Investment is the most important but also the most difficult field to master for pension plan boards. Fund managers are hired to produce good investment results, and good performance makes life easier for all parties involved in the pensions deal. In bad times, however, they get bashed in trustee meetings, although often for the wrong reasons.
The relationship between trustees and their fund managers is very delicate and it needs to work well through the ups and downs of market cycles. Much has already been said about manager selection and monitoring over the years. So, there is no need to repeat the established procedures as most trustees seem to pretty familiar with them.
Nonetheless, things are not as settled as they might appear at first sight. Why? Both trustees and fund managers are currently facing a number of major problems. To name a few:
q Pension plan directors don’t feel very comfortable with their investment side. It is difficult to match rising pension liabilities with low, if not negative, investment returns. Trustees are wondering what went wrong: it may not all be the fund managers’ fault, but what are they really paid for?
q At the same time, various governments in Europe are raising the trustees’ fiduciary responsibilities in investment matters. How should ‘prudent experts’ design the appropriate communication framework?
q On the other side, fund managers feel they have been increasingly ‘side-lined’ in the 1990s, when it comes to the core investment decisions of pension plans;
q There is heavy structural change underway in the industry and there are new entrants into the pensions investment market. At the same time, regulators get tougher with them;
q As sponsoring companies are coming to grips with their pension obligations, they take a different view on ‘risk’ than the plans’ actuaries and investment specialists;
q Many direct contribution (DC) plan members have lost confidence in the investment arrangements provided by trustees and the results delivered by managers.
When facing investment-related problems, the easiest thing to do for trustees is to simply sack their fund managers. However, the last few years have demonstrated more widely that rotating fund managers make things even worse.
In addition, many pension plan boards now realise that they were victims of the ‘relative return fallacy’. Their fund managers may do well against the agreed benchmarks while overall assets still fall short of liabilities, sometimes increasingly so.
More so, during good times, investment matters were often low on trustees’ agenda. They spent too much time on things that matter little (eg, specific stock selection issues) and too little time on things
that matter most (ie, strategic asset allocation).
Facing big investment issues, what is the way forward for pension boards in relation to their dealings with asset managers?
Firstly, it needs to be put into the bigger context of pensions governance. The whole direction and control of the investment side needs to be fundamentally reviewed from time to time as part of a pensions business plan. It can be useful to think in terms of three layers of responsibility: governing fiduciaries (pension plan board), managing fiduciaries (eg. CIO, investment committee) and operating fiduciaries (fund managers).
Secondly, put in place a clear process for strategic investment decisions and the interfaces with tactical decisions. For example, how could fund managers’ knowledge of markets and instruments be better used for the plans’ strategic investment decisions? What type and level of risk are they allowed playing with?
Thirdly, decide on a delegation model. Who is in charge of investment manager selection and monitoring? Different delegation models work in different places: delegation to an investment committee, internal CIO, external consultant, multi-manager, or no delegation at all.
The role of fund managers
Once there is clarity about the top-level issues, investment management can be re-structured to suit the needs of the specific pension plan.
Various fashions have been coming and going over the years, ranging from the old style ‘balanced’ manager (in charge of everything) to the most sophisticated ‘core-satellite’ arrangements (with dozens of specialist managers across the whole spectrum of asset classes and investment styles). ‘Overlay managers’ and ‘manager of managers’ see their time coming. The latest additions to this list are managers of ‘liability-benchmark-mandates’ and ‘absolute return’ or ‘alpha’ boutiques, while ‘new balanced’ is aiming at combining these two rather different animals.
There are pros and cons to the different approaches. Whichever delegation model is used, pension directors must put themselves into a position that they can critically assess the status quo and any advice they receive. Talking directly and openly with the people “in the market” helps.
This is just to highlight some key issues from a trustee perspective that need not to be overlooked:
q PPP: Despite all the attempts at assessing ‘people, process and philosophy’ more scientifically, ‘hiring at the top and sacking at the bottom’ is still widespread. However, it is admittedly very difficult for trustees to operate on a ‘contrarian’ basis and hire an underperforming manager;
q Time horizon: The established three year performance horizon is much shorter than the typical length of pension liabilities. This has lead to the demand for ‘longer term mandates’, eg, 10 or 20 years;
q DC: Selecting a DC investment platform and products is a completely different ballgame. In particular, investment administration and communication need to be efficient, if not faultless.
All the classic agency problems apply to the trustee-manager relationship (eg, asymmetry of information, risks and incentives). Plus there are some important specifics:
q Volatility: Given the high level of market noise, the skill factor in investment returns is small relative to the luck factor. It is unfair and counter-productive to judge the fund managers’ ability by the short-term outcome.
q Fiduciary responsibility: In case of underperformance, when does sticking to the guns start to conflict with trustees’ fiduciary duties?
q Delivery: Get the best from all departments, including administration, middle office and product development.
Review and dismissal
Good governance requires regular review procedure for all aspects, not just short-term performances. In practice, areas to watch out for are in particular:
q Changes in ownership and
q High staff turnover;
q Overconfidence in good times;
q Cyclical style changes in bad times;
q Poor risk controls;
q Failings in administration;
q Inconsistent reporting and communication;
q Failure to understand the changes affecting the pension scheme.
When dismissal is inevitable, be aware of the costs of a manager change, eg, transaction costs, costs of new search, management time.
Standard agreements have their merits but it is important to include or amend points that are critical to the specific plan. Some examples:
q Is the investment mandate (ie, asset classes, investment instruments, style, performance targets, risk parameters, time horizon) well-specified and understood by everybody on both sides?
q Where is the responsibility for additional services, such as custody, stock lending, performance analysis, risk reporting?
q How to not to lose out in cash management, foreign exchange, trading practices, transaction costs, soft commissions?
q How are corporate governance and voting policies set and implemented?
q Are the reporting requirements agreed?
This area has come into considerable flux. Low nominal market returns and industry pressures have lead to a move from the middle ground to the extremes, ie, very low fees for unitised passive investments on one side and very high fees for some hedge funds on the other side.
There is an endless debate about performance related fees. How to set strong but realistic performance targets? How to make sure that you don’t reward for luck? There is no point in being dogmatic about these questions. Trustees simply have to weigh the benefits and risks of alternative fee models in great detail - as it needs to be done in all other businesses with complex principal-agent relationships.
Georg Inderst is an independent consultant based in London. firstname.lastname@example.org