sou · H0B353 · 2012-08-24 00:00:00 — In the light of the global financial crisis, our research has sought to establish the ways in which pension institutions have coped with market volatility and relatively poor performance (measured against historical norms). It was found that funds that augmented the skills of their boards, reinforced board members commitment to the goals and objectives of the funds, and clarified the roles and responsibilities of boards in relation to fund executives tended to be more effective in risk management, tactical and strategic asset allocation, and in dampening the volatility of fund performance (and Urwin 2010). This research has been extended by and Monk to an assessment of pension reserve schemes similar in constitution and purpose to the in . Here, we have sought to identify the principles of best practice as regards the relationships between government (sponsors) and these types of institutions. We suggest that these relationships are best seen as reciprocal, based upon a shared commitment to the goals and objectives of the institution, and characterised by a high degree of knowledge and understanding on the part of the sponsor (and Monk 2011). The logic underpinning pension fund investment is owed to the principles and practices of financial theory, including modern portfolio theory, the efficient market hypothesis, and the concom- itant expected relationship between risk and return (and Bodie 2005). Widely recognised, these principles and practices have been the reference points for investment management for 25 years and more. So, for example, investment strategy has been framed by expectations as regards the equity risk premium (over government bonds), the costs and benefits of versus passive investment, and the ways in which risk and return relate to one another (e.g., risk should be rewarded by commensurate returns). the past decade or so, however, developed financial mar- kets have been affected by a series of financial crises that have begun to erode the plausibility of this model of investment man- agement. The Asian and Russian crises (1997–1998), the LTCM debacle (1998), the TMT bubble and bust (2000–2002), the sub- prime bubble and bust (2007–2009), and the Euro sovereign debt crisis (2011– ) have separately and together introduced a level of uncertainty in markets that has forced practitioners to reconsider conventional assumptions about the nature and performance of financial markets. The Swedish AP system, established as the TMT bubble unwound, has had to cope with these new realities, which have driven considerable change and innovation throughout the investment management industry. One consequence of these new realities has been a greater focus upon the effectiveness of fund governance in and else- where. At one level, the available empirical evidence suggests that the size of a fund is positively correlated with long-term invest- ment returns. In effect, the size of a fund is a proxy for the resources available to an institution when framing and implement- ing investment strategy (2004). In and Urwin (2008a), these resources are shown to include the time available to make decisions, the expertise available to inform those decisions, and the mechanisms or means by which decisions are made and then implemented. often than not, small funds have less time and less expertise available when contemplating investment strategy; more often than not, their decision-making is reactive to markets rather than strategic with respect to market . A second consequence of these new realities has been greater focus upon risk management, distinguishing between the assess- ment and control of the risks associated with investment strategy and practice of portfolio investment by asset class. Some of the most innovative funds have established risk management officers that report directly to senior executives and their governing boards. generally, in and Urwin (2008a) it is suggested that the relationship between the risks assumed by funds and their capacity to assess those risks should be symmetrical, such that institutions risk budgets and governance budgets should cohere with one another. This applies to individual funds and systems of funds. Another consequence of these new realities has been the reali- sation that optimistic assumptions about long-term target rates of return are unlikely to be realised unless funds are willing to take significant risks on the opportunities available at the of markets (and Monk 2012). Many US public sector pension funds continue to assume that returns will be in the order of 8 to 10 per cent per year over the long-term (forestalling reconsidera- tion of funding levels and the risk preferences of sponsors and par- ticipants). These are significant issues and are recognised as such around the world. One more consequence of the new realities has been the recog- nition by investors that their investment time-horizons have become too short, as market volatility, pressure from stakeholders, and the distorted incentives driving the behaviour of external man- agers have compressed the duration of investment strategies. This is problematic. By allowing their time horizon to creep closer to the present day, institutional investors, and in particular pension reserve schemes, have given away one of their key competitive advantages in the marketplace: time. than likely, there is an illiquidity premium that long-term investors such as pension reserve funds can collect. Further, there are asset with attractive risk and return characteristics, such as timberland, which are really only the domain of long-term investors. In the wake of the most recent crisis, funds have had a renewed focus on how they access financial markets. It is widely believed that external asset managers are (in many cases) not worth the high costs they charge. This renewed interest in asset management fees has prompted consideration of the costs and benefits of in-house investing, through co-investments, clubs, or even more innovative and rare models, such as seeding vehicles. These are some of the new realities of finance, driving change and innovation at a remarkable pace. The changing nature of global financial markets offers considerable opportunities for the long- term investor, notwithstanding attendant costs and uncertainties. Taking advantage of these opportunities requires a sophisticated and dynamic governance apparatus, able to adapt to changing cir- cumstances and able to articulate and implement a coherent invest- ment management system that can cope with short-term volatility in the face of long-term opportunities. Ideally, form should follow function: the design of an institution should be consistent with its desired functions such that there is a clear and unambiguous link between the structure of an institution and its intended goals (Summers 2006). Few institutions begin with such an advantage. often than not, compromises are made when institutions are created and powers and responsibilities are allocated to the component parts of institutions (2006). Even if the form of an institution is well-matched with desired functions, as the environment changes and new demands are made on these institutions, it is likely that mismatches will develop. Governance refers to the mechanisms and procedures whereby the resources of an institution and its component parts are mobilised to realise certain goals and objectives. The governance budget of an institution is a finite and measur- able set of resources. In our research, we have shown that some institutions under-invest in governance whereas others over-invest in governance. In the former case, underinvestment in governance can result in an institution overreaching (going beyond what it can reasonably accomplish given its resources). In other cases, over- investment in governance can result in bureaucratic inertia (sys- tematically producing shortfalls in performance). As such, there is a close relationship between the size of an institution's governance budget, its goals and objectives, and what might reasonably be expected in terms of realising those goals and objectives (and Urwin 2008a). Where institutions operate in changing national and global envi- ronments, characterised by anticipated changes in underlying con- ditions as well as punctuated by unanticipated shifts in system- wide stability, there is a premium on adaptation and innovation (Lo 2004; Brennan and Lo 2010). On the one hand, if governance is effective, and if institutions are flexible in terms of their form and functions, institutions can adapt and innovate accordingly. On the other hand, institutions may lag behind changing realities and become caught somewhere between the past, present, and future. In some cases, where governance is unable to the gap between inherited institutional form and changing realities, insti- tutions may have to be abandoned and/or redesigned. It is notable that most financial institutions, including the AP funds, face four types of governance problems. First, they must govern themselves with respect to the changing environment. Second, they must govern the relationship between their sponsors and themselves, including other stakeholders that are relevant to the institutions goals and objectives. Third, they must govern their relationships with external providers whether directly by contract or by ongoing commercial relationships which require oversight and scrutiny (and Monk 2012). Fourth, they must govern their relationships with other institutions, especially those with whom they share similar interests and responsibilities. Each of these governance problems is demanding in its own right. Together, however, they may paralyse an institution, impede its effectiveness, or mesh together in ways that reinforce poor institutional performance. Not surprisingly, the most effective institutions rank-order these issues assigning priority to one while managing the others so as to make good on their goals and objec- tives. It is also apparent that funds that find it difficult to govern themselves, and find it difficult to maintain coherent relationships with their sponsors and stakeholders, also struggle to govern their relationships with external providers and their relationships with similarly placed institutions. Principles of Best Practice As reported in and Urwin (2008a, 2008b, 2010) and in and Monk (2011), we can summarise the principles of best practice according to 4 separate headings: institutional coherence, the skills and expertise of funds, the processes whereby decisions are made and implemented, and the relationship between the institution and its sponsor. It is important to emphasise that the size of funds (AuM) is a crucial determinant of institutional resources. How- ever, some large funds are paralysed by bureaucracy and complex- ity, just as some small funds are fleet-of-foot and more innovative than size would suggest. Institutional coherence: the formal arrangement of an organisa- tion's powers and responsibilities, sustaining the effective link between goals and objectives and their realisation in practice. Here, the clarity of an institution's mission statement and the commitment of the sponsor to that mission statement are essential ingredients in the effective performance of an institution. Equally important is an explicit link between the institutions mission statement and its investment objectives, with appropriate governance and risk bud- gets resourcing investment strategy. Each element in the invest- ment value chain is managed in accordance with its potential payoff and the risks assumed in doing so. Skills and expertise (human capital): the qualities that boards and senior executives bring to the governance and management of the institution, including the appropriate division of responsibilities accor- ding to the available skills and expertise. In effective institutions, boards are of a certain size (6–9 people) and are comprised of individuals who, separately and together, have the depth and range of skills consistent with their responsibilities. Boards delegate to fund executives the roles and responsibilities consistent with their skills and expertise (in areas of investment management and finan- cial markets). Terms of appointment, levels of compensation, and the mechanisms whereby board members and senior executives are reviewed are consistent with the continuity of commitment and domain-specific expertise. Process of decision-making: the mechanisms whereby institutional goals and objectives are realised, distinguishing between the types of decision-making, the consequences of decision-making, and the degree to which decisions are time-dependent or time-sensitive. The alloca- tion of decision rights within the institution distinguishes between, for example, strategic policy issues and tactical investment strategy recognising the very different skills needed in these two domains, and the costs of consequences of blurring these distinctions. Equally important, boards should have the competence to delegate to fund executives the appropriate responsibilities and have the capacity to evaluate the decisions made by fund executives against institutional standards and market standards. Sponsor–fund relationships: the authority and scope of independ- ence delegated to financial institutions by their sponsors, sustaining their roles and responsibilities particularly over the long term. With authority and independence comes an obligation to inform the sponsor, and relevant stakeholders. Equally, authority and inde- pendence should be consistent with the time horizon of the insti- tution's mandate and its investment goals and objectives. Further, the appointment of board members and senior executives should match the institution's mandate and its goals and objectives distin- guishing, for example, that time horizon from the short-term imperatives facing sponsors and stakeholders. Having conducted in-depth case studies of each of the AP funds, we evaluated the AP funds against the standards of governance set in and Urwin (2008a, 2008b, 2010), and and Monk (2011). , we provide a summary of the gaps or short com- ings as regards the governance of the AP funds in relation these standards. Note that this list highlights opportunities for construc- tive change rather than reporting on all aspects of these funds. There is a lack of clarity as to the mission of the AP funds. Is their role... to insure long-term pension obligations? to maximise short-term returns at least cost? to prevent the break being invoked and affecting pension con- tributions and payments? There is a lack of clarity as to who is the sponsor or client of the AP funds: abstract of the sponsor as Swedish citizens etc. are not helpful; the interest of the finance ministry appears short-term rather than long-term; few stakeholders appear to be knowledgeable of the operations of AP funds. There is considerable ambiguity as to funds proper investment objectives. Each fund has: made its own assessment of its share of the liabilities of the pen- sion system; put forward its own fund-specific long-term investment return targets and associated risks; lacked an over-arching policy maker that can evaluate the plau- sibility of these investment objectives in relation to the perfor- mance of the whole system. There are considerable doubts about the competence and skills of AP boards: the available skills vary a great deal between funds; the appointment process tends not to take into account fund requirements; low compensation levels cut against commitment, notwith- standing responsibilities. The composition of AP boards tends to constrain effective deci- sion-making: there are shortfalls in the knowledge and understanding of investment strategies; these shortfalls are especially significant when considering alter- native investments; the boards encourage convention by converging on strategies pursued by other APFs. There is ambiguity as to the powers of fund executives: formal statements of delegated responsibilities are rare; amplifies the problems faced by funds when dealing with market volatility; managing the expectations of boards has become important in these circumstances. There is also concern about the skills of fund executives and port- folio managers: preoccupation with costs may impair recruitment of the most talented individuals; this is particularly true for those that have skills and experience outside of conventional asset ; these types of skills are especially important given the risks incurred by each fund. AP funds face a very challenging environment: their notional share of pension liabilities results in ambitious rate of return targets; the scope of effective investment strategies are constrained by investment rules; one consequence is over-reliance on certain asset and the assumption of high levels of risk. Information management systems are crucial for effective decision- making: the obsession with costs cuts against large-scale investment in information architecture; this creates a patchwork network of fund-specific information systems; combining bespoke systems with various (different) external suppliers is not ideal. Throughout our interviews, we kept a checklist of the issues raised by respondents that require resolution. Whatever the shape and size of the AP system going forward, the following issues were identified by respondents as crucial for the future of the AP sys- tem. Respondents believe that it is crucial to: clarify who is the sponsor; and clarify the objectives or mandate of the AP system and the spe- cific AP funds therein. Just as important is clarification of the relationship between the sponsor and the funds including: reconciliation of fund-specific target rates of return with sys- tem-wide risk exposure; and reduce or eliminate investment restrictions on asset . Notwithstanding the status of AP funds board members, it was noted that many board members believe that the time given to the funds is fungible (given their other demanding roles and responsi- bilities in the public and private sectors). In this respect, it is cru- cial to reform the procedures regarding board appointment; clarify board members responsibilities and the powers of fund executives; set compensation levels consistent with responsibilities. A number of issues were deemed important but less significant, including the following: the costs of services, including investment management; the recruitment and compensation of younger staff; the headcount of each AP fund. Most respondents indicated that size (AuM) is not a problem: at about 20 billion, the AP funds are large compared to peers (in the UK, US, ); AP funds have access to global service providers and investment managers; AP funds are desired clients, even if at the of markets (e.g. hedge funds). On the other hand, there would appear to be constraints related to size: innovation is difficult, being costly and often requiring scarce skills; risk diversification is a challenge, accentuated by investment restrictions; access to global opportunities typically relies upon external pro- viders; large European institutions have highly competitive compensa- tion regimes; especially for the most needed talent. It is rare for a national retirement system to be reconsidered both in its entirety and with respect to the functionality or otherwise of its institutions. often than not, these types of systems are adapted incrementally; attempts are generally made to reconcile the gap between functional effectiveness and changing realities. The Swedish system is widely recognised around the world as more fit for purpose than many other systems because of the reforms taken in the late 1990s and the institutional framework, including the buffer funds, established in 2000/2001. Most other developed economies have systems that owe their origins to the decades immediately following the Second World War. At the same time, the new realities have brought to the fore issues and considerations that warrant concern: the buffer fund institutions may not be as effective as hoped, and the challenges they face going forward over the coming decades may undercut their viability. In our assessment of the governance of these insti- tutions, we have drawn upon our experience with other similar institutions, pension funds, endowments, and sovereign wealth funds. One lesson to be learned from our research is that no insti- tution is ever perfect. Equally, it is apparent that institutional inno- vation in response to changing circumstances can reap enormous social benefits. We have had the privilege of meeting many stakeholders in the current system. We were especially pleased to meet those that had responsibility for the reform process and institutional design. Amongst those that were responsible for the design of the system and those currently responsible for its oversight, management, and implementation, there is widespread recognition that crucial issues are still to be resolved. Here, then, is an opportunity to make good on the remarkable vision that sustained the reform process and institutional design. In this respect, three issues stand out: First, the relationship between the notional sponsor and the AP funds: the current arrangement would seem to be unsatisfactory, more often than not emphasising short-term issues at the expense of a genuine long-term perspective on the AP funds mandate and their goals and objectives. Second, the missing oversight institution and the relationship between the AP funds: the AP funds would benefit from an over- sight institution which with it strategic responsibilities for the entire system, the representative functions of a Swedish social institution, and the responsibility for allocating investment and risk mandates to fund managers. Third, the coexistence of five separate funds: the current arrange- ment of AP funds has not resulted in beneficial competition between funds. Rather, there are many pressures on these funds to converge rather than compete, just as there are many pressures on these funds not to cooperate or to share services. In our view, these problems can be resolved in favour of a more effective and dynamic system. 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