understanding benchmarks and performance measurement ... · understanding benchmarks and...

Understanding Benchmarks and Performance Measurement Within Fiduciary ManagementOctober 2013

Aon HewittDelegated Consulting Services

Risk. Reinsurance. Human Resources.

Aon Hewitt Understanding Benchmarks and Performance Measurement Within Fiduciary Management 1

Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

The importance of benchmarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Traditional benchmarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Benchmarks under a fiduciary approach . . . . . . . . . . . . . . . . . . . . . . . . . 4

Measuring performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Comparing fiduciary provider’s performance . . . . . . . . . . . . . . . . . . . . . 5

Example: Comparing performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Key details behind the headline performance . . . . . . . . . . . . . . . . . . . . . 7

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Table of contents


Overview

Fiduciary management is arguably the fastest

growing area of the UK pensions industry.

Appointing a fiduciary manager is an exciting

opportunity for trustees, sponsor and provider

to work in partnership, creating a bespoke

solution that addresses the increasingly complex

challenges facing the pensions industry.

When considering fiduciary management

and looking to select a provider to work in

partnership with, it is important for trustees to

understand exactly what it is they are buying

and all its component parts. The performance of

fiduciary managers is specific to their particular

mandate and can be difficult to compare.

Benchmarking is one element that will help the

trustees to understand whether their fiduciary

manager is performing as they would expect,

and that the solution reflects the parameters

agreed by the trustees at the outset. Just as no

two clients are the same, neither are any two

fiduciary solutions. Each client’s benchmark

should be bespoke to their scheme and their

solution. It is therefore vital that trustees

ensure their fiduciary manager understands the

need to construct a performance benchmark

which reflects their precise objectives.

In this paper we look at the different

benchmark options to consider as part of a

full fiduciary mandate. We also draw upon

our experience within the UK fiduciary

market to shed some light on the instances

where each might be appropriate.

Sion Cole

Partner and Head of Client Solutions Delegated Consulting Services

+44 (0)207 086 9432 [email protected]

Follow me on twitter @PensionsSion


The importance of benchmarks

Choosing the right benchmark is crucial for a number of reasons. Most importantly, the solution’s risk and return profile will be influenced by the chosen benchmark, and the benchmark can also determine what asset classes should be included in the portfolio. A benchmark should therefore be appropriate to the mandate or specific goal in place, and reflect the governance challenge the trustees and sponsor are aiming to solve. For example, where trustees are delegating responsibility for their emerging markets or hedge fund portfolio, then an asset class specific benchmark or cash plus type target should be used. However, a full fiduciary mandate would typically incorporate a benchmark based on the performance of the scheme’s liabilities.

Given the importance of selecting the right benchmark, the trustees should be considering the right questions; What is our end goal? What is our tolerance for risk (or volatility)? What asset classes do we want our fiduciary manager to invest in (or not)? What is the make up of our scheme’s liabilities?

When appointing a fiduciary provider the trustees and sponsoring employer should work with the chosen provider from the outset, not only to set the strategic direction for the scheme but also to be involved in setting the provider’s benchmark and the metrics chosen to measure the performance of the fiduciary solution. This will help the trustees judge if the provider has been successful compared to the objectives set.

Traditional benchmarks

Traditional pension scheme benchmarks are typically a combination of market indices (weighted by the specific benchmark allocation of the scheme) rather than being linked to the pension scheme’s liabilities. For example, if a scheme allocated 50% to global equities and 50% to gilts, their benchmark might be 50% MSCI World Index and 50% FTSE Over 15 Year Gilts Index. This approach can make it difficult for trustees to understand what is happening to their scheme’s funding level and hence would make it inappropriate for a full fiduciary mandate.

Traditional benchmarks make it easier for the trustees to compare how their underlying fund managers are performing in each asset class relative to both a representative market index and their peer group. However, this can lead to trustees focusing on an underperforming fund manager rather than on the more important strategic investment decisions which will drive the scheme’s performance. Under a fiduciary mandate, underlying fund manager performance monitoring would be undertaken by the fiduciary manager rather than the trustees, ensuring that the trustees can focus their time on the key strategic decisions.

The trustees should ensure their fiduciary manager understands the need to construct a performance benchmark which reflects the client’s precise objectives and allows them to assess properly their fiduciary provider’s success in achieving the trustees’ objectives.

What is a benchmark?

A model portfolio against which a scheme’s structure and performance can be assessed. When evaluating the performance of any investment, it is important to compare it against an appropriate benchmark


Benchmarks under a fiduciary approach

We believe fiduciary management works best when the fiduciary manager is given the responsibility to manage the entire portfolio relative to a scheme’s unique liability benchmark and risk / return objectives.

The fiduciary provider will work with the scheme sponsor and trustees at the outset to agree the benchmark(s) that will be used to monitor performance. This should take account of the factors that are most important for each individual client. However, the ‘flavour’ of fiduciary management employed by the pension scheme will, to a certain extent, dictate the benchmark used to monitor performance.

The trustees should ensure their fiduciary manager understands the need to construct a performance benchmark which reflects the client’s precise objectives and allows them to assess properly their fiduciary provider’s success in achieving the trustees’ objectives.

Full fiduciary management

Full fiduciary management is where the trustees set the overall strategy and then delegate all investment decisions to their fiduciary manager. In this case, the client’s own liability cashflows will be the starting point for most benchmarks. If a client has decided not to be fully hedged on either interest rates or inflation (or both), then a combination of the scheme’s liability cashflows and the return on cash may be used. In this case, if a scheme was 60% hedged on both interest rates and inflation, their benchmark would be 60% of the return of the scheme’s cashflows plus 40% of the return on cash. A cashflow benchmark ensures there is a focus on liabilities, which in turn results in a portfolio that is designed to improve funding levels.

There are two options for the trustees to consider when setting a liability benchmark for their fiduciary provider. One option is for the trustees to specify the split of growth-seeking and liability hedging assets, say 75% / 25%, and the fiduciary manager is then asked to manage the portfolio according to this benchmark. The agreed split would then dictate the return needed over the liabilities. Alternatively, the trustees stipulate, for example, that the fiduciary manager must generate a return of 2% p.a. above the liabilities with 50% of liability risks hedged (the hedge ratio). The manager then has the flexibility on the growth / matching split in order to meet (or exceed) that benchmark. With both options there is some discretion to add value within pre-agreed parameters.

Partial mandate

Under a partial fiduciary approach, the trustees delegate the management of a specific section or element of their portfolio. For example, their emerging markets or hedge fund portfolio. For these mandates, a cashflow benchmark would not be appropriate, rather an asset class specific benchmark or cash plus type target should be used.

Strategic de-risking mandate

This is a solution where the fiduciary manager is asked to implement the de-risking triggers (typically funding level driven) that form part of the trustees’ ongoing strategic plan. In this instance, either a liability benchmark or liability and cash benchmark (depending on the client’s hedge ratio) which adjusts as de-risking occurs is most appropriate.

The liability and strategic benchmarks would be customised to the scheme and form the basis of the mandate. These benchmarks would be agreed by the trustees following advice from the scheme’s investment consultant. The underlying manager benchmarks would be determined by the fiduciary manager in conjunction with the managers.

It is important to understand at the outset what success looks like so that along the journey trustees can assess if the fiduciary manager is delivering what they promised, in the way they said they would do it.


Benchmark definitionsAs part of any fiduciary mandate, we would expect to be analysing some or all of the three main benchmarks detailed below.

1 Liability benchmarkThis is a model portfolio based on the scheme’sspecific liabilities against which the scheme’sstructure and performance will be assessed. In fiduciary management, it is used to track changes in the scheme’s liabilities and in determining the structure of the scheme’s liability risk hedging assets.

2 Strategic benchmarkThis would be calculated using the results of the initial asset liability study and would determine the split between growth and liability matching assets. Depending on what growth solution is selected (i.e. a pooled diversified growth portfolio or separate asset class funds), the modelling would also be used to determine the strategic allocation within the growth seeking asset portfolio.

3 Manager benchmarksIn terms of setting benchmarks for the individual components, most of the underlying funds haveboth a short term market benchmark, primarilyused for manager performance benchmarking,as well as a longer term cash plus target.

Fiduciary management solutions, by their very definition, are bespoke and so it is near impossible to compare directly the headline performance of different providers on a consistent basis.

Measuring performance

It is important to understand at the outset what success looks like so that along the journey trustees can assess if the fiduciary manager is delivering what they promised, in the way they said they would do it.

In order to do this, and effectively monitor their fiduciary provider’s performance, it is essential to delve beneath the headline numbers. We would therefore expect the trustees to drill down into the relevant detail in each of the areas outlined below:

1. Has the portfolio achieved its overall objective – both in terms of risk and return relative to liabilities, i.e. has the fiduciary provider’s actions helped to improve the funding level in a risk controlled fashion?

2. How has the fiduciary provider performed within each aspect of the portfolio?

3. Has the provider’s asset allocation decisions added or detracted from performance?

4. Have the manager selection decisions added or detracted from performance?

5. Has the protection strategy successfully managed the interest rate and inflation sensitivity of the scheme?

The performance of the fiduciary provider should be independently verified by the underlying fund managers’ custodian and / or the fiduciary provider’s custodian depending on the structure of the mandate given to the provider by the trustees. In addition, a pension scheme may choose to use an independent performance measurer to monitor their fiduciary provider’s performance.


Comparing fiduciary provider’s performance

Fiduciary management solutions, by their very definition, are bespoke and so it is near impossible to compare directly the headline performance of different providers on a consistent basis.

The different hedge ratios, target returns, growth / matching split, benchmarks, timeframes and fees deployed by providers for their clients mean that looking at (and comparing) just the headline number has little meaning and gives a limited picture. However, our Delegated Investment Survey 2013 highlights that a proven track record remains one of the leading quality indicators for a fiduciary provider and so trustees need to consider how they can establish the quality of a provider’s track record.

It is also important to understand where the returns have come from and what levels of risk the provider has been taking.

When looking at quoted performance, you should first study what the benchmark and the target return / investment objective is for any representative client portfolios being referenced. The relevant benchmarks and target returns will differ between clients for a variety of reasons, but will typically reflect the individual flight plan each client has in place, and its associated balance between growth seeking and liability risk hedging. This balance will directly alter the appropriate construction of, and therefore the resulting returns from, the provider’s solution. One would naturally expect different overall returns for a client that has largely fixed liabilities, low hedge ratio and a target return of liabilities plus 1% p.a., compared to another client that has largely inflation linked liabilities, high hedge ratio and is targeting liabilities plus 3% p.a.

Looking at the headline number alone does not illustrate if the client has underperformed or outperformed their benchmark, what happened to their funding level, and, even if they did outperform, whether they met their investment objective.

It is also important to understand where the returns have come from and what levels of risk the provider has been taking.

What was the volatility of the portfolio during the time period and what level of hedging is in place to protect the scheme against inflation and interest rate risks? How does this compare with the neutral position as defined under the mandate in question?

The underlying flight plan (and accompanying dynamic de-risking programme) adopted by the client will impact on the performance seen. In rising markets, you would expect a scheme with a higher growth allocation to provide better performance than a scheme with a lower growth allocation. The performance seen could also be more volatile, depending on the underlying components of the growth portfolio. Some solutions may have a greater reliance on equities to achieve the target return whereas others may allocate more to alternative asset classes.

Example: Comparing performanceThis is a very simple illustration of two example clients who utilise different fiduciary providers. If you looked at just the headline total return numbers you would immediately think Client A had experienced the best returns. However when you look beneath those numbers the risk-adjusted returns are near identical. As the old adage goes, don’t judge a book by its cover.

Client A Client B

Total return +10.5% p.a. +3.5% p.a.

Benchmark return (Liabilites)

+7.3% p.a. +2.4% p.a.

Target (Investment objective)

3.0% p.a. 1.0% p.a.

Relative return (Outperformance)

+3.2% p.a. +1.1% p.a.

Risk-adjusted returns 1.15 1.14


Case study

The clients below reflect how different solutions, investment objectives and returns can look depending on the long term objectives and unique requirements of a pension scheme. Client D has a higher scheme deficit and therefore needs a more aggressive strategy targeting higher returns, meaning

higher risk. The solution therefore looks very different to a more representative client (Client C) and the headline returns delivered will also look very different at first glance.

Developedequities

Bonds

Alternatives

Liability hedging

component

Developedequities

Bonds

Alternatives

Liability hedging

component

Key details behind the headline performance• Benchmark

• Target return

• Investment objectives

• Growth / liability matching asset allocation

• Volatility and risk

• Key drivers of returns

• Focus on risk-adjusted returns

The trustees can only truly assess each provider’s performance by effectively pulling the headline returns apart.

It is imperative that the trustees start with the high level return and then delve into the detail to understand the target return / investment objectives, risk and volatility seen, benchmark and hedging levels / protection for each client. Once this detail has been assessed, the trustees can then consider the source of the risks seen, the growth / liability matching component performance and the underlying drivers of that performance, before considering the risk-adjusted returns.

Fiduciary providers typically show their returns on a net of all fees basis but the trustees should confirm whether this is the same in each case as it could have a significant impact, depending on the type of fee (bundled or unbundled) and mandate used.

In the table to the right, we have shown the performance for each client, net of all fees, over the 12 months to the end of June 2013.

Client C

• Size: £258m

• Investment objective: +3.0% p.a. over liability benchmark

Client D

• Size: £530m

• Investment objective: +4.7% p.a. over liability benchmark

Client C Client D

Asset return (%) 8.7 17.1

Liability return (%) 0.1 1.6

Relative (%) +8.6 +15.5

Source: Aon Hewitt. All data to 30 June 2013


The trustees can only truly assess each provider’s performance by effectively pulling the headline returns apart.

The performance of fiduciary managers is specific to their particular mandate and hence can be difficult to compare. It is therefore important not to focus on just headline numbers as these do not give the full picture of the mandates in question. It is, however, vital that the trustees ensure their fiduciary manager understands the need to construct a performance benchmark which reflects their precise objectives and the trustees understand what is behind the headline numbers provided – after all, you could be comparing apples with oranges.

At Aon Hewitt we believe that working closely with all interested parties of the scheme from the very outset will help to ensure that the trustees are fully involved in setting the provider’s benchmark and that they understand how to measure their fiduciary provider’s performance.

Conclusion

The benchmark provides the trustees with the means to monitor the performance of their fiduciary manager. Picking the right benchmark is therefore crucial as it will help to determine the parameters to which the fiduciary provider will manage the mandate.

Traditional benchmarks do not take a scheme’s liabilities into account and hence it is hard for the trustees to understand what is happening to their funding level under this approach. Under a fiduciary mandate, there are several different benchmarks that can be utilised by the scheme, depending on the ‘flavour’ of fiduciary management employed. The chosen benchmark should reflect the client’s precise objectives and allow them to properly assess their fiduciary provider’s success in achieving the trustees’ objectives.

We have previously highlighted that, when choosing a provider, not understanding the details behind the different solutions and therefore basing any decisions on incomplete information could result in the trustees coming to the wrong conclusion on which provider delivered the best performance for their client.

At Aon Hewitt we believe that working closely with all interested parties of the scheme from the very outset will help to ensure that the trustees are fully involved in setting the provider’s benchmark and that they understand how to measure their fiduciary provider’s performance.


Contact

Sion Cole

Partner and Head of Client Solutions Delegated Consulting Services

+44 (0)207 086 9432 [email protected]

Follow me on twitter @PensionsSion

About Delegated Consulting Services

Aon Hewitt’s fiduciary offering (Delegated Consulting Services) is focused on helping trustees and sponsors achieve better security for their scheme members. We do this through helping you meet your unique long term objectives and, importantly, through improving your scheme’s funding level. What makes us different? Only we ask the best questions and then really listen to exactly what our clients tell us. By working in partnership in this way we can then create a truly bespoke solution that is designed to meet your unique requirements. We don’t just say bespoke, we live by it.

Aon Hewitt currently holds fiduciary manager of the year awards from three of the industry’s leading publications; Professional Pensions (2015), Pensions Age (2015) and the FT (2014). Our ability to create truly bespoke solutions has been cited as part of these award wins and is one of the reasons why our clients vary significantly in size and how we work with them. Examples of some of the solutions we can offer clients include full fiduciary with bespoke growth and liability matching portfolios and daily monitoring of triggers. We also offer single solutions (partial fiduciary mandates) such as hedge funds, alternatives mandates and flight planning with dynamic de-risking programme.

Aon Hewitt empowers organisations and individuals to secure a better future through innovative talent, retirement and health solutions. We advise, design and execute a wide range of solutions that enable clients to cultivate talent to drive organisational and personal performance and growth, navigate risk while providing new levels of financial security, and redefine health solutions for greater choice, affordability and wellness. Aon Hewitt is a global leader in human resource

solutions, with over 30,000 professionals in 90 countries serving more than 20,000 clients worldwide. For more information on Aon Hewitt, please visit: aonhewitt.com

Follow Aon on Twitter: twitter.com/Aon_plc

Sign up for News Alerts: http://aon.mediaroom.com/index.php?s=58

About Aon Hewitt

Working in partnership with our clients

At Aon Hewitt we believe in working closely with our clients from the very outset

to understand the challenges they face and their individual needs. Working in

partnership with the trustees and sponsor, we create a bespoke solution to help

address these issues and help them to meet their long term goals. No two clients of

ours are the same and each have their own bespoke liability benchmarks, reflecting

our truly tailored delegated offering.

To talk to us about any of the points we have raised in this paper or to find out more

information about our delegated offering, please do not hesitate to contact your

Aon Hewitt Consultant or Sion Cole, Partner & Head of Client Solutions, Delegated

Consulting Services, on +44 (0)207 086 9432 or at [email protected].

aonhewitt.com/delegatedconsulting

About Aon Aon plc (NYSE:AON) is a leading global provider of risk management, insurance brokerage and reinsurance brokerage, and human resources solutions and outsourcing services. Through its more than 69,000 colleagues worldwide, Aon unites to empower results for clients in over 120 countries via innovative risk and people solutions. For further information on our capabilities and to learn how we empower results for clients, please visit: http://aon.mediaroom.com/

© Hewitt Risk Management Services Limited. All rights reserved.To protect the confidential and proprietary information included in this material, it may not be disclosed or provided to any third parties without the prior written consent of Hewitt Risk Management Services Limited.

Hewitt Risk Management Services Limited does not accept or assume any responsibility for any consequences arising from any person, other than the intended recipient, using or relying on this material. Hewitt Risk Management Services Limited is authorised and regulated by the Financial Conduct Authority.

Hewitt Risk Management Services Limited

Registered in England & Wales. Registered No: 5913159.

Registered Office: The Aon Centre, The Leadenhall Building, 122 Leadenhall Street, London, EC3V 4AN.

Authorised and regulated by the Financial Conduct Authority, reference number 459481.

VAT Number: 480840148

Copyright © 2015 Aon plc

aon.com

Risk. Reinsurance. Human Resources.

understanding benchmarks and performance measurement ... · understanding benchmarks and...

Documents