Once a year, the US professional basketball league organises its all-star competition. Players from teams across the country are selected as the best in their respective positions. Could we have an all-star pension industry, uniting the best standards and practices under one roof?
Former director of research, NEST, UK, and Credit Suisse
In his July letter, Keith Ambachtsheer, director emeritus of the Rotman International Centre for Pension Management, discussed steps to fixing the governance deficit, and the July/August edition of IPE collated a series of articles in a comprehensive governance report.
Governance can serve as a stimulus to improve and nurture the running of pension organisations. While good governance can be a source and guarantor of value for beneficiaries, it is often perceived as an administrative burden and left to the policy teams within organisations or used only by front-office teams as a sanity check or a marketing alibi.
In this article, I review parts of the value chain of pension provision, focusing on how governance can create value. For participants, it offers incentives to commit to the best standards of governance, since the benefit of doing so becomes obvious. I mention several existing solutions or providers. The purpose is to illustrate that the propositions are achievable in practice, not to express a recommendation.
Short- versus long-termism
This is a constant debate in our industry. From a governance perspective the ‘versus’ is misplaced, and slow progress on this issue is due to fact the two are often seen to be diametrically opposed. A short-term decision must not be detrimental to the long term, while a long-term decision is not to be taken at the sacrifice of the short term.
Finding a suitable balance enables value creation across all time horizons. Poor governance occurs when decisions are taken over a particular timeframe (short or distant) while consequences over other timeframes are overlooked. For instance, Redington’s ‘seven steps’ approach helps on the design and ongoing management of a scheme’s objective and liabilities.
The UK CDC debate
The UK intends to introduce collective defined contribution (CDC) schemes, providing a middle ground between a defined contribution (DC) and defined benefit (DB) scheme. The state’s governance issue is to understand whether allowing CDC will create value for the end-beneficiaries.
I would draw a parallel between CDC and smart beta. Smart beta is a middle way between passive and active management, meaning asset owners are better able to scale the value proposition between passive, smart beta and active products.
CDC schemes would not be cornered into a limited decision set and it would be possible to judge the value of doing or not doing certain things, such as asset allocation derived from mandatory indexation in DB or lack of a liability benchmark in DC.
The government would not be saying it believed one type of scheme is better than another; it would simply be providing a more flexible environment for value creation and efficient comparison.
A question of risk
Let’s consider two dimensions: quantity and quality. In terms of quantity, conservative risk budgets can cause too little exposure to potentially profitable assets, while trend following or herd mentality can create excessive risk taking.
As for quality, it is necessary to assess the types of risks that are carried, voluntarily or not, and evaluate which ones are likely to be rewarded over an explicit time horizon. For instance, one might use a volatility risk budget over an investment cycle. In practice, volatility will not be homogeneously rewarded over such a cycle. The same would apply to any other risk factor.
Taking the right risks over the right time horizon might be a more relevant decision than how much risk is taken. For instance, minimum variance strategies help control the risk budget.
Institutions caught in the financial crises of the past century have seen asset classes correlated during the turmoil. A common mistake is therefore to seek diversification by avoiding concentration risk. An asset owner must distinguish between a solution that is diversified or diversifying. It is diversified when, as a standalone, it is exposed to several sources of value (risk factors); it is diversifying if, when added to the others assets held by the institution, it provides new sources of value.
A concentrated product (one exposed to a limited number of sources of value) can be perfectly suitable if such a source is not already available in the portfolio. Conversely, a fully diversified product could be used as a standalone solution, giving access to the full investable universe. One example would be TOBAM’s Maximum Diversification range.
In most organisations, requests for proposals (RFPs) are completed by a team that is distinct from the portfolio management staff as it is preferable to have portfolio managers doing what they are good at, yet some of the value proposition is inevitably lost in translation.
For the asset owner, the aim of the RFP is to identify a manager whose claim meets expectations and whose internal resources and processes are commensurate to the claim. Meanwhile, whole sections of RFPs are drafted where it is rather unclear how the steps described are adding value to the investment process. Effective consultant due-diligence processes and manager reports can help decompose the value proposition.
Managers also need to spell out why they have made a particular choice. For example, most quantitative asset managers include a sizable team of mathematicians. Some have developed all of their systems based on advanced in-house mathematical research. In such cases it is apparent that a miscalibration of any of the parameters of the formulas could damage the expected outcomes. This justifies the choice of hiring and maintaining a large research team and is consistent with the original proposition.
For investment processes where the value proposition is not fully dependent, if at all, on arithmetic and algorithms, an off-the-shelf risk solution will be more appropriate.
Readers might be surprised I include such a technical calibration example in an article on governance, but would they board a 747 knowing that the zero altitude has not been calibrated properly?
Refocus on value
Most pension schemes are organised around a three-tier governance structure: the chief investment office, in-house or not; the investment committee, of which a minority has an investment background; and the board of trustees. Most investment decisions are escalated to the investment committee and some to the board.
But most asset managers continue to pitch propositions exclusively to the attention of the investment savvy. They overlook the fact that when decisions reach the higher levels of governance, it is precisely because they include considerations beyond investment matters. Managers who can appreciate the internal governance mechanisms of a pension scheme would have a competitive edge.
Let’s refocus governance on the value proposition for end-beneficiaries: the current and future pensioners. It is up to pensions schemes to select their ‘all-star’ team of providers of investment services.