On whales, turtles and risk governance
“What is good governance all about?” asks Andrew Davison, head of institutional asset consulting at Acsis. He was addressing an audience at an Acsis Good Governance presentation held at the Wanderers Club, 11 August 2009. What can we learn from his practical assessment of risk and governance issues as it applies to investment decisions?
“Good governance is the process of optimising investment decisions within a framework that is compliant with statutory and common-law fiduciary duties,” says Davison. People that make investment decisions without such a framework tend to chase returns, taking emotional decisions that inevitably lead to the destruction of value. For trustees in the pension fund space the governance challenge is to create a comprehensive investment strategy that strikes a balance between the long-term horizons of members, while accommodating short-term market pressures.
Being a trustee is a serious business
Davison has plenty of advice for pension fund trustees. The first thing is for trustees to ‘know’ what they are doing! Trustees don’t receive years of training for the difficult tasks they face. “Once you are elected a trustee you have a duty to know what that means,” says Davison. He believes far too many trustees arrive at the first trustee meeting expecting to familiarise themselves with the requirements of their function. Instead they should arrive at these meetings ready to fulfil their role.
He urged trustees to apply their minds to the task at hand at all times. One of the main mistakes made by trustees is the failure to separate their personal likes and dislikes from governance issues. Finally trustees should “wear the right hat” when attending trustee meetings. There are often dominant members in boards of trustees who push their own interests ahead of the interests of pension fund members. Davison warns, for example, that union appointed trustees should set aside union members’ interests in favour of the interests of all pension fund members.
Another pitfall to avoid is the appointment of, and management of, service providers. These appointments should only be made once an investment framework is in place. The board of trustees can then approach the relevant service providers and tell them what the pension funds’ goals are. The trustees should be procurers of a service that fits their investment framework, and not simply accept a solution that the service provider foists on them. “It’s got to be your framework and you’ve got to dictate to the service provider – not the other way around!” says Davison. The fundamental step for trustees responsible for investment decisions is to create an investment framework before selecting service providers and implementing other investment decisions. Trustees must answer the question: “What do we think about investment?”
Some further words on risk
By now you’re probably wondering where whales and turtles enter the mix. Davison unearthed a gem of a quote to open his presentation. Commenting on risk, Charles A. Jaffe notes: “Whales only get harpooned when they come to the surface, and turtles can only move forward when they stick their neck out, but investors face risk no matter what they do.”
There is risk inherent in every decision an investor takes. If you remain in cash you face the risk of negative real yields. “Cash is unlikely to beat, or even match inflation over a long time period, yet people think that is the risk-free option,” says Davison. Investing in structured products exposes you to liquidity risks while various smoothed bonus and guaranteed funds could miss the upside during good years. Risk governance is important because it affects every defined contribution pension fund member. Years ago – when defined benefit pension funds were in the majority – companies carried the risk for underperforming pension fund investments. These pension funds soon reached a crisis due to critical under funding. Companies realised they could only remedy the problem by investing with higher risk or making larger contributions to the fund.
“That risk and those deficits have moved from the defined benefit funds [and companies] to the individual defined contribution pension fund member,” said Davison. The risk is as big as it ever was, but unlike the company in the defined benefit scenario that received an actuarial valuation on an annual basis, the individual member is totally unaware of potential funding shortfalls. “Every single person in a defined contribution fund probably has a worse funding position in their personal portfolio than they did 12 or 24 months ago,” says Davison.
Editor’s thoughts:
Studies have shown that improved pension fund governance can ‘boost’ annual return by between 1% and 2%! If trustees neglect governance issues they severely limit the returns that accrue to members. Do you think the majority of local pension fund trustees possess the skills to serve their members adequately? Add your comments below, or send them to [email protected]
