CHAPTER 14
Achieving Investment Excellence
Key Take Aways
Congratulations! You have almost finished the book. The only thing left is to effectively implement the lessons discussed in the previous five parts. They have provided you with insights about the activities that contribute to excellence. To summarize, the five parts are (i) Pension Funds: Understanding the Role, Shaping the Mission; (ii) Designing the Process; (iii) Implementing the Investments; (iv) Organizing the Board; and (v) Learning, Adapting and Improving.
This chapter is about moving your pension fund towards investment excellence. After reading this book, you will know the activities that contribute to excellence; and you will be able to identify the key differences between the levels of excellence.
What has to be done in order to start moving is essentially quite simple. You have to understand and accept where you stand now as a pension fund, and you have to know where you want to go to best serve the future needs of your participants. Subsequently, you have to define sensible steps to get there and you then have to take them. How to do this successfully is less straightforward. There are hurdles to overcome: How do you make sure the goal is one that participants share, how do you arrange the necessary governance budget of the board in terms of time and skill, and who will actually lead the process? Along the way, how do you overcome resistance to change and how do you, as a board, develop alternatives that allow you to achieve the goals as well? Finally, how do trustees make sure that what is being achieved sticks within the board culture and investment organization, for example when new trustees join the board?
A pension fund faces two demands: it must execute its current activities so as to survive today's challenges, and it must adapt these activities to survive tomorrow's. Today's pension funds have to balance both. Boards that are overly focused on effective execution create high barriers to adaptation for tomorrow. On the other hand, a pension fund board that spends too much time on strategic long-term issues runs the risk of not dealing effectively with the short-term challenges, in turn reducing the chances of being around in the long term. Since execution as well as adaptation requires resources, trustees face an unending competition for money, people and especially time to address the need to perform in the short run and the equally vital need to improve and change in the long run.1
This chapter summarizes the key activities required to achieve investment excellence. We present the key characteristics and prerequisites for becoming a learning organization, realizing that the transition towards investment excellence is a multiyear, multistage process. To make this process more practical and manageable for the board, we introduce different levels of excellence coupled with which characteristics and qualities are needed to move one step closer to achieving the long-term investment goals for the participants.
THE FIVE ACTIVITIES DRIVING TOWARDS EXCELLENCE
It is actually not that difficult for an adequate pension fund to achieve excellence if you know where to improve. This requires work but is achievable. There are examples available to copy and learn from. Attaining investment excellence and remaining excellent, however, is difficult for pension funds to achieve.
Going from being a fine pension fund to an excellent pension fund can translate into better structural results. Doing 1%–2% better is a considerable amount in a world in which expected returns for well-diversified portfolios are somewhere in the range of 3%–6% in nominal terms. It involves designing an investment process that helps to achieve your fund's goals, as well as tackling the main governance issues that are out there for everyone to see. We believe that there are five activities that together can achieve “excellent investing.” These are visualized by Exhibit 14.1. We feel these are the roughly the same for every fund, even though pension funds come in all shapes and sizes around the world. Our experience is that the same issues pop up around the globe. These five activities correspond with the five parts of this book.
EXHIBIT 14.1 The investment excellence loop.
Part I covers how to shape the strategy, thereby setting the framework for the board to design the investment process in Part II. Part III focuses on implementing the investment cycle. Part IV shares the latest insights on how to organize the board. Finally, Part V highlights the learning and adaptation process that is vital for the pension fund's long-term success.
Hereunder we recap the key aspects of these activities. To summarize this in a way that is practical for boards with limited time, we list the desired outcomes for each of these activities. These statements are meant to be food for thought for trustees. If you can affirm that each of these outcomes have been achieved by the board without reservation, then your fund has taken some major steps towards investment excellence. If not, then you get a feeling of the kind of work that remains to be done.
Activity 1: Setting the Strategy (Chapters 1–2)
This activity lays the foundations for the pension fund, defines purpose and translates purpose into strategy. What is the role of the fund, what are the roles and responsibilities of the board? Who are you and what do you want to achieve for your participants? This consists of having clarity about your purpose – why you exist for your participants, what the added value is that trustees want to highlight. Purpose, mission and strategy translate into achievable goals, such as the pension deal that you are you offering.
The output of this activity should be a clear purpose, a clear strategy that fits the changing context, and a clear set of board responsibilities—be they delegated or not. These elements should be laid down in documents easily accessible to the people within the fund and its stakeholders. These documents have to be alive and be written in simple language. The board should use them for everyday practice, regularly review them and update them (Exhibit 14.2).
EXHIBIT 14.2 Key Elements Activity 1: Setting the strategy.
Activity 2: Designing the Investment Process (Chapters 3–6)
This activity covers the design of the investment activities. Before designing the investment process, the board has a shared understanding of the key concepts of risk and investments. Having a shared starting point helps trustees to distinguish between minor and major details, and the difference between risk and uncertainty. Additionally, developing investment beliefs and/or principles are important tools for the investment set-up. With a clear purpose and investment beliefs, the next step is choosing, or reaffirming the right investment model that helps you align realistic goals, implementation and governance budget. In other words, how do you organize the investment process in such a way that it leverages the strong point of the pension fund identified in the mission, purpose and investment beliefs discussion?
The output of this activity is a clear and shared investment language and a set of investment beliefs that are owned by the board. The investment beliefs should be used by everyone who plays a role in the investment process of the fund, even—or especially—when it's an external party. The beliefs should be transparent to beneficiaries and stakeholders, and understood and accepted by the trustees and the investors. This activity results in a clear and fit for purpose investment process based on a number of building blocks that realize the investment objective by transforming the premiums of the participants into investment returns for the pension payouts. Finally, a choice for an investment model should be made, in which there are a number of choices that, to a large extent, reflect whether the fund believes in a top-down benchmark-oriented structure or in a more bottom-up, entrepreneurial structure. Size, governance budget and culture all play a role in this choice (Exhibit 14.3).
EXHIBIT 14.3 Key Elements Activity 2: Designing the investment process.
Activity 3: Implementing the Investments (Chapters 7–9)
This activity is about the effective execution of the investment process. Effective execution combines portfolio construction, implementation and feedback, monitoring and evaluation, and translating the objectives into investment outcomes in the best way possible. There will always be leakage between implementation and plan but this should be minimized. The board will delegate the entire or almost the entire process to an internal or external fiduciary manager who has to be selected and evaluated. Therefore, for pension fund boards and investment committees, execution predominantly translates into the question, how do you organize the investment process in such a way that the different steps build on each other's insights, and how do you make sure that the results are continuously evaluated where the art is to separate random short-term noise from results that affect the fund's long-term goals? Finding and keeping the right distance, horizon and altitude to the parties to which the process is delegated is a key to excellence here. In addition, the board or investment committee commands a serious dose of investment knowledge to be able to delegate, counterbalance and monitor effectively.
The output of this activity is a well-designed portfolio, which is executed in a cost-effective way by fit-for-purpose managers, who are monitored continuously with a management by exception approach. The identification of potential weak areas is done in a structured way (Exhibit 14.4).
EXHIBIT 14.4 Key Elements Activity 3: Implementing the investments.
Activity 4: Organizing the Board (Chapters 10–12)
This activity focuses on the oversight and governance of the investment process; designing, steering and overseeing the realization of the mission of the pension fund. In the earlier activities, the emphasis was on relatively hard and objective matter: strategy, process, and implementation. The present activity is performed by boards and committees consisting of individuals with different backgrounds, skillsets, and mental makeups. To turn these into a well-performing orchestra, both in peace and in wartime, is an enormous task. So, in this activity the harder-to-pinpoint human factor plays the main role: How will the board organize itself to realize purpose and mission? What are the board's key tasks; what does it delegate to whom? What should the board be aware of, and organize beforehand when setting up investment committees and executive offices to support their tasks? And what are valuable insights in dealing with the investment management organization (IMO)? The fund needs significant governance budget to have serious countervailing power to the investors. It is a key task of the board to oversee the investment organization and to verify and make sure that it is fit for purpose. Often, the understanding between board members and investors is limited and vulnerable because of the differences in their perspectives. Key concepts that will come up time and again are: the right distance, the right altitude and the right horizon.
The key output of this activity is fourfold: a well-functioning board, a well-functioning board investment committee, a fit-for-purpose investment organization to which the implementation of the investments is delegated, and an effective working relationship with that organization. The board should have the trust and respect of everyone it deals with and be able to both define and execute on the strategy (Exhibit 14.5).
EXHIBIT 14.5 Key Elements Activity 4: Organizing the board.
Activity 5: Learning to Adapt (Chapter 13)
This activity focuses its attention on board room dynamics. What does it take to make a good decision and what special challenges does a pension fund board have when it is supported with complex decision tools such as Asset Liability Management? Is the board aware of the special role advisors have, and how they can influence decision-making? In the end, it probably comes down to a down-to-earth board to take all the necessary steps to implement the elements to achieve investment excellence. It requires, on the one hand, an exceptional board to hold on to the strategy and beliefs and financial markets become under stress and, on the other hand, the ability to keep an open mind to adapt insights as new research and developments in the industry come to light that require the board to adjust its principles (Exhibit 14.6).
EXHIBIT 14.6 Key Elements Activity 5: Learning to adapt
THE LEARNING BOARD AND THE CHARACTERISTICS OF THE LEVELS OF EXCELLENCE
Learning forms the bridge between the present and the future of the pension fund in a systematic way. The term “learning organization” was coined by management author Robert Senge,2 who stated that “an organization that is continually expanding its capacity to create its future. For such an organization, it is not enough to merely survive…‘Adaptive learning’ must be joined by ‘generative learning', learning that enhances our capacity to create.”
So what is a learning organization? It is an organization that is able to consider the external environment (opportunities and threats) in an open, strategical way; to practice introspection in an open and critical way (strengths and weaknesses); and it has a strong sense of where it is and where it wants to be, and to create the movement in the direction it wants to go.
The board plays a large role in shaping the learning organization. It can encourage and stimulate an open, learning environment, but also easily kill a learning attitude (“waste,” blame games, “if you admit that you can improve, why haven't you done better in the past,” etc.). It also can play an important part in creating a learning system. And, last but certainly not least, the board itself has serious collective learning to do. Otherwise, with each change of board membership, important lessons may be lost. There are a number of important prerequisites to create a learning system and a learning board: leadership, resources, mindset and cultures, measure scorecard, maintenance, and education.
Leadership
Often, the spark of the creation of a learning board comes from an individual leader or board member, who dares to step out of the box and say, “Why are we doing this? Are we doing this in the right way? Are we all on the same page in terms of doing this?” They translate these questions into action. For example, in the case of the Dutch healthcare pension fund PFZW, it was the chairman of the Investment Committee, Florent Vlak, who asked these questions. And to answer them, he initiated an annual summer course at PFZW that grew into a mechanism to educate PFZW's board over the past decade.
Resources
It is often surprisingly hard to find the resources, the “governance budget”—essentially, time and money—for learning, both by board and the organization. We feel that learning is an integral part of the cost of doing business and therefore should be budgeted for, both in terms of (board) time and money. We have negative and positive examples for both aspects. In current years, with solvency being low, we have come across boards that have, for instance, cut their travel budgets to close to zero out of fear of public outcry. One could just as well state that it is “forbidden to learn.” However, we also see many positive examples, such as the Future Fund from Australia and Railpen from the UK, who spend serious time and money to learn from peers and systematically work towards achieving and maintaining investment excellence. For many boards, time may be an even more precious resource than money. It may feel uncomfortable to dedicate one or two board meetings per year to learning and change.
Mind-Set and Culture
We have come across executives who communicate ideas such as “Change and learning come after you have completed your day time job.” This sends a clear message: change and learning are hobbies, and to be dealt with in your own time. In many organizations, being extremely busy is the way to strongly convey that you are important. For many leaders, both in boards and in IMOs, life is about back-to-back meetings. However, this type of message is counterproductive in the face of the observation that financial markets are adaptive, that today's participant is changing, and that the macroeconomic environment—such as low interest—might become more disruptive than we currently expect. In that sense, change and learning are an integral part of fulfilling the fiduciary duty. This is why we advocate spending 20% of board time on learning and achieving excellence—take a step back from the day-to-day execution, and learn and reflect. Of course, 20% is a bit of an arbitrary number, but you get the idea.
A learning organization is about the board and its organization learning, not the individual trustee. A highly individualistic, based on zero-sum game winning (I win—you lose) corporate culture is hard to reconcile with a learning culture. In environments like that, it is not that easy to imagine that the sum is sustainably greater than the parts, because there is some vulnerability in learning, which often starts with being open about the fact that things can be improved, that there are things you do not know and that sharing these things lays the basis for collective improvement.
Also, in many organizational cultures, being certain about things is highly rewarded. Admitting that you have doubts about whether you are doing things in the right way is often seen as being “soft.” In cases where uncertainty is deeply ingrained in the problem that you are trying to solve, and feedback loops take time—as is the case with investing—this is outright counterproductive.
That overconfidence (or acting in an overconfident way) may come at a great cost has been documented extensively, for example in the medical world. People who are certain—or have to appear certain—have no need to learn. Therefore, the board has to carefully create settings and a culture in which there is room for a conversation on what can be improved, both individually and collectively. The challenge is to look at the whole pension fund from a bird's eye view, seeing it as a “machine” or integral value chain designed to deliver pensions. This includes the board itself and all activities and decisions we discuss throughout this book. Then, ask the question of where you could improve the machine, or parts of it, to deliver even better output.
Measures and Scorecards
In order to learn and improve, an organization needs to take score of where it is in order to understand collectively where it stands, to be able to measure progress, and to pinpoint in which areas it wants to improve. Often, in the investment industry, we use output measures: risk, return, added value. We do this even on short horizons where we know that the noise overwhelms the signal. To admit where you are now may be painful sometimes, but it is unavoidable in order to become better, to learn and adapt. We take the view that the five activities done well will lead to great outcomes, but the relationship is a long-term one. Therefore, we put the emphasis on assessing the level of excellence of each of the activities, and not on the output measures.
Also, of course, people like to use SMART ways in goal-setting: specific, measurable, attainable, realistic and time-bound. Our point of view is, measure as SMART as you can, but be very aware of the fact that SMART is inherently reductionist in nature. You reduce a complex, often ambiguous reality to a few numbers. There should be room for subjectivity in the way you keep score, for things that do not fall neatly into a measurable box. Otherwise, you will end in “what gets measured gets managed” territory. Interpreting a scorecard as a starting point or a menu for a deep conversation leading to questions such as ‘”Why have you scored culture so low?” or “Why do you rate the governance so poorly?” is a much richer approach.
Maintenance and Education
Being a learning organization requires maintenance and education. Learning to be a learning organization will almost certainly require education. And, similarly to stopping with smoking, it is easy to fall back into old habits, for example in times of stress. New people should be immersed in the learning culture. If they bring bad habits from old companies they should be gently familiarized with the learning culture of the pension fund before being introduced in the board or in the organization.
The drive to move towards investment excellence emanates from this opinion, not only because it will enhance the current and future capacity to deliver the returns that pension funds need in order to deliver on the promise they made, but also in the form that is required by the current world. So, for example, it might require changing from collective defined benefit (DB) to individual defined contribution (DC). “Enhancing the capacity to create” in our minds means creating options to be fit for purpose under conditions of uncertainty. Creating a proprietary learning capacity is an important strategic consideration when thinking about whether to outsource or not: the learning is often almost free when you're doing things in house, and more difficult to capture externally.
LEVELS OF EXCELLENCE AND THE BOARD LEARNING PERSPECTIVE
Exhibit 14.7 relates the characteristics of the level of excellence to the learning perspective of the board. The way this builds up is the same as the levels of excellence: levels of weak practice and sufficient practice can be described with terms such as reactive, ad hoc, coincidental, individual, local, dogmatic and rigid; and the higher levels with terms like proactive, planned, systematic, collective, holistic, learning and adaptive.
EXHIBIT 14.7 Levels of excellence and the learning perspective of the board.
THE BOARD'S JOURNEY TOWARDS ACHIEVING EXCELLENCE
As stated in the introduction to this chapter, there are four steps in the journey towards achieving excellence. First, understand where you stand now based on honest self-reflection. Second, decide where you want to go in the long term. Third, define sensible steps towards the goal. Fourth, execute them.
Step 1: Determine Where You Are Now
In order to learn and improve, an organization needs to take score of where it is in order to understand collectively where it stands, to be able to measure progress, and to pinpoint in which areas it wants to improve. To honestly admit where you are now may be painful sometimes, but it is unavoidable in order to become better, to learn and adapt.
How to do this? There are three different situations that initiate processes leading to achieving excellence: (i) An individual (e.g. a trustee) identifies the wish or need to change or improve; (ii) there is a serious crisis that forces change; and (iii) other, for example the regulator raising the quality standard. In the first situation, there often is a new leader. This makes life relatively easy, because a fresh look is expected from new leaders. A much more difficult situation is when an individual trustee gets the insight or the ambition to bring the fund to a higher level. In this case, they have to at least build a small group of people who share the vision or ambition in order to get the clout needed to put the change on the agenda. The second situation, crisis, is much easier, because crisis is easy to recognize collectively and the need for action is unquestionable. But even then, there is the question of whether a fund uses a crisis just to fix what was broken or as a catalyst to become fundamentally better, and move up on the scale of excellence. In addition, this often depends on the ambition or leadership of a small group of people.
In all cases, what we propose is to go through a process in which a set of relevant people asses the level of excellence of the fund on the five activities in two stages. Who are these relevant people? The board could consider involving at least a combination of board and investment committee members, trustees' key personnel of the investment office or IMO, or trustees from respected peers. First, the people involved individually should reflect on a set of questions, identify what they feel is the level of excellence for each of the activities and bring up topics for further reflection and action. Armed with this information, the answers are brought together and a structured conversation is built on this. An issue can be that the people chosen to answer the questions do not have a relevant frame of reference, for example they do not know the best practices or the practices of the relevant peers. In that case, it probably makes sense to retain a party that does have this frame of reference, such as a consultant. At the same time, a board should collectively have this frame of reference. Understanding what the others do and why is, in our eyes, part of their remit.
The outcome of the process should be at least a brief report in which the output of the different ideas and discussions is recorded; where there is a collectively shared supported outcome in terms of level of excellence (weak, sufficient, strong, excellent); and where there is a structured list of agenda issues by activity (order by importance and urgency) that need to be addressed. Effectively, this is the zero measurement of your fund.
Step 2: Define Your Long-Term Ambition
The next step is defining your long-term ambition. Do you want to become and remain an excellent fund? This has consequences is terms of governance budget spent, organizing, and keeping alive the energy needed to move into that direction. Sometimes it may make more sense to strive for “strong practice” for example. The key is to have a collective definition of what level of excellence the fund is aiming for, and understanding what that looks like in terms of the different activities. Our advice would be to create this picture of the desired situation totally independently from the current situation, otherwise is will be hard to see through the inherent limitations of the current situation. If you describe the situation you want to reach on a 5 to 10-year horizon you can make evolutionary steps towards the goal.
Step 3: Define the Roadmap
The connection between the outcomes from step one, in which the current situation is assessed, and step two, where the ambition is formulated, is the roadmap towards achieving your ambition. We estimate that moving up the ladder of excellence by one step, for example from sufficient to strong, can easily take three or even five years. So moving from sufficient to excellent might theoretically take up to 10 years. The amount of time needed is dependent on a number of factors. When you start from a crisis situation, or when you have the luxury of starting from scratch, often you can move relatively fast. When the urgency is not that high, processes tend to take longer. In terms of the roadmap, it probably makes sense not to plan the whole journey towards excellence from the start. If you build a roadmap for three to five years, with clear annual steps, then you are planning for a foreseeable future. An advantage of this horizon is that the board members who initiate and support the transformation will still be there. Examples of roadmaps are the roadmap that CalPERS' Chief Investment Officer Joe Dear created to improve CalPERS after 2008–2009 and PGGM's Investment Strategy 2020, a five-year plan to realize the strategic goals formulated by PFZW in its investment framework.
Step 4: Execute the Roadmap
Executing on the roadmap requires a strong and explicit team led by a board member and/or reporting to the board. The execution should be done in acceptable steps, so that there will be measurable progress on a short horizon. There will be moments when it will be tempting to aim for lower goals, but this should be avoided.
ENDURING INVESTMENT EXCELLENCE
Organizational learning, staying fit for purpose, is or should be a part of fiduciary duty. Investment excellence requires serious maintenance. Financial markets and consumers are adaptive. If you do not maintain the quality of your investing, it will wear down. Like with cars, an excellent model from 2008 is no longer an excellent model in 2018.
The best IMOs in the world understand this. Australia's Future Fund has a legal obligation to inform itself about global best practice and takes this very seriously. The Norwegian Government Pension Fund Global (GPFG) commits top-notch academics to do deep research into improving its investment strategy. The British pension fund Railpen rates itself annually against a scorecard and very consciously and measurably improves itself. Boards and executives make combined research trips to visit and study the practice of peers.
Becoming a learning board means embracing the fact that change and continuous improvement are facts of life and therefore, should be part of the normal process of the board and the IMO. Exhibit 14.8 shows an execution and adaptation framework. This is opposite to what most organizations are used to; “big” change comes in big shocks, causing a lot of upheaval, once in 5–10 years. It is reactive rather than proactive, and it is stacked on top of everyday practice instead of being part of it. Often, the fund needs a serious crisis before the change happens, as we've seen in multiple cases throughout the book, such as the case of Californian pension fund CalPERS.
EXHIBIT 14.8 Execution versus adaptation decisions for pension investors.
In order to be a learning board and operate in a learning system, the board can plan six steps. First, it needs to understand and regularly review the external environment. How will demographics affect the affordability of a pension scheme? What will populism mean for the way society looks at pensions? How will technological disruption affect its investment beliefs? How should it integrate climate change in the way it invests? This is probably most effectively done in a combination of board and representatives of external parties such as the IMO. It can be prepared by the IMO, but make sure that this organization is not—consciously or unconsciously—selective in its interpretation because of certain beliefs and interests it may hold. You might want to involve beneficiaries, non-governmental organizations (NGOs) or other stakeholders. Also, keep in mind that you can be blinded by your own deep beliefs. For example, if you very deeply believe in the superiority of a collective pension system, opening your eyes to a societal movement towards DC may be extremely difficult. Therefore, use influential, external sources to open your eyes! Confront the brutal facts.
Second, you need to receive honest input about all the relevant dimensions—which form the content of this book—from multiple angles. The board members should provide their inputs, and we strongly recommend that you also ask a few trusted and respected peers and, for example, a good consultant to provide you with an objective picture of the current state of affairs. Make sure that the people involved have ample room to add their observations to the inputs. Encourage honesty. This will give you a sense of where you stand and a list of topics to think about. Create safety for everybody around this exercise; if anonymity is required, then make sure it is there. It probably doesn't hurt to make this an annual exercise. The board may expect the IMO to be capable of judging its own issues. If it is not, then it is not yet a fully mature organization. At the same time, when you are part of the process, it is hard to get an outside-in view. A board really should open itself up for frank criticism from the outside.
Thirdly, set a realistic target for where you want the board to be three to five years from now. Build programs to improve weak spots (board, governance), or demand programs to improve weak spots from the management of the executive office or IMO supporting the board. Create measures to monitor progress.
Fourth, create a serious amount of time in the annual agenda for the learning process. We feel that 10% of board time is a bare minimum, and we would encourage boards to make this 15%–20% of their total scarce time.
Fifth, make sure the learning is collective between boards, IMO and, as far as possible, a broader set of stakeholders. Document the learning history and the lessons and make sure it is accessible to newcomers joining the board; otherwise they might start from the beginning of the learning curve. There are funds like GPFG and Future Fund that extensively document what they do, how they do it and why they do it on the Internet—this is also collective learning, even on a larger scale! Spending a day on the Internet may be very enlightening.
As a sixth step, enjoy as much diversity as possible, in a broad sense. Often, investment people in senior positions are middle-aged, high-earning, white, finance-trained males. They generally work for segments of the population they hardly know. When thinking of the potential futures of the pension system, some funds also involve historians and sociologists. In addition, if you want to understand the future: involve young people.
In this respect, our aim is to help trustees to identify activities that need to be carried out in order to achieve a good pension fund and, if their ambition reaches higher (which, in our opinion, should), what is needed to achieve an excellent pension fund. While drawing on the authors' own experiences and research and that of generations of trustees and investment professionals, the Self-Reflection Questions section offers trustees a practical set of “how to” questions grasping the fundamentals of creating and operating a pension organization successfully, helping boards to start and integrate the processes towards a higher level of excellence and becoming a learning board.