GUEST BLOG: The missing reform in the Kay Review
Simon Wong is partner at investment firm Governance for Owners, adjunct professor of law at Northwestern University School of Law, and visiting fellow at the London School of Economics. He can be found on Twitter at @SimonCYWong. The opinions expressed reflect his personal views only.
There is much to commend in the Kay Review final report. It contains a rigorous analysis of the causes of short-termism in the UK equity markets and wide-ranging, thoughtful recommendations on the way forward. Yet, it is surprising that John Kay omitted one crucial reform that would materially affect of the achievability of several of his key recommendations – shortening the chain of intermediaries, eliminating the use of short-term performance metrics for asset managers, and adopting more concentrated portfolios. What’s missing? Reconfiguring the structure and governance of pension funds.
A major challenge facing pension funds in the UK and elsewhere is the lack of relevant expertise and knowledge at board and management levels. Consequently, many rely heavily – some would argue excessively – on external advisers. I have been told by one UK pensions expert that inadequate knowledge and skills within retirement funds means that investment consultants are effectively running most small- to medium-sized pension schemes in Britain. Another admits that trustees, many of whom are ordinary lay people with limited investment experience, are often intimidated by asset managers.
Because these funds cannot afford to build in-house investment capabilities, they outsource this function to external managers. What’s more, some pension funds will utilize intermediary “funds of funds” to help them make investment decisions, thereby extending the equity ownership chain.
Strengthening board and management capabilities at pension funds would bring substantial benefits to their schemes and the broader economy. First, trustees and executives would be better equipped to make investment and other key decisions on their own, including questioning prevailing practices that may benefit investment intermediaries more than them. For example, they could challenge their investment consultants and fund managers on why adequate diversification requires holding 8,000-10,000 stocks rather than a more manageable 3,000-4,000 (or an even smaller number).
Second, they would be more capable of assessing investment manager performance rigorously and thoroughly. Presently, reflecting their trustees’ paucity of expertise on investment matters, many pension funds employ crude performance metrics (e.g., quarterly return against a pre-selected market benchmark) to evaluate fund managers.
A trustee of a mid-size UK pension scheme told me several weeks ago that her board was guilty of such a transgression. Moreover, she added, the trustees don’t always understand fully why investment managers are retained or terminated. By contrast, the chair of a large Canadian pension fund shared with me earlier this year that the board – which has been revamped to bolster financial expertise – pays scant attention to short-term investment returns. Instead, they focus on whether investment managers are sticking to agreed investment strategies and continue to possess distinctive capabilities.
More broadly, if investment managers are relieved of the strain to “outperform” each quarter, they may in turn focus less on short-term performance at investee companies.
How then should pension funds reconfigure their structures and governance to enable them to assemble a strong board and management team?
First, asset size is an important factor in the ability of pension funds to attract talent and to manage investments in-house. In the UK and other countries with many small schemes, policymakers should consider facilitating the consolidation of sub-scale pension funds or introducing industry-based schemes with potential to achieve sufficient scale.
Second, a reconsideration of the required qualifications for pension fund trustees may be needed. For example, contrary to many of their counterparts globally, the members of a large Canadian pension fund have determined that their interests would be better served if the board seats allocated to “beneficiaries” are occupied by outsiders possessing the requisite financial expertise rather than by them.
Lastly, public pension funds may need to amend civil service-type pay structures that constrain their ability to recruit suitably qualified executives and investment professionals.
Without reforms at the top of the investment chain, it is doubtful that the key recommendations in the Kay Review can be successfully implemented.