Without behavioural change, recent adaptations in the governance practices of European pension plans merely amount to re-spraying an old car when an entirely new model is needed, according to Sally Bridgeland and Amin Rajan
Since the 2008 global financial crisis, business models in the pension world have undergone a considerable makeover. Governance practices, asset allocation and execution capabilities have come under the spotlight, as described in our latest paper for the 300 Club*. The resulting changes have been necessary but unfortunately insufficient.
This is because pension funds have pursued low-hanging fruit: targeting specific areas that are easy to define and tackle without reinventing operational or governance capabilities. Corresponding improvements in the intangibles that enable them to rethink and adapt their strategies have been slow to develop. In many cases, trustees have yet to move much beyond the traditional model of managing the easy things that do not matter and avoiding the harder things that do.
Decisions are scarier
The context for trustees’ decisions is changing. Funding deficits and the sense that defined benefit pension schemes are a legacy problem – rather than a valuable element of employee remuneration – creates a less supportive backdrop. Every decision that trustees make faces greater scrutiny from a more critical sponsoring employer.
This is not going to get easier. In the past, the risk of not being able to pay pensions was a dim and distant event somewhere over the horizon. Now, scheme closures and tax changes mean that the cost of benefits still accruing is modest and dwarfed by outgoing benefit payments to current pensioners. Underlying cash flows are negative, masked temporarily by deficit contributions.
As plans advance in their run-off phase, it is not hard to see how negative cash flow diminishes the capital base that could previously have been used to right a sinking ship. Compound interest becomes an ogre, not a friend.
So decisions are scarier, risks are emphasised and the funding problem framed in terms of failure. Loss and risk aversion kicks in. In the fight-or-flight instinct, the brain screams ‘run away’ from the difficult decision. The simple fact is that trustees can never get the answer right because they can’t know the future. They know they will be wrong.
Instead, faced with this inconvenient truth, trustees focus on compliance and governance processes that emphasise the avoidance of bad decisions – where they take advice from qualified advisers or executives, challenge the advice and err on deferring to advisers or deferring decisions. It seems safer not to make a decision or to put it off rather than to act – a bias familiar in behavioural finance.
The fact that these are group decisions makes them even more conservative. A group is more likely to be influenced by the doubts of the pessimist who can see the risks vividly than by the enthusiast, however well informed. Such naive enthusiasm is easily dismissed by just one naysayer. There is a shared desire for the decisions not to be too scary. No outliers and nothing that might cause too much regret.
Easy decisions: path of least resistance
So the tendency is to stick to decisions that will not cause trustees and their advisers pain.
Hiring managers through beauty parades may be entertaining but is costly and generally poor at leading to the right decision. And beating up fund managers about poor performance might help trustees and advisers feel better but rarely has a significant impact other than encouraging them to retrench to a peer group benchmark or risk-controlled processes.
Employing an executive team in-house and having a financial and emotional alignment that is stronger than that with an external adviser is a common solution because it provides the ability to make decisions, additional accountability and control. But, it can also add an inflexibility that bakes in an inability to change radically. This is status quo bias again.
As always, playing to organisational strengths and daring to be different (that is, taking risks not avoiding them) are the way to win. Sometimes it feels like trustees have simply given up. Who can blame them given the sharp focus they are under from the sponsoring employer, regulator and their members?
Breaking free: a way forward
One possible step forward within the existing governance model is to take greater risk with a defined portion of the assets, dependent on the risk appetite. Crucially, the decisions to be made within this portion may either play to the organisation’s existing strengths or preferences, or they may lead it towards where it wants to be in five years’ time.
This allocation becomes an incubator – or controlled experiment – that might then be used as a model for the rest of the assets in time. The critical aspect is that that model goes beyond maths and assumptions and looks at the resources and relationships needed to deliver the strategy and mission, as outlined in the panel.
The steps outlined below aim to bring pension fund strategy back into the sphere of business decisions. There is no right answer. Effective governance means reducing discomfort so that difficult decisions can be made with confidence.
Some steps along the way forward:
• Open a different kind of dialogue with the sponsoring employer on the nature of risks to be managed and the skills required in-house or externally. Only then will trustees be driving a ‘new model’.
• Develop a strategy for how the pension fund will succeed and deliver its financial mission of paying everyone the right pension. The aim is to create a stronger sense of what the fund wants to be good at and what business model will deliver it.
• Carry out scenario thinking about different financial outcomes to test the resilience of the fund’s business strategy, what its downside risks are and what contingency plans are needed.
• Identify the right external partners or providers for success. Having the right skills and services is one aspect, but with more clarity about the business strategy, other qualities will be important in making sure that the relationships have staying power.
• Be demanding. Take control of meeting agendas and priorities. With a clear business strategy, it should be easier to identify what is noise, what can be delegated and what matters. Raise your eyes and raise your game.
• Avoid knee jerk reactions, micro management and change for the sake of it. Challenge your strategy but think longer term.
Change is expensive. Do the best for your beneficiaries.
*Governance practices: Bridging the gap between rhetoric and reality
Sally Bridgeland is senior adviser, Avida International, and Amin Rajan is CEO of CREATE-Research