Keith Ambachtsheer argues that pension funds are in a unique position to move capitalism in a direction that is more wealth-creating, more sustainable, less crisis-prone, and more legitimate than it is today
Since the advent of the nineteenth century industrial revolution, capitalism has been celebrated as the dominant wealth-creating mechanism in the now-developed world. However, it faces strong headwinds today. For example:
• Physical limits to continued economic growth in such forms as carbon emissions, pollution, water usage, and food production;
• Ageing populations and diminished economic growth prospects in the developed world;
• Preferences by collective electorates and individual family units to maintain or enhance public services and private living standards through borrowing rather than through current taxes and earnings;
• Increased frequency of bubbles and crises in financial markets;
• A growing societal ‘have-have not' divide in both perception and reality;
• Continued alignment-of-interests challenges between corporate managers and corporate owners.
Can the $30trn global pension-fund sector ameliorate some of these headwinds while at the same time fulfilling its mission to provide retirement income security to hundreds of millions of beneficiaries? In other words, can pension funds shape the future of capitalism?
The short answer is: "Yes we can." It is within our reach to move capitalism in a direction that is more wealth-creating, more sustainable, less crisis-prone, and more legitimate than the ‘headwinds' capitalism we have today.
Why specifically pension funds? Because they are the only global investor class that has a fiduciary duty to invest across generations. In determining their investment strategies, pension funds are duty-bound to be even-handed between the financial needs of today's pensioners, and those of young workers, whose retirement years lie years ahead of them.
This transformation to ‘pension fund capitalism' will not be easy for two reasons:
• It requires the redesign of pension systems so these systems themselves become more sustainable and intergenerationally fair; and
• It requires the redesign of pension fund organisations so that they themselves become more effective and hence more productive stewards of the retirement savings of young workers and pensioners alike.
Let me tell you why I believe these two pre-conditions are essential, and what must be done to bring them about.
The designs of traditional DC and DB plans are both problematic:
• Traditional DC plans force contribution rate and investment decisions on participants that they cannot, and do not want to make. Also, little thought has been given to the design of the post-work asset decumulation phase. As a result, DC plan investing has been unfocused, and post-work financial outcomes have been, and continue to be highly uncertain, raising fundamental questions about the effectiveness and sustainability of this individualistic pension model.
• Traditional DB plans lump the young and the old on the same balance sheet, and unrealistically assume that they have the same risk tolerance, and that property rights between the two groups are clear. These unrealistic assumptions have had serious consequences. Over the course of the last decade, aggressive return assumptions and risk-taking, together with falling asset prices, falling interest rates, and deteriorating demographics, have punched gaping holes in many DB plan balance sheets. Unfocused responses to this situation have ranged the full spectrum, from complete de-risking at one end, to piling on more risk at the other.
Fortunately, there is a growing understanding of these traditional DC and DB design faults, and of the problems they have caused, and will continue to cause for plan participants in the years ahead. There is also the beginning of an understanding of what must be done to address these design faults.
The Dutch economist Jan Tinbergen won the first Nobel Prize in Economics for his proof of the proposition that the number of policy goals must be matched by the number of policy instruments. This fundamental proposition has direct application in pension system design.
Pension systems have two goals: pension affordability for workers (and their employers), and payment certainty for pensioners. Therefore they must offer participants two instruments: first, a long-horizon return maximisation instrument to support the affordability goal, and second an asset-liability matching instrument to support the payment certainty goal. Logically, young workers should favour using the first instrument, and pensioners, the second. Over the course of their working lives, participants should transition steadily from the first to the second instrument.
Unfortunately, there continues to be considerable resistance to adopting this more transparent, robust ‘two goals-two instruments' pension model. Some continue to defend traditional DB models for emotional rather than rational reasons. Others continue to defend the ‘caveat emptor' philosophy of traditional DC plans because they profit from it.
The ‘two goals-two instruments' design feature is critically important to pension funds' ability to reshape capitalism.
Effective pension fund organisations
Such investment instruments are a necessary condition for a pension fund-led transition to a more functional form of capitalism. However, it is not a sufficient one. Something else is required. We must also have pension organisations that can effectively construct and manage the two needed implementation instruments. Fortunately once again, we know what such pension organisations look like. They have five success drivers:
• Aligned interests with pension plan participants;
• Strong governance;
• Sensible investment beliefs;
• Competitive compensation.
Unfortunately, there are only a handful of pension organisations on the planet today that score well on all five counts.
• Most pension organisations employ many layers of agents in the execution of their mission. The greater the number of layers of agents employed, the greater the likelihood that principal-agent problems will arise with their attendant costs.
• Ideal boards of trustees are passionate about the cause and understand the purpose of the governance function as distinct from the executive function in the complex business of pension management. While most actual pension boards pass the first test, they do far less well on the second.
• Actual investment behaviour suggests many pension funds do not have sensible investment beliefs. John Maynard Keynes pointed out the distinction between short-horizon ‘beauty contest' investing and genuine long-horizon wealth-creating investing way back in 1936. Yet, even today, the former dysfunctional investment style continues to dominate the latter.
• Effective pension organisations need scale to afford the requisite resources to be successful, and to drive down unit costs. Yet, far too many funds continue to be too small to attain either of these two critical success drivers.
• Executing long-horizon wealth-creating investment strategies successfully requires a special breed of investment managers working inside pension organisations. Yet, because these people are not cheap, this requirement is usually discarded, in favour of hiring far more expensive people outside the organisation. Why? Because their cost can be buried by only reporting net returns to plan stakeholders.
Again, let me be clear about the bottom line of all this: without the existence and legitimacy of pension organisations willing and able to create and execute long-horizon wealth-creating investment mandates, they cannot play the wise intergenerational investor role we have cast them in.
Opening up a second front
Many people and organisations are working hard on the project around the world today. However, I believe the time has come to accelerate the implementation of the pension fund transformation project by opening up a second front. We must develop explicit strategies to move from saying to doing at a faster pace.
To that end, in the area of pension design, the Dutch have publicly acknowledged that the traditional DB plan is dead, but that does not mean moving to traditional DC plans. A serious, collective search is on for a middle way between these two designs, and I believe they will find it.
In the pension area of delivery, my colleague David Beatty at the Rotman School of Management advocates a ‘measure, disseminate, and celebrate' strategy - measure what should be managed, disseminate results widely, and celebrate successes publicly. Three examples of this include:
• CEM Benchmarking Inc. has been measuring the cost-effectiveness of pension organisations since 1991. Research using the resulting databases is validating the ‘five success drivers' model.
• FairPensions founding executive director Alex van der Velden and his colleagues at the Dutch pension organisation PGGM have, for the past three years, managed a €3bn euro-equity portfolio in a manner that would have received John Maynard Keynes' hearty stamp of approval. The portfolio has an explicit long-horizon focus, which considers both macro and micro economic, financial, as well as environmental, social, and governance (ESG).
• Ontario Teachers' Pension Plan was designed in 1990 as a high-performance pension organisation, explicitly endowed with the five success drivers set out in this speech. Today, more than 20 years later, it has verified investment and pension administration track records unequalled anywhere in the world. It is most encouraging that the growth in other large pension institutions, both in Canada and elsewhere, adopting OTPP's ‘five success driver' formula is beginning to accelerate.
In closing, imagine thousands of investment managers with the kind of mandate Alex van der Velden is fortunate to have had for the past three years, all working for hundreds of ‘five success drivers' pension organisations like OTPP has been for the last 20 years. The result would be trillions of dollars of retirement savings managed with a truly long-horizon focus, carefully considering both macro and micro economic, financial, and ESG factors, all consciously acting as active owners of the thousands of corporations they have invested in.
If we could achieve that vision we would not just create more wealth for current and future pensioners. We would, in the process, transform today's ‘headwinds' capitalism into a more sustainable, wealth-creating version, less prone to generate the financial bubbles and crises of the last decade and more legitimate in the sceptical eyes of today's Occupy movement.
Keith Ambachtsheer is director of the Rotman International Centre for Pension Management, Rotman School of Management, University of Toronto.