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

Independent Partners; request a free guide on NISAs from Hargreaves Lansdown

News
A model of a Neanderthal man on display at the National Museum of Prehistory in Dordogne, France
science
News
Richard Dawkins dedicated his book 'The Greatest Show on Earth' to Josh Timonen
newsThat's Richard Dawkins on babies with Down Syndrome
Arts and Entertainment
Eye of the beholder? 'Concrete lasagne' Preston bus station
architectureWhich monstrosities should be nominated for the Dead Prize?
Extras
indybest
PROMOTED VIDEO
Finacial products from our partners
Property search
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    AIFMD Business Analyst / Consultant - Investment Management

    £450 - £600 per day: Harrington Starr: AIFMD Business Analyst / Consultant - I...

    Business Analyst Solvency II SME (Pillar 1, 2 & 3) Insurance

    £450 - £600 per day: Harrington Starr: Business Analyst Solvency II SME (Pilla...

    Manager - SAS - Data Warehouse - Banking

    £350 - £365 per day: Orgtel: Manager, SAS, Data Warehouse, Banking, Bristol - ...

    SQL DBA/Developer

    £500 per day: Harrington Starr: SQL DBA/Developer
 SQL, C#, VBA, Linux, SQL Se...

    Day In a Page

    Middle East crisis: We know all too much about the cruelty of Isis – but all too little about who they are

    We know all too much about the cruelty of Isis – but all too little about who they are

    Now Obama has seen the next US reporter to be threatened with beheading, will he blink, asks Robert Fisk
    Neanderthals lived alongside humans for centuries, latest study shows

    Final resting place of our Neanderthal neighbours revealed

    Bones dated to 40,000 years ago show species may have died out in Belgium species co-existed
    Scottish independence: The new Scots who hold fate of the UK in their hands

    The new Scots who hold fate of the UK in their hands

    Scotland’s immigrants are as passionate about the future of their adopted nation as anyone else
    Britain's ugliest buildings: Which monstrosities should be nominated for the Dead Prize?

    Blight club: Britain's ugliest buildings

    Following the architect Cameron Sinclair's introduction of the Dead Prize, an award for ugly buildings, John Rentoul reflects on some of the biggest blots on the UK landscape
    eBay's enduring appeal: Online auction site is still the UK's most popular e-commerce retailer

    eBay's enduring appeal

    The online auction site is still the UK's most popular e-commerce site
    Culture Minister Ed Vaizey: ‘lack of ethnic minority and black faces on TV is weird’

    'Lack of ethnic minority and black faces on TV is weird'

    Culture Minister Ed Vaizey calls for immediate action to address the problem
    Josephine Dickinson: 'A cochlear implant helped me to discover a new world of sound'

    Josephine Dickinson: 'How I discovered a new world of sound'

    After going deaf as a child, musician and poet Josephine Dickinson made do with a hearing aid for five decades. Then she had a cochlear implant - and everything changed
    Greggs Google fail: Was the bakery's response to its logo mishap a stroke of marketing genius?

    Greggs gives lesson in crisis management

    After a mishap with their logo, high street staple Greggs went viral this week. But, as Simon Usborne discovers, their social media response was anything but half baked
    Matthew McConaughey has been singing the praises of bumbags (shame he doesn't know how to wear one)

    Matthew McConaughey sings the praises of bumbags

    Shame he doesn't know how to wear one. Harriet Walker explains the dos and don'ts of fanny packs
    7 best quadcopters and drones

    Flying fun: 7 best quadcopters and drones

    From state of the art devices with stabilised cameras to mini gadgets that can soar around the home, we take some flying objects for a spin
    Joey Barton: ‘I’ve been guilty of getting a bit irate’

    Joey Barton: ‘I’ve been guilty of getting a bit irate’

    The midfielder returned to the Premier League after two years last weekend. The controversial character had much to discuss after his first game back
    Andy Murray: I quit while I’m ahead too often

    Andy Murray: I quit while I’m ahead too often

    British No 1 knows his consistency as well as his fitness needs working on as he prepares for the US Open after a ‘very, very up and down’ year
    Ferguson: In the heartlands of America, a descent into madness

    A descent into madness in America's heartlands

    David Usborne arrived in Ferguson, Missouri to be greeted by a scene more redolent of Gaza and Afghanistan
    BBC’s filming of raid at Sir Cliff’s home ‘may be result of corruption’

    BBC faces corruption allegation over its Sir Cliff police raid coverage

    Reporter’s relationship with police under scrutiny as DG is summoned by MPs to explain extensive live broadcast of swoop on singer’s home
    Lauded therapist Harley Mille still in limbo as battle to stay in Britain drags on

    Lauded therapist still in limbo as battle to stay in Britain drags on

    Australian Harley Miller is as frustrated by court delays as she is with the idiosyncrasies of immigration law