Sunday, November 30, 2008

OECD Will Release New Pension Guidelines


According to the Organisation for Economic Co-operation and Development (OECD), companies should help staff make the right investment decisions as employees play an ever larger role in managing their pensions:

In a review of its pension fund governance guidelines expected next month, it will recommend employers and financial supervisors fill a "governance vacuum" in pension schemes known as defined contribution (DC) schemes.

Under these schemes, the final lump sum accrued through investments depends on the contributions set aside and the market and employers no longer guarantee a fixed outcome.

These schemes are growing quickly in the UK and are the main offering in most continental European countries already, because they are cheaper to finance.

"Although in theory it (the scheme) is an individual contract, it is the employer who selects the provider and what the investment choices are," said Fiona Steward, who is an pension expert at the OECD.

The new OECD guidelines are expected to be approved by the OECD Working Party on Private Pensions next week and published by the end of the year.

While these guidelines address defined contribution plans, the current OECD guidelines to pension fund governance offer important recommendations for defined benefit plans on pension fund governance (most public plans are DB plans while most private plans are DC plans).

Let's examine a few key recommendations but first, I want to bring to your attention the importance of the governing body of the pension fund:

The central figure in pension fund governance is the governing body that is the person, group of persons or legal entity responsible for the management and safeguarding of the pension fund.

Where the pension fund is established as a pension entity, such entity's governing body will normally also be responsible for the management of the fund. Where the fund consists of a separate account, the financial institution that manages the account is the governing body of the fund.

In some countries, only dedicated financial institutions (pension fund managing companies) are permitted to manage pension funds.

So who is the governing body for these big public pension funds? The OECD states the following:

Every pension fund should have a governing body vested with the power to administer the pension fund and who is ultimately responsible for ensuring the adherence to the terms of the arrangement and the protection of the best interest of plan members and beneficiaries.

The responsibilities of the governing body should be consistent with the overriding objective of a pension fund which is to serve as a secure source of retirement income.

The governing body should not be able to completely absolve itself of its responsibilities by delegating certain functions to external service providers. For instance, the governing body should retain the responsibility for monitoring and oversight of such external service providers.
For most of the big public pension funds, the governing body is the board of directors because they are ultimately accountable for the final investment decisions taken by senior pension fund officers.

But having prepared, presented and defended several documents to the Board of Directors at PSP Investments when I was working there as a senior investment analyst, I can tell you that the board of directors rely a lot on the input of senior pension officers.

This isn't necessarily a bad thing. The only other option for the board of directors is to outsource the work to external consultants who typically charge an arm and a leg for their reports and they often do not add any additional insight.

The OECD guidelines clearly favor expert advice if the board requires it:

Where it lacks sufficient expertise to make fully informed decisions and fulfil its responsibilities the governing body could be required by the regulator to seek expert advice or appoint professionals to carry out certain functions.
In the U.S., board of directors heavily rely on external consultants to cover themselves in case something goes wrong. Most of these pension consultants were spewing out the same packaged advice to all their pension fund clients: diversify into alternative investments to counter the meager returns of public equities.

Unfortunately, many of these consultants were not independent, recommending funds that they were investing with to their pension fund clients.

When it comes to pension consultants make sure they are truly independent and aligning their interests with your pension fund's return objectives and risk tolerance.

You might be asking why is the board of directors the governing body if the supervisor is the government? The problem is that while the government is ultimately responsible for the pension plan, the pension fund is managed independently to minimize political interference in pension investments.

This makes perfect sense, however, the latest pension debacle clearly illustrates that if you give pension funds too much leeway, they might screw up in a spectacular way.

This is why I have been arguing for a different governance model - one that respects the independence of the pension funds that manage pension investments - but that also takes into account the supervisory role of governments that need to make sure taxpayers are not at risk if a pension fund blows up.

In Canada, most of the large public pension funds have been investing in all sorts of complex investments including ABCP, CDOs, CDS, private equity, real estate, infrastructure, commodity derivatives, leveraged loans, private debt, complex hedge fund strategies and other structured products.

I am telling you straight out, even the most experienced board of directors cannot keep up with everything that is going on in these new "improved" pension funds on steroids. They are overwhelmed and they rely heavily on what their senior pension officers tell them. For the most part, they receive good advice from their senior pension fund managers, but they also receive some specious advice too.

From stakeholders' point of view, this is why it makes sense to conduct external, independent performance and operational audits of all internal and external investment activities at least once a year. The board of directors and pension fund managers need to be evaluated by an objective independent body that reports to the Auditor General's office or some government pension regulator.

I have already written about the need for independent performance and operational audits. There is a way to respect the independence of the governing body with the supervisory role of governments and the right of stakeholders to know what is going on in public pension funds.

Let's look at one other important recommendation from the OECD on disclosure:

The governing body should disclose relevant information to all parties involved (notably pension plan members and beneficiaries, supervisory authorities, etc.) in a clear, accurate, and timely fashion.

I think we can all agree that quarterly results must be the norm and that the minutes of the board of directors, including how each board member voted on big investments must be made public. A great example of this is the Alaska Permanent Fund Corporation who publishes board minutes on their site.

Disclosure also includes a detailed and clear discussion of the benchmarks governing each and every investment activity. Importantly, we can't continue paying senior pension officers at public pension funds millions of dollars based on bogus benchmarks that do not reflect the risks of the underlying investments.

I keep hammering away at this last point because it represents a true scandal of modern day pensions. Teachers, nurses, doctors and public servants all work hard to earn a living and they deserve to know that public pension funds are appropriately remunerating senior investment officers based on merit and not some sham benchmark that does not reflect the risks and beta of the underlying portfolio.

Finally, I was quoted in the National Post over the weekend in an article discussing how public plans stay quiet on rumours of losses:

Leo Kolivakis, a former analyst with PSP Investments, says that after the market declines in October and November, many big public sector pension plans are facing enormous challenges, largely because of forays into risky alternative markets that have suddenly turned bad.

"This is a huge crisis in the making," says Mr. Kolivakis.

He argues the crux of the problem is lack of transparency. Many pension money managers are partly compensated based on how well their investments perform relative to benchmark returns. Alternative markets often offered the best opportunities for big returns and a chance to beat the benchmarks. But they also contained hidden risks.

"The biggest scandal is how these pension funds moved public assets from public markets to private markets, claiming they are adding [a better return] but what they were doing is taking a lot more risk," says Mr. Kolivakis. [claiming they are adding diversification benefits was what I said]

I want to make something very clear. I am not against real estate, private equity, infrastructure or hedge funds. They can offer important diversification benefits and downside risk protection to traditional stocks and bonds.

The problem is that you need to invest with the best funds to achieve meaningful diversification benefits and downside risk protection. The dispersion of returns between the top funds and the median funds is so wide that it simply didn't make sense for most pension funds to invest in these asset classes (because they couldn't secure capacity in the top funds). Most are just better off investing in a portfolio of stocks and government bonds and using plain vanilla option strategies to hedge against equity risk.

Worse still, once every pension fund started piling into these investments, the returns started falling (no shock there!) and they fed the bubble in alternative investments.

I saw this coming from a mile a way and so did smart investors like Jeremy Grantham of GMO. I went to conferences where the big investment banks were all peddling the "benefits of alternative investments." In hindsight, they were feeding business to their big hedge fund and private equity clients, fattening up their own pockets in the process.

There is no free lunch. If you want to make money in alternative investments, you'd better reflect carefully about where these markets are heading over the next five to ten years and think hard about where and how you are going to invest in different segments of alternative investments.

The worst mistake you can make is to invest looking at last year's returns. This is plain stupid because I can guarantee you that last year's winners will not be next year's winners.

To sum up, we need more transparency in public pension funds. We need to understand how these investments are being managed and how the board of directors compensates senior pension fund officers.

Hopefully the new OECD guidelines will provide more information on how pension funds can bolster their governance structure.

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