Pension Revolution

KEITH P. AMBACHTSHEER is the Director of the Rotman International Centre for Pension Management at the University of Toronto and founder of KPA Advisory Services, Ltd. He is an award-winning analyst of pensions and investment issues who advises governments, industry associations, pension plan sponsors, and money managers on pension governance, finance, and investment. His advisory publication, the Ambachtsheer Letter, regularly reaches 150 different institutional clients across the world. Ambachtsheer is also a cofounder of CEM Benchmarking Inc., which monitors the management quality of 300 of the world's largest DB and DC pension funds. He is the coauthor of Pension Fund Excellence: Creating Value for Stakeholders (Wiley).

• Preface: Peter Drucker’s Pension Revolution: Here at Last xxiiiIntroduction: Why a Pension Revolution Now? xxviiThe Trouble with DB Plans xxviiDC Plans Are Not the Answer Either xxviiiExpert Pension Co-ops xxixTOPS Tipping Points xxxPART ONE The Pension Revolution: TouchstonesCHAPTER 1 Are Pension Funds ‘‘Irrelevant’’? 3An ‘‘Unreasonable’’ Actuary? 3Exley’s Four Irrelevance Propositions 4So What Is Relevant? 4Responding to Exley 6Relevant Pension Funds: Building the Case 6Managing Retirement Income Risks 7Leveling the Informational Playing Field 7Getting the Execution of the Idea Right 8CHAPTER 2 The Pension Revolution—Are You a Believer Yet? 9A Revolutionary Reordering of the Pensions Firmament 10From Fuzzy Pension Deals to ‘‘Risk-Sharing Co-ops’’ 10Toward Pension ‘‘Business Models’’ That Work: The Risk Issue 11Toward Pension ‘‘Business Models’’ That Work: The Scale Issue 12The Pension Governance Issue 13COPYRIGHTED MATERIALTwo Role Models 14PGGM 14SunSuper 15Great Treasures? 15CHAPTER 3 After the Perfect Pension Storm: What Now? 16From Vegas to Oxford: In Search of Answers 16Do Nothing or Something? 17The Corporate Context: Two Basic Choices 18New DC Plan ‘‘Business Model’’ Also Needed 19The Industry/Public-Sector Pension Context 19The ‘‘Fair Value’’ Question 20Better Public Pensions Policy 21CHAPTER 4 Beyond Portfolio Theory: The Next Frontier 22Investment Theory’s Next Frontier: The Academic View 22Investment Theory’s Next Frontier: Two Further Considerations 24The Next Frontier: ‘‘Integrative Investment Theory’’ 25CHAPTER 5 The United Airlines Case: Tipping Point for U.S. Pension System? 29The United Airlines Case 29A Good Question and Two Very Different Answers 30ERISA’s ‘‘Sole Interest’’ Rule 31Lessons from Abroad 32Searching for ‘‘Supreme’’ Answers 33The UAL Case in Context 34CHAPTER 6 Peter Drucker’s Pension Revolution After 30 Years:Not Over Yet 36Two Unfashionable Themes 36Politico-Agency Issues 37Pension Contract and Risk Issues 39Investment Beliefs 40Pension Fund Governance 40Still Much Work to Do 41CHAPTER 7 Winning the Pension Revolution: Why the Dutch Are Leading the Way 42The Globe’s Number One Pensions Country 42Culture, Compactness, and Leadership 44Regulatory Leadership 45Research Leadership 46A Remaining Challenge: Solving the Organization Design Puzzle 46What About the Other Pensions Countries? 47CHAPTER 8 Pension Reform: Evolution or Revolution? 48A Pension ‘‘Tipping Point’’ Indeed 48What Should Happen? 49Pension Reform in the United States 50Pension Reform Elsewhere 51Pension Reform: Evolution or Revolution? 52PART TWO Building Better Pension PlansCHAPTER 9 Can Game Theory Help Build Better Pension Plans? 57Pension Games 57Why do Pension Game Switches Occur? 58Who Are the Stakeholders and What do They Want? 59Sources of Risk in Pension Schemes 60Mitigating Micro Risks 60Can We Mitigate Macro Risks? 61Is Investment Risk Worth Taking in DB Plans? 61Can Game Theory Build Better Pension Plans? 62CHAPTER 10 If DB and DC Plans Are Not the Answers, What Are the Questions? 63From Answers to Questions 63Ultimate Pension Questions and Their Consequences 64Underwriting Pension Mismatch Risk: Any Volunteers? 64Should Pension Mismatch Risk Be Minimized? 66Pension-Delivery Institutions 67Benchmarking Traditional DB and DC Plans 67The Way Ahead 68CHAPTER 11 Human Foibles and Agency Dysfunction: Building Pension Plans for the Real World 69Some Fundamental Questions First 69Back to First Principles 70Human Foibles 71Agency Issues 72Counteracting Human Foibles 73Minimizing Agency Costs 74TOPS, Employers, and Public Policy 75TOPS and DB Plans 77CHAPTER 12 DB Plans and Bad Science 78Science and the Design of Pension Contracts 78The TOPS Contract 78Taking on Investment Risk: Implications 79Is Investment Regime Risk Insurable? 80Intergenerational Bargaining 81Robust Course-Correction Mechanisms Required 82The Flawed DB Model 82Bad Science 83CHAPTER 13 Peter Drucker’s Pension Legacy: A Vision of What Could Be 84Two Handshakes to Remember 84The Melbourne Message 85TOPS: Neither DC nor DB 86TOPS and Investing 87TOPS and Governance 87TOPS and the Real World 88The Drucker Visit 89PART THREE Pension Fund GovernanceCHAPTER 14 Reinventing Pension Fund Management: Easier Said than Done 93A Paradigm Shift? 93Novelties of Fact 94Novelties of Theory 94Pension Industry Responses 96Crossing the ‘‘Innovation Chasm’’ 97CHAPTER 15 Should (Could) You Manage Your Fund Like Harvard or Ontario Teachers’? 99Four Things in Common 99Legal Foundations: Solid or Not? 100Governance and Management: Understanding theDifference 101Investment Beliefs: Theirs or Yours? 102Investment Processes: Like Wall Street? 103Should You Manage Like HMC or OTPP? 104Could You Manage Like HMC or OTPP? 104CHAPTER 16 ‘‘Beauty Contest’’ Investing: Not Dead Yet 106‘‘D´ej `a Vu All Over Again’’ 106Why ‘‘Beauty Contest Investing’’ Is Ugly 108Integrative Investment Theory 108Investment Beliefs 109Managing from the Inside Out 110CHAPTER 17 Eradicating ‘‘Beauty Contest’’ Investing: What It Will Take 112The Ugliness of ‘‘Beauty Contest’’ Investing 112A Two-Pronged Eradication Strategy 113What Corporations Must Do 114What Investing Institutions Must Do 114A Debilitating Pension Fund Governance Problem 115Light at the End of the ‘‘Beauty Contest’’ Tunnel? 117CHAPTER 18 High-Performance Cultures: Impossible Dream for Pension Funds? 118Thinking and Acting Like Goldman Sachs 118New Research Results 119Specific Governance and Management Challenges 121In Conclusion 122CHAPTER 19 How Much Is Good Governance Worth? 124Governance Quality and Organization Performance ShouldBe Related 124A Road Map for the Journey of Discovery 125The Pension CEO Score and NVA Metrics: The Data 126Pension CEO Scores Meet NVA Metrics 127Further Insights 128The Value of Good Governance 129PART FOUR Investment BeliefsCHAPTER 20 The 10 Percent Equity Return Illusion: Possible Consequences 133Consequential Miscalculations 133Why 10 Percent Doesn’t Work 134Painted into an Awkward Corner? 136Consequences 137CHAPTER 21 Stocks for the Long Run? . . . or Not? 139A Debate with Jeremy Siegel 139How Investment Theory Became Investment Practice 140What Is Wrong with These ‘‘Proofs’’ 141What if ‘‘Reality’’ Is Not a Random Walk? 141Investment Regimes, Dividend Yields, and ERPs 143The Post-Bubble Blues Decade 143CHAPTER 22 ‘‘Persistent Investment Regimes’’ or ‘‘Random Walk’’? Even Shakespeare Knew the Answer 145The Ambachtsheer-Siegel Debate Revisited 145History on Our Side 146The Investment Returns Story: How to Tell It 147The ‘‘Investment Regime’’ Game: Spot Today’s Well BeforeIt’s Over, and Tomorrow’s Before It’s Gone on Too Long 148‘‘Regime Spotting’’ versus ‘‘Random Walk’’: Which Is MoreUseful? 149Contents xvTheory on Our Side, Too 150Fellow Travelers 150CHAPTER 23 The Fuss about Policy Portfolios: Adrift in Institutional Wonderland 151Tempest in a Teapot . . . or Not? 151Duality in Finance: A Brief History 152Financial Duality in Pension and Endowment Funds:Building the Conceptual Framework 153New Insights from the CEM Database 154Enter Organizational Dysfunction 155Decisions by Default 156CHAPTER 24 Shifting the Investment Paradigm: A Progress Report 157The ‘‘Policy Portfolio’’ Debate Continues 157A Lens to See the World 158Why the ‘‘Old’’ Lens Distorts 158A Varying Equity Risk Premium 159A New Lens 160A Higher Level of Thinking 161Glimmers of Light 163CHAPTER 25 Whose ‘‘Investment Beliefs’’ Do You Believe? 164Writing an ‘‘Investment Beliefs’’ Statement 164Inferring Beliefs from Actions 165Measuring Predictive Ability 166What about Market Timing and Strategic Asset Allocation? 167Expected ERP Powerful Predictor 167Enter Woody Brock 168In Conclusion 169CHAPTER 26 Our 60-40 Asset Mix Policy Advice in 1987: Wise or Foolish? 171Why Roll the Clock Back 20 Years? 171Leibowitz’s Immunization Campaign 172Investment Beliefs in 1987 173Investment Beliefs in 1997 173The Right Kind of Active Management 174Wise or Foolish? 175CHAPTER 27 ‘‘But What Does the Turtle Rest On?’’ A Further Exploration of Investment Beliefs 177‘‘But What Does the Turtle Rest On?’’ 177The Efficient Markets Hypothesis: Fact or Fiction? 178The Three Strikes against the EMH 179Economists and ‘‘Operationally Meaningful Theorems’’ 180The Adaptive Markets Hypothesis 180The AMH’s Five Practical Implications 182The AMH and Integrative Investment Theory 182CHAPTER 28 Professor Malkiel and the New Investment Paradigm: Raining on the Parade? 184Raining on the ‘‘New Paradigm’’ Parade? 184The Bases for Malkiel’s Skepticism 185An Alternative Conclusion 186Winning Evidence 187The ‘‘Good Governance’’ Boost 188We’re Both Right 189CHAPTER 29 The ‘‘Post-Bubble Blues Decade’’: A Progress Report 190Another Nail in the IID Coffin 190Why Non-IID Logic Wins 191Investment Regimes in the Real World 192What Seems to Actually Be Happening? 193Some Actual Numbers 194The Bottom Line 195PART FIVE Risk in Pension PlansCHAPTER 30 Rethinking Funding Policy and Regulation: How Should Pension Plans Be Financed? 199The Devil in the Details 199How Many Course-Correction Tools? 200Making Financing Decisions: In Whose Interest? 201An Analytical Framework for Assessing DB Plan FinancingDecisions 202‘‘Rational’’ Explanations 203Four Principles to Fund By 204CHAPTER 31 Funding Policy and Investment Policy: How Should They Be Integrated in DB Pension Plans? 206Principles to Fund and Invest By 206What Makes DB Pension ‘‘Contracts’’ Risky? 208Should DB Funding Target Calculations Assume That MoreRisk Means More Return? 208Is Current ‘‘Accepted Actuarial Practice’’ Unacceptable? 209What Is an ‘‘Acceptable Level of Certainty’’? 210Surplus Ownership 211Cleaning Up Our Act 212CHAPTER 32 Resurrecting Ranva: Adjusting Investment Returns for Risk 213Resurrecting RANVA 213RANVA in 1998 214Measuring RANVA in the Real World 215The 2000 to 2004 Experience: Lessons 216Remaining Barriers 217CHAPTER 33 Adjusting Investment Returns for Risk: What’s the Best Way? 219Resurrecting RANVA 219The ‘‘Cost of Market Volatility’’ Approach 220The ‘‘Cost of Insurance’’ Approach with Risk Buffers 222The ‘‘Cost of Insurance’’ Approach with Put Options 223PART SIX Measuring ResultsCHAPTER 34 Pension Plan Organizations: Measuring ‘‘Competitiveness’’ 227Pension Plan Organizations and ‘‘Legitimacy’’ 227‘‘Provider of Choice’’ for Which Services? 228Benchmarking Pension Services 229Costing the Benefit Administration ‘‘Business’’ 229The Benefit Administration Cost Equation 231Build or Buy? 232CHAPTER 35 Measuring DC Plans as ‘‘Value Propositions’’: The New Imperative for Plan Sponsors 233Silk Purses from Sows’ Ears 233Measures of ‘‘Prudence’’ 234The ‘‘Own-Company Stock’’ Phenomenon 234Understanding DC Plan Total Returns 235DC versus DB Plan Cost Performance 237Other DC Plan Performance Metrics 239‘‘Value Proposition’’: Yes or No? 239CHAPTER 36 Measuring Pension Fund Behavior (1992 to 2004): What Can We Learn? 240A Well-Endowed Database 240Current International Investment Policy and ImplementationStyle Differences 241Ten-Year Investment Policy and Implementation StyleTrends for U.S. Funds 242Did Active Management Add Value? 243The Selection ‘‘Alphas’’: Good News and Bad News 244Is There Also a Payoff from Actively Managing Pension Fund Costs? 247Two Important Lessons Learned Thus Far 249PART SEVEN Pensions, Politics, and the Investment IndustryCHAPTER 37 Whither Security Analysis? 253Bubble, Bubble, Toil and Trouble 253Fortune Trashes Wall Street 254Is Better Regulation the Answer? 255Reversing the Financial Food Chain 256What Is Security Analysis, Anyway? 257Even Good Security Analysis Needs Context 257Effective ‘‘Buy-Side’’ Structures 258In Conclusion 259CHAPTER 38 Pension Funds and Investment Firms: Redefining the Relationship 260Who Are the Simbas of the Pension Investment Kingdom? 260The Money Flood 261A Question of Governance 261Enter the Anthropologists 262A Call to ‘‘Excellence’’ 263What Do ‘‘Excellent’’ Pension Funds Look Like? 264A Supplier-Driven Market 265The Tiny Equity Risk Premium Factor 265‘‘New Paradigm’’ Pension Funds: What Kind of InvestmentServices Do They Want? 267New Pension Fund–Investment Firm Partnerships 270Could You Be a ‘‘New Paradigm’’ Player? 271CHAPTER 39 The New Pension Fund Management Paradigm: Feedback from Financial Analysts 272Test Driving the New Paradigm 272Pension Politics and Economics 273Pension Plan Governance 276The New Pension Fund Management Paradigm 277Putting the Paradigm in Practice 278Performance Measurement 281Did the Yardsticks Move Forward or Backward? 282CHAPTER 40 Reconnecting GAAP and Common Sense: The Cases of Stock Options and Pensions 283Closing the Information GAAP 283When Are Employee Stock Options ‘‘Expenses’’? 284The Common-Sense Solution in Action 285Current Pension Accounting Rules Defy Common Sense, Too 285Sensible Pension Accounting Rules 287Common Sense in Action 288Carpe Diem 289CHAPTER 41 Is Sri Bunk? 290SRI and Zen 290What Is ‘‘Socially Responsible Investing’’? 290A Slippery Slope? 291Sustainable Investing 292Assessing the Sustainability of Dividend Growth 293From Saying to Doing: A Case Study 294Redefining the SRI Revolution 294CHAPTER 42 Alpha, Beta, Bafflegab: Investment Theory as Marketing Strategy 296Giving Alpha and Beta a Rest 296The Beautiful Art of Language 297The Myth of ‘‘Absolute-Return Investing’’ 298Investment Theory with the End in Mind 298The Critical Role of Fund Governance 299Pension Revolution 300CHAPTER 43 The Turner Pensions Commission Report: A Blueprint for Global Pension Reform 302Pension Wisdom from the United Kingdom 302Turner’s Recommendations 303The Power of Integrative Thinking 303Blueprint for Global Pension Reform 304NPSS Governance, Management, and InvestmentOptions 307Moving Forward 308CHAPTER 44 More Pension Wisdom from Europe: The Geneva Report on Pension Reform 309Eight Hands, Four Economists, and One Point of View 309Powerful Pension Policy Implications 310Labor Markets and Human Capital 311Optimal Risk Sharing 312Optimal Pension Fund Organizations 313A Powerful Pension Vision 314PART EIGHT The Case of PERSCHAPTER 45 PERS and the Pension Revolution: Active Participant . . . or Passive Bystander? 317Alyson Green’s New Job 317History of Workplace Pensions 319The 1976 to 2005 Period 319Governance–Organizational Issues at PERS 320Finance–Investment Beliefs 321Pension Contract–Risk Issues at PERS 321Is a Higher Contribution Rate the Answer? 323More Drastic Action Indicated 324Spreading the Pain Evenly 326Is Risk-Sharing an Essential Pension Plan Feature? 327Getting from Here to There 329Devising an Action Plan 329CHAPTER 46 Advice for Alyson Green: How PERS Can Join the Pension Revolution 331Case Discussion Summary from October 25, 2005 331The PERS Situation 332The PERS Debate 332In Conclusion: A Call to Arms 335

“I enjoyed reading the book…Well documented, the author makes it clear that it is time to change our thinking about asset management.” (Investment & Pensions Europe,  April 2007)  “This book is a valuable tool in raising awareness of the current climate and provides people with the information they need to create efficient pension solutions in the future." (Pensions World, May 2007)