Down with pension silos
Peter Drucker was in town recently. Well, at least electronically, as at a ripe 93 years of age, the world-renowned business philosopher doesn’t fly anymore. He was the final speaker in a series on ‘integrative thinking’ at the University of Toronto. Drucker observed that in both higher business education, and in the way we organise our for-profit and not-for-profit organisations, we have built far too many silos. So we produce marketing specialists, computer specialists, accounting specialists, finance specialists, investment specialists, actuarial specialists, and so on. All needed specialties, admittedly. But, Drucker argued passionately, all these specialists and society at large lose out if we don’t also instill a capability to think ‘integratively’. In other words, specialists must be able to see how their own silo relates to all the other silos out there, and to see the greater purpose of their work.
It is hard to think of a field where Drucker’s observation is more relevant than in pensions and investments. For example, even after decades of the preaching and cajoling that some of us have done on the importance of looking at pension plans integratively through their ‘mark-to-market’ balance sheets, investment and actuarial specialists continue to largely labour inside their own silos. So on the asset side of DB pension plan balance sheets, investment specialists still treat ‘risk’ as tracking error versus market-based investment benchmarks. On the liability side, actuarial specialists still pretend they control ‘risk’ by controlling the liability valuation discount rate. Not surprisingly, these two ‘risk’ perceptions have absolutely nothing to do either with each other, or with managing DB balance sheet risk. No wonder so many DB plan sponsors have only recently realised that they have had gaping unfunded liabilities on their balance sheets for years already. Silo thinking can have very painful consequences for DB balance sheet stakeholders.
Even larger questions loom behind those that integrate DB balance sheets. For example, who are the balance sheet stakeholders, and what does the ‘pension deal’ say about how balance sheet risks are to be borne? If there is default risk, who bears it? What about inflation risk? Contribution rate risk? What about the allocation of these risks between this generation of balance sheet stakeholders, and the next generation? Then there is the related question of how to measure and manage the extent of these risk exposures over time. It turns out that the best integrative framework is that of contingent claims valuation, as ‘pension deals’ can be decomposed into a series of put and call options issued and held by various stakeholder groups Without integrative thinking, these kinds of fundamental DB pensions questions will not even be asked, let alone answered.
Things are no better on the DC side of the pension playing field. Here, the idea of a pension ‘liability’ has disappeared altogether. So now there are only investment specialists competing for the opportunity to manage the accumulating capital of DC plan participants. Yet, there is an obvious accumulating ‘liability’ on personal DC balance sheets as well. Its capital value is equivalent to investing a participant’s contributions in inflation-indexed, default risk-free government bonds (ILBs). Why? Because this is the most direct path to converting a stream of contributions into an eventual stream of predictable pension annuity payments in real terms. The reward and risk characteristics of other possible investment strategies (net of usually material management fees) only take on meaning when benchmarked against this risk-minimising ILB strategy alternative. Ironically, most DC plans neither offer an ILB investment strategy as an investment option, nor offer the facility to benchmark alternative investment strategies against the ILB option. Thus we have yet another example of the debilitating impact of silo thinking in the pensions and investments field.
Indeed, thinking integratively about the more fundamental question of pension plan design would lead to more collaborative ‘win-win’ solutions, superior to the current garden-variety DB or DC pension approaches with their potential ‘win-lose’ outcomes. Avoidable risks such as longevity risk would be eliminated in such ‘win-win’ designs. Unavoidable risks involving investment and inflation exposures should be made transparent and managed so that they are sustainable over time. The connections between these risks and their impact on future benefits and contributions would be clear. Institutions managing these win-win ‘pension deals’ would be co-operatively owned, and so avoid misalignments in stakeholder interests. They would have sufficient scale to operate at low unit costs.
The pensions and investments silo list doesn’t end with these DB and DC plan design and management examples. To them, we could easily add the ‘disconnect’ many pension people suffer from between expressing a strong desire for good corporate governance practices in the companies they invest in on the one hand, yet seldom acknowledging the need for equally good pension fund governance practices on the other. Integrative thinking leads directly to the obvious conclusion that it is very hard to have one without the other. Our January column set out “The 7 habits of highly effective pension funds”. Not surprisingly, topping the list of good fund habits was “develop effective governance practices”, immediately followed by “develop effective strategic planning and review practices”. What is good for the goose is good for the gander.
Then there is the ‘disconnect’ many of our elected leaders and their regulators suffer from, wishing for healthy retirement income systems on the one hand, yet not acknowledging the need for a set of sensible legislative and regulatory rules that would foster such an outcome on the other. Once again, integrative thinking will tell you very quickly that can’t have one without the other. So for example, restricting reasonable risk-taking in DB plans, as the Dutch pension regulator is currently proposing, does not foster a healthy pension system. On the other hand, permitting employees to put up to 100% of their DC assets in own-company stock, as is still permitted in the US, is not good regulatory practice either. The challenge of integrating a healthy pension system vision with legislative and regulatory rules that would actually foster such a system has not yet been met.
A final personal wish. I will be 93 in 2035. If I could be only half the integrative thinker then that Peter Drucker is now, I will be a happy man.
Keith Ambachtsheer is president of KPA Advisory Services, a strategic adviser to ‘best practices’ pension funds around the world. He is also co-founder of Cost Effectiveness Measurement Inc. Both firms are based in Toronto, Canada.
His email address is firstname.lastname@example.org.