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A FRAMEWORK FOR PUBLIC PENSION FUND MANAGEMENT

A FRAMEWORK FOR PUBLIC PENSION FUND MANAGEMENT. Public Pension Fund Management Conference The World Bank Discussion Materials Keith P. Ambachtsheer KPA Advisory Services Ltd. Washington DC September 24, 2001. Key Keynsian Message:. “S = I is only half the story”

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A FRAMEWORK FOR PUBLIC PENSION FUND MANAGEMENT

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  1. A FRAMEWORK FOR PUBLIC PENSION FUND MANAGEMENT Public Pension Fund Management Conference The World Bank Discussion Materials Keith P. Ambachtsheer KPA Advisory Services Ltd. Washington DC September 24, 2001

  2. Key Keynsian Message: “S = I is only half the story” (perhaps much less than half the story!)

  3. 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

  4. 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)

  5. 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”.

  6. Ambachtsheer’s Pension Scheme “legitimacy” test: (from “The Ambachtsheer Letter” #186/187 July-August 2001) • Adequate target income replacement rates to be maintained in real terms. • Early vesting and portability. • Clarity on the part of all stakeholders as to what the ‘pension deal’ actually is, and who bears what risks.

  7. Ambachtsheer’s Pension Scheme “legitimacy” test: (from “The Ambachtsheer Letter” #186/187 July-August 2001) • Symmetry between risk bearing and reward allocation. • Reasonable opportunities for risk pooling. • Transparency through the regular reporting of assets, liabilities, and contribution rates using generally agreed-upon pension finance and economics principles.

  8. Ambachtsheer’s Pension Scheme “legitimacy” test: (from “The Ambachtsheer Letter” #186/187 July-August 2001) • Sufficient organizational autonomy in how the ‘pension deal’ is implemented so that its governance, management, and operations layers can be clearly defined. • Sufficient scale to deliver the necessary investment and administration services at reasonable unit costs.

  9. LIABILITIES 1.  What is the DB pension deal? 2.  How much pension debt is outstanding? 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? 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? Figure I: Seven Critical Pension Business Questions Source: Pension Fund Excellence, page 7.

  10. 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

  11. 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

  12. PREVIOUS EXCELLENCE RESEARCH (2) Median Estimate of Excellence Shortfall: 66 basis points per annum 50 Senior Pension Fund Executives Symposium on “Excellence in Pension Fund Management” New York, 1994

  13. BARRIERS TO EXCELLENCE Rank Barrier Cited 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%

  14. THE 11 DRIVERS OF ORGANIZATION PERFORMANCE

  15. THE 11 DRIVERS OF ORGANIZATION PERFORMANCE

  16. 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 policy • Approve management’s business plans for the asset management and benefit administration ‘businesses’ • Monitor outcomes vs. targets

  17. AN ORGANIZATIONAL FRAMEWORK FOR DB RETIREMENT SYSTEMS BASED ON PENSION FUND EXCELLENCE: CREATING VALUE FOR STAKEHOLDERS (c) THE MANAGING FIDUCIARIES • Develop, with governing fiduciaries input, an organization vision • Develop and implement consistent HR and IT strategies • Advise the governing fiduciaries on the balance sheet risk policy • Propose and carry out approved business plans for the asset management and plan administration ’businesses’ consistent with the organization vision • Analyse 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 Management • Manage pre-defined investment portfolios within pre-defined risk and cost constraints to achieve pre-defined results Benefit Administration • Deliver benefit administration services to clients at pre-defined service and cost effectiveness levels

  18. Key Financial Governance Decisions in Pension Schemes: =+1.5% MRPR performance target RF = (eg.,TIPS with 15 yr. dur.) Max Risk = 10%

  19. Match CF requirements with default risk-free nominal and/or inflation-protected bonds How do we characterize the choices? BUILDING THE STRATEGIC PLAN (I) RISK FREE STRATEGY RISKY STRATEGIES

  20. “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

  21. “[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

  22. LONG HORIZON PRIVATE OR PUBLIC Markets Markets = CF Projection/Valuation Strategies Core public equities Merchant banking Venture capital Other? SHORT HORIZON PUBLIC Markets = Active Management = Absolute Return Strategies Event-driven Value-driven Other? BUILDING THE STRATEGIC PLAN (II) Risky Strategies

  23. 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 BUILDING THE STRATEGIC PLAN (III) Risky Strategies LONG HORIZON PUBLIC MARKETS CORE PUBLIC EQUITIES

  24. 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 BUILDING THE STRATEGIC PLAN (IV) CORE PUBLIC EQUITIES Which is the better way to build a core public equities portfolio?

  25. 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?

  26. 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?

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