Pension fund governance 1: expertise and organizational form · public and private standards. This matches an OECD definition of pension fund governance which involves “a robust,

Pension fund governance 1: expertise and organizational form Gordon L Clark, School of Geography & the Environment, and Said Business School,

University of Oxford, Mansfield Rd., Oxford OX1 3TB, United Kingdom Abstract. Responsible for the welfare of beneficiaries, pension funds have many tasks

and functions. Consequently, their governance and regulation are issues of public

concern with direct bearing on the interests of stakeholders and ultimately the

performance of Anglo-American financial markets. Nominally subject to common law

expectations regarding proper trustee behavior, also important are statutory requirements

regarding the equitable treatment of beneficiaries and the management of assets and

liabilities. At one level, discretion is an essential attribute of the trust institution—

trustees act on behalf of others not so well placed to manage their own long-term welfare

because of lack of knowledge and/or competence. At another level, pension funds are

presumably regulated by a well-defined purpose—the welfare of beneficiaries. In this

paper, I look at the internal governance of pension funds emphasizing codes of practice,

the rules and procedures for decision-making, and trustee competence and expertise.

While it is important to observe codes of conduct like those advocated by the OECD,

there may be significant problems with any system of governance that relies upon rules

and procedures. Inertia rather than innovation may be the net result. These issues are

developed with reference to defined benefit and defined contribution schemes (and their

variants). Ultimately, the governance of pension fund institutions reflects, more often

than not, its nineteenth century antecedents rather than the financial imperatives of the

twenty-first century.

JEL codes: G23, G28 Key words: pension funds, governance, codes of practice, expertise, competence Acknowledgements. This paper is part of a project on the governance and regulation of pension funds. It is funded in part by the National Association of Pension Funds (NAPF). My thanks go to my colleagues Tessa Hebb, John Marshall and Emiko Wakasugi for their insights and inspiration. I also wish to record my appreciation for interest shown in this work by John Evans, Christine Farnish, Simon Ford, Giles Keating, James MacLachlan, Michael Orszag, and Ann Robinson. None of the above should be responsible for any errors or omissions, or for that matter my inability to take into account their well conceived comments and criticisms.

PFGovernance1(February 16th, 2004) 1

Introduction

Pension funds are remarkable institutions. In the Anglo-American world, public and

private pension funds provide employer-sponsored pension benefits (including defined

benefit, defined contribution, and hybrid schemes). These are vital supplementary

institutions given the modest value of most countries’ social security benefits (see

Emmerson 2003 and Munnell 2003). Charged with the responsibility of protecting and,

in some cases, insuring beneficiaries’ promised retirement income, pension funds are

institutions that must be governed.1 Golden-rules such as the exclusive benefit rule do

not always resolve the dilemmas, conflicts of interest, and reasonable doubts over the

proper course of action (Clark 2004). One goal of this paper is to explain why this is the

case—those knowledgeable of pension funds and related institutions will readily

acknowledge this fact of life.2 Those more removed from the practice of decision-

making in trust institutions and drawn to parsimonious recipes of institutional form in

economic theory may find the argument contentious (compare with Jensen 2000).

Historically, trustees have had considerable discretion (in the scope of decision making)

when exercising their responsibilities (in protecting the welfare of beneficiaries). Given

the covenant or mandate of each fund when established, and given the presumption in

favor of supervision as opposed to direct regulation, trustees have wide-ranging powers

consistent with the English common-law trust institution (Langbein 1997). Discretion

with responsibility provides an opportunity for plan-specific efficient and equitable

solutions to retirement income provision, perhaps more so than if the state were to

directly regulate plan decisions. Over the twentieth century, however, legislation became

more intrusive with regard to trustee responsibilities and the scope of discretion was

1/. In this paper, the term “governance” is used to refer to the formal mechanisms by which an institution makes decisions, is held accountable to its stakeholders and beneficiaries, and acts in accordance with public and private standards. This matches an OECD definition of pension fund governance which involves “a robust, process-oriented decision-making framework” including administrative and oversight functions as well due regard to the investment of pension fund assets (Galer 2002, 62). 2/. See, for example, the essays on pension fund governance published by AMP (a financial services company) in their Insights magazine (www.amp.com.au). In a brief editorial (June 2003, p. 3), John Evans suggests that current interest in pension fund governance reflects growing unease about the responsiveness of pension fund officials to stakeholder interests.


narrowed with respect to the public interest in pension security and equity (Blake 2003).

The scope of discretion however foreshadows the principal-agent problem just as trustee

responsibility could be understood in terms of the moral hazard problem.3 The

governance of trustee decision-making is a crucial issue for the integrity of private

pensions and the provision of pension benefits whether defined benefit, defined

contribution, or some hybrid version thereof (Clark 2003a).

Much is expected of pension funds, in part because of their importance as institutional

investors in national and global financial markets. In the aftermath of the dot.com boom,

bubble and bust, academic and policy commentators have raised doubts about the skills

and expertise of pension fund trustees. Shiller (2002), for example, suggested that the

herd behavior of institutional investors combined with the use of benchmarks measuring

the relative performance of pension funds contributed to the escalation of the speculative

bubble. He contended that if pension fund trustees had exercised appropriate judgment in

a timely fashion, the bubble could have been contained. In a related vein, the Myners’

(2001) report on UK institutional investors and pension fund trustee decision-making

suggested that trustees lacked the expertise necessary to make independent judgments in

the face of the influence of consultants and the financial services industry. And yet,

throughout the industry, an often-heard lament is the risk aversion of fund trustees;

sophisticated risk-management strategies are often eschewed in favor of convention.

Inertia seems commonplace.

In this paper, part of a larger project devoted to pension fund governance, I explore the

problem of pension fund governance focusing upon the internal governance of pension

funds given the scope of trustee discretion and responsibility. Implied by discretion is a

supposition that trustees have considerable expertise whereas the reality is, at best, a

world characterized by trustee competence and, at worst, amateurish confusion. Absent 3/. As Williamson (1996, 56) observed, in theory the principal-agent problem and the moral hazard problem are closely related (when we combine self-interest with the asymmetrical distribution of information). Even so, in reality they are separable in that the scope of discretion depends upon the governance of the principal-agent relationship while the costs of trustee decision-making are borne, more often than not, by beneficiaries. There are many agents in financial markets, inside and outside of pension funds. At the same time, it is not always clear precisely who are the principals—plan sponsors, trustees, and plan beneficiaries and retirees can all claim to be heard in this respect (see Black 1992).


trustee expertise, governments may be tempted to regulate the actions of plan officials in

ever finer and more comprehensive detail. In doing so, I suggest that the tension between

discretion and regulation is actually a dispute about the nature of decision-making in

general and the prospects for trustee expertise in the context of financial risk and

uncertainty. As is apparent from previous work, I argue that trustee competence is more

likely than trustee expertise in these circumstances; expertise suggests a quality decision-

making rarely achieved by most people.

In the next sections of the paper, I look at the form and functions of pension funds. As

intimated above, the pension fund institution is an unusual institution when compared

with much of continental Europe. Its functions follow its historical form, with due regard

to its evolution over the 20th century. Thereafter, I look more closely at the relative status

of competence and expertise before moving on to consider Rawls’ (1954) classic paper

on rule-based decision-making. This allows us to re-consider the virtues or otherwise of

procedural as opposed to substantive measures of trustee decision-making. To sustain

my argument, I refer briefly to the path-breaking work of Gigerenzer et al. (1999) and his

colleagues on heuristics and short cuts. In the penultimate section of the paper, I look

once again at the governance of contractual relationships arguing that pension funds must

develop the institutional form and expertise consistent with their reliance upon

consultants and the fund management industry. Unfortunately, recent commentators on

the topic tend to rely on idealized models of the trust institution and trustee decision-

making; in the end, I argue that better governance demands a different institutional form

than that inherited from the 19th century.

This paper develops these arguments with respect to internal governance (the principal-

agent problem). In the following paper (Clark 2004), I look closely at the regulation of

plan governance (the moral hazard problem), noting the evolution and development of

different regulatory regimes used to manage the issue. In total, these two papers provide

a critical perspective on the problem of pension fund governance relevant to the Anglo-

American world of public and private pension systems.


Pension fund form and functions

For F. W. Maitland, one of the leading legal historians of the nineteenth century, the trust

institution had a unique place in English law and statute.4 Historically, the trust

institution provided private agents considerable discretion outside of the direct scrutiny

and tax powers of the crown. It allowed for the preservation of wealth and its transfer

between generations, separating the interests of beneficiaries from those charged with the

responsibility of administering the trust. In fact, Maitland suggested that the perpetual

nature of the trust and its reliance upon a functional model of trustee responsibility

encouraged economic and financial innovation. He cited a number of examples including

the creation of Lloyd’s of London and the London Stock Exchange. Maitland observed

that by the end of the nineteenth century, the combination of trustee discretion and

responsibility had facilitated the liberalization what counted as an investment asset and

the transfer of wealth between the landed gentry and the emerging urban industrial elites.

He noted, moreover, that the trust relationship was neither a contractual relationship nor a

strictly commercial relationship—it was (and is) a form of obligation.5

Pension funds inherited from English common law and the trust institution their

governance procedures. Much has been written about this institution, its significance for

Anglo-American commercial and financial systems (Langbein 1997), and its significance

for the evolution of private retirement income systems over the last 50 years or so

(Hawley and Williams 1999). Although now just one element in a comprehensive web of

nation-state statutory and market regulation, it remains an important reference point in

setting the roles and responsibilities of pension fund trustees (Ellison 2003). It provides

justification for trustee discretion in the interests of beneficiaries’ welfare subject to the

public interest in the equitable treatment of beneficiaries. At the same time, the trust

4/. Here, I refer to his essays on trust, the state and the corporation published in the first decade of the 20th century recently collected and edited by Runciman and Ryan (2003). 5/. Obligation refers to a social claim on private agents to act properly—a normative imperative that may be defined by law but could be just a moral standard. Whether private agents act in accordance with an obligation is open to scrutiny and, at the limit, may be enforced by sanctions. However, I do not believe that an obligation is necessarily defined by its sanctions. Like Johnson (1991, 134-135), I would argue “among the characteristic features of obligation is the idea that the performance of obligation is conceived to be a matter of legitimate interest and concern of others, whether they be members of some immediate group or community, or of humanity generally.”


institution has no equivalent in much of continental Europe; it requires a stretch of the

imagination to equate trustees’ responsibilities for beneficiaries’ welfare to fathers’

responsibilities for their family welfare (as in France). In fact, the trust institution is an

important element in observed systematic differences between whole countries’ legal

systems and financial systems (see La Porta et al. 1997, 1998 on the global map of

financial systems and their rather different regulatory regimes).

At the same time, we have shown that pension funds are hardly transparent organizations

governed without fault or favor by trust and statute (Clark 2004). In fact, there remain

systemic problems of asymmetrical information that work against the efficacy of fund

governance (compare with Jensen 2000). Trustee intentions are difficult to observe, the

interests of plan administrators and service providers are not always apparent, and the

costs of market failure are, too often, borne by those that should otherwise benefit from

pension fund decision-making. In this respect, pension funds are organizations like other

organizations with shortfalls in governance and regulation thereby being vulnerable to the

principal-agent problem and the moral hazard problem. See Clark (2000, 2003b) on the

scope and significance of these issues for the Anglo-American and continental European

circumstances. As a consequence, there is a significant premium associated with the

proper internal governance of pension funds; that premium can be priced as beneficiaries’

welfare but can also be priced as the value of innovation in the design of pension benefit

systems and the investment of pension fund assets.

The trust institution provides pension funds with a generic form. But as we know, there

are all kinds of pension funds: some are governed by a single trustee, some are governed

by sponsor-nominated trustees, some are governed by a mix of sponsor and beneficiary

representatives, and some include independent and professional trustees. There are also

public and private funds, single and multi-employer-sponsored funds, craft, union, and

industry-sponsored funds. As well, funds vary according to the nature of offered

benefits: final salary (defined benefit), accumulation (defined contribution) and related

hybrid versions thereof (including cash-balance schemes). Few defined benefit plans

hold elections for trustee boards; most trustees are nominated and appointed by the plan


sponsor. On the other hand, larger defined contribution plans tend to seek nominations

and hold elections for member representatives. There are systematic differences between

countries in terms of the dominant type of fund just as there are differences within

countries. For example, in the US there are a number of very large public DB funds

governed and administered by a single trustee just as there are many thousands of small

DC schemes governed by plan sponsor appointed trustees.

Whatever their differences, there are a number of commonalities. Most funds perform

three functions (although most functions can be out-sourced to industry service

providers): (1) administrative, (2) the determination of benefit eligibility and value, and

(3) asset-management. Administrative functions include the collection, tagging, and

protection of pension contributions. In a mature fund, administrative procedures may be

dominated by the valuation and distribution of benefits to retirees. At issue is the cost-

efficiency of these functions, especially if a fund is small relative to the provision of such

services by third-party agents. Benefit adjudication functions may include the

determination of eligibility against plan criteria, the resolution of difficult cases, and the

enforcement of procedures regarding the interests of plan sponsors and beneficiaries. As

for asset-management functions, these may include asset-liability matching and asset

allocation (in DB plans) and the evaluation of investment product providers and advice

for plan participants on their investment options and policies (in DC plans).

Whatever the functional performance of funds, it is apparent that funds have considerable

discretion and responsibility in executing these functions. Plan participants are, more

often than not, participants by virtue of their employment contract; in most cases, plan

participation is a condition of employment.6 In the few countries where a market exists

for pension participants to switch between plan providers, it is not clear that switching

decisions are consistent with the time horizon over which the relative virtues of

6/. Mandatory plan participation is often encouraged by government regulation and tax benefits (see Bateman et al. 2001). In some countries, however, employees are given the option to opt-out to another pension benefit provider at the time engagement. In the UK, it is not obvious that the opt-out option has been beneficial to those that have taken the option; plan participation is often more cost-effective than any similar benefits available in the private insurance market. In any event, stability of plan membership is one condition for minimizing administrative costs.


competing plans should be considered. It is also apparent that plan participants rarely if

ever play an active role either in the governance of pension funds or in the scrutiny of

administrative and trustee decision-making. Even when plan participants are adversely

affected by specific actions and policies, few participants appeal. When they do appeal,

the relevant procedures are obscure, cumbersome, and over-whelmed by the language of

the plan covenant. Third-party appeal procedures are similarly problematic and time

consuming. Finally, it is clear that collective action by plan participants regarding plan

governance has proven very problematic. The costs of such action are prohibitive. As a

consequence, prior membership of an employee representative group such as a union is

an important way of mobilizing plan participants and beneficiaries.

Exit, voice, and loyalty—conventional mechanisms used in governing the principal-agent

relationship—are rarely if ever directly available to plan participants. Trustees may be

“representative” of plan participants but are not directly accountable in the sense we

associate with representative democracy. Indeed, Maitland argued that the trust

institution was conceived, as it was, precisely to avoid the need for on-going close

scrutiny and regulation of agent decision-making.7

Codes of conduct

Given lack of direct accountability, it is not surprising that the regulation of pension fund

tasks and functions is an important issue. Elsewhere, I look at the "external" regulation

of funds emphasizing moral imperatives, legislation, and market mechanisms (Clark

2004). There is a different model of regulation, one focused upon internal governance

procedures and the nature and quality of trustee decision-making. In this section, we

consider codes of conduct. Recently, governments have sought to strengthen corporate

codes of conduct in the aftermath of accounting and financial scandals such as in Enron

and WorldCom (in the US) and Ahold and Parmalat (in Europe). At the same time,

7/. This is evident in a number of ways. For example, plan administrators and trustees are only liable for wrongful decisions; any appeal against their actions must in some way show that those actions violated either the terms of the plan covenant or natural justice. Even if decisions may result in adverse outcomes for plan beneficiaries, it is presumed that administrators and trustees act on behalf beneficiaries’ best interests. Poor decisions are not the same as wrongful decisions. See Coleman (1992) for a theoretical exposition of this point and the related judicial decision Harvard College v. Amory 26 Mass. 446 (1830) .


public sector pension fund intervention on issues related to corporate governance and

global standards of behavior have prompted industry commentators to raise exactly the

same questions about the governance of pension funds (and especially the role of political

appointees on trustee boards) (Clark and Hebb 2004).

Unlike the corporate arena, however, it is very difficult to design and implement a single

pension fund code of conduct; as noted above, pension funds come in many different

shapes and sizes recognising, no doubt, the historical legacy of English common-law,

employer interests, and nation-state development. The trust institution has been

important precisely because of the multiplicity of possible formations (as noted by

Maitland). However, debate over the pension fund directive, the financial services

directive, and the development of a single European capital market have all served to

underline the importance of common expectations if not a common history of such

institutions. In this regard, the OECD's (2002) guidelines for pension fund governance

stand as an important reference point, being designed for "autonomous, collective and

group pension funds that support private occupational pension plans." The guidelines

deliberately and explicitly exclude individual pension funds and insurance systems, but

recognise trusts, foundations, and corporate entities as pension plan sponsors.

It should be also recognised that the OECD guidelines have a form and logic consistent

with the OECD’s (2004) proposed principles of corporate governance. One way or

another, the implied relationship and apparent overlap between these two types of

regulatory instruments suggests a common concern for the financial performance and

stability of these types of institutions. However, common concern does not exhaust the

interests of the constituencies served by these different types of regulatory regimes.

Indeed, given the debate in Europe over the proper role and status of private pension

funds, the OECD guidelines can be seen as part of a larger agenda aimed at encouraging

European pension “reform” and institutional innovation (as illustrated by the blue-print

for pan-European pension institution published by the European Federation for

Retirement Provision 2003).


In large part, the OECD guidelines have a significant normative quality being focused

upon the proper organisational form of pension funds and their accountability. While not

expressed as such, we can identify three core principles underpinning the OECD

guidelines. In the first instance, the guidelines are conceived to ensure that pension fund

decision-making is consistent with the terms and conditions of the pension plan covenant

or mandate. Here, there is a concern for the interests of the plan sponsor and

beneficiaries. In the second instance, the guidelines encourage the design and

implementation of coherent internal rules and procedures. Here, there is a concern with

the formal structure of decision-making implying logic and order rather than

arbitrariness. In the third instance, the guidelines suggest that the organisation of pension

funds must be compatible with high standards of behaviour. Probity and professional

standards are the issues, in this regard. These three principles consistency, coherence,

and compatibility—are, at base, all about ensuring that pension funds are managed and

organised according to recognised standards of behavior.

In more detail, the OECD guidelines recommend that pension funds are governed by

recognised statutes, by-laws, rules and regulations that provide for (amongst other

functions) the monitoring and oversight of administrative decision-making. It also

recommends high standards of behaviour, indicating that those responsible should be as

much as possible fully informed about the nature and consequences of their decisions

consistent with their responsibilities. At times, the guidelines suggest a need for high

levels of professionalism and expertise and that pension funds should seek appropriate

advice external to the fund. Reporting should be accurate, timely, and clear in a manner

consistent with full disclosure to plan stakeholders. The guidelines recommend the

appointment of external auditors, actuaries, and custodians such that there are

independent checks upon plan solvency, financial integrity, and pension benefit security.

In sum, the OECD guidelines suggest that pension funds should be rationally organised

rather than being subject to the whims of plan officers or the fait of plan sponsors.8

8/. In the UK, in the wake of the inquiry into Robert Maxwell’s diversion of the Mirror Group’s pension assets, the Pensions Act of 1995 went some way to require rules and procedures so as to sustain the integrity of the trustee decision-making process.


There are, however, three basic questions that may be raised about the

comprehensiveness of these guidelines. Most importantly, there is an ambiguity at the

very heart of these guidelines: recognising that private pension plans have sponsors and

beneficiaries, the guidelines are silent on their respective powers and responsibilities.

Furthermore, the guidelines are all about establishing and maintaining pension funds as

whole organisations protected from the pernicious interests of insiders and outsiders.

Again, if this is to be the case, what are the powers of pension funds in relation to their

sponsors and beneficiaries? This issue comes into play, most obviously, in relation to

plans that offer defined benefit pensions. In this case, plan sponsors may pay a high price

indeed for their separation from pension fund decision-making in the interests of

sustaining coherence and compatibility. Likewise, in other cases such as defined

contribution plans, where beneficiaries carry the risk of benefit value they may pay the

price for coherence and compatibility.

Implied by the guidelines, moreover, is an assumption that the formal organisation of a

pension plan according to the principles of consistency, coherence, and compatibility are

sufficient to drive its functional performance. On the face of it, this is a remarkable

assumption.9 It may be true if functional performance is measured in terms of the cost

effectiveness of administrative and service-related tasks measured against industry

standards. Cost efficiency is a most important criterion by which to judge performance

even if comparable data is difficult to obtain (especially in a world where industry

providers bundle together services). If apparently self-evident in terms of the economic

theory of institutions (see Jensen 2000), it ignores the reality of transaction costs,

multiple and inconsistent objectives, and a lack of clarity in large organisations between

the means and ends for any particular task and function. Of course, greater efficiency is

possible and desirable. But organizational form is one component amongst many in

determining institutional performance (March 1994).

9/. This is most apparent when considering the failure of formal mechanisms of corporate governance and the related external audit agents used by institutional investors over the 1990s to assess corporate risk. See Coffee (2003) on the limits of such “gatekeepers” in relation to the Enron debacle. He noted that not withstanding their reputational capital, “professional gatekeepers do acquiesce to managerial fraud” (p. 14).


At the same time, the guidelines are clear about the need for responsible plan officials to

obtain, where necessary, the expert advice needed to make better decisions. As with

many codes of conduct governing corporate boards of directors, the OECD guidelines

recognize that pension fund officials and board members may not have the specialist

skills or expertise available in the financial services industry. This is especially true for

some functions rather than other functions: investment management including strategic

and tactical asset allocation requires a level of expertise and experience that is in very

short supply in the academic world and industry let alone private pension funds (see

Campbell and Viceira 2002). It is clear, moreover, that the connection between fund

governance and investment decision-making in the context of risk and uncertainty is quite

problematic. The OECD guidelines are properly vague about this particular issue not

withstanding the fact that investment decision-making is as important for fund sponsors

and beneficiaries as cost effectiveness in the provision of member services.

Trustee expertise and competence

In previous sections, we analyzed plan officers’ discretion and responsibility in managing

pension plans. The presumption in favor of plan officers means that a great deal is

expected of their decision-making capabilities. As I suggest in this section, there are two

rather different views about this matter. Before proceeding, however, we should be clear

about the assumptions we might make about rationality—a core concept in social science

theory and a crucial behavioral anchor in studies of the performance and structure of

financial markets (see Houthakker and Williamson 1996 and Litterman et al. 2002). In a

related move, Williamson (1996) assumed economic agents to be intentionally rational

rather than ipso facto rational in the strong sense associated with much of neo-classical

economic theory (compare Jensen 2000). This definition is owed to Herbert Simon

(1982) and suggests that rationality is a social practice subject to cognitive limits and the

vagaries of the environment in which decision-making takes place rather than a universal

once-and-for-all state of mind. Moreover, emphasis upon intentionality implies

deliberate planning and the possibility that decision-making may improve over time.10

10/. Much of economic theory implies that the rational decision maker is an expert. At the same time, there is a wide distribution of agent skills and knowledge. It is not assumed that we are the same. Rather, there


For policy makers, the Myners’ (2001) report makes this connection clear. The Myners

review was sponsored by the UK Treasury to determine "the extent to which institutions

approaches to investment decisions are: rational; well-informed; subject to the correct

incentives; and as far as possible, undistorted." After brief comment regarding the

significance of UK institutional investors in terms of the volume of assets they own and

their significance for equity markets, the report identified occupational pension funds as

the most important group of institutional investors whose decision making is the focus of

the report itself. In doing so, the report noted that a survey of about 250 trustees

conducted for the review indicated, "many trustees are not especially expert in

investment." To illustrate, the report also noted that a majority of trustees have no

professional qualifications in finance or investment, have little initial training, tend not to

attend training courses after the first 12 months of appointment, and spend very little time

in the course of the week preparing for pension fund investment decisions (confirming

qualitative evidence presented by Bunt et al. 1998 and Thomas et al. 2000).

If being an “expert” is so important, what is meant by the terms “expert” and “expertise”?

The Myners report is not entirely clear. But in discussion with UK industry insiders,

policy makers, and pension fund representatives it has been suggested experts should

have four qualities: 1. high levels of formal education, 2. professional qualifications, 3.

task-specific training, and 4. significant experience. These four qualities are generic in

that they are neither particular to the pension fund sector nor the investment services

industry—they are the qualities of an expert whatever their occupation and industry.

None of these qualities are quickly acquired. In combination, they require time, effort,

and resources. Further more, to be an expert requires continuity of occupation, the

incremental accumulation of relevant knowledge, and its application to related problems

and issues over a long period of time. Most troubling, it would seem that few people are

truly experts and very few people under the age of 40 years could be experts. Not

is a supposition that, where it matters, only expert decision-makers will survive market arbitrage and competition. Survival of the fittest is the mantra (see Alchian 1950).


surprisingly, in many cases formal education and professional qualifications may be

deemed sufficient to compensate for the lack of experience.11

Being an expert, however, need not translate directly into expertise. Wagner (2002, 57)

suggests that expertise is performance-related with respect to problem solving in specific

settings. Summarizing the literature, he suggested expertise has four cognitive

attributes: “1. Experts spend proportionally more time assessing the problem and less

time solving it, compared to novices who do just the opposite. 2. Experts recognize and

categorize problems on the basis of deeper principles, whereas novices recognize and

categorize problems on the basis of surface features. 3. Experts are able to perceive large

patterns of information quickly. 4. Experts have superior memory, both short- and long-

term, for problem-relevant information.” In essence, a person’s problem-solving ability

can be measured, assessed, and evaluated over time against accepted benchmarks of

performance. As in completing crossword puzzles, each attribute can be practiced,

improved, and honed to perfection. We can judge who is, and who isn’t, good at problem

solving in specific contexts. Expertise combines cognitive attributes with cost-

effectiveness and consistency over time assuming that deeper principles and calibrated

experience allow individuals to adapt quickly and efficiently to changing circumstances

and new situations.

Are plan officers experts if judged against the 4plus4 model of expert qualities and

attributes presented above? Myners and many in the Anglo-American financial services

industry have no doubt about the answer to the question: too few, given the importance of

their tasks and responsibilities. At the same time, there are many plan tasks and functions

few of which demand the statistical and pattern-recognition skills associated with

investment management (Bunt et al. 1998). Experience in personnel management,

dispute resolution, and rule interpretation may well be just as important. In this respect,

there are often significant differences between sponsor-nominated and member- 11/. This is certainly common in the investment management industry given the proliferation of professional certificates and accreditation boards. See, for example, the web site of the UK Society of Investment Professionals, a member of the Association for Investment Management and Research. These institutes oversee “the Chartered Financial Analyst (CFA) qualification, a globally recognized professional qualification.” http://www.uksip.org


nominated trustees in terms of their expert qualities and attributes. In a survey of recently

appointed pension plan trustees under-taking training by the UK NAPF, it was found that

many sponsor-nominated trustees had at least the first two expert qualities and were

familiar in their own professional lives with some of the attributes associated with

effective problem-solving. Member-nominated trustees were rarely as skilled although

they may be, by virtue of their experience, familiar with the problems of personnel

management. In our survey, neither group had the substantive knowledge or the

experience industry observers claim are so important in expertise.12

The available evidence would suggest that plan administrators and trustees are less

skilled than their peers (advisors, service providers, and perhaps even some regulators).

The fact that plan administrators are paid substantially less than those who perform

similar functions in large financial services companies suggests that there is an unequal

distribution of administrative and financial skills across the industry. And the fact that

pension fund trustees are hardly ever compensated in proportion to their responsibilities

suggests that their motives are quite different than industry service providers.

Considering that pension fund trustees are rarely appointed for their expert qualifications

and attributes in pension fund management and investment, it would appear that few plan

officers would qualify for the 4plus4 model of expertise. Only in the largest corporate

pension funds dominated by sponsor-nominated trustees and the knowledge and skills of

corporate treasury departments might the 4plus4 model be realized. Short of replacing

nominated trustees with a cadre of independent professionals appropriately compensated

for their responsibilities, the 4plus4 model remains an abstract ideal (compare with

Horack et al. 2004).

The alternative model is the competency model associated with the market for financial

services: that is, a model of pension fund governance that combines the available skills of

administrators and trustees with well-defined rules and procedures for decision-making.

12/. This survey was conducted on behalf of the NAPF with Dr John Marshall and Ms Emiko Wakasugi from Oxford University. Further details on the nature of the survey and our results can be obtained from the author or from [email protected] The UK government is also conducting an extensive quantitative survey of over 1000 pension fund trustees (results are expected in March 2004).


In this model, funds should take advantage of the mix of skills available within the

institution recognizing the different skills needed for the effective performance of the

various functions of a fund and the need to locate responsibility with well-managed sub-

committees. Fund performance would depend, in part, on the extent to which internal

competence allows for the recruitment of expert advice from industry consultants and

financial service providers subject to appropriate safe-guards regarding conflicts of

interest and independence. At the limit, the competency model puts the weight of

governance on the governance of contractual relationships and implies that a crucial test

of fund competence is its ability to hire and fire industry service providers according to

independent standards of performance. The competency model of pension fund

governance implies that plan officers are best seen as consumers of expertise rather than

the locus of expertise. At the same time, the 4plus4 model of expertise provides plan

officers with a set of criteria by which to judge those that offer their services.

At one level, the competency model is a version of what often happens in the industry

(Clark 2000). At the same time, the competency model makes four presumptions: first,

plan officers should be chosen, in part, for their skills in relation to the mix of functional

responsibilities; second, internal rules and procedures should be well-conceived with

respect to the execution of management of tasks and functions; third, where-ever

possible, tasks and functions should be out-sourced to industry providers according to

independent competitive standards of performance; and fourth, purchase of external

services should be governed by selection criteria and assessment procedures based upon

high standards of expertise.

Decision-making, rules and procedures

Considering their importance for pension fund decision-making, we should be clear about

the nature and significance of rules and procedures. In doing so, we should recognize

that our lives are governed by rules. Most obviously, there are rules for driving a car (the

side of the road we drive upon etc.). More subtly, there are rules for conducting

economic and social relationships. Some rules are formal and are codified in law. Others

are informal and are part of customary practice learnt over time through context-specific


experience. In many ways, the rules governing everyday life are rarely, if ever, explicitly

considered. More often than not, such rules are fully integrated into behavior and are

only considered if, for some reason, they fail to work. On the other hand, the rules and

procedures governing pension fund decision-making and their relationships with external

service providers have a deliberate or an explicit quality to them such that their design

and implementation is (or should be) continuously monitored.

One (strong) theory of rules would have it that their design and implementation are

determined by the expected value of desired outcomes. By this logic, one rule or one set

of rules may be judged better than others by virtue of their consequences. Following

Rawls (1954), a number of implications follow from such a theory. In the first instance,

it is supposed that we make each and every decision on its merits, applying the available

skills and experience in such a way that we maximize the results of our actions. In the

second instance, it is commonly supposed that people with similar skills and experience

sharing similar goals would decide issues in much the same way. So, for example, if

pension fund boards are comprised of trustees with the same expert qualities and

attributes and are similarly committed to maximizing beneficiary welfare then decision-

making should be unproblematic at least with respect to the shared criteria used to make

decisions. Thus, it is arguable rules develop over time such that as each issue is

confronted it is simultaneously placed according to past decisions and decisions made in

past cases are applied as rules to current cases.

In this theory of decision-making, expertise is crucial. The four attributes of expertise

identified above have important roles to play in locating each and every issue with

respect to inherited rules—assessing the problem, categorizing the problem, placing the

problem in relation to recognized patterns and processes, and using knowledge of the past

to adjust the decision-making process are all important for the integrity of rules. Over

time, with a sequence of issues more or less the same, it is supposed that the classification

of issues becomes quicker and the application of rules to those cases becomes more or

less automatic. We would expect that both the speed of decision-making and its

efficiency improve over time as the rules themselves become more coherent and better


defined with respect one another. Even so, it should be recognized that rules are only

valuable with respect to their utility. If new cases or issues come along that don't fit with

the rules, then the rules would have to be adjusted and refined. Ultimately, each and

every issue becomes a test of the inherited rules; the rules themselves have no virtue

other than the substantive value of their results.

This is a most demanding theory of rules. Consider the following objections, relevant to

the issue of pension fund decision-making. Underpinning the whole logic of the argument

is an assumption of homogeneity both with respect to the skills and expertise of trustees

and their commitment to a single objective function (maximizing beneficiary welfare).

While such an assumption may be necessary for the logic of governance, it seems quite

unlikely given the nature and composition of many pension funds. As well, the

importance of information processing with respect to case recognition in relation to a

priori defined patterns presupposes that trustees have the knowledge, time, and resources

to undertake such analysis. More likely, the only groups with the requisite knowledge,

time, and resources are the external service providers. Even expert pension fund trustees

are likely to depend upon others for this kind of analysis hence the necessity of governing

the principal-agent relationship. Furthermore, the formation of rules out of cases

presupposes the stability of the underlying processes. Uncertainty may cloud judgment,

introducing doubt about the placement of cases against pre-existing patterns and

ultimately the allocation of issues to their relevant rules. Cases and rules may be lost in

ambiguity, conflict and doubt.13

Most importantly, the strong theory of rules verges on the super-rational. In allocating

cases to rules, in revising and adapting rules in relation to new cases, and in judging the

utility of rule behavior against their consequences remarkable assumptions have to be

made about the robust rationality of trustees and their agents. Implied is a process of

comprehensive and continuous assessment of each and every issue ignoring resource

13/. In these circumstances, conflict between those deemed responsible may become endemic to the trust institution prompting the invention of rules and the arbitrary allocation of cases in order to sustain the social if not economic process of decision-making. See Clark (2000) on the collegial logic of collective decision-making.


constraints, cognitive limits, and the need for timely decision making. In this idealized

world, there are no systematic psychological biases (for example, risk aversion) or

cognitive traps (for example, herd instinct and market speculation). Against all the

psychological evidence to the contrary, trustees are assumed to follow issues in all their

complexity through to conclusion; the real world of decision-making is largely ignored

(see Gigerenzer et al. 1999). It is a theory of rule making that would disqualify most

trustees from the decision-making process; indeed, it would seem to disqualify almost

anyone from serving on trustee boards. In the end, this theory of rule-based decision-

making is as profoundly paternalistic as it is idealistic.

A rather different view of the nature and significance of rules and procedures would have

it that they are social assets, embedded in institutions, and driven by the need to

economize on resources and time. By this logic, rules and procedures are task-related

and develop as institutions develop in an incremental fashion around the execution of

those tasks and functions. More often than not, economic agents rarely take the time to

design or remake inherited rules; at most, they adapt or adjust existing rules within the

constraints of their organizations. Where rules and procedures are imposed upon

institutions, as is often the case of statute-based rules and regulations, economic agents

may have to deal with overlapping and even conflicting sets of rules that are neither

coherent with respect to one another nor unambiguous as to their ultimate objectives. At

the limit, rules and procedures are a bureaucratic skeleton resistant to the kind of rule-

rationality sketched above but nevertheless valuable for the ways in which they define

expected practice.14

As in the strong theory of rule making, I assume that the utility of rules has to do with

their consequences. At the same time, if we assume that economic agents in general and

pension plan trustees in particular have limited knowledge, time, and resources then rules

allow economic agents to take short cuts—to economize on the costs of decision-making 14/. See Rawls (1954, 24) on the value of rules. He says, in part, “practices are set up for various reasons, but one of them is that in many areas of conduct each person’s deciding what to do on utilitarian grounds case by case leads to confusion, and that the attempt to coordinate behavior by trying to foresee how others will act is bound to fail.” A more recent development of the notions of practice and behavior is to be found in the work by Bourdieu (1990).


by providing an a priori reference point for issues as they arise. They are used, more

often than not, as automatic filters for classifying the significance or otherwise of those

issues. This is despite the fact that the consequences of such shortcuts may be seen, in a

larger context, less than optimal. In fact, this suggests that the social value of rules and

procedures is to be found not in their precise utility on a case-by-case basis, but in their

generality. Being 80 per cent right may be sufficient for economic agents to hold to a set

of rules recognizing that evaluating exceptions is a time-consuming process. Only when

exceptions accumulate and a pattern is revealed in those exceptions might those that rely

on rules look to revising the rules themselves.

Of course, the reform and revision of rules is more problematic than the strong theory of

rules would seem to suggest. In many cases, rules and procedures are social practices

shared between institutions on the basis of their common problems and overlapping

legislative frameworks. Rules and procedures maybe both informal and formal, and their

interpretation and application to specific cases is likely guided, in part, by the

expectations of the relevant community (as noted by Shiller 2002). This suggests that

institution-specific revisions to inherited rules and procedures may fall foul of

community expectations not withstanding their theoretical virtues. Furthermore,

recognizing the widely shared nature of such rules and procedures, it may be difficult for

any institution to claim authority in establishing new rules and procedures. The 4plus4

model of expertise may warrant such innovations; even so, rules and procedures have a

life of their own outside of their immediate consequences. This is surely the reality

experienced by many in pension fund management.

Most importantly, working by inherited rules and procedures maybe a refuge for pension

plan officers that are best characterized as competent rather than expert in their fields.

The challenge, in this context, is to design a set of rules and procedures in the public

domain that require pension plan officers to interrogate the efficacy of their decision-

making practices whilst, at the same time, being sufficiently flexible to accommodate

local innovations that go beyond common practice. More often than not, rules and

procedures establish minimum standards of competence; however, those rules and


procedures must also be able to accommodate changing circumstances that demand

expert qualities and attributes. Too often, public rules and procedures and only penalize

non-compliance when they should also reward innovation outside of the inherited

framework of rules and procedures.

Governance through contract

Rules are oftentimes effective but may promote less than optimal results. As well, there

is a sense in which the object of such governance instruments are defined benefit plans.

This is most apparent in the Myners’ report where UK Treasury concerns about pension

plans’ lack of expertise in areas such as asset allocation and private equity partnerships

were given a great deal of weight. But, of course, the numbers of DC plan participants

out-weigh DB participants and the rate of DB to DC conversions appears to be increasing

not withstanding the significance of DB plan assets (Clark 2003a). Embedded in the DC

world is a model of plan governance that relies more upon contract in the market for

financial services than upon plan expertise and the internal provision of tasks and

functions. In this respect, contract buttressed by fiduciary duty represents an alternative

model of plan governance.15 More over, given the problems apparent in many pension

plans regarding competence as opposed to expertise, one option is to simply transfer to

consultants and then to service providers the shortfall in requisite expertise.

There is a massive literature on contract, governance and organizational form (see

generally Masten 1996 and Williamson 1985). I do not intend to rehearse well-known

claims and counter-claims regarding the virtues of contract for the design of institutions.

Rather, we look at a simple and conventional view of governance through contracts and

then suggest how that view should be modified in the light of the particular circumstances

of many pension funds. As is well appreciated, the neo-classical theory of contract

assumes there are many buyers and sellers in the market place, full information is

available to market agents, there are negligible transaction costs and there is nothing that

15/. Herein lies a most important difference between US and UK regulatory systems. In the US, those involved in the management of pension fund assets must observe the principles of fiduciary duty whereas in the UK this level of commitment is reserved for trustees and plan officials. Myners recommended the extension of the principle to the financial services industry although, to date, this has not been enacted in statute.


would lock-in parties to second-order contracts. In effect, this is a world of discrete

exchange that can be costlessly executed and revised (indeed revoked) if better

opportunities are available. There is considerable debate about the empirical and logical

plausibility of this model (see Epstein 1999 and compare with Trebilcock 1993, 1999).

For our purposes, it represents a conceptual reference point if not exactly current practice.

Less discussed in the literature, is the competence of contracting parties. There has been

considerable discussion regarding the fairness of contracts where one party is deemed

less competent by virtue of the asymmetrical distribution of information (Cartwright

1991). Similarly, there has been a long history of state intervention designed to protect

parties to contracts against the costs of coercion, collusion, and exploitation (Atiyah

1979). But, in relation to pension fund governance, while these issues may be important

on a case-by-case basis, it should be apparent that pension fund trustees must often defer

to the expertise of other parties. Even if service providers are bound by fiduciary duty, in

many cases pension fund trustees do not have the expertise necessary to question the

expert judgment of service providers—the only option available to many trustees are

questions relating to the efficacy and efficiency of the procedures whereby service

providers fulfil their tasks. In this respect, consultants have a vital role in representing

trustees’ best interests at the nexus of contracts. This contract is the most important

contract, one that is characterised by continuity (over many cases) and longevity (over

time) given the specificity of plan circumstances and interests.16

In these circumstances, any contract between a plan and its consultants must be sensitive

to the costs and benefits of long-term commitment and the inability of trustees to observe

the relationships between plan consultants and financial service providers. There is a

subtle and difficult to calibrate trade-off between discounting the value of a contract

given its long-term commitment against the unknown opportunities for immediate reward

offered by the financial services industry for specific deals. Indeed, to reap the benefits

16/. Klein (1996) provides a useful case study of significance and possible consequences of institutional specificity for the formation of contracts. Most importantly, specificity may result in the vertical integration of financial functions and the formation of long-term contractual relationships that may effectively capture of those on either side of the contractual divide (see below).


of contract as a system of pension plan governance it would seem necessary to have

different types of contracts—some relational and some discrete—using the prospect of

switching between providers and varying the terms of contract as mechanisms for

disciplining potential and actual service providers. One response to these problems of

governance may be to introduce third party auditors and advisers. But, as we have seen

in recent scandals of corporate governance, there is no guarantee that auditors will pick-

up conflicts of interest if secrecy between conspiring partners is the organising principle.

Transparency is an essential ingredient in governing such relationships (Hebb 2004).

At the core of this model of pension fund governance is the management of contract.

This requires systems of over-sight and assessment that are comprehensive and detailed.

There is, however, an alternative. Instead of governing external contracts, pension funds

may wish to keep internal their tasks and functions governing their own employees

through personnel contracts and the like. A variety of arguments may be made in favour

of this approach. One is that internal contracts may be cheaper because employees may

be willing to take lower salaries in return for tenure of employment. It is apparent that

the high cost of industry service providers is due, in part, to the cost of employees

recognizing that most trade-off high current salaries against limited job tenure. Of

course, there are dangers in such compensation strategies including the selection bias

implied regarding the risk adverse nature of employees in different organizations.

Another argument in favour of such an approach would invoke the mission of pension

funds: unlike many industry service providers, pension funds’ have a beneficial ethic or

moral mandate. This may allow for the co-existence of internal (less expensive) contracts

with external (more expensive) contracts since the moral mandate is a form of self-

governance shared by employees (Clark 2004).

Here, of course, there is an issue of scale: that is, few pension funds are large enough in

terms of their asset base to be able to provide both the routine and the highly specialized

tasks and functions at a competitive performance-related price. Given the fact that the

overwhelming majority of pension funds whether defined benefit or defined contribution

are very small, this option is practically irrelevant to most funds. Only in circumstances


where funds amalgamate together and form their own service providing organizations

may small funds be able to take advantage of their moral mandate. This is, of course,

precisely the option favored in a number of countries including Australia and The

Netherlands.17 Even if these larger organizations do not internalize all tasks and

functions, larger size allows for the employment and retention of highly qualified and

experienced plan officials evening-out the distribution of expertise between funds,

consultants and service providers (Clark 2003b). Missing in the UK and the US, it

appears, are adequate incentives for fund amalgamation and collective governance.

Conclusions

Maitland's history of the trust institution stretches back over many centuries. When

comparing it to Germanic legal traditions, Maitland emphasized its uniqueness against

continental traditions and the special place it occupied relative to the Crown and

corporation. For Maitland, the trust has many beneficial features not least, of which are

the separation between trustees’ own interests and the interests of beneficiaries. He also

suggested that it was a site of innovation especially with respect to financial institutions

and instruments. Likewise, legal scholars such as Langbein (1997) argue that the trust

institution is crucial in differentiating Anglo-American financial systems from their

European cousins. These ideas find common cause amongst those that advocate the

relevance of trust-based pension fund institutions for European private pension and

retirement income systems over the coming decades. It is arguable that idealization is a

necessary element of any comparative analysis of nation-state economic and financial

institutions (Allen and Gale 2000). But in this case, there are increasing doubts about the

capacity of pension funds to operate as equal players in the market for financial services.

Doubts have been raised about the internal structure and management of pension funds;

not withstanding widely recognised case of outstanding pension fund management, it

would appear that the vast majority of such funds are poorly organised relative to

beneficiaries’ welfare. In any event, to the extent to which they rely upon external

17/. See Buckley (1999, 306) where he notes, in relation to the conceptual niceties of current theoretical debate, that “an ounce of comparative law is worth a pound of theory.”


service providers for the execution of their many tasks and functions, it would seem that

the vast majority of pension fund trustees defer to the expertise of service providers. In

both cases, Maitland's 19th century ideal has been overtaken by the increased complexity

of fund tasks and functions and the astonishing growth of the financial services industry

and its instruments over the past 50 years. In the UK, the Myners report argues that if

funds are to fulfil their obligations to beneficiaries and if they are to take an active role in

the financial services industry commensurate with their significance in terms of total

assets then the governance of pension funds must improve along with the knowledge and

expertise of pension fund trustees. As is widely appreciated in the industry, most pension

funds lack even a rudimentary knowledge of advanced financial instruments.

In this respect, moves to "reform" pension fund governance have taken a variety of

forms. Most obviously, codes of practice have encouraged the development of

management systems more consistent with pension plan tasks and functions. Codes of

practice have added a level of specificity to governance not apparent in the generic

qualities attributed to trust institutions. I have suggested that codes of practice are both

valuable for their contribution to the cost-efficiency and consistency of decision-making

and for their value as benchmarks in evaluating the functional performance of plans.

Arguably just as important is the quality of internal decision-making distinguishing

between trustee expertise and competence. This is most obvious when considering

pension fund investment management functions, but can be extended to consider any

issue involving judgement about beneficiaries’ welfare. One response has been to invest

a great deal in internal rules and procedures invoking tests of efficacy and efficiency.

But, as we noted, rules and procedures are more than instruments for promoting

economic welfare (in general) and beneficiaries’ welfare (in particular)—they have a

vital social role in coping with limited resources in the context of risk and uncertainty.

But too many "solutions" do not confront the most important issue—that is, the relative

power of pension funds and their officers in the market for financial services. In that

regard, I would suggest that by the only real solution to apparent problems of governance

and lack of expertise within pension funds is the transformation of those institutions into


organisations that have sufficient internal resources that would allow them to employ

professional managers and advisers. This suggests that pension fund governance is an

issue of size and scale as much as it is an issue of proper rules and procedures,

competence and expertise. One of the lessons to be learnt from the Australian and Dutch

experience is that large, industry-based pension funds are better able to compete in the

marketplace for tasks and functions than smaller single-sponsor pension funds. This does

not mean that large multi-employer pension funds ought to be financial institutions in

their own right; size and scale provides pension fund trustees a choice about the nature of

their organisational form recognising the costs and benefits of internal provision as

opposed to being at the nexus of contracts with external providers.

Poor organisational systems combined with a palpable lack of expertise makes many

pension funds a soft target for unscrupulous financial service providers. Furthermore, at

a time when large public sector pension funds have played a significant role in promoting

reform of corporate governance, the prospect of other large financial institutions being

formed to occupy similar positions in the market for financial services will surely not be

welcomed by entrenched corporate management. And yet, this is exactly what is implied

by government rules and regulations that to require pension funds and related institutions

to vote their proxies. At present, however, the small size and lack of expertise that

characterises most pension funds means that this policy is likely to remain the terrain of

only the biggest funds. Only if governments promote the formation of larger multi-

employer pension funds will the apparent deficit in pension fund expertise be addressed

in a manner consistent with the conscientious exercise of their responsibilities. Similarly,

only this solution is consistent with the financial service industry’s interest in promoting

financial innovation.


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Documents

Pension fund governance 1: expertise and organizational form · public and private standards. This matches an OECD definition of pension fund governance which involves “a robust,