Despite the significant changes made to European pension business models since the financial crisis, a more fundamental behavioural shift is needed to address the yawning gap that exists between the rhetoric of governance improvements in recent years and their reality on the ground, according to Sally Bridgeland and Professor Amin Rajan in their paper entitled Governance practices: Bridging the gap between rhetoric and reality.
European pensions have made some notable improvements in governance practices, asset allocation and execution capabilities as the last decade demonstrated that the assumptions about risk and return underpinning the traditional asset allocation strategy were not working as bonds outperformed equities, that the core/satellite approach did not deliver as actual and expected returns diverged markedly, and that diversification didn’t meet expectations as excessive liquidity ramped up correlations.
As a result, European pension funds have adopted new approaches to investment and risk management that stand in stark contrast to the old ways. However, Rajan and Bridgeland warn that these changes do not go far enough.
According to Sally Bridgeland: “In many cases, trustees have adhered to the traditional model of managing the easy things that don’t matter and avoiding the harder things that do. Many of the changes so far have focused on low-hanging fruit: targeting specific areas that are easy to define and tackle without reinventing operational or governance capabilities.”
Amin Rajan says: “There have been far fewer improvements in the less tangible aspects of pension business models. To create fundamental and meaningful change, a behavioural and cultural shift is needed for pension funds to navigate the new waters they face today.
“Without that behavioural shift we risk merely re-spraying an old car when, in reality, a new model is needed,” Rajan says.
However, at the same time, the backdrop for making decisions has become scarier, according the paper. Funding deficits and the increasing sense that defined benefit (DB) pension schemes are a legacy problem rather than a valuable incentive in employee remuneration, creates a less supportive backdrop. As a result, every decision that trustees make faces greater scrutiny from an increasingly critical sponsoring employer.
According to Rajan: “Against that backdrop, loss and risk aversion take over. The risks are increasingly emphasised and the problem becomes framed in terms of avoiding failure. As the fight or flight instinct kicks in, the brain is screaming “run way” (from the difficult decision).”
As a result, there is a tendency to avoid difficult decisions or defer to advisors, the paper argues.
Bridgeland says: “It is this tendency, however, that reinforces the gap between governance rhetoric and reality, and holds schemes back from implementing genuine change to ensure their business model is able to cope with the new reality. However, tackling the difficult decisions, playing to organisational strengths and daring to be different (i.e. taking risks) are the way to win.”
Creating the willingness to tackle the big, difficult decisions requires a behavioural shift on behalf of today’s trustees. It also requires an environment and culture in which trustees feel comfortable making decisions about which risks the pension fund should take and, most importantly, how it should take them.
The paper sets out six-steps for pension funds to consider along the path forward. As the paper concludes, there is ultimately no right answer, but reducing discomfort and building appropriate confidence at an appropriate cost can be done through the right governance.
“If that is achieved, then difficult decisions can be made with confidence and pension business models stand a far greater chance of being able to implement effective change to adapt to today’s new investment reality,” Rajan argues.