The 'prudent man' wins approval

At the start of this year, International Investment introduced its 'Cut the Red Tape Campaign'. The campaign aims to highlight solutions and promote discussion on policy approaches to a range of investment problems. We have printed extracts from, External Prescription or the Prudent Man, an essay by Sir David Walker, chairman at Morgan Stanley Dean Witter (Europe) and formerly chairman at the Securities and Investments Board. It is part of a collection published by the newly-formed European Asset Management Association (EAMA) entitled Prudent Man and European Pensions.

Commenting on the release of the essays, Donald Brydon, president of EAMA and chairman at AXA Investment Managers, said: "If the single market in financial services is to benefit pensioners and other investors, rules governing pension funds must be limited to those that advance their interests. Regulation must not prevent pension funds growing to their full potential or be used to advance extraneous economic or national causes."

The last few years have seen rapid growth in the array of products designed to enable market participants to manage their risk/return profiles more closely in accordance with their financial objectives. This has special relevance for pension funds in Europe and those who oversee and manage them, given the combination of demographics and widespread underprovision for retirement.

As a result, an increasingly insistent question is how to ensure satisfactory returns, in terms of some combination of capital appreciation and earnings streams, while maintaining the underlying financial soundness of schemes.

There are two broad policy approaches, at opposite ends of the spectrum. One involves some form of detailed external prescription, limiting the exposure of a fund to various categories and sub-categories of investments through the imposition of specific boundaries. In this way, a degree of diversification is built into the asset mix with the object of preventing an undue concentration of assets in one area.

The alternative is the 'prudent man' approach. Sceptics frequently cite the definition of prudence as a major difficulty, arguing that what might be regarded as prudent in one situation or culture might not be considered so in another. There will always be scope for those of an adventurous nature to strain the flexibility of the system.

However, financial theory shows that artificial restrictions on asset allocation will tend to lead to an outcome falling short of the efficient frontier. Sub-optimal investment leads to sub-optimal returns.

The recent history of Japanese pension funds is a good example. The shortfall in pension provision has prompted the current efforts for reform. While the precise scale of the pension shortfall is unknown, analysts estimate it to be in the region of ¥60 trillion (E560bn).

Demographics are clearly a big factor in the ballooning deficit - almost 17% of Japan's population is now over age 65, increasing to 22% by 2010. However, poor returns have aggravated the position. Over the decade from 1985 to 1995, Japanese pension funds earned a return on average of only 5%pa, barely one-third of the returns achieved by the average US pension plan over the same period.

Returns were hampered by restrictive investment regulations. Until late last year, pension funds were subject to the '5-3-3-2' rule. This required them to invest a minimum of 50% of their portfolios in Japanese bonds or cash, to place no more than 30% of funds in foreign assets, to invest no more than 30% of assets in domestic equities and to limit exposure to real estate to a maximum of 20%.

Separate restrictions meant that only 50% of a pension fund's assets could be managed by an external investment manager other than a life insurer or trust bank, while all funds were required to target a realised return of 5.5%pa. Consistent failure to meet this last target has led to the recent abolition of all three restrictions.

What would the effects of this restriction have been if applied to a market regulated on a 'prudent man' approach? We have looked at the returns that might have been achieved if the average asset allocation of US pension funds had been subject to such a rule. We have taken a typical asset allocation of US pension plans today and compared it to 20 years ago, assuming an inner progression thereafter. This table gives the following start, average and end allocations:

Using, respectively, US long-term government bond indices for bond performance, the S&P 500 Index for US equity returns, and the MSCI EADE Index for foreign equities. Using the same data, but restricting the asset allocation by class, we then re-ran the numbers in lines with the '5-3-3-2' rules, again with a base of 100. Where the level of US equity had been capped at 30%, we reallocated the excess between foreign equities and bonds in a manner consistent with the asset allocation at the time. The strategy significantly outperformed the constrained strategy over the period, achieving a return of 14.6%pa versus 13.3%pa for the latter. The volatility of the actual strategy (10.6%) is fractionally less than the volatility of the externally prescribed, or constrained, strategy (10.7%). So the constraints would have cost 1.3%pa return with no reduction in risk.

It is clear that, in the US market at least, the imposition of the Japanese restrictions would have had a material impact on pension fund returns and on the financial cost of pensions. So a restrictive approach brings some degree of security, but at a potentially significant cost. How serious, then, is the risk that a regulatory environment based on the prudent exercise of judgement, as opposed to external prescription, would be abused?

A 'prudent man' rule relies on judgement based on knowledge as the basis for decision. Those charged with supervising assets in such an environment must have due regard to the inheren

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