Irrationality and self-interest in pension funds

Q: What do you call a system in which everyone bets on something they don’t really think is going to happen? A: Institutional asset management. Why do pension fund and endowment sponsors pay so much attention to past performance by fund managers and to the recommendations of consultants when neither shows much evidence of being a useful gauge of the ability to outperform in the future? The answer, according to a new study, lies in two familiar forces which govern so much of human endeavour: irrationality combined with the desire to cover one’s own rear end. Some US$7.6 trillion of assets are controlled by U.S. institutional funds, a mix of public and private pension and charity or endowment funds. This money is overseen by plan sponsors, who manage the funds, choosing managers and strategies. Plan sponsors, in turn, rely on consultants, who help them to evaluate and choose fund managers for given mandates. A total of 94 percent of plan sponsors use consultants, according to data from Pensions and Investments Magazine. One of the great mysteries of this process is that sponsors appear to lean heavily on past performance, as well as on the recommendations of consultants, to help them choose fund managers, despite studies showing that neither strategy works particularly well. Howard Jones of the Saïd Business School, University of Oxford, and Jose Vicente Martinez of the University of Connecticut delved into the data to try to determine why. Their new paper looked at 13 years of data from Greenwich Associates covering about half of all U.S. institutional equities holdings. Greenwich Associates polls sponsors on a variety of measures, allowing the authors to work out how plan sponsors actually expect managers to do in the future. Sadly expectations don’t seem to marry up with reality. “Neither plan sponsors’ expectations, nor past performance, nor the non-performance factors they evaluate in their asset managers, reliably predict the performance of those asset managers,” Jones and Martinez write. “As for flows, we find that these are at best only marginally a function of plan sponsors’ expectations, but they are driven significantly by past performance and by investment consultants’ recommendations far beyond the effect that these have on expectations.” Career risk and irrationality In other words, all of the analysis done by plan sponsors doesn’t predict how managers will do, and even taking expectations into account they give money to the fund managers who’ve done well in the past anyway. As well as those who manage to get on the good side of consultants. Earlier research indicates that consultants do help to determine which funds get money, but find no evidence that these recommendations add value. So what on earth is going on? There is, after all, a fair bit of money at stake, not to mention the retirement of a chunky proportion of the public. The authors find a fair bit of irrationality at work, as sponsors choose based on past performance and soft factors, like service, despite neither being a good indicator of future outcomes. What we also have is a good old-fashioned agency problem, in that the best interests of the plan sponsors as individuals are a good deal different than the best interests of the funds for which they act as agents. “Plan sponsors chase past performance and consultants’ recommendations because they feel that, as a rationale for selecting asset managers, these indicators are more defensible to their superiors, stakeholders and, possibly, the courts than their own expectations are,” the authors write. Interestingly, past performance is a more important driver of flows than future expected performance. Perhaps that’s because it is a lot easier to point to a track record when in front of a judge, or just in an annual review, than say “I thought they’d outperform.” Plan sponsors window-dress their pension plans, according to the study, larding them with fund managers with recent strong track records. This is much like what mutual fund managers do, buying top-performing stocks just before mandatory reporting periods. And remember, we are not talking about mutual fund choices by amateurs. This is a money-intensive and sophisticated process, yet one which in the end seems to produce perverse results for perverse reasons. “The policy implications of this are sobering,” Jones and Martinez write. “For, as long as sponsors consider that they will be judged by others who do believe that past performance and consultants’ recommendations are informative about future performance, sponsors will behave as if they do so themselves, even if this is not the case.” Pension savers deserve something better.