Practical analysis for investment professionals
24 June 2013

Fixing the “Loser’s Game”: What It Will Take

The following guest editorial was written by Keith Ambachtsheer, director of the Rotman International Centre for Pension Management (ICPM). It was published in the May/June 2013 issue of the Financial Analysts Journal.

In preparing to write this editorial, I compared Charley Ellis’s 1975 FAJ article “The Loser’s Game” with his 2012 FAJ article “Murder on the Orient Express: The Mystery of Underperformance.” The comparison confirmed for me his remarkable ability to stay “on message” for a very long time. Equally remarkable is that over that same very long time, so little has changed in an industry he continues to accuse of producing too little value at too high a price. Why is that? Why has his multidecade criticism of the global investment management industry (along with a few fellow travelers, such as Jack Bogle and Burt Malkiel) had so little impact? And what will it take for the industry’s services to produce measurable customer value at a reasonable price in the future? Could it happen?

Asymmetric Information

George Akerlof was awarded the 2001 Nobel Prize in Economics for a profound idea captured in his 1970 article “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,” in which he showed that the classic “value-for-money” outcomes attached to market competition require informational symmetry between buyers and sellers. If sellers know more about what they are selling than buyers know about what they are buying, the sellers will be able to extract too high a price from buyers for too little value. Although Akerlof chose the used-car “lemons” market to make his point, he could just as well have chosen the market for investment management services — it would be hard to conceive of a market with greater informational asymmetry between buyers and sellers. If asymmetric information is the underlying problem in the market for investment management services, then simply removing the informational asymmetry must be the solution. Can we create a demand side in that market that understands the realities of financial markets, security pricing, and the economics and motivations of security issuers as well as the supply side does? This question is essentially about institutional design. So, more specifically, can we create investment institutions with both the requisite knowledge of finance and economics and a legal requirement to use that knowledge solely in the best financial interests of their clients? Put more succinctly, can we create knowledgeable investment institutions with clear fiduciary responsibilities to their stakeholders/beneficiaries?

Can We?

Both deductive and inductive approaches are useful in finding answers to these questions. The deductive approach follows from the application of Peter Drucker’s principles for the design of an effective organization: clear mission, proper alignment of interests between principals and agents, being right-scaled, good governance, effective executive function, and competitive compensation. Organizations with these attributes should be able to produce customer value at a reasonable cost. An inductive approach asks, Are there investment institutions in the world that have offered their clients a measured value-for-money proposition for long periods of time? And if we can find such institutions, what are their key attributes? A virtuous circle would see these attributes as aligned with Drucker’s principles of effective organizations, which he applied to pensions in his 1976 book The Unseen Revolution: How Pension Fund Socialism Came to America.

One problem with testing this virtuous circle hypothesis is that there are too few observations with which to perform standard tests of statistical significance. So, we must use abductive reasoning, in which logic and intuition replace the comfort of strong statistical confirmation. In fact, I know of only one investment institution that was explicitly built on Drucker’s organizational principles and also has a long operating history and verifiable performance metrics. The globally respected Ontario Teachers’ Pension Plan has generated a top-percentile annual net excess return of 2.1% since its inception, in 1990, relative to its passive policy portfolio while incurring only a minimal increase in balance sheet mismatch risk. Its pension benefit administration services have also received a top-percentile ranking on a value-for-money basis from the same benchmarking organization.

What Do Drucker Principles–Based Investment Institutions Do Differently?

These long-term investment results are sufficiently removed from the typical institutional performance experience to beg an explanation. A plausible one is that Drucker principles–based investment institutions are organized and behave fundamentally differently from the “loser’s game” investment institutions that Ellis continues to describe so graphically in his writings.

The five differentiating elements are as follows:

  • Clear mission: The organization’s sole purpose is to create value for its stakeholders/beneficiaries, suggesting that the organization must be at arm’s length from its sponsors/owners in order to act independently and must also be noncommercial to remove the motivation of asymmetric information exploitation.
  • Being right-scaled: The organization must be large enough to capture significant scale economies for its stakeholders/beneficiaries.
  • Good governance: Board members are carefully selected on the basis of (1) passion for serving the organization’s stakeholders/beneficiaries and (2) skill, experience, and aptitude for contributing to effective board oversight of a complex financial institution.
  • Sensible investment beliefs: The organization understands both the continuously evolving nature of the global investment opportunity set and its own capabilities to engage those opportunities effectively.
  • Competitive compensation: Although noncommercial, the organization recognizes that it must attract “the best and the brightest” investment professionals in a competitive, highly compensated labor market. Only in these circumstances can it make informed insource versus outsource decisions on a pure value-for-money basis.

How do we populate the globe with this kind of investment institution?

From One to Many

Happily, over the course of its now 22 years, the story of the Ontario Teachers’ Pension Plan has spawned a growing number of investment institutions explicitly based on Peter Drucker’s design principles, both in Canada and internationally. Not surprisingly, this growth first occurred in Canada, with the birth and evolution of such organizations as AIMCO, BCIMC, CPPIB, HOOPP, La Caisse, OMERS, and PSP Investments. Their strong global impact has not gone unnoticed. An article in the Economist noted,

They own assets all over the world, including property in Manhattan, utilities in Chile, international airports, and the high-speed rail line connecting London to the Channel tunnel. They have taken part in six of the top 100 levered buyouts in history. They have won the attention of both Wall Street firms, who consider them rivals, and institutional investors, who aspire to be like them.

The Drucker model has also been taking hold outside Canada. The final report of the government-sponsored Cooper Review noted that Australia’s mandatory superannuation system is too expensive and must be re-engineered “to operate more in the best interests of its members.” Its recommendations of greater industry efficiency, better governance, and lower costs are now being implemented. Leading the way are such noncommercial pension organizations as Australian Super, QSuper, and Sunsuper. Northern European countries are also actively working to align their pension investment institutions with the Drucker model. Dutch, Danish, and Norwegian organizations — including APG, ATP, NBIM, PGGM, and MN — are in the forefront. Sweden and Finland are reviewing how to bring their national buffer funds and employment-based pension funds more in line with the Drucker model.

In the United States, the Drucker principles–based organizations TIAA-CREF, Commonfund, and Vanguard go back to 1952 (in its current form), 1969, and 1974, respectively. The Thrift Savings Plan of 2008 for federal government employees is a more recent example. Some state and local pension organizations have dismantled, or are in the process of dismantling, their dysfunctional “Murder on the Orient Express” organizational structures, which have historically featured ill-governed, understaffed, poorly compensated inside employees and highly paid, underperforming outside employees. CalPERS has been a prominent leader in this difficult transformational process.

Reaching Uncovered Workers

A common theme in this “from one to many” story is organizational sponsorship. Given their noncommercial constraints, Drucker principles–based pension organizations have thus far been fostered mainly by large public sector and industry/labor entities. Their missions flow from their buffer fund roles in national Pillar 1 “pay-go” (i.e., not pre-funded) pension schemes and from the pre-funding requirements in employment-based Pillar 2 schemes. Collectively, they currently constitute a $5 trillion financial force that will continue to grow. Another source of future growth is workers at midsize and small private sector employers in countries where Pillar 2 pension coverage is voluntary (e.g., the United States, the United Kingdom, and Canada). This large group of workers has had to sort out its own supplementary pension arrangements and has been especially vulnerable to the negative consequences of informational asymmetry in building its pension pots.

In the United Kingdom, this vulnerability was identified as a serious market failure by the Turner Pension Commission in a series of reports submitted to Parliament between 2004 and 2006. The commission noted both demand-side and supply-side failures in the U.K. pension market. The demand-side failure was inadequate retirement savings by many workers who were not members of Pillar 2 pension schemes. The supply-side failure was the absence of low-cost, expert pension management and delivery organizations acting in the sole best interest of participating workers. To solve these two problems, the commission recommended (1) mandatory auto-enrollment in a qualifying plan of all U.K. workers without a Pillar 2 pension plan and (2) a government initiative to create a default-qualifying plan to ensure that all workers would be expertly covered.

These recommendations led to the creation of the National Employment Savings Trust (NEST) through the Pensions Act of 2008. Only recently — after extensive debate and research on how best to design the auto-enrollment protocol and how best to put the NEST pieces together — has the plan become operational. Even now, such features as the roles of guarantees, risk pooling, annuitization, and member communications continue to be researched and developed. Organizationally, NEST fits the Drucker model closely. It has a clear noncommercial mission, operates at arm’s length from government, and has a top-notch board and knowledgeable management team. Moreover, as NEST expands coverage to millions of U.K. workers currently without pension plans, it will operate with large-scale economies and thus low unit costs.

In a promising development in the United States last year, Senator Tom Harkin, chair of the Senate Committee on Health, Education, Labor, and Pensions, announced an initiative similar to NEST: USA Retirement Funds. He noted that over half of the 130 million U.S. private sector workers have no employment-based pension plan of any kind. USA Retirement Funds would be licensed, pooled, and overseen at arm’s length by qualified boards and would take over the fiduciary duties currently carried out by employers. North of the border, Canada is also debating the launch of a NEST-type initiative to cover its millions of private sector workers without pension plans.

In short, 37 years after the publication of Peter Drucker’s The Unseen Revolution, his pension revolution is finally becoming visible.

Fixing the Loser’s Game

There is surely irony in the fact that Peter Drucker solved the “loser’s game” problem only a year after Charley Ellis first described it in his 1975 FAJ article. It is tempting to say that the greater irony is that it has taken three decades to connect the problem to the solution. But that would ignore the reality that periods of gestation between a major discovery, its “translation,” and its widespread implementation have always been multidecade affairs. The exciting thing about the global pension revolution and its growing impact on the institutional structure of the investment management industry is that it is now moving out of the translational phase and into widespread implementation. This transition is not happening because the investment profession is suddenly being guided by a new “greater good” compass — it is happening because the root problem of asymmetric information–driven market failure is finally being addressed.

I encourage investment professionals to see the creation of strong Drucker model–based pension institutions around the world as an opportunity rather than a threat. These institutions are our best hope for articulating and implementing the truly long-horizon, wealth-creating investment programs that workers everywhere will rely on for their future prosperity.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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