A FRAMEWORK FOR PUBLIC PENSION FUND MANAGEMENT Public Pension Fund Management Conference The World Bank Discussion Materials Keith P. Ambachtsheer KPA.

A FRAMEWORK FOR PUBLIC PENSION FUND MANAGEMENT

Public Pension Fund Management ConferenceThe World Bank

Discussion Materials

Keith P. Ambachtsheer

KPA Advisory Services Ltd.

Washington DCSeptember 24, 2001

Key Keynsian Message:

“S = I is only half the story”

(perhaps much less than half the story!)

Evolving Perspectives on Savings and Investments

Socialism vs. capitalism Principals vs. agents ‘inside’ capitalism vs. ‘outside’

capitalism Ownership vs. control Integration vs. segmentation Rationality vs. irrationality Individual risks vs. pooled risks

Retirement Income System Design: the World Bank Model

Pillar #1: Minimum Income Support(unfunded, means-tested)

Pillar #2: Mandatory Universal Pension Scheme (funded, employment-based)

Pillar #3: Voluntary Pension/Savings Schemes (funded, tax-deferred, DB, DC)

Key Peter Drucker Messages:(from “The Unseen Revolution: How Pension Fund Socialism Came to America”, 1976)

RIS design will become an increasingly important element of modern capitalism.

This will be a positive development only if pension schemes are endowed with “legitimacy”.

Ambachtsheer’s Pension Scheme “legitimacy” test: (from “The Ambachtsheer Letter” #186/187 July-August 2001)

1. Adequate target income replacement rates to be maintained in real terms.

2. Early vesting and portability.

3. Clarity on the part of all stakeholders as to what the ‘pension deal’ actually is, and who bears what risks.

Ambachtsheer’s Pension Scheme “legitimacy” test: (from “The Ambachtsheer Letter” #186/187 July-August 2001)

4. Symmetry between risk bearing and reward allocation.

5. Reasonable opportunities for risk pooling.

6. Transparency through the regular reporting of assets, liabilities, and contribution rates using generally agreed-upon pension finance and economics principles.

Ambachtsheer’s Pension Scheme “legitimacy” test: (from “The Ambachtsheer Letter” #186/187 July-August 2001)

7. Sufficient organizational autonomy in how the ‘pension deal’ is implemented so that its governance, management, and operations layers can be clearly defined.

8. Sufficient scale to deliver the necessary investment and administration services at reasonable unit costs.

Figure I: Seven Critical Pension Business Questions

ASSETS 

5.   What is the risk-free asset mix that would ‘immunize’ the pension debt outstanding?

 6.   Should the plan undertake asset mix 

policy risk?

7.   Should the plan undertake active management risk?

LIABILITIES 

1.  What is the DB pension deal? 

2.  How much pension debt is outstanding?  

SURPLUS 

3.  What is the target asset/liability ratio? 4.   How are balance sheet gains and losses      allocated between plan stakeholders?      Who owns the surplus on termination? 

Source: Pension Fund Excellence, page 7.

PENSION FUND PERFORMANCE DRIVERS

1. SIZE

2. PROPORTION PASSIVE

3. ORGANIZATION DESIGN QUALITY

Source: “Improving Pension Fund Performance”, By Ambachtsheer, Capelle, Scheibelhut, Financial Analysts Journal, Nov-Dec 1998 

PREVIOUS EXCELLENCE RESEARCH (1)

“After reading our book, you’ll feel a little bit like the airline passenger who peeks into the cockpit at 30,000 feet and discovers there is no-one there.”

O’Barr and Conley

“Fortune and Folly:

The Power and Wealth 

Of Institutional Investing”, 1992

PREVIOUS EXCELLENCE RESEARCH (2)

Median Estimate of Excellence Shortfall: 66 basis points per annum

50 Senior Pension Fund ExecutivesSymposium on “Excellence in  Pension Fund Management”

New York, 1994

BARRIERS TO EXCELLENCE

Rank BarrierCited

 1 Poor process (including structure, communication and inertia)  98%2 Inadequate resources 48%3 Lack of focus or of clear mission 43%4 Conservatism 35%4 Insufficient skills 35%6 Inadequate technology 13%7 Conflicting beliefs 8%7 Difficult markets 8%9 Lack of innovation 5%9 Suppliers 5%

THE 11 DRIVERS OF ORGANIZATION PERFORMANCE

Question No. QUESTION

Governance

2 My governing fiduciaries have good mechanisms to understand and communicate with plan stakeholders

7 My governing fiduciaries do a good job of balancing overcontrol and 

9 Our fund has an effective process for selecting, developing and terminating its governing fiduciaries

13 My governing fiduciaries and related committees use their time efficiently (focused and do not waste time.)

14 There is a high level of trust between my governing fiduciaries and the pension investment team.

15 There is a clear allocation of responsibilities and accountabilities for fund decisions between the governing fiduciaries and the pension investment team.

THE 11 DRIVERS OF ORGANIZATION PERFORMANCE

Question No.

QUESTION

Planning and Management

19 I can describe our vision of where we should be in the future.

22 I can describe our fund’s strategic positioning (how we provide better value to stakeholders than alternatives).

24 I can describe our resource plan (obtaining and optimally utilizing the required human, financial and information technology resources).

28 Developing our asset mix required considerable effort on the part of myself and the governing fiduciaries and it reflects our best thinking.

Operations

37 My organization uses its time efficiently (well focused and does not waste time).

AN ORGANIZATIONAL FRAMEWORK FOR DB RETIREMENT SYSTEMS BASED ON PENSION FUND EXCELLENCE:

CREATING VALUE FOR STAKEHOLDERS

(a) THE PLAN SPONSOR(S)

Define/negotiate ‘the pension’ deal (including benefit formula, who bears which risks, how surpluses and deficits are to be dealt with, funding policy, etc.)Appoint/elect the plan trustees/directors

(b) THE GOVERNING FIDUCIARIES

Decide the plan’s risk policy (e.g. how much balance sheet risk is acceptable, and what ‘payback’ is targeted)Hire/fire the organization’s CEO and establish executive compensation policyApprove management’s business plans for the asset management and benefit administration ‘businesses’Monitor outcomes vs. targets

AN ORGANIZATIONAL FRAMEWORK FOR DB RETIREMENT SYSTEMS BASED ON PENSION FUND EXCELLENCE:

CREATING VALUE FOR STAKEHOLDERS

(c) THE MANAGING FIDUCIARIESDevelop, with governing fiduciaries input, an organization visionDevelop and implement consistent HR and IT strategiesAdvise the governing fiduciaries on the balance sheet risk policyPropose and carry out approved business plans for the asset management and plan administration ’businesses’ consistent with the organization visionAnalyse and report outcomes vs. targets to the governing fiduciaries.

(d) THE OPERATING FIDUCIARIES(operating either internally as employees or as third parties on an outsourced basis)

Asset ManagementManage pre-defined investment portfolios within pre-defined risk and cost constraints to achieve pre-defined results

Benefit AdministrationDeliver benefit administration services to clients at pre-defined service and cost effectiveness levels

Key Financial Governance Decisions in Pension Schemes:

performancetarget

=+1.5%MRPR

RF= (eg.,TIPS with 15 yr. dur.)

Max Risk = 10%  

BUILDING THE STRATEGIC PLAN (I)

Match CF requirements with default risk-free nominal and/or 

inflation-protected bonds

How do we characterize the choices?

RISK FREE STRATEGY   RISKY STRATEGIES

“It is long term investors who most promote the public interest. Yet it is they, wherever investment funds are managed by committees or boards, who will in practice come in for the most criticism. For the behavior of long term investors will seem eccentric, unconventional, and rash in the eyes of average opinion. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally”.  

John Maynard Keynes, 1936

 “[Active management] is like a game of Snap, of Old Maid, of Musical Chairs. He is the victor who says ‘snap’ neither too soon nor too late, who passes the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.

John Maynard Keynes, 1936

BUILDING THE STRATEGIC PLAN (II)

LONG HORIZON

PRIVATE OR PUBLIC

Markets Markets=

CF Projection/Valuation Strategies• Core public equities• Merchant banking• Venture capital • Other?

SHORT HORIZON

PUBLICMarkets

=

Active Management=

Absolute Return Strategies

• Event-driven• Value-driven• Other?

Risky Strategies

BUILDING THE STRATEGIC PLAN (III)

Index Funds

Trust market participants to do CF projections/valuations

‘Build Your Own’

Don’t trust market participants to do CF projections/valuations

Build or acquire your own processes

Decide on your own MRPR

Risky Strategies

LONG HORIZONPUBLIC MARKETS

CORE PUBLIC EQUITIES

BUILDING THE STRATEGIC PLAN (IV)

Index Funds

hold market weight in Cisco regardless of price

the rule holds whether Cisco is at $60 or $18

‘Build Your Own’

hold Cisco if it passes the MRPR test if MRPR = 0, hold Cisco at $60 or less if MRPR = 3%, hold Cisco at $18 or 

less

CORE PUBLIC EQUITIES

Which is the better way to build a core public equities portfolio?

BUILDING THE STRATEGIC PLAN (V)

‘Asset Allocation’   

            Risk-Free Long Horizon Short Horizon Strategy Risky Strategies Risky Strategies

 A B C D E

Expected Excess Return 0% 0% 3% 0% 3% 10% Excess Return Volatility 0% 20% 20% 2% 20% 5%  

WHAT ARE THE ‘OPTIMAL’ WEIGHTINGS? 

CONCLUSIONS

Current fund management paradigm needs to be challenged Any new paradigm should be grounded in common sense and 

good OD principles This presentation introduces a ‘new paradigm’ candidate 

involving a re definition of OD roles, and a redefinition of ‘asset classes’ and ‘asset allocations;

It promises more focused and integrated risk management, and improved fund reward/risk ratios in a zero/low equity risk premium environment

Do you agree?