Pension funds don't deserve our money

The so-called experts reckon we're not saving enough for our retirement. This claim has the same credibility and motivation as Fred Elliott's belief that we're not eating enough meat.

If you want to know why we're not saving enough, just look at the latest numbers from performance consultants Russell Mellon Caps. They show that pension funds don't deserve to manage our money.

They show that, in the last 10 years, actively managed UK equity funds have consistently under-performed the market. That means managers' arrogance and incompetence has probably cost investors more than £10 billion*.

Also, funds' asset allocation is just silly. 'Balanced' funds now have 30.8 per cent of their assets in overseas stocks - a record high. This is despite the fact that the major global markets are increasingly correlated and so are poor ways of diversifying UK equity risk; at 52.4 per cent of holdings, these remain funds' biggest asset.

What's more, there's a whiff of bandwagon-hopping about this investment. Funds have switched into Japanese stocks this year. They might be right. But the best time to have done this was last spring, before the market rose 50 per cent. But of course, there was no such major shift.

Most scandalous of all is the fact that 'balanced' funds have over 83 per cent of their assets in equities. This is as balanced as Heather Mills on a highwire in a strong wind. It is twice as much as a sensible asset allocation rule would recommend putting into stocks**. Only absurd optimism about equities could justify this.

That said, there are oases of excellence in the pension fund industry. Managers of UK small cap stocks in particular seem to have earned their corn.

But the bottom line is simple. If pension funds want our cash, they should show that they can manage it well. So far, they haven't done this. Until they do so, SIPPs or unit-linked pensions - where we have some control over our money - are the best options.

* I calculate this as follows. Official figures show that pension funds had £251.1 billion in UK shares at the end of 1993. Caps figures show that the index has returned 6.9 per cent a year in the last 10 years. So this money should have grown to £489.4bn. But Caps also calculate that active managers have made only 6.7 per cent a year. So the £251.1bn has in fact grown to only £480.3bn. This is a shortfall of £9.1bn.

This calculation overstates funds' losses to the extent that some of the £251.1bn was passively managed anyway. But it understates the losses to the extent that it ignores the fact that new money - that invested in pensions after 1993 - was invested actively. I reckon the understatement is greater than the overstatement - hence my claim of “more than £10bn.”

** The rule I'm thinking of here was proposed by Robert Merton, a Nobel laureate, back in 1971. He said that the proportion of risky assets you should hold in your wealth should be equal to their excess return divided by the product of their variance and a coefficient of your risk aversion.

Let's assume we expect an excess return on shares over bonds of 3 percentage points a year, or 0.03. And let's assume equity returns will have a standard deviation of 20 per cent, in line with their historic average. This gives us a variance of 0.04 (20 per cent squared). The coefficient of risk aversion is trickier to measure. A risk-neutral person has a coefficient of one, and most people aren't humungously risk-averse, so let's put this at 2.

These numbers imply we should have 37.5 per cent of our wealth in equities - that is, 0.03 / (0.04 x 2).

Pension fund weightings are more than twice this. That means they are either risk-tolerant (a coefficient of less than one), or they expect equities to out-perform bonds by more than six per cent a year, or they are not applying this rule.

Chris Dillow

Pension funds don't deserve our money | Investors Chronicle