By Richard Todd and Martin Walsh
Sponsors of defined benefit pension plans face an increasingly difficult task: honoring their fiduciary duties in an era of record-low interest rates and record-high regulations. Adding to this complexity is that most corporate boards and their investment committees, which are charged with overseeing the pension plan, tend to consist of noninvestment professionals. A new committee member confronts significant challenges in learning both the investment details of a pension portfolio and their own fiduciary obligations.
Pension plan sponsors make mistakes in two areas: managing investments and exercising fiduciary responsibilities. Identifying the most common errors investment committees commit can help prevent potential damage—and instill best practices.
The single most important investment decision that investment committees make is the asset allocation of a portfolio. An asset class is a group of securities or investments that have similar characteristics and behave similarly in the marketplace. The three most common asset classes are equities (stocks), fixed income (bonds) and cash equivalents (money market and stable value funds). Another class, often referred to as alternative investments, includes a broad range of nontraditional products such as private equity in companies that are not publically traded, natural resource holdings and even hedge funds.
The asset-allocation mix, not the underlying fund managers selected within each asset class, drives the majority of the risk and return in the portfolio. According to some well-known studies, more than 90 percent of the variability of a typical plan sponsor’s performance over time is attributable to asset allocation.
A good process for constructing a pension plan’s portfolio follows these steps:
- Determine the time horizon.
- Evaluate which asset classes to include.
- Choose the percentage of each asset class based on risk and reward.
- Select fund managers within each asset class.
Many plan sponsors start at the end of the process by asking, “Which managers should we hire?” Based on historical research, asset allocation is literally 18 times more important than fund manager selection.
Here are other common portfolio construction errors:
Not focusing on plan liabilities. Plan sponsors often create an investment policy without considering their outstanding pension liabilities. To the extent possible, sponsors need to clearly understand their future liabilities and match these to an investment portfolio that is reasonably projected to meet these returns. For instance, a typical 60/40 stock/bond portfolio constructed without regard to a company’s estimated future distributions can be a fatal long-term mistake if the organization’s pension liabilities are higher than the portfolio can reasonably deliver.
A diversified investment portfolio could include a healthy allocation to growth-oriented stock funds and alternative investments. Although short-term results will be more volatile when riskier asset classes are included, these assets help deliver superior long-term results in an era of historically low bond yields.
Backward-looking bias. Unfortunately, investment committees are subject to the same biases as retail investors, such as a tendency to look in the rear-view mirror when making decisions, which causes them to increase their investments in asset classes that have performed well recently. This backward-looking approach is dangerous. Instead, plan sponsors need to be forward-looking by asking, “Based on current valuations, what can each asset class (and the whole portfolio) reasonably expect to return on a forward basis?”
The classic investment mantra is “Buy low and sell high.” To that end, it is a prudent discipline for fiduciaries to rebalance the portfolio’s asset classes to a targeted percentage when the portfolio receives contributions or makes distributions. Moreover, value is added when the asset classes are rebalanced after market fluctuations cause them to stray from their targeted allocations by 3 percent to 5 percent. But often, plans lack an automatic rebalancing process.
By periodically trimming investments that have appreciated and buying investments that have depreciated, rebalancing encourages a value approach to investing. Meanwhile, rebalancing allows a plan to keep the portfolio’s risk/reward within its targeted limits.
Fiduciary errors are common because of the extent and complexity of retirement plan regulations. Below are some causes of fiduciary missteps.
Lack of an investment policy statement (IPS). An IPS defines an investment committee’s duties in clear and actionable language. It outlines the process and guidelines around the investment process by addressing the question, “How should the board evaluate the existing investment portfolio, and what are the guiding risk and return principles of the defined benefit plan?” Creating an IPS and following it are a best practice that plan sponsors ignore at their peril.
Dysfunctional investment committees. Although committees of this type are all too common, the reasons for dysfunction vary. However, there are a few common themes among bad investment committees. For instance:
- A “bully” member may exert an inordinate amount of influence on a committee’s investment decisions. The role of the committee’s chair is to build consensus from the group, not drive a specific agenda.
- The committee should have members from a variety of backgrounds and corporate positions. Nondiverse committees typically fall victim to groupthink and do not properly evaluate their decisions.
- Committees require some experience. A totally inexperienced committee often has difficulty evaluating investment decisions.
Failure to exercise the duty of loyalty. As fiduciaries, board and investment committee members have a duty of loyalty that applies solely to the plan and its participants; therefore, any conflicts of interest must be disclosed. Committee members sometimes ignore these conflicts by failing to address the question, “As a result of the committee’s decisions, are there economic benefits to any person on the board/committee or an indirect benefit to a board/committee member’s family, friends or employer?”
Conflicted advisor. Using a conflicted investment advisor is another common pitfall. Committees must have policies in place to address advisor conflicts of interest and ensure that all investment decisions are made in the plan’s best interest. An advisor who gets commissions from an investment recommendation certainly has a conflict.
Richard Todd is CEO, and Martin Walsh is vice president, of Innovest Portfolio Solutions LLC, a Denver-based investment management consultancy.