They move too slowly. They take too long. They lose out as a result. Are pension funds so hidebound by their own rules that they are missing the chance to generate returns? Shayla Walmsley finds out
Take these two diagnoses, both from UK pension funds. Vanessa James, investment director at the £3.6bn (€5bn) London Pensions Fund Authority (LPFA) pension fund, in October suggested that her recent move to a public sector pension fund had involved a complete change of pace for the former fund manager. Public-sector pension schemes are required to conduct periodic strategic reviews every three years, and major changes are unlikely in between.
Earlier, in March, David Crum, then chief pensions officer of the £9.4bn (€13.84bn) Strathclyde fund, told the Fund Manager Selection 2007 conference in Zurich that the local authority fund would have to wait for the next review before deciding whether to invest in hedge funds and commodities. Crum, who has since decamped to Hewitt, said the investment committee's perception of these asset classes was "not very favourable". Some "educational work…needs to be done", he said of a committee stacked with 10 local elected politicians - that is, non-specialists.
That lack of professional expertise, it seems, is part of the problem - but it's a problem confined largely to the UK and North America.
One reason is that, if compare UK pension funds with their continental counterparts, there's a strong difference in the weight of professionalism. Morag Torrance of fund manager Capital Partners claims that in the Netherlands, for example, pension funds are "professional" - in that their managers tend to have studied finance and are financial professionals. In the UK, in contrast, trustees are effectively "political" appointments. "They have a big role - more than in other countries," she says.
But that doesn't explain why North American pension funds with equally complex and amateur-dominated governance structures have become almost a byword for aggressive investment.
The CA$48bn (€31bn) Ontario Municipal Employees Retirement System (OMERS) in Canada, one of the world's strongest real estate investors, and CalPERS in the US are good examples. OMERS in recent years secured a change in Canadian law that would allow the transfer of fund governance from the government to a 14-strong board representing all the province's municipalities and 45 trades unions. When Michael Nobrega, then head of OMERS infrastructure subsidiary Borealis, took over as head of the scheme in March, one of the reasons given for his appointment was his workable relationships with local, provincial and federal government leaders and trade union barons - in contrast to his predecessor.
It seems we might be looking in the wrong place for the logjam, if there is one. The relative flexibility of decision making at the point of asset allocation is determined much earlier, when the mandate decisions are decided.
Mandates are arguably set so rigidly that investors reject out of hand proposals that would benefit them because it would mean changing the asset allocation.
Not so, says Greg Wright, a principal at Mercer. "Within property portfolios, mandates are discretionary. Flexibility is subject to guidelines within the definition of the mandate, and that's roughly the animal trustees want it to be," he says. Criticisms of pension schemes' allegedly inflexible approach to allocation tend to focus on the funds' structure and decision-making process. But what if it isn't all down to them? One suggestion is that fund managers are too pushy - and they're pushing inappropriate ideas. Pension schemes, as a result, turn down proposals that they might otherwise consider - though arguably this is about the speed of pension funds' decision-making rather than the sharpness of fund managers' elbows.
According to Ubbe Strihagen, international director at Aberdeen, pension fund allocation "is a long decision-making process and it needs long-term relationships with clients. It's about gaining trust and allowing for decision-making. It isn't about being pushy - it's more towards education and reasoning and developing a long-term relationship.
"We have long-term relationships with institutions. We talk to investors about their challenges and problems, then we go to the drawing board and design a solution."
Wright agrees that "things are not that rigid anymore. Fund managers tend to set up a control system that will tell them if they're breaching a mandate. Then they'll take it back to the client and say: ‘Look, I know we have the mandate, but it's a good opportunity," he says. "If fund managers kept coming back with ideas that lose money, it'd be different. But it's a minority of clients who wouldn't touch an idea until the next review. There's a lot of flexibility around." A fund manager who preferred not to be named suggested that, in markets where consultants dominate - such as the UK - their role might not be entirely beneficial to their clients. Sit fund managers and pension fund managers down together, and they'll hammer out an optimal solution for the scheme. Consultants are merely in the way although, arguably, the plethora of products offered by fund managers is hardly likely to diminish their advisory role.
In any case, property isn't the asset class for dipping in and out of. Strihagen points out that, although most pension funds have too low an allocation to real estate and therefore miss out on opportunities to boost performance and diversification, they're rightly cautious. "The lack of liquidity makes a wrong decision more costly because it locks capital in," he says.
Sherry Reser, a spokeswoman for the US$144bn (€100bn) California State Teachers Retirement System (CalSTRS) in the US, gives an insight into the convoluted workings of the investment decision-making process even within a large - and relatively fast-moving - fund.
"It's prudent to look at all sides and fully understand the ramifications," she says of a currently mooted investment in infrastructure. "We'll go into education mode, when we look at opportunities." The fund assembles a panel of experts, then - if the board is still interested - directs staff to conduct further research. "When you're in the delving down phase, you won't go into detail."
Somewhere between overly cautious amateurs and aggressive return-seekers is the CalPERS model: rigorous in laying out the principles and mandate, favouring discretionary management over political interference. When real estate opportunities fall outside the ranges prescribed by policy, for instance, the scheme tries to get back within target allocations within three years "with ample consideration given to preserving the investment returns".
"Overall, a proposal is sensible or otherwise," says Wright. "It can either be advisory or discretionary. There's a drift away from advisory. Pension funds just want to make sure the fund managers are sticking to the rules of the game and any delay in implementing the mandate is a bad thing."
Wright argues that investors act rationally, if cautiously, in their own interests. But his is not necessarily a consensus view. There is some evidence that even allegedly slow-moving pension funds move quickly when infected by market panic. Has the extent to which pension fund investment managers make decisions based on gut feeling (or their horoscopes) been underestimated? Apparently so, according to Vesa Puttonen, a professor at Helsinki School of Economics and co-author of a recent paper on on Finnish pension funds' " irrational" asset allocation in the Journal of Pension Economics & Finance.
Although Puttonen admits that "defining ‘irrationality' is a tough task", he adds: "It is obvious that fund managers are human beings like any investors. What we know from behavioural finance studies is that, on average, investors trade actively, they do not diversify enough and they're overweight based on recent historical performance. I do not see any reason why pension fund portfolio managers would behave any differently."
It seems pension funds are stuck with allocation legacies. "It is obvious that you cannot explain these existing portfolios with liability structures and regulation. The question is, what explains the dispersion in current portfolio structures other than the liability structure? Would you as a pension fund manager build the portfolio you have today if you had the opportunity to start from scratch? I guess the answer in most cases would be no."
A study of professional and non-professional investors to be published next year confirmed that investment professionals were susceptible to ‘anchoring'. In other words, they showed a tendency to be overly influenced by a starting value in decision-making, despite a strong assumption that they would be relatively immune to a behavioural bias against a control group of students. The researchers postulated that even long-term return expectations are likely to be based on recent returns, which serve as an anchor. In other words, the anchor encourages unconscious extrapolation into future return estimates based on (very) few initial data points.
The upshot is that it's less that pension fund managers are slow to respond to opportunities presented to them by consultants and fund managers than that they fail to respond appropriately to the market.
You don't have to be a behavioural economist to buy the line that pension funds are irrational investors. Alan Greenspan told an audience at the London School of Economics in October that pension funds were effectively to blame for the sub-prime crisis.
"Pension funds - funds of all sorts, really - gravitated towards these [debt] instruments, induced securitisers to supply them. You had usually conservative lenders saying: ‘If you can sign your names, you get the money.' Some had trouble with their names but got the money.
"There's no avoiding the fact that, human nature being what it is, in periods of euphoria people reach beyond the rational. Then you have fear and implosions of various sorts. There are flaws in the way human beings behave in the marketplace. The journey towards euphoria is gradual and persistent. The downturn is sharp, dramatic and short. There's been a 180-degree swing from euphoria to fear - and fear's a big challenge because trust is eliminated."
If investors react slowly, irrationally and unpredictably, so do markets, according to Paul Kennedy, head of real estate at Invesco Real Estate. "Markets overreact on the upside and the downside. But they're slow to react to pricing by up to 12 months," he says. Despite a speedy recovery in investor sentiment - one Kennedy claims already to be seeing - the market has changed, he says.
"You hear all the time that ‘this time it's different'. But this time it is different. The market will revert to mean-level pricing - but it will be a different mean. The change is that pricing is higher and yields are lower. Markets are not rational. I've been arguing for the past four or five years that prices in central and eastern Europe don't make sense - until now, when they do. But when you're trying to suggest that the whole market is wrong, it's hard because you're pushing against the consensus. "We're all naturally pessimistic. If someone questions the basis of the pessimism, there's a natural tendency to pick holes in their argument. I'm not trying to suggest investors are slow or sleepy. It's their responsibility to limit the downside. Large funds can sometimes be cautious, but that isn't necessarily a bad thing."
The whole business of investing in real estate has changed, according to Kennedy. Even with the past few years, he identifies change created by the availability of cheap finance and commingled vehicles, which allowed investors to access real estate more easily. "Real estate used to be 10% of the portfolio but took up 90% of the manager's time. That's no longer the case," he says. Moreover, data - especially cross-border data - has improved.
"Perceptions of appropriate prices for real estate have changed," he says. "Whenever you get change, you get improvements to liquidity and transactions."
Critics of the alleged inefficiency of pension funds' decision-making argue that when assets change risk profile, for example moving from core to value-added, the investor demands that this asset is sold, creating liquidity which then has to be placed in the market again. This is arguably inefficient for the investor who may not need the liquidity and who will also incur unnecessary transaction costs.
But is hesitancy such a bad thing anyway? There are two reasons it might be not just not a negative trait but a positive advantage. The first comprises the benefits of a culture of caution. The second is what pension funds want to achieve.
"It's fair to say that larger schemes - those with larger [governing] bodies and investment subcommittees -take a considered approach to everything. That isn't a bad thing," says Marcus Whitehead, a partner in the investment practice of consultancy Barnett Waddingham. "It can take 100 meetings to get anything done but there's definitely more expertise. It's the smaller ones that tend not to be overly confident - so there tends to be a delay."