How do public pension governing fiduciaries make risk-return policy decisions?

By Christian Gaya: Business Times 25 January 2013

Risk tolerance the measure of an investor's willingness to accept a higher probability of loss in exchange for an increase in expected return is a pivotal parameter in all investment decisions, and is perhaps the most difficult metric for investors to specify, be they individuals or investment committees. Without a clearly articulated statement of risk tolerance investors will inevitability adopt unsuitable investment policies and strategies, either because they are unknowing too risky or insufficiently risky.

Investors also find it difficult to evaluate short-term investment performance objectively, be it good or bad performance, and then formulate and implement suitable investment responses. Turnover of public sector trustees can be significant.  John Por of Cortex Applied Research Inc, a Toronto-based consulting firm specializing in fund governance, observed an annual 25% trustee turnover rate among his 75 clients.  This equates to a whole new board about every four years.   

The new field of behavioral finance has provides many examples human errors in decision-making that stem from perceptual illusions, over-confidence, over-reliance on rules-of-thumb, emotions and incorrect farming of problems and solutions.  All investors find it difficult to articulate their risk tolerance but pension fund trustees arguably face a unique combination of challenges.

First, they must reach a collective expression of risk tolerance on behalf of not only the plan beneficiaries but also the plan sponsor, whose risk-tolerances are seldom coincident.  Second, because plan trustees are seldom directly affected financially by success or failure of the investment program they authorize.  

This means the process of reaching a consensus risk tolerance can easily become an academic trade-off between risk and return.  Third, risk tolerances are dynamic and change not only with changing economic environments, but also with changes in board membership, funded status of the plan and the financial health of the plan sponsor.  Fourth, statistical measures of risk and return provided by the asset and liability modeling studies undertaken by trustees cannot convey the emotional pain and regret that accompanies the actual realization of disappointing investment scenarios. Disappointing outcomes are clinically described as below median results, and very disappoint scenarios are described as "very-low probability single-path events".   

Finally, and perhaps most significantly, governing fiduciaries tend to under-estimate their collective risk tolerance-both with respect to setting a fund's asset mix policy, and a fund's active management policy. Positive and negative outcomes of equal magnitude are usually accorded the same emotional weighting when viewed as statistical exercise.

However, in reality, the emotional disappointment endured when actually living through a negative outcome is often more than twice the emotional satisfaction enjoyed from a positive outcome. In the absence of a crisp and robust articulation of risk tolerance, how do governing fiduciaries make risk-return policy decisions?  Many look to see how their peers in other pension funds have answered the same questions, and then adopt similar policies.

This is a reasonable approach given that prudence is often judged within the context what others investors do when faced with the same similar circumstances.  However, there is no guaranty that industry-norm investment policy is best policy for all public sector pension plans.  Trustees should adopt an investment policy only after full consideration of the particular circumstances facing the plan for which they have fiduciary responsibility.

This includes liability structure, funded status, management resources and the ability of the sponsor to underwrite poor investment performance if it should materialize. Others seek the guidance of their investment advisors in the believe that their advisors experience and expertise gives them a better understanding to what extent pension plan assets should exposed to investment risk.  

Advisors certainly provide governing fiduciaries a thoughtful framework for understanding and evaluating risks, but few advisors are willing to assume the responsibility for specifying their client's risk tolerance.   Advisors are seldom in command of all the factors that help trustees evaluate their risk tolerance, and the experienced advisors recognize that risk tolerance ebbs and flows in response to a host of events including board turnover and stock market cycles.

Nonetheless many governing boards adopt the risk preferences on their advisors; the adoption process is subtle and often unrecognized by both parties.  If the risk preferences of the board and the advisor are a good match, then future investment experience-good and bad-will viewed in proper context.  However, if risk preferences are mismatched, future problems are inevitable. The advisor will be blamed for any bad news, either in terms of "the fund lost too much money in bad times", or "didn't earn enough money in good times".