What every fiduciary should know
'Pension Fund Excellence'
Keith P Ambachtsheer and D Don Ezra,
Wiley Frontiers in Finance, 1998 £50/$64.95
There was a time when pension funds were an obscure subject, discussed only by obscure people..." Hence the beginning not of a fairy tale, but of this recently published book.
In this well-structured and easy-to-read book, the authors, both long-time experts on the pension fund business, aim to pull together "all the strands of pension governance, finance and investments together into a unify-ing, tangible, transparent whole".
The authors claim that the rising visibility of pension funds since "there was a time" has not led to a broader understanding of what pension funds do, how well they do it and how they could improve their performance. Disturbingly enough Ambachtsheer and Ezra observe that even many of the governors of pension funds themselves do not fully understand what they are governing, and what it takes to do a better job. This lack of understanding and lack of a guiding paradigm of how pension funds should be managed may have led to a global 'excellence shortfall' of approximate-ly $60bn a year. Clearly, there is a lot at stake in improving the performance of pension funds, even more because they perform a critical role in converting retirement savings into the wealth needed when the babyboomers retire. If money is wasted by bad governance and management, this conversion is not certain to happen.
A pension fund is a special sort of financial business that needs to be managed in a businesslike fashion in the best interest of all its stakeholders: those who have a financial stake in its success. Pivotal to this success is a clear view on what those stakeholders' interests are; these can be expressed in a mission statement, and good organisational design to tackle agency problems that lie behind the above mentioned excellence shortfalls. Accountability of pension fund fiduciaries is an important point here.
Pension Fund Excellence proposes a way to measure how well a pension fund is really performing and thus how good its fiduciaries are. This is the heart of the matter, because there is no management without measurement. Pension fund performance can be expressed in RANVA (Risk Adjusted Net Value Added), a concept that should be well known to anyone who is familiar with the work of Ambachtsheer, who introduced this term. RANVA makes a correction to the gross fund investment return not only for operating costs, but also for the costs implied by the risk of having an investment portfolio that differs from the fictitious portfolio that is least risky vis-à-vis the liability structure of the pension fund. However, measuring RANVA is not easy. For example: what is this least risky portfolio? And how can the risk taken be translated in cost terms? But the concept of correcting for risk certainly makes it a more relevant measure than 'net investment return', which most pension funds use to decide whether they have done well or not. RANVA is a measurement system for people who would rather measure the right things imperfectly than measure the wrong thing perfectly or measure nothing at all.
A four-year sample of almost 100 North American pension funds has produced a RANVA of -0.5% per year. Analysis of the results from the sample and other research reveals three important points. The first is that large pension funds fare better than small pension funds. This is due to economies of scale and their higher percentage of passively managed assets. Secondly, passive management is better than active management. In the North American sample active management did not generate sufficient returns to compensate for the risk taken. The third point is that good organisational design helps to generate higher returns.
Besides giving a view on how pension funds should be managed, the authors elaborate on "what every pension fund fiduciary should know ... or have a view on". Inter alia pension law and pension economics, relevant properties of capital markets and the market for investment management services are covered. The book concludes with a discussion of three important issues concerning pension funds now and in the future. First is the defined benefit (DB) versus defined contribution (DC) debate. A critical review is given on the DC concept, which some view as the answer to the weaknesses of the DB system, but in the authors' view both systems have their drawbacks. Second, the issue of 'broke' national pension schemes is discussed and third the growing economic power of pension funds. With respect to this last point Ambachtsheer and Ezra find that pension fund shareholder activism most probably has a positive effect on the targeted firms.
Pension Fund Excellence addresses those people that should run their pension fund as a financial business: trustees, senior pension fund executives and - also as a means to better understand part of their business - pension fund investment managers, actuaries, accountants and consultants. It can help them understand how they can produce value for the pension fund stakeholders net of operating costs and net of adequate compensation for bearing risk.
In our view it gives a good overview of what pension fund governance is all about and what can be called 'best practice' in the pension fund business at present. Thus it is a useful book for the people it is written for because, honestly, we can't all be best practitioners.
Roderick Munsters is managing director investments of PGGM, the Dutch pension fund for the health care and social work sector. Jet Gerla is a member of PGGM's investment policy and strategy department"