Quantifying Returns on Pension Governance?
Pension blogger Leo Kolivakis recently wrote about the importance of good pension governance. He rightfully points out that the governance model at US public funds is one, if not the main culprit of our pension woes. I agree with Leo Kolivakis on that.
I believe, however, that for as long as we are unable to measure the effects of poor plan governance, not much will change. Up until now, the talk about good plan governance has been a lot of prose without hard numbers attached to it. And I worry and fear – based on my own experiences – that these hard numbers will be difficult to come by. Not for lack of an algorithm to determine such “Returns on Governance”, but for lack of detailed input data.
You may remember that I recently proposed the Pension Plan Internal Rate of Return (PenPIRR) as the appropriate plan sponsor return that plan sponsors should be looking at when judging their ultimate pension success. I wrote that
“PenPIRR goes beyond the investment sphere. PenPIRR translates the funding status effects of typical plan sponsor actions into return space. All factors that influence overall pension plan success (e.g., investment returns, benefit and funding decisions) become comparable to each other. PenPIRR measures overall pension plan success and is thus the only return measure that can meaningfully be compared to one’s expected rate of return.”
I did not mention, however, my PenPIRR-based performance attribution system. In short, PenPIRR is the top measure of ultimate pension plan success. It is a combination of investment returns (measured in money-weighted return space) and a return component called the “Returns on Governance”. It is my hypothesis that the “Returns on Governance” have been negative for most pension plans, especially for public plans.
To calculate PenPIRR and the Returns on Governance, however, I need detailed liability cash flow projections for each of the years within the performance evaluation period, typically all Projected Benefit Obligations (PBO) data. If we want to calculate a 25-years PenPIRR and the “Returns on Governance”, I would need 26 such PBO structures. I need to quantify the changes in funding status that are not caused by the investment sphere, but by mere plan sponsor actions. For instance, by a decision to grant higher benefits. Or by a decision to not fully fund new benefit accruals.
Let me describe my recent journey to quantify the “Returns on Governance” in an intended pilot study for the three statewide public pension plans in my home state Minnesota. PERA and TRA responded that the data requested does not exist. TRA furthermore claims that “the actuaries never consistently prepared PBO schedules for valuations.” MSRS simply responded that “the data is unavailable” and that its actuary said that “there are no easy (or inexpensive) ways to recreate projections for prior years.”
I find this perplexing as the PBO data are the basis for all subsequent pension calculations. The present value of liabilities and its actuarially distorted relatives such as the “Accrued Actuarial Liabilities” (AAL) and “Unfunded AAL” (UAAL) are all based on PBO data. I even believe that the asset management process is severely impaired without knowledge of the liability structures: What are the upcoming liquidity needs? What is the duration of pension liabilities? Additionally, the lack of past PBO data will now make it all but impossible for the pension plans to calculate a number that they can actually compare to their expected rate of return.
One “huge” success in public pension reform here in Minnesota includes a stipulation that going forward, these PBO structures will have to be published by the pension plans. Yet PenPIRR and the “Returns on Governance” are most useful when viewed over a longer investment horizon. Here is my hypothetical long-term ranking of return measures:
Standard Money-Weighted Return > Time-weighted return > Expected Return > PenPIRR (still positive) >> Returns on Governance (negative by a large degree)
Well, of course, I cannot prove this hypothesis for as long as pension plan executives refuse to publish their PBO data. But below is the rationale behind this ranking.
The National Association of State Retirement Administrators (NASRA) usually goes back 25 years or more to report impressive time-weighted returns that exceed the expected returns as indication or “proof” that taxpayer’s dollars have been saved over this time period. The particular return sequence of good asset returns early on followed by below average returns later on, however, lifts the corresponding money-weighted return above the reported time-weighted return. Pension plans experienced a positive “Path Dependency Effect” since financial markets were benevolent to plan sponsors. Given that return sequence, pension plans should be well overfunded by now – if it weren’t for plan sponsor actions such as contribution holidays or additional benefit increases. While the effects of these actions show up in a plan’s funding status, they are not captured by time- or standard money-weighted returns. But because of our reliance on expected rates of return when deriving funding cost expectations, we need a return measure that is comparable to an expected return. This return measure is PenPIRR.
Aforementioned plan sponsor actions typically lead to negative “Returns on Governance”. Since
PenPIRR = Investment Returns + Returns on Governance,
it may very well be that PenPIRR, the relevant plan sponsor return, is well below the expected rate of return, even if the investment manager succeeded in earning a higher time-weighted return.
I can understand the motivation by pension plan executives to not publish their PBO data – do they really want to know the extent to which their actions negatively impacted investment returns?
But giving them the benefit of a doubt that they really don’t know, I am interested if readers could let me know their experiences with regard to PBO or ABO data (either publicly in the comment section below or by writing to Ehrentreich@ldi-research.com). Are you a corporate or a public plan sponsor? Do you know your PBO and/or ABO numbers? Are you an actuary? Do you provide these numbers to your clients? Do they request them? How long do you have to retain those numbers?
It is my hypothesis that most corporate plans would know their PBO data by now, but my experience with the Minnesota case makes me quite pessimistic for public plans. I believe that public pension plan administrators and their investment managers are flying blind – they do not have the necessary data to effectively manage their plans. And without knowing what was going on the past, they will continue to make the same mistakes that brought the funding crisis upon us.
The financial crisis did not cause the funding crisis of pension plans. It just exposed their structural flaws. If we won’t address them by the time the next crisis – or a simple recession – comes around, I believe that we will see many more DB to DC conversions in the public sphere. A couple years ago I wrote in my blog ("Quo Vadis, Public Pensions?") that if
“we do not act soon with meaningful pension reform, I believe that the few states that are currently considering a DB to DC switch are just the beginning of a tsunami wave that will eventually lead to an almost complete abandonment of DB plans in the public sector – similar to the one we are currently witnessing in the corporate sector. It will play out over several decades, but economic reality is going to catch up eventually with public plan sponsors.”
The pension reforms that we have seen so far are steps in the right direction – but those steps usually pale in comparison to the magnitude of the funding problem. It is thus not surprising that Pension & Investments is now going to host a “Public Funds Defined Contribution Summit.” We are well on our way to the scenario that I depicted two years ago.
Norman received a few off-list remarks and questions concerning the Returns on Governance concept. Below, he clarifies what the concept covers and what not:
My Return on Governance concept is part of a performance attribution system for pension plans that only analyzes the adequacy of benefit and contribution policies. It thus answers the questions whether plan sponsors sufficiently supported their benefit policies through adequate contributions.I thank Norman for sharing his insights with me and urge all pension funds reading this comment to get your actuaries to contact him (Ehrentreich@ldi-research.com) to share your thoughts and PBO data, assuming you keep track of it.
One reader asked about administrative costs such as investment fees, due diligence, legal fees, advice and other services. Paying excessive administrative costs – either in relation to the invested funds or in comparison to a peer group – might point to some serious governance problems. However, those are not covered in the concept I introduced.
Another reader opined that “governance is … substantially based and required in law and by regulation: non- compliance is a real potential risk with a significant cost. There are real examples of the cost of bad governance and it can be explained.” He thinks that calculating an ROI on that kind of governance is a “waste of time.” That kind of governance typically deals with board composition, independence, due diligence, political influences, conflicts of interests, etc. etc. For as long as those governance aspects do not affect the benefit and contribution policies, they won’t show in my Return on Governance concept either.
My Return on Governance concept is thus quite narrow – but it is not fuzzy and therefore quantifiable if the PBO data were available. It answers the question whether the benefit structure is adequate or too generous for the amount of funding the pension fund receives from the plan sponsor.
Norman is correct to point out that most public plan administrators and investment managers are "flying blind" as they do not have the necessary data to effectively manage their plans. He is also bang on when he states the financial crisis did not cause the funding crisis of pension plans, it just exposed deep structural flaws.
As for his ominous and dire warning at the end of his blog post, I'm afraid he's right, if things don't change, the tsunami of switching from defined-benefit to defined-contribution will eventually lead to the complete abandonment of DB plans in the public sector.
Yesterday, the Montreal Gazette published an article by Robert Gibbens, Defined benefit pension plans on the wane, Standard Life says:
Montreal-based Standard Life Canada says it wants to persuade boomers and others following to accept that costly and burdensome defined benefit pension plans are being replaced by defined contribution plans where they will bear greater direct investment choices and risks.Apart from the fact that this was a sloppily written article full of mistakes and misinformation, the author is right, companies are shifting out of defined-benefit into defined-contribution plans, effectively transferring retirement risk entirely onto their workers.
The shift toward defined contribution plans has become more pressing due to market volatility and low interest rates — which reduce investment returns and defined benefit plans’ ability to function effectively.
“Low interest rates could well last for another five years,” said Gerry Grimstone, chairman of the board at parent Edinburgh-based Standard Life Plc., during a Montreal visit Tuesday. It means Standard Life Canada, which stopped selling individual life insurance products last January while remaining in group life, is becoming a long-term savings and investment company providing a full spectrum of products suited to boomers’ need for a comfortable retirement.
It is also focusing on managing defined contribution plans for small and medium-sized businesses as governments move toward making them mandatory, said Charles Guay, Standard Canada’s CEO.
“Our biggest asset in a highly competitive market is the variety of products we can offer ... from annuities, segregated funds, mutual funds and term funds in the retail space,” he said.
With defined contribution (error: benefit) plans, workers make fixed contributions and are guaranteed set monthly retirement income. The employer is responsible if the plan’s ability to pay falls short.
Rating agency DBRS says a review of 451 North American defined benefit plans showed a combined funding gap of a record $389 billion last year. More than two-thirds of the plans were “significantly underfunded.”
Defined benefit plans have become burdensome and fewer companies are offering them to new employees. Instead they offer defined contribution plans where the employer and employee make set contributions and the employee chooses his investment strategy.
Standard Life Canada, which started business in 1833, is Standard Life Plc’s largest operation outside the U.K., accounting for 34 per cent of group operating profit last year. It is issuing $400 million of 3.938 per cent 10-year subordinated debentures, the first such issue in Canada, “We took advantage of favourable market conditions to optimize our capital position and provide more flexibility,” Guay said.
Makes perfect sense for companies to do so but the reality is this will exacerbate income inequality and pension poverty, enriching banks and insurance companies peddling their crappy mutual funds. With all due respect to Gerry Grimstone and Charles Guay of Standard Life, the products insurance companies and banks are offering are woefully inadequate to meet the pressing needs of an aging population worried to death about their retirement security. These people are better off buying Standard Life bonds than their products.
Let me repeat this: large, well-governed defined-benefit plans are vastly superior to any defined-contribution plan. They pool resources, lower costs, invest in the best public and private market managers across the world, and in Canada, Denmark and Netherlands, are increasingly bringing assets internally to lower the costs more, which means all stakeholders will benefit when the cost of their plan goes down.
Take the time to read a speech by the former President & CEO at CPPIB, David Denison, on Canadian pension funds as “Maple Revolutionaries” ‐ lessons from our success. This is an excellent speech which covers some of the issues affecting Canada's retirement system and why Canadian public pensions have led their peers.
According to Denison, the four key reasons why Canadian public pension funds have enjoyed such success are: scale, governance, internal capabilities, and investment horizon.
On governance, Denison emphasized the following:
One absolutely critical aspect of the Canadian model of pension fund management is its governance structure; this is really the Achilles heel for most other organizations around the world.
In CPPIB’s case, we have a professional board of 12 directors chosen solely for their experience and capabilities to guide and oversee the CPPIB organization. They are not political appointees and are meant to ensure that CPPIB operates without any political involvement or influence. They understand what it takes to build and operate a sophisticated investment management organization and have adopted policies, including our compensation system, to enable and promote a high performance culture.Now, to be clear, I have some issues with the way some Canadian public pensions funds compensate their senior managers based on 'loose' benchmarks that don't reflect risks they're taking. Have been a stickler on rewarding senior pension fund managers for risk-adjusted returns and think that many of our "Maple Revolutionaries" are gaming their benchmarks to reap multi-million dollar bonuses.
But even though I think some senior managers at Canada's public pension funds are way overpaid (they're not exactly brain surgeons but comp in finance is outrageous), still feel that our governance model is far superior to the one plaguing most US public pension funds and the long-term results speak for themselves. Canadian public pensions have far outperformed their US counterparts and the main reason why is they got the governance right (still, it can be considerably better).
Below, Lloyd Blankfein, chief executive officer of Goldman Sachs Group Inc., said he is not a socialist, though he believes the economy hasn’t done a good job of distributing wealth fairly. Christine Harper reports on Bloomberg Television's "In The Loop."
Goldman is passing the torch to the next generation, as the investment bank announced that chief financial officer, David Viniar, would retire in January and Harvey Schwartz would take over. We'll see if this improves their governance and sagging public image (stock will shoot up the minute Blankfein announces he's stepping down).