LONDON -- J. Sainsbury PLC pension fund plans to rewrite contracts with its active managers to include financial penalties for underperformance and missed investment targets, in a move likely to put the fund on a collision course with its managers.
The plan's trustees agreed at a meeting last month to try introducing a penalty system that will be implemented on a case-by-case basis, said Geof Pearson, pensions manager for the 2.9 billion ($4.6 billion) defined benefit fund for the employees of the British supermarket chain.
And incumbent active managers Mercury Asset Management Ltd., J.P. Morgan Investment Management Ltd. and Deutsche Asset Management, all based in London, will be approached by the plan over the next six months, he said.
Mr. Pearson declined to be specific about penalties, saying they would be negotiated with each manager.
Capital International Ltd., London, will not be asked to participate as its 18 million emerging-markets mandate is too small for a penalty system, he said.
But market sources said Mr. Pearson would have a tough time implementing a penalty system, as few active money managers would be willing to take the financial risk of underperforming in volatile markets.
Consultants also are concerned that managers working under such a penalty system will become simply de-facto index funds in order not to underperform, which would defeat the object of hiring an active manager in the first place.
"There will be no welcome for this among the managers, that's for sure. . . . But managers will not take risk controls seriously unless they are punished by more than just being fired," said Mr. Pearson.
Managers not prepared to accept a penalty system may not have sufficient faith in their internal risk management systems, he said.
He would not say what would happen if any of the fund's managers refused to agree to such a system. "We will cross that bridge when we come to it," he added.
"We expect a manager to be able to construct a portfolio that behaves within the risk-control parameters that are set down" in the manager agreement, he said. "The penalty system is designed to avoid legal disputes so that pension plans can truly establish the level of confidence a manager has in his or her ability to control risk."
Sainsbury's planned move to underperformance penalties arose from performance problems the plan experienced with Mercury Asset Management during 1997 and 1998, when the money manager underperformed a U.K. equity mandate by almost 10 percentage points. Sainsbury fired MAM from the mandate in January 1999, but the manager continues to run a 200 million fixed-income mandate and 200 million in Japanese, European and U.S. equities for the fund.
MAM currently is facing a court battle with the Unilever UK Ltd.
Superannuation Fund, which is suing the manager for claims related to poor performance. Sainsbury will apply for similar damages from MAM if Unilever's case is successful, but would try to avoid taking legal action, said Mr. Pearson. "Our confidence in managers' ability to handle risk through statistical techniques has been undermined," he added.
The group's other active management mandates are J.P. Morgan's 400 million portfolio of North American, European and Japanese equities, and Morgan Grenfell's 160 million fixed-income portfolio of international bonds and U.K. gilts.
None of the managers were prepared to comment.
Latin American precedent
Sainsbury's penalty system would be similar to that used by a number of Latin American governments when dealing with money managers of their "second pillar" mandatory defined contribution schemes, said Mr. Pearson.
Countries such as Chile, Uruguay and Peru require managers to compensate schemes if they underperform a given benchmark by more than two percentage points. If the rate of return is above a defined maximum -- two percentage points in Chile and Uruguay -- the excess is credited to an excess return account. Money in the excess return account then would be used to make up for a manager's underperformance in subsequent years.
In Sainsbury's case, manager fees would not be affected by the system, which also is not a substitute for performance-related fees, he said. A manager that agreed to work under a penalty system would continue to be paid fixed, value-added or performance fees as agreed.
Mr. Pearson maintains the fees and the fines for underperformance will be managed separately. But a money manager familiar with the Latin American system said the fee and fine boiled down to the same thing, and the fine effectively reduced the overall management fee. Under the Latin American system, managers forfeit outperformance and are fined for underperformance, an arrangement unlikely to be attractive to U.K. money managers.
At this stage it is unclear exactly how Sainsbury will treat this issue.
He would not give specific examples of the limits that would be applied to each manager, as the penalty system would be constructed on a case-by-case basis with each mandate.
Many U.K.-based pension plans are reviewing their contracts with investment managers in light of the MAM/Unilever dispute. The case has encouraged many plan trustees to articulate more clearly what they expect from their managers, said Robin Ellison, national head of pensions at law firm Eversheds PLC, London.
But he also was concerned that pension funds were being forced to strip risk and volatility out of their portfolios due to the strictures of Britain's minimum funding requirement, which requires pension funds to match their assets and liabilities and remain fully funded, and of newly introduced accounting rules that will force companies to disclose their pension assets on their balance sheets at market value.
"Pension plans should be looking for good performance over the medium to long term. The legislation is pushing them to focus on terribly short-term performance.
"Moving towards a more refined articulation of what the arrangement with the manager is has its good and bad sides. The down-side is that you may be asking for something that, with hindsight, you may not actually want. The bottom line is, does it add value. And I am not sure," said Mr. Ellison.
His concerns are supported by research due to be published later this month by Morgan Stanley Dean Witter Investment Management Ltd., London, and Mark Britten-Jones, assistant professor at London Business School. Evidence from Latin American countries that impose underperformance penalties shows that managers tend to follow one another's strategies in order not to underperform or outperform the market.
"If pension plans don't want to take on risk, they should hire index managers; but then they run the risk of simply tracking the market up or down, with no ability to add value beyond that," said an active money manager who would not be named.
"There is evidence from Latin America that simple underperformance penalties do lead to bunching of returns and so may do more harm than good," said Alan Rubenstein, managing director for Morgan Stanley Dean Witter and head of the firm's European pensions group. "An approach that rewards active managers for outperformance while penalizing underperformance should provide adequate incentive for those active managers who are able to add value."