Lions love eating grass. In fact, lions gain most of their nutrition from eating grass. It just so happens that lions like delegating the digestion of grass to impala. The reference here, of course, is to the food chain. Pension funds take a similar approach to the basics of their business. As principals, or owners, they delegate to a wide array of agents, or providers, ranging from investment managers to brokers, consultants, lawyers, auditors, actuaries and administrators.
This is where the problem arises. The principal and the agent do not share the same interests. Their interests may be close, but they may also be widely divergent. Pension funds are interested in paying pensions, whereas agents are more interested in performing to a set target. So the investment industry has become a game of incentives, monitoring, obtaining information and holding people to account.
The situation is complicated by the issue of ‘ownership’. In general, the more distant the owner is from the action, the lower the return is likely to be – although ownership remains with the principal, agents typically exercise control. The other basic tenet is that food chain problems typically arise when ownership and control become separated. This is very germane to the UK equity market, and also to other developed markets, where it has become difficult to determine who exactly is the principal (see table).
With retail investors, ownership is clear, although it is questionable whether this group acts like principals. But with pension funds and other institutional investors, ownership is fuzzier. Pension fund liabilities (and thus assets) effectively lie on the company’s balance sheet, so the shareholders of the sponsoring company are the principals, not the trustees. Unit trust holders are technically the principals of the underlying holdings, but in reality they expect the manager to do the investing for them. The same line of reasoning can be applied to the with-profits and unit-linked products of insurance companies.
The point is that if it is unclear who the principals are (or they are not sure who they are), they are unlikely to maximise the return on their assets – the agents will fill the power void. In other words, they may be letting the agents take too much of the return.
That leads to how much pension funds are paying, and to whom.
According to our analysis, the cost of running a pension fund is about 65 basis points a year (Dutch pension fund costs are lower because they hold more bonds and manage more internally).
Here, we would like to stress that we are not sitting in judgement, or covertly pointing a finger at any sector of the industry. We have to assume that all the agents in the pension fund food chain, ourselves included, add value. But we are equally sure that this value could be improved.
To see how this might be achieved, it helps to look more closely at the divergent interests and incentives within the investment industry. We have mentioned that pension funds are interested in paying pensions, while agents are interested in delivering their area of expertise to a level at or above an agreed target. This can work fine as long as the incentives are well specified to ensure an alignment of interests between principal and agent.
Unfortunately, the incentives in our industry are often mis-specified. This generic problem exists for all agents, but in different forms for different agents. For instance, one uncomfortable issue for consultants to address is that, if we operate on a time charge basis, where is our incentive to be efficient? It is true that the discipline of market pricing acts as a control and prevents us from being much more expensive than our competitors, but in a concentrated market that control is limited. Selling product is much cheaper than giving advice, which needs to be thought about and tailored. Ultimately, the onus is on the principals to ensure that they are getting what they pay for.
Moving on to managers, within the past two decades, investment management has evolved from a profession into a business – a business that is engaged in manufacturing relative returns. That is a shame because pensions are ultimately paid with absolute returns. In aggregate, there can be no positive relative return, only the market return less fees and costs.
As for fees, basing these on the value of assets under management acts as an incentive to gather assets. This has led to excess capacity, as evidenced by product proliferation. An equity management firm that did nothing for the 20 years to 2001 other than retain all its clients and grow their portfolios in line with the market would have enjoyed earnings growth of 15% a year – 12% for a bond manager.
In fact, at the end of that 20-year period, the investment management industry was one third as concentrated as the average US industry, but two to three times as profitable. That degree of competitive advantage is not sustainable unless there are massive barriers to entry, or the principal is not exerting enough control.
Brokers also have an incentive problem, which is, of course, that they make money on asset turnover. This is not diametrically opposed to pension funds’ interests, but it is close.
Unfortunately, these principal/ agent problems are deeply rooted in the structure of the industry, so we need to step back and examine the basics of our business. Structures develop for good reasons. We have to ask ourselves if the reasons for the structure of the UK investment industry are still good.
There are two more key questions specifically for trustees to address. Am I measuring my agents well, and is my measurement period optimal? Good measurement is key to good management, and short-term measurement conflicts with long-term goals.
Principals should be able to squeeze more value from their ‘food chain’, and we can suggest several ways in which they might do this. The first is to pay agents a lower fixed fee plus a performance fee top-up. This was voted a top priority by the audience at our recent Global Asset Study conference in London.
Other options are to measure consultants more; to keep managers responsible for research expense; to spend more on internal resources and outsource less, and to keep consultants and funds of funds separate. There are also ways that we can reduce turnover and save on unnecessary costs. Finally, we see a strong call for engagement. Indications are that pension funds are willing to take a more active stance towards corporate governance than before.
To sum up, all of us need to work harder to understand the motivations, incentives and alignments of interest in our industry. Remuneration is a powerful tool, and we think that trustees should exercise more control over what they spend and where they spend it. That will necessitate a rethink of corporate governance, and concerted collective action to bring about change. Pension funds need to gain the upper hand if they want good value from the food chain.
Tim Hodgson is a senior investment consultant with Watson Wyatt in the UK