Recently there has been some suggestion that pension funds have been calculating their returns incorrectly. In his letter to the editor (Flaw in time-weighting returns, Feb. 21), Mr. (David) Spaulding suggests that pension funds use a time-weighted return, rather than an internal rate of return, for a number of reasons, not the least of which is because the global investment performance standards require it. He goes on to suggest that pension funds control the timing of the cash flows and, therefore, should use an internal rate of return.
Mr. Spaulding's comments come amid misconceptions regarding pension funds and their ability to comply with the GIPS. Although they were not the audience to which the standards were originally directed, pension plans that manage discretionary assets, either internally or via third-party investment managers, can comply. If the GIPS are focused primarily on presenting performance to prospective clients, why would a pension fund choose to comply? That's simple: for most of the plans to which I have spoken, it is a matter of good governance. The pension fund board wants assurance that the information being presented adheres to the highest ethical standards. A few other plans have offered other institutional and/or retail investment products to the public, and having a compliant track record is useful. Applying the standards to pension funds may not be as straightforward as compared to an investment manager, but we are working to develop guidance to provide assistance.
It is true that the GIPS require the use of a time-weighted return, with the exception of private equity and real estate closed-end funds. A time-weighted return adjusts for external cash flows, which are not typically controlled by the investment manager, but rather are subject to the client's decisions as to timing and amount of funding of the manager's portfolio. When presenting performance to prospective clients, the investment manager should neither benefit nor be penalized by the timing of client cash flows. When reporting the performance of a client's portfolio to that client, an internal rate of return may be useful and appropriate.
Mr. Spaulding assumes that a pension fund controls the timing of its cash flows. Is this accurate? Is it the fund that controls the funding level and the related cash flows, or is the board? Additionally, does the fund control when plan participants retire and begin to draw benefits, or what those benefits are? These are critical questions that cannot be assumed away. So before changing from the way it has always been done, weight, I mean wait, a minute, and determine what you are trying to measure and who controls the cash flows. You may just conclude that you have been doing it right all along.
Jonathan A. Boersma
Executive director, global investment
performance standards, CFA Institute