Guaranteed to limit performance

PENSION funds shouldn't ask their fund managers for performance guarantees. This increases the probability of poor performance. At first sight there seems to be an offsetting advantage. The risks of really bad results are also lower. But there are cheaper and easier ways to get the same benefit.

Pension fund trustees rightly want to know how well their managers are doing. It is therefore sensible to select a suitable benchmark, such as the FT-All Share index. The trustees and fund managers then hope for success. They will have it if the returns of the portfolio are better than those of the index. Over time, managers' performance will vary around their benchmarks, either through luck or judgment.

Because the investments held will differ from those in the benchmark, the long-term returns will diverge and the relative performance will be volatile.

These two characteristics go together and will depend on how the money is invested. The chances of both will be higher the more the portfolio differs from its benchmark. To outperform, fund managers must take risks.

If there is no guarantee, the managers will invest as well as they can. They have plenty of incentive to do well as theirs is a lucrative business if success is forthcoming. Having a guarantee, however, changes the way they behave - they would be mad if it didn't.

But even the successful will have the odd poor patch. If they have taken on new mandates just before one of these periods, the new accounts will do badly.

When performance is at a minimum, fund managers will invest the portfolio to match the benchmark and will effectively run a tracker fund from then on. This will happen even if fund managers are confident they can outperform in the future. If they were to continue as before, they would be at risk for all the losses, but not stand to gain from the profits.

They would be better off running the portfolio for themselves. They would still have to pick up the losses, but at least they would then get 100% of the profits. Contracts which penalise fund managers who underperform increase the risk of this happening. They limit the risk, but of course this has a cost.

Limiting the risk of underperformance might be sensible, but there are better ways to do it than by getting managers to give guarantees. Pension funds can, for example, increase the ratio of money in tracker funds. This will have the same effect at lower cost.

Contracts with these guarantees are not sensible. Pension fund trustees shouldn't sign them and if they have them they should renegotiate them.

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