Tuesday, July 15, 2008

Pension Governance: The Need for Independent Performance and Operational Audits


Today I am going to elaborate a little more on the importance of pension governance. This post is somewhat lengthy but important. Why is pension governance important? Well just look at the financial debacle going on in the United States and elsewhere and ask yourself a few simple questions like who is governing these financial institutions and how did they escape the watchful eye of federal and state regulators? When public pension plans suffer material losses, plan sponsors and beneficiaries are impacted and all too often, taxpayers end up footing the bill.

I started off writing this blog by discussing the ABCP's of Pension Governance and Alternative Investments and Bogus Benchmarks. I also touched on the problem of hedge fund benchmarks in another post on Canadian liquid alpha. The important point I was making in all these posts is that benchmarks matter because compensation is based on whether or not pension fund managers are beating the benchmark that governs their investment activity. You do not want to compensate someone for taking undue risks or for taking on beta exposure.

Benchmarks for all investment activities (internal and external) must be clearly reported, well explained and they must reflect the underlying risks and beta exposure of the investment portfolio.


While some investment activities have straightforward benchmarks (S&P 500 or S&P/TSX), other activities have benchmarks that do not reflect the underlying risks of the investment portfolio. This typically happens in illiquid asset classes like private equity, real estate, and infrastructure but benchmark problems also arise in public markets when pension funds undertake internal hedge fund activities, invest in illiquid securities like CDOs and illiquid hedge funds strategies with long lock-up periods or invest in supposedly safe ABCP to shore up the yield on their cash reserves.

If the benchmarks governing each and every investment activity do not accurately reflect the risks or the beta of the underlying portfolio, then chances are that pension plans are overcompensating pension fund managers for beta exposure or for taking on more risk, including credit risk and liquidity risk.

So how do pension plan sponsors and beneficiaries know if their pension fund is adopting appropriate benchmarks for each and every investment activity? Unfortunately, the majority of public pension funds in Canada are less than transparent when it comes to divulging information, especially sensitive information on benchmarks. Why? Because benchmarks determine compensation and most public pension funds adopt an easy benchmark to beat, especially in private markets, allowing senior pension fund managers to collect huge bonuses at the end of the fiscal year.

But aren't these public pension funds following industry "best practices" for pension fund governance? Moreover, aren't they being audited by government auditors? The answer to these questions is yes, most large public pension funds in Canada are following best practices for pension governance and all of them are being audited by the federal or provincial auditors.

However, there are two important caveats attached to that last statement. First, pension governance is constantly evolving as financial markets evolve and there is no pension fund on earth that is following best practices in each area of pension plan governance. Second, financial auditing is not the same as performance auditing. Just because a pension fund passes a financial audit with flying colors, it doesn't mean that their investment benchmarks accurately reflect the underlying risks or beta of each investment activity.

Importantly, financial audits do not equate to performance audits or operational audits.

So why aren't large public pension funds subject to intense performance and operational audits by independent fiduciaries who have the requisite knowledge and expertise to assess the performance benchmarks of each and every investment activity (internal and external)? Part of the problem is that many public pension funds were set up with the view that the governing body must be independent from the plan sponsor. The rationale is simple: by keeping an arm's length relationship between the government and pension fund managers, pension funds' Board of Directors are ensuring that they are governing investment activities without undue political interference.

But who governs the governors? How do plan sponsors and beneficiaries know that their pension fund is truly sound operationally and following performance benchmarks for each and every investment activity that accurately reflect the risks and beta of the underlying portfolios?

One way to respect the independence of the Board of Directors and pension fund managers from plan sponsors is for government supervisors/regulators to use independent fiduciaries or consultants to undertake a performance and operational audit of the plan. The image above (click to enlarge) was taken from a recent presentation and adopted from a public document, The Norwegian Petroleum Sector and the Government Pension Fund – Global.

As shown, the Norwegian Ministry of Finance used Mercer Investment Consulting to evaluate the performance of Norges Bank Investment Management (NBIM), the pension fund and wealth fund manager. Importantly, this performance audit is public for all stakeholders to view and different from the financial audit of the Central Bank Audit done with Deloitte. (You can read more about the Norwegian government pension fund and NBIM by clicking here).

Now, we can argue about whether or not Mercer Investment Consulting is the appropriate independent fiduciary to use but I think the Norwegians have figured out the right governance model for their government pension fund. It is worth noting that NBIM only invests in stocks and bonds. Large Canadian public pension funds are much more "sophisticated", investing in all sorts of complex instruments/strategies including alternative investments like real estate, private equity, infrastructure and hedge funds.

As the complexity of the underlying investments grows so should the rigor of the external independent performance and operational audits. This might necessitate one or a few independent consultants to assess the performance of each and every investment activity as well as the soundness of the operational activities supporting these investments.

There is no doubt in my mind that Canada is blessed with leading global public pension funds. But in my opinion, complacency has set in and a lot more work needs to get done to increase transparency and bolster pension governance at each one of these public funds. Stakeholders, including plan beneficiaries and the general public, deserve independent expert assessments of each and every pension plan activity.

These independent assessments need to be publicly available documents so all stakeholders can evaluate the health of these public pension plans.


Failure to act on a proactive basis will just weaken pension governance and possibly lead to material losses - an outcome that we cannot afford at a time when more and more beneficiaries are relying on their pensions as retirement income.

No comments:

Post a Comment