CalPERS' recent decision to exit the hedge fund space made international headlines. On the same day that The New York Times ran the story “Top pension system to drop hedge funds,” the lead editorial in London's Financial Times read “CalPERS gives up on the hedge fund dream.” Generalizing beyond the specifics of the California Public Employees' Retirement System's rationale for its decision, both articles noted the apparent ambivalence in the investment goals, beliefs and implementation strategies the decision symbolized, not just at CalPERS, but at many other American public-sector pension funds as well.
Why this apparent ambivalence in investment goals, beliefs, and strategies? Where does it come from? Is there a clearer, less ambivalent way to run large public-sector pension organizations? What would organizations like CalPERS have to do to become more focused, effective pension organizations? I note with some irony that management philosopher Peter Drucker took a good shot at answering these questions in his 1976 book, “The Unseen Revolution: How Pension Fund Socialism Came to America.” Here I update Mr. Drucker's answers based on “real world” experience since 1976.
Effective pension organizations do three things very well:
- Play a proactive role in adapting pension design to changing economic and demographic circumstances;
- Support plan members through the work and post-work phases of their lives by (a) keeping them informed on the progress they are making to financing their retirement, and (b) meeting lifetime pension payment expectations in a timely, accurate way; and
- Manage accumulated retirement savings cost-effectively, recognizing their dual goals of long-term wealth creation and providing shorter-term payment safety.
To do these three things very well requires that a pension organization has three key attributes:
- An arms-length legal structure with an unconstrained mandate to be excellent in executing all three functions;
- A public service-driven, high-ethics governance board that is strategic, understands the mandate, and understands the board's role in achieving it; and
- A strong implementation capability for each of the three organization functions, requiring the ability to pay competitive market compensation for talent.
I was a member of a task force created in the late 1980s by the government of Ontario to recommend how the province's public-sector pension plans might be restructured for better performance. The essence of the task force's three recommended organization functions and the three attributes required to perform them were those set out above.
Somewhat miraculously, the Ontario government and the Ontario Teachers' Federation accepted all six of the recommendations. The result was the creation of the Ontario Teachers' Pension Plan in 1990. While its nine-member board had an independent chair, it still had four government and four OTF appointees. However, as part of the appointment process, there was also an agreed-on skill-and-experience matrix to ensure the board would end up with the right skill-and-experience set to provide professional oversight of a complex financial institution.
So, 24 years later, how have things turned out? In short, aspiration has become reality.
The OTPP's board and management have indeed played a proactive role in adapting the pension plan's design to changing economic and demographic circumstances. As a result, the plan is fully funded, despite using a conservative liability discount rate.
According to OTPP's 2013 annual report, the plan has a benefit administration program that was ranked No. 1 in CEM Benchmarking Inc's global “value for money” calculations. On the investment side, the OTPP since its creation in 1990 has generated the top net return of 10.2% a year through Dec. 31, 2013, in the CEM pension fund universe. This return compares with 8% for OTPP's risk-equivalent composite benchmark over the same time period. This outperformance has added $68 billion, including compounding, to OTPP's balance sheet since 1990. Plan assets were C$140.8 billion (US$128.6 billion) at the end of 2013. With these results, it should not be surprising that other Canadian pension funds, and even funds outside Canada, have adopted or are adopting the Drucker/OTPP pension model.
Now we return to the current American public-sector pension fund situation.
In many cases, the boards of these funds have not played proactive roles in adapting plan design to changing economic and demographic circumstances. They have not been public-minded, strategic, arms-length bodies free of political and union influence. They have not instituted cost-effective, long-term, wealth-creating investment programs with the accumulated retirement savings under their care. They have not attracted and retained sufficient internal investment talent to go toe-to-toe with Wall Street's finest.
Miraculously, some American public-sector funds have done well despite many of these handicaps. On the whole however, there is considerable logical and empirical evidence that suggests the organizational shortcomings of the current American public-sector pension model has a material negative impact on both pension design and delivery in the U.S. state and local government sector.
So where to go from here? The case for the Drucker/OTPP pension model is strong in logic and in outcomes. Yet, its adoption by American public-sector pension plans is far from certain. Why is that? I urge the boards of all of these organizations to put this question on the agenda of their next board meeting.
Keith Ambachtsheer is director emeritus of the International Centre for Pension Management at the Rotman School of Management, University of Toronto, and founder and president of KPA Advisory Services Ltd., a Toronto-based firm that provides strategic advice on governance, finance and investment matters to clients that include pension sponsors and other institutional investors worldwide. He is a co-founder of CEM Benchmarking Inc, Toronto, and continues to be a shareholder.