Pension Fund Governance and Long-Term Investing: Why Old Habits Die Hard
If short-termism is so short-sighted in global capital markets, then why does it continue to dominate investment management strategies and corporate decision-making?
The short answer is: old habits die hard.
CFA Institute and the Business Roundtable Institute for Corporate Ethics first focused on the issue in 2006, and issued the seminal paper, Breaking the Short-Term Cycle, to recommend strategies for issuers and investors to resist so-called “quarterly capitalism,” and take a longer view of things. Since then, growing interest by investors in stewardship, engagement, and sustainability is encouraging, but benchmark-driven strategies in an age of heightened peer performance sensitivity that encourage short-termism persist, and new strategic frameworks that relate the long-horizon investment objectives and risk tolerances of asset owners to implementation of investment strategies can be complicated.
Why Take the Long-Term Approach?
The problem of short-termism is well understood, if still subject to more precise definition; but prescriptions for change are a bit more elusive. So it is especially gratifying to see the recent publication How Effective Is Pension Fund Governance Today — and Do Pension Funds Invest or the Long Term; Findings from a New Survey from Keith Ambachtsheer and John McLaughlin, which builds upon 20 years of work in understanding pension fund governance issues with a refreshed view of current challenges based on surveys of 81 major pension organizations across the globe. The report highlights the essential linkage between how these significant institutional investors govern their own affairs and their roles in driving a longer-term orientation in capital markets, and suggest issues with potentially high impact in improving fund governance and facilitating long-horizon investing.
Anyone otherwise inclined to think that fund governance issues are secondary will take note of the 1995 survey results cited in the paper in which 50 US pension executives estimated the “excellence shortfall” (that is, the potential increase in performance if barriers to excellence were removed) of their funds to be 0.66% — a material sum given the huge assets represented by those funds. Those barriers to excellence turn out to be largely strategic and within the realm of how boards interact with fund management. And the governance barriers are persistent, as shown by a comparison of the most acute issues identified by pension fund CEOs in surveys in 1997, 2005, and 2014. Those issues are the design and level of staff compensation; the autonomy of staff to hire and fire investment managers; and the selection and development of the fund’s governing fiduciaries.
Aligning Compensation and Long-Term Objectives
Public pension funds will likely remain challenged to pay their staff competitively, and even corporate pension managers may be outbid by the high compensation traditionally earned by investment professionals. It is curious that governing boards — and media and politicians — are relatively comfortable with paying multiples of their payroll expense to the private sector as investment management fees, but balk at elevating compensation of in-house staff above what other employees earn, especially in the public sector. Some funds will navigate these treacherous political waters better than others, and attract and retain excellent professional staff, but it seems likely that the more common path will be to continue to outsource many functions. But as the Ambachtsheer and McLaughlin paper suggests, growing awareness of imperfect alignment of funds’ long-term objectives and investment managers’ revenue is creating a strategic imperative to consider compensation structures that account for a longer-term view, going beyond managing compensation and fee budgets to focus on whether the incentives are appropriate and supportive of long-term objectives. At least some investment managers recognize that a more sustainable arrangement is necessary; in an informal survey conducted by CFA Institute in 2013, 61% of the 750 respondents indicated that deferring more variable compensation over longer time periods was a useful step to line up with their clients’ long-term horizons.
Given the continued reliance on outside managers, defining the investment mandate carefully and managing the relationship is of critical importance, and very relevant to funds’ ability to operationalize whatever aspirations they have to long-horizon investing. And yet the pension CEOs surveyed seem to indicate that internal governance mechanisms around investment manager relationships often fail, with strategic oversight by a board giving way to outsized influence over individual manager relationships. The potential for conflicts of interest in this oversight is high, but best practices (such as the CFA Institute Code of Conduct for Members of a Pension Scheme Governing Body) and regulatory changes around political contributions and sales incentives are a start at reducing some of the dysfunction.
Preparing Boards for Success
Perhaps pension fund board members feel less able to exert influence strategically and gravitate towards decisions with immediate impact, which fits with the survey findings of shortcomings in how fund boards are selected, developed, and terminated. The issues are twofold: first, board members are often unprepared to develop a strategy and evaluation framework because they lack knowledge of investing and capital markets. Second, pension boards are susceptible to the same challenges facing any other board in terms of melding styles, arraying useful skills, and fulfilling a strategic role that guides rather than intrudes on executive functions. We should be focused more on training and developing the fund stewards; the Rotman Board Effectiveness Program cited in the paper is but one example of attempts to professionalize fund board members, and our own Claritas Program, and the CFA Institute Research Foundation trustee primer and online course might serve as useful context for board members.
“Going Long” Within Our Grasp
Rather than a piecemeal approach, however, it is time for a globally relevant set of standards and curricula to equip fund fiduciaries to function effectively. Maybe the costs of suboptimal pension governance is the 0.66% estimated in 1995, or maybe it is something less — or more — than that. The future of finance requires ethical, competent actors all along the supply chain of investment management, and most of the impetus for change away from a short-termist culture will come from what asset owners demand of asset managers. Those demands should be the result of a pension-fund strategy that reflects effective governance by informed stewards, and Ambachtsheer and McLaughlin begin to make the case for effective governance correlating with effective long-horizon investing. This dimension of short-termism, at least, is well within our grasp to address and remedy.
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