Pension Fund Governance: Objectives then implementation
“What I really need is to get clear about what I must do, not what I must know, except insofar as knowledge must precede every act,” wrote the Danish thinker Søren Kierkegaard in an 1835 journal entry. It was one of the first articulations of existentialism – the idea that “existence precedes essence”, that we define ourselves by our thoughts and actions, rather than discovering our essence through them.
There is a kind of institutional existentialism, too, which has become the focus of attention across many areas of life and business, including investment.
“The word ‘governance’ appears increasingly frequently,” says Roger Urwin, global head of investment content and the top thinker on these issues at Towers Watson. “And for good reason: how people take decisions and organise themselves is absolutely critical to success in any venture.”
There is no “essential” institutional investor. A pension fund is different from a sovereign wealth fund, a US fund different from a Dutch fund, a big fund different from a small one. But, more profoundly, this is an existential statement: if you don’t deliberately define your beliefs, and organise accordingly, you cannot expect the right decision-making structure to emerge. In his governance work with clients, Urwin articulates this by identifying three types of institutional change: incremental, developmental and transformational. Organisations he has worked with over recent years tend to have changed incrementally but are now looking for transformation.
“The 50 asset owners above $75bn [€55bn] are all well-resourced with investment teams and CIOs, but none have had their resources for a tremendously long time,” says Urwin. “With very few exceptions that means their organisational structure has developed incrementally, and this is why some have decided to stop and have a check-up on how it all fits together.”
This began when a Middle Eastern sovereign wealth fund approached Towers Watson with a request that took the ad-hoc governance-related work that Urwin’s colleagues had called upon him to do – in recognition of earlier thought leadership in this sphere, including a seminal 2007 paper with Oxford University’s Gordon Clarke, Best-Practice Investment Management – and raised it to a new level. The two-year project built a knowledge base that has since been applied to projects with CalPERS and the UK’s Railways Pension Scheme.
At CalPERS the process resulted in an apparently simple re-statement of investment beliefs, adopted in September 2013. But subtleties in the statement hint at the way the in-depth consultation work with executives, board members and stakeholders profoundly extended investment beliefs into CalPERS’ governance practice. Beliefs IV, V and X are indicative: “Long-term value creation requires effective management of three forms of capital: financial, physical and human”; “CalPERS must articulate its investment goals and performance measures and ensure clear accountability for their execution”; “Strong processes and teamwork and deep resources are needed to achieve CalPERS goals and objectives”.
These echo the 12 factors in Urwin and Clarke’s governance best-practice model, and to their paper’s three “principles of good governance”, covering “organisational coherence”, “people”, and “process”. The same paper’s first key finding was that “return targets and constraints have played a vital role in focusing boards on the nature and scope of their governance processes”.
“We do usually work on the investment policy,” says Urwin. “But we forget at our peril that, in order to get to that we need what I call enablers: the characteristics of the organisation that include culture and leadership, organisational design, talent and reward, outsourcing strategies - what we would call the governance budget.”
So often a non-optimised governance budget determines an investor’s risk budget, Urwin says. But by putting governance at the heart of investment beliefs and risk budgeting, investors can ensure that objectives influence decision-making structures rather than having decision-making structures constrain objectives.
“The big proposition in transformational change is that it doesn’t make sense for risk budget to be defined by governance budget: what you have to do is optimise the product of the two,” he explains. “If I really do have a tiny governance budget, something like fiduciary management or passive-investment is an organisational design feature that probably works well with that budget. At the top-end of the scale, by contrast, organisations can deploy an internal competition model. In some ways these seem like statements of the obvious – and yet people often don’t think this way. There are so many studies out there on how much alpha there is in active management, but almost no work, until very recently, on whether asset owners manage line-ups well enough to add value.”
One important insight from all of this is that large size is not a simple advantage. Every structure has its imperfections, every structure can be optimised. The flipside of having several teams of dedicated specialists is the struggle to preserve a coherent approach across all asset classes, and between assets and liabilities.
“There is a tipping-point at which organisations run up against problems of complexity and leave the benefits of specialisation behind – it’s that sort of trade-off,” says Urwin. He points to investors like The Railways Pension Scheme, PGGM and the UK’s Merchant Navy Officers Pension Fund as having made good progress in optimising this trade-off: the latter uses Towers Watson for implemented consulting but also Hymans Robertson to oversee the arrangement.
“I’m a believer in that type of structure, and the need to bolster oversight – because the board may not see all the imperfections without the help of an independent overseer,” says Urwin.
Should more organisations try to go from incremental to transformational change? It’s not easy, not least because it forces fundamental questions about institutional culture, and requires a refashioning of governance structures around the best aspects of that culture. This is why Urwin emphasises work he is currently engaged in with his firm’s Thinking Ahead Group on the issue of quantifying organisational culture, which makes it clear that aspects of culture can be attributed as positive and negative in advance, and assessed objectively.
“That can be a pretty brutal process, which is why measurement is important,” he says. “There is a business-as-usual ethos which is overpowering – returns have to be competed-for heavily, now, it’s a tougher environment for everyone – and ‘investment beliefs’ is a bit squishy. But if we state that we believe certain things, then only certain actions will be possible – actions that agree with our key objectives.”
Kierkegaard could not have put it better.