PENSION FUND TRUSTEES ’ DECISION-MAKING 1 Behavioral biases in pension fund trustees ’ decision-making Leonardo

Purpose. Behavioral finance research has almost exclusively investigated the decision-making of lay individuals, mostly ignoring more sophisticated institutional investors. This paper aims to better understand the relatively unexplored field of investment decisions made by pension fund trustees, an important subset of institutional investors, and identify future avenues of further exploration. Approach. This paper starts by setting out the landscape in which pension fund trustees operate and make their decisions, followed by a literature review of the extant behavioral finance research applicable to similar situations. Findings. Despite receiving training and accumulating experience in financial markets, these are limited and sparse, therefore pension fund trustees are unlikely to be immune from behavioral biases. Trustees make decisions in groups, are heavily reliant on advice, and make decisions on behalf of others. Research in those areas have uncovered many inefficiencies. It is still unknown how this specific context can affect the psychological effects on their decisions. Implications. Given how much influence trustees’ decisions have on asset allocation and by extension in financial markets, this is a surprising state of affairs. Research in behavioral finance has had a marked influence on policy in the past and so we anticipate that exploring the decisions made within pension funds may have wide ramifications for the industry. Value. As far as we are aware, no behavioral research has empirically tested pension fund trustees’ decisions to investigate how the combination of group decisions, advice, and surrogacy influence their decisions and, ultimately, the sustainability of our pensions. Most of the published research in behavioral finance has investigated systematic biases in investment decisions made by individuals (for comprehensive reviews, see Barberis & Thaler, 2003; Shefrin, 2009). This biased behavior can be described as anomalous departures from normative decisions as predicted by economic and financial theory. For example, Benartzi and Thaler (2001) have shown how individuals display naive diversification when deciding how to invest their own savings plans: they allocate a uniform distribution of their assets across the options available. Individuals’ choices are determined by the number of options available, regardless of the nature of the options. Hence their choices reflect the options offered, e.g., the proportion invested in stocks depends strongly on the proportion of stock funds offered, while normative financial theory claims they should be informed by the risk-return characteristics of each option. While some individuals decide their retirement asset allocation directly, as researched by Benartzi and Thaler, most people rely on institutions, such as their pension funds, to invest the assets on their behalf. In this situation, the investment decision is not made at an individual level, but at an institutional level. Financial investors can be traditionally split into two main categories: individual investors and institutional investors; with the latter covering pension funds, insurers, mutual funds, hedge funds, corporations, and the public sector. Despite the overwhelming interest of behavioural finance research in individual investors and their decisions, they are not the most important influencers in the financial markets. In the UK, according to the Investment Association,1 a trading body representing UK investment managers, only 19% of the assets under management in the UK were held on behalf of retail clients, with an overwhelming 79% being held for institutional clients (The Investment Association, 2017). More than half of the institutional investors assets belong to pension funds. In Europe, according to the European Fund and Asset Management Association,2 the proportions in 2015 were 27% in retail and 73% in institutional hands, with pension funds representing around one third of the latter figure (European Fund and Asset Management Association, 2017). The proportional representation of pension funds assets has also grown in the last ten years, and is expected to continue growing, with government pushing individuals to enroll more aggressively into pension funds, for example by using automatic enrollment. While institutional investors, and pension funds in particular, are large significant players in financial markets, very little academic attention has been given to researching the behavioral aspects of their financial decisions. Given the issues facing pension funds worldwide, their importance to global financial markets, and the lack of attention their decision-making has received in research, further exploration of their decision-making is crucial. It is essential that investment decisions of pension funds are made wisely, in order to ensure the retirement income of future pensioners. Before defining the potential areas where cognitive biases can surface in pension fund trustees’ decisions, we first need to establish the landscape in which they operate. The assets of occupational pension funds are typically organised as trust entities, and managed by a board of trustees (Bunt, Winterbotham, & Williams, 1998). According to 1www.theinvestmentassociation. org 2www.efama. org This research is supported by a grant from the Institute and Faculty of Actuaries. PENSION FUND TRUSTEES’ DECISION-MAKING 2 a survey in Clacher, McNair, and Hodgett (2017b), the majority of trustee boards have between five and seven members. Larger funds with larger sizes of trustee boards will tend to create specialised sub-committees, thus reducing the size of the group ultimately making certain decisions, such as investment decisions (Myners, 2001). The trustee board has a fiduciary duty to act in the best interests of the underlying members of the fund, who are its ultimate beneficiaries. It is possible that these fiduciary pressures, and the threat of legal action if they are breached, might influence the decision-making of trustees for example, by increasing behavioural inertia (Myners, 2001), by increasing the reliance on external advisers (Pratten & Satchell, 1998), or by relying on non-financial criteria for investment decisions (Del Guercio & Tkac, 2002). Crucially, they decide on how and where to invest the assets of the pension fund, in order to ensure that members will receive a satisfactory income upon retiring (Pratten & Satchell, 1998). The boards tend to meet quarterly or half-yearly, which means that the decisions they make are not frequent, and the feedback they receive on their decisions may take years to emerge (Clacher et al., 2017b). Contrast this against more dynamic market decisions made by traders and brokers, which typically involves immediate feedback. Delayed feedback can disconnect the causal link between action and outcome, and impair learning, leading to poorer decisions in the future (Sutton & Barto, 1990). Pensions regulations in the UK state that at least one third of trustees have to be nominated by the members of the pension fund (typically the employees of the company associated with that fund), with the remainder being assigned by the employer (Myners, 2001). Some of the trustees are professional trustees, and the remainder of the trustees tend to be employees of the company itself. The former group has considerably more experience, are better trained, and are more sophisticated than the latter (Myners, 2001). While pension funds are legally required to provide training, the training provided tends to be very limited, and likely falls short of creating truly sophisticated financial agents, with trustees lacking sufficient financial and investment knowledge and skills. Some trustees interviewed by Myners (2001) have claimed that they did not have a good understanding of the financial markets. By contrast, in the survey by (Clacher et al., 2017b), 69% of trustees reported above average financial literacy, although this was self-reported, and could have resulted from hubris or the illusory superiority resulting from the better-than-average fallacy (Alicke, 1985). Subsequent investigation by Clacher, McNair, and Hodgett (2017a) concluded that trustees were familiar with the most basic investment management concepts, but struggled with more specialist areas, while overall trustees of larger schemes fared better than those of smaller schemes. Because of the lack of crucial knowledge to perform their duties, and the weight of their fiduciary responsibilities, trustees rely heavily on external advice, in the form of consultants and advisers (Myners, 2001; Pratten & Satchell, 1998). These advisers bring with them knowledge in diverse fields, such as legal, financial, accountancy and actuarial. They are likely to have a disproportional weight on the final decisions made by pension funds. Pension advisers are also called upon for handling the daily administrative duties of pension funds, and thus might also have a large influence in the running of pension funds, for example, by influencing the way that questions and issues are framed and presented for trustees when decisions are required, which can make a major difference to the choices made (e.g., Tversky & Kahneman, 1981). According to the Myners report: “trustees tend PENSION FUND TRUSTEES’ DECISION-MAKING 3 to feel that they lack the expertise to do so, and advisers that they lack the power to make decisions” (p. 6). Although it is impossible to deny that investment consultants have great influence on the decision-making of trustees (Myners, 2001), the majority of trustees claim to challenge and question their advice, by considering alternatives, instead of taking it for granted (Clacher et al., 2017a). Despite this, trustees admit that they rarely reject the consultant’s recommendations in the end, and that they are very reliant on their advice (Clacher et al., 2017a). While the advice provided by consultants is likely to