Are trustee views on complexity leading to worse outcomes?
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Asset managers and advisers often need to bridge a considerable gap when trying to explain a product or strategy to a group of trustees. Is there a risk that trustees dismiss investments as complex when they are unfamiliar with them, foregoing opportunities?
Investment is a technical area, and not all trustees will feel confident in assessing products presented to them, with some asset managers saying trustees dismiss products as ‘complex’ when they are in fact simple but require learning on the trustee’s side for being new.
But what is perceived as complex or simple is not the same for everyone, and something that is new or unfamiliar can easily be dismissed as too ‘complex’ by trustees – such as liability-driven investment in the early 2000s – while instruments like equities may be seen as simple when they are actually dependent on multiple changing factors.
Lack of familiarity and training
Some in the industry with an investment background say it is quite common for lay trustees to rule things out as complex when what they really mean is they don’t understand it – or haven’t taken the time to understand it.
Steve Delo, chairman of trustee firm Pan Trustees, says LDI is a good example for this. “There are some trustee boards that have run with kamikaze under-hedges because they find LDI impenetrable,” he says.
The rule of not investing in what you don’t understand is a good one, he notes, “but there also needs to be a rule about making sure that you devote enough time to trying to understand it”.
The term complexity, he says, is used to cover a range of different things, including “something that is just poorly explained, something that is over-engineered, something that is highly technical, something that needs multiple moving parts, something that is counter-intuitive etc. Hence one should always probe what is meant if somebody rejects an investment option as 'too complex’.”
He admits there is the possibility that boards put in place overly complex solutions that add little or no value versus simpler routes to achieving the same thing but says that sometimes only what seems a more complex option will deliver what is required.
“This is all about questioning and understanding before deciding – and not skimping on training or being too accepting of lousy communications. Of course, the investment world likes to sell the complex and sophisticated so none of this is easy for trustee boards,” says Delo.
Logically, a ‘complex investment’ should be defined as an investment with unknown or poorly understood risks, which in turn point to a broad range of possible outcomes, “but this would catch equity, which trustees do not consider complex because of familiarity”, says LawDeb trustee Natalie Winterfrost, noting that many, if not most, lay trustees have little investment experience outside that which they have encountered in their role as trustee.
She points to the way familiarity changes what is considered complex: “Even just 20 odd years ago, a typical trustee might still talk of corporate bonds being complicated, but they are now a mainstay of pension scheme investing and a trustee would be unlikely to claim they are complex.”
Asset-backed securities are also often considered complex by trustees, “yet in reality the stream of income backing the ABS structure may be easier to understand than, say, the profits of an investment bank which supports the dividends on its equity”, she observes.
For a trustee board, “it is neither right to invest in an asset class you do not understand nor is it right to overlook investments that would benefit members, simply because you do not understand them”, she says. To overcome the issue of understanding, she says boards could seek advice from a second adviser, opt for the fiduciary management route or appoint a professional trustee.
Lay trustees can be intimidated by the language of investments, with the industry often repackaging old concepts using new jargon and in particular acronyms, says Huw Evans, a director at Bestrustees. Evans compares investments with modern technology, where most people do not understand the inner workings but can use it effectively nonetheless: “A smartphone is a very complex piece of kit but still entirely appropriate for lay people to use.”
Trustees are capable of understanding most of the assets well enough to invest in them, he says, with the key question they need to have answered often being, ‘What would need to happen for this to go wrong’. Understanding the economic characteristics, including any environmental, social and governance issues, is also important, for example in asset classes like forestry.
Beware the 'curse of knowledge'
But the more familiar a concept is, the less complex it seems. “Familiarity breeds comfort. I’m sure this is true whether a trustee or otherwise,” says Calum Cooper, a partner at consultancy firm Hymans Robertson.
He agrees that “for new trustees, unless you come from a finance and investments world, there is a blur of investment alphabet soup to warp your head around and [often] it may appear unfamiliar and complex" for that reason.
He also finds that while trustees need to understand what an investment can do to help deliver pensions, including its benefits and risks, the understanding does not need to be as deep as an expert’s.
Said experts do not always appreciate this, however. “Sometimes I’ve seen the ‘curse of knowledge’ kick in, and a simple investment is overcomplicated because it’s described in terms of the ‘how’ it works rather than what it does and why it’s helpful. Trustees need to understand the why and the what,” he explains.
It is therefore important that trustee boards have an open and inclusive culture, where individuals feel comfortable to speak up when they do not understand, he stresses. “Advisers have a role to play here in setting the tone. It is, however, perfectly reasonable to rely on the expert to understand the how and ensure that the implementation is done effectively,” he argues.
Are DC members trapped in complex and risky investments?
Investments that could be beneficial should not be ignored simply because the trustee does not understand it, says Hugh Cutler, business development at asset manager Pollen Street Capital, who also thinks that a lack of familiarity is often what makes trustees consider something at complex.
“Equities are complex, risky and familiar”, while interest rate or inflation swaps are simple but were considered complicated in the past. “It's inconceivable to me that you understand how a share in Barclays works but not an RMBS,” he says. “People have lost a lot more money and caused a lot more harm badly investing in equities than anything else.”
Some options-based hedge fund strategies are by definition more complicated than equities, he admits, “but I don’t think you could [call] private credit or LDI or real estate or infrastructure [complex],” he adds.
He says trustees should keep an open mind and take the time to learn and understand investments. Education is up to everybody, he argues but “it’s very specifically up to trustees to educate themselves on what they’re doing” as they have a legal duty to do so.
Not doing so has a societal cost, says Cutler, also pointing the finger at regulators. “Regulators played a massive role in getting us to where we are today, which is not a good place. If you compare us to other countries, we’ve gone from a very good place to a much worse place” in terms of pension provision, with large numbers in defined contribution schemes “not being terribly well looked after” because they are not invested in diversified portfolios.
“It’s about the members. Once they’re in DC, they’re going to be stuck investing in daily dealing highly regulated equity funds, and a lot of them are going to retire at really bad points,” he says.
What’s your view on complexity and understanding in investments?