Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Tough lessons for super from abroad
Consultant Peter F. Drucker’s assertion, in his 1976 book “The Unseen Revolution”, was that Marx was wrong; workers would not wind up owning the means of production through violent revolution, but through their pension fund.
Keith Ambachtsheer, director emeritus of the International Centre for Pension Management at the Rotman School of Management, believes that’s now come to pass, but says the system will only keep working if two things are kept in mind: legitimacy – retirement savings have to be managed in the best interests of participants – and good governance.
In the 1980s, Ambachtsheer applied Drucker’s ideas of legitimacy and good governance to the redesign of Ontario’s pension system. His team’s report was called “In Whose Interest?” – a “classical Drucker-ism”. The study caught the attention of the Treasurer of Ontario, Bob Nixon, and the President of the Ontario Teacher’s Federation, Margaret Wilson. The Ontario Teacher’s Pension Plan (OTPP) was set up as a result – an independent, arms-length organisation jointly owned by the government and the union.
Its board was not just “like-minded, well-meaning people”, but ones with strategic insights into running large financial organisations; the then recently-retired governor of the Bank of Canada was the first chair. That board, and the fund’s CEO and CIO, “radically changed” how retirement savings were managed. The key breakthrough was going to the private markets as well as the public, and to in-source investment management – a shift that Australia’s biggest funds are now contending with.
“It meant hiring people at higher pay levels than used to be the case with pension organisations,” Ambachtsheer told the ASFA conference last week. “The board agreed. Successes started to come through the 1980s, and other funds started to notice how this radical new approach was changing things and started adopting similar methods. Then it went international, and today we talk about the Canadian Pension Model.”
OTPP, a defined benefit plan, has averaged a 9.7 per cent return since inception and has been fully funded for nine years. Ambachtsheer believes that the return differential of managing retirement savings with the ideas applied to OTPP is about two per cent per year on average. On the question of whether good governance matters from a returns perspective, Ambachtsheer believes it’s worth another 100 basis points per year – “a night and day situation as to what a contribution rate over a worker’s lifetime can do in terms of the pensions it produces.”
Ambachtsheer has been watching the Australian discussion for some time, and believes that the Your Future, Your Super performance test – an idea that the industry holds is better in theory an in practice – will be a boon for both legitimacy and governance.
“The more constructive thing that’s happened is creating this new rule where funds have to pass a performance test over eight year periods in order to stay in business,” Ambachtsheer said. “My friends at CM Benchmarking and McKinsey just did a study that shows that that rule – if you apply it to the CM database, which has 20 or 30 years of continuous data – does eventually weed out the significant systemic underperforming funds through time.”
Scale is “empirically very powerful” for legitimacy; smaller funds are being taken over in a wave of ultra-fast consolidation, and Ambachtsheer believes that governance thinking has become more strategic as a result, with funds casting a wider net to source board members.
“I think that significant progress is now being made in Australia.., if (Drucker) was here with us today, looking at what’s happened in Australia over the course of the last five or ten years, in the context of “The Unseen Revolution”, I think he would be pleased.”
But if big super wants to be more like the Canadian Model, it’s going to need to pay more like the Canadians do.
“You need to have a governance process that understands that value and understands that you’re going to have to hire people in pay scales that you may not be used to,” Ambachtsheer said. “If you’re going to compete with the investment bankers of the world, the smart investment bankers of the world, you need to be just as smart as they are.”
“Even if you don’t pay them Wall Street compensation, you still need significantly higher pay scales than most pension organisations are paying. That’s the big caveat. If you want to play that game and win, you’re going to need people who have skills and operate in a highly-compensated marketplace.”
