December 2000

Q/A:Keith To the Kingdom

Truth, transparency, and the North American way

There is no one quite like Keith Ambachtsheer in the pensions business. To some extent, this is a function of duration—for 30 years and counting, Ambachtsheer has been dispensing advice to North America's plan sponsors—but it also stems from a widespread belief in the industry that the Toronto-based consultant's world view has rarely been cluttered by anything other than the interests of plan sponsors. Ambachtsheer, president of KPA Advisory Services, is also a prolific author—the Ambachtsheer Letter is his principal outlet, but he has also authored two well-regarded books, Pensions Funds And The Bottom Line (Dow Jones-Irwin, 1986) and Pension Fund Excellence—Creating Value for Stakeholders (with Don Ezra, John Wiley & Sons, 1998). He is also a cofounder of Cost Effectiveness Measurement, which benchmarks the organizational performance of large plans. Plan Sponsor Editor-in-Chief Charles Ruffel talked to Ambachtsheer about the present state of the industry.

Probably more so than any other individual, you have been given access to how countless defined benefit and defined contribution plans are designed and run. How well, in your view, are American pension assets managed?

Ambachtsheer: In most cases, not as well as they could be. Quantitatively, this shows up as "implementation shortfall." That is, in the last 10 years, the typical American pension fund underperformed its passively implemented benchmark asset-mix policy by about 50 basis points per annum, net of costs and an implementation risk haircut. Qualitatively, it shows up as what might be called "organization design shortfall." Many pension funds have governance functions that are less than fully focused on the true purpose of the fund in a broader context. This lack of focus at the governance level translates into a lack of clarity about the fund's specific goals, how they are best attained, and how results should be measured.

Is there one design flaw common to many pension plans?

Complexity. Most pension plans have too many moving parts too little understood by too many people. The result is a lack of transparency, which, in turn, creates a lack of trust and a feeling of dissatisfaction on the part of pension plan stakeholders. While it is easy to blame the actuaries, the accountants, the regulators, the legislators, or the judiciary for this unhappy state of affairs, I think that would miss an important point. Again, we must look to the governors of pension plans for the leadership required to reduce complexity and, thus, increase transparency for all concerned. This leadership has not been forthcoming in sufficient quantities.

How well do plan sponsors pick investment managers? Do you think in either the short or medium term that Internet-enabled searches will replace the RFP process as it exists today?

The current dysfunction is not so much in picking managers as it is in failing to create the internal organization design needed to engineer successful alpha-generation processes. Success here requires—once again!—a governance function wise enough to create an internal executive function to which it can delegate the management of the pension fund business, including alpha generation within a specified risk budget. Once partner-like relationships have been negotiated with outside service providers, information systems must focus on assessing implementation shortfall and its causes. These information systems should be completely transparent to the pension fund executive team. Finding outside partners with reliable alpha production processes is an extremely challenging task. Internet-enabled searches could well sharpen the pension fund executive team's search process. One final thought—pension funds unwilling or unable to hire a competent internal executive team have only two rational choices: (1) don't play a game you can't win by going 100% passive, or (2) outsource the executive function to an external organization prepared to be accountable for results, and willing to be paid on a results basis.

Cost Effectiveness Measurement, of which you were a cofounder, has raised the bar when it comes to establishing benchmarks that allow plan sponsors to compare their own metrics with their peers. Why has it been so difficult to establish benchmarks in this industry?

I think the answer lies in the origins of the pensions industry. It was never created as a bottom line-oriented, competitive industry. Thus, results measurement evolved haphazardly. The invention of the time-weighted rate of return in the mid-1960s created a facile—but illusionary!—basis of comparison of fund results. Governing fiduciaries were taught that first quartile was good, fourth quartile bad. Now, three decades later, we know that "what gets measured gets managed." With pension assets growing so dramatically over the last 30 years, it has become imperative to get measurement right. Fortunately, an increasing number of governing fiduciaries are beginning to wise up to that. So, for example, in DB plans, the measurement focus must be the balance sheet. What is the funded ratio? How is it changing? Why? Are the fund's alpha generation processes performing as expected? Within the agreed-upon risk budget? Within the agreed-upon cost structure? How do our results compare to a 'best practice' peer group? These are the fundamental business questions the governing fiduciaries must have a good handle on.

Charles Ruffel
editors@plansponsor.com