Once upon a time it looked good on paper. A pension scheme has assets and a fund manager is expert in managing assets. The trustees can achieve efficient implementation through the appointment of a fund manager to invest the entire scheme assets. This is the balanced mandate where the fund manager makes discretionary decisions over not only stock selection but also the allocation across asset classes.
The problem is that a pension scheme, nor an asset manager, exists in isolation. A pension scheme, quite naturally given human nature, compares itself to other pension schemes, even though they are not in competition. A fund manager compares its performance to those of other fund managers. And fund managers are in competition, as there are less fund managers than pension schemes. As pension schemes grew they split the assets across 2 or more fund managers, each with the same balanced mandate. This diluted the impact if a manager were to fail, but otherwise diluted the investment process of the entire assets. A pension scheme with two fund managers, A and B, could find fund manager A selling a security to fund manager B with no resulting change on the scheme’s portfolio!
A dynamic which started as one between pension scheme and its fund manager migrates over time to a dynamic between asset managers. Success for a fund manager means being top of the performance league table, and most definitely not bottom. Being top means winning new mandates from pension schemes, being bottom means losing mandates. And the extent of being top of the performance does not matter, one basis point outperformance relative to peers is all you need.
A balanced mandate creates an incentive on fund managers to continuously look over their shoulder at their competitors, rather than look at the markets, and definitely not the look at the investment objectives of their clients. And a balanced mandate creates an incentive of unnecessarily prudent investment decision making, as outperformance in a year, in the eyes of the fund manager, of 1 basis point delivers just as much as 10 or 100 basis points. A fund manager should not take more risk than defined in the investment mandate but nor should they take less.
In the real world there is a difference in the extent of outperformance. 100 basis points pays a larger pension than 1 basis point. Especially when it is compounded over a time horizon of up to 40 years that is typical for an employee saving for a pension. When outperformance is determined relative to peers, the member is always the loser.
The solution to this misalignment is to realise that a balanced mandate represents delegation of the strategic asset allocation from its owner – the trustees of the pension scheme – to the fund manager. Many studies – from the original one by Brinson, Singer and Beebower – have shown that the strategic asset allocation is the most important factor in determining whether the investment strategy meets the objectives of the investor. Pension scheme trustees need to spend time to set the strategic asset allocation, using analytic tools like asset-liability models. Such tools analyse strategic asset allocations against the objectives of the pension scheme and the risk appetite of the trustees to determine the optimum to implement. By delegation the strategic asset allocation fails to get proper definition. But through use of asset-liability models the strategic asset allocation becomes explicitly defined in the Investment Policy Statement., and understood by the trustees and members.
Implementation of a strategic asset allocation is then performed with the appointment of fund managers each of which is given a specialist mandate for a particular asset class. Each fund manager is benchmarked not against its peers but against the appropriate market index. It is such market indices which appear in the asset-liability model which ultimately determined the strategic asset allocation. There is an aligned process from the top to the bottom of the hierarchy of investment decisions.
This specialist approach does require more work. But it is work that is rewarding. It generates a return that is aligned, not misaligned, with the objectives of the pension scheme, and hence gives a greater success for trustees and members. It is an approach where the trustees have ownership of their strategic asset allocation. And it is an approach which is already proven – for many decades – in many countries as the balanced approach has, for the reasons given, fallen out of favour.
