Sainsbury PLC, a British supermarket company, might have opened a Pandora's box with its plan to penalize for underperformance the managers of its L2.9 billion ($4.6 billion) pension fund.
This is not a performance-based fee scheme. But it is a penalty for missing investment targets, without a necessary upside to the manager for beating benchmarks.
This odd fee payment system raises a number of issues. First, how many money managers will accept such an arrangement? Second, within J. Sainsbury management itself, would the company put into place a similar arrangement for its own executives?
As for the money managers, volatile stock and bond markets could cause any firm whose performance is otherwise superior over the long term to occasionally underperform its benchmark.
J. Sainsbury executives, according to a Pensions & Investments report revealing the plan, didn't provide details on how the penalty arrangement would work, such as over what time period the penalty would apply.
Money managers will have to think long and hard before agreeing to accept what is a one-way performance disincentive.
Therefore the penalty fee could put the pension fund at a disadvantage by reducing the universe of managers willing to work for the fund. Many money managers likely will decide not to compete for J. Sainsbury's business when they would be subject to such a peculiar arrangement.
And money managers who accept the penalty fee plan might choose safer investments to stay close to their respective benchmarks to avoid triggering the penalty for missing a target. The J. Sainsbury pension fund could then be paying, in effect, high fees for closet index fund performance.
Top executives at J. Sainsbury might take the penalty idea in-house. They could similarly inflict a penalty on the executives overseeing the pension fund for missing their own performance targets. They might see their own compensation dunned, for example, when an active allocation strategy underperforms a cheaper, passive alternative.
The penalty fee could generate unintended consequences. In general, the penalty arrangement will do little in the long run to enhance performance of the pension fund or its money managers.