Secrets Of Success: Fewer happy returns in 21st century

Ned Cazalet, the life insurance industry analyst, had some good cracks in his presentation at the annual conference for directors of investment trusts this week.

Ned Cazalet, the life insurance industry analyst, had some good cracks in his presentation at the annual conference for directors of investment trusts this week.

It was cheeky, I thought, but effective, to use two pictures of the footballer George Best. One was taken in his heyday as a player; the other was a more recent shot showing the ravages of years of booze and excess. The idea was to underline the force of the regulator's favourite slogan - that "past performance is no guide to the future".

But there was nothing light-hearted about Cazalet's main message, which was uncompromising in its analysis of how all investment institutions are having to change their approach in the light of the new realities of investment in the 21st century. This, he pointed out, is a period when investment returns are going to be much lower than in the recent past.

Investment institutions of all kinds will most likely continue to be squeezed by a painful combination of unhelpful developments - falling returns on equities and other asset classes, low bond yields and tighter regulation, to name but three.

These developments have already put a painful squeeze on the free capital of with-profits funds, and forced a number of the big industry players to abandon the with-profits business. The free capital of life companies fell from £130bn to more or less nothing at its low point in 2003, Cazalet calculates, though it has revived a little since.

It is no accident that even the biggest players, such as the Prudential and Legal & General, have recently felt the need to raise new capital through rights issues. The shake-out in the industry may appear to have slowed a little, with the arrival of new entrants competing to buy the assets of some closed with-profits funds, but Cazalet is confident that the game is not yet over.

Putting two life companies together rarely proves a success, in part because the information systems of competing players are so often incompatible (if they work at all). The reality is that the amount of cash that the industry is having to pay out each year is less than it takes in as income, so the sector in aggregate is, in effect, shrinking.

That, you might argue, is capitalism for you, and not necessarily a bad thing. What is more worrying for investors, however, in Cazalet's view (and it's one I share), is that the new environment is driving the industry to change its investment policy quite radically, with far-reaching consequences for investors.

Insurers are slashing their equity holdings and are casting around desperately for returns elsewhere, not on any fundamental assessment of valuation or investment merit, but merely to meet tougher new regulatory requirements and manage their cash flows.

Most recently, this has driven them wholesale into buying fixed-interest securities, and corporate bonds in particular, often at prices that seem to take little if no account of the underlying risk. There will, no doubt, be a bill to be picked up in due course for this profligate behaviour. Bad things do happen in financial markets, and ignoring or mispricing risk, as many institutions appear to be doing, must catch up with you in the end.

The regulators' requirement that life companies must now provide more fully for guarantees they offer policyholders, and factor in the effect of volatility, is only the latest headache facing the industry. It is, of course, legitimate to wonder why life companies and their now-so-active regulators were not a little less complacent in anticipating some of these changes during the long years of the bull market, when preventive action could have been taken earlier.

However, I thought that Cazalet's most potent observation was that nearly all the problems that the life companies have been so publicly experiencing in the past five years hold true for pension funds as well. Final salary schemes, as we know, are being closed all over the place as the cost of providing for expensive future benefits becomes more visible. But this is only the tip of the iceberg of a range of big issues - including increased life expectancy and ageing populations - which are belatedly exercising pension fund trustees.

The difference from the life companies is that while they face the same investment issues, pension funds have no solvency regime, and the way they are run and controlled is full of ambiguity. The spectre Cazalet raised in his presentation is of a sector drifting towards a painful crunch, with little in the way of coherent direction. The only thing that is clear is that it will be taxpayers and employees who have to pick up the bill for all the future promises that have been made, but not fully provided for. For public sector pensions in particular, the bill will be a massive one.

Inflation

One thing that might ease the pressure on insurance companies and pension funds would be a return to inflationary conditions. One of the charts Cazalet used in his presentation is one I also use, showing graphically how real rates of return on equities, as measured by their rolling 10-year returns, have fallen steadily for two decades.

The reason, of course, is the success of anti-inflationary policies around the world, which have driven both actual and expected inflation to levels that would have been thought inconceivable a generation ago.

The question of whether what comes next is renewed inflation, deflation or more of the same is central to everyone's financial future, professional and amateur alike. That in turn brings us back to the question of who succeeds Alan Greenspan as chairman of the Federal Reserve when his third term of office comes to an end at the end of this year.

The decision, points out Andrew Teufel, research director at the private client firm Fisher Investments, could have potentially far-reaching consequences for investors.

His firm is bullish about prospects for equities this year, for much the same reason as Bill Miller of Legg Mason, whose views I quoted a couple of months ago (you can find links to both Cazalet's and Fisher's views on my website, www.intelligent-investor.co.uk).

Most of the obvious worries for equity investors - such as oil prices, the dollar, budget deficits - Fisher thinks are already priced into the market. But one concern that cannot yet be priced in is the risk that President Bush makes a quixotic or even disastrous appointment to the Federal Reserve, and that - judging by his track record of past appointments - is not something that can be readily discounted.

jd@intelligent-investor.co.uk

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