is totally aligned with the trustees' overall aims.

Using a liability benchmark has another key advantage. It allows trustees to help assess if their approach to managing their scheme is working. There has been a lot of debate in the industry about whether schemes should be using an advisory or fiduciary management approach to investing, whether fiduciary is a silver bullet or whether you can actually compare different fiduciary approaches. These are not easy questions to answer, but having clear goals and clear, relevant metrics are a first stage.

If your goal is to improve your funding ratio and reduce your deficit then the first question to answer is whether the approach you are adopting gives you a better chance of doing this. Does the approach to pension fund management you are using give you a better chance of getting your assets to outperform your liabilities in a controlled way? There is no reason why an advisor or fiduciary manager shouldn't be able to help you by answering this question.

Whether the answer for you is a liability benchmark or not, the message is simple: think more holistically and align your metrics with your goals.

Written by Emma Adair, client manager, Cardano

E.Adair@Cardano.com