“Pension Fund Trustee Competence” By Gordon L Clark, Emiko Caerlewy-Smith, and John C Marshall

1. “Pension Fund Trustee Competence” By Gordon L Clark, Emiko Caerlewy-Smith, and John C Marshall Sponsored by the NAPF University of Oxford July 2005

2. 1. Introduction • Anglo-American pension funds are envied by continental Europe • Crucial to many people’s total retirement income • Trustees are crucial to pension institutions • Subject to “fiduciary duty” as well as related statutory requirements. Pension Fund Trustee Competence

3. 2. Trustee competence • Emphasised in the UK Myners Report • Questioned by industry analysts re. innovation • Now considered by The Pensions Regulator with respect to trustee codes of practice • This project is about the nature and scope of trustee decision-making (in conjunction with the NAPF). 1 Pension Fund Trustee Competence

4. 3.Summary of the project • Beginning with the education and experience of trustees (based on participation in training programmes) • We also assess trustee competence focusing upon problems relevant to investment • Drawing implications for fund governance • And the relationships of trustees with advisors, service providers. 2 Pension Fund Trustee Competence

5. 4.Steps in the project • Surveys of trustees at NAPF training programmes • Socio-demographic profiles and attitudes re. governance procedures • Including reference to trustee "knowledge and understanding” (cf. Myners principles etc) • With the focus on empirically evaluating and “measuring “ trustee competence. 3 Pension Fund Trustee Competence

6. 5.Problem-solving abilities • Design and execution of problem sets relevant to investment decision-making • Enrolling about 40 trustees, 80 undergraduates • Two sets of problems, each taking about 1 hour to complete (together or separately) • Drawn from a relatively small group of DB pension funds, and Oxford undergraduates. 4 Pension Fund Trustee Competence

7. 6. Problem qualities • Not intelligence tests (eg. IQ tests etc) • Not categorical tests - rational v irrational • Level of education not crucial (although this is subject to specific training in finance etc.) • Basically tests of comprehension and cognition, with reference to logic and numerical inference in the context of responsibilities. 5 Pension Fund Trustee Competence

8. 7. Methodological Issues • Problems with recruiting trustees and undergraduates • Limited options for discrimination by socio-economic status and education • Gaps between the problems and the “real” world • Expectations of psychology v. the social sciences on issues such as “representativeness”. Pension Fund Trustee Competence

9. 8.Findings - discounting the future • Some trustees discount the future, some don't, and some are inconsistent over time • There is a wide range of discount functions only some of which appear “exponential” • Male undergraduates do discount the future (strongly) • Results are consistent with the psychology literature (re. weakness of will etc.). 6 Pension Fund Trustee Competence

10. 9. Findings - my money, your money • Trustees (as individuals) willingly accept “moderate” risk if asked their attitudes (although this varies) • Trustees are risk-averse regarding others’ money when required to calibrate options • Undergraduates are more risk tolerant (esp. males) • Consistent (somewhat) with psychological evidence although there is little in the experimental literature on the effect of “commitment to others”on risk-taking. 7 Pension Fund Trustee Competence

11. 10. Trustees’ attitudes to risk Pension Fund Trustee Competence

12. 11. Trustees’ risk calibration Pension Fund Trustee Competence

13. 12. Undergraduates’ risk calibration Pension Fund Trustee Competence

14. 13. Findings - probabilistic reasoning • Neither trustees nor undergraduates are “good” at probabilistic reasoning • Often unable to recognise or link together the elements necessary to assess probability (in a Bayesian sense) • As well, surprising variation in the “methods” used to assess probability • Consistent with the psychology literature, even if probabilities are often involved in discussion of investment strategies. 8 Pension Fund Trustee Competence

15. 14. Findings - information processing • Trustees and undergraduates are inefficient users of information • Undergraduates often use too much information • Trustees, sometimes, use too little information • Rules can make a substantial difference to the use of information and attaining “correct solutions” (consistent with the psychology literature). 9 Pension Fund Trustee Competence

16. 15.Conclusions I • Should we rely on older men rather than Oxford undergraduates to be trustees? • Many of the trustees sampled have poor problem-solving skills relevant to investment issues • Worse, the range of trustee “solutions” may be wide AND rarely correct • Most trustees are unable to deal with probabilities, and most are inefficient information processors. 10 Pension Fund Trustee Competence

17. 16. Conclusions II • Qualifications to findings would include the sample size, the nature of problems etc. • Reasonable concern over the formality of testing v. real world settings • In any event, recent research suggests that “short-cuts” dominate decision-making procedures • With little regard to how “collectivity” makes a difference. Pension Fund Trustee Competence

18. 17.Implications I • Boards carry a diversity of trustee competence • With important differences in the skills appropriate to investment fundamentals • With profound differences of approach to the solving of problems. • Suggesting the possibility of considerable disagreement (or silence on basic issues of disagreement). 11 Pension Fund Trustee Competence

19. 18.Implications II • Fund governance could be important in this context • Leadership and structured decision-making crucial in “managing” ignorance, confusion, and disagreement • Otherwise, there will be high levels of (caution) risk aversion (or worse), seeking refuge in expert advice, rules and procedures • With low levels of innovation and slow adaptation to changing circumstances. 12 Pension Fund Trustee Competence

20. 19.Implications III • Can trustee codes of practice make a difference? • Yes, for basic procedures; but no, considering the importance of expertise • Implying the possibility of deference to experts • And reliance upon advisers to articulate and implement coherent investment strategies (in the absence of “knowledge and understanding”). 13 Pension Fund Trustee Competence

21. 20. Future research • Can organisational structure and coherent board decision-making procedures “overcome” the heterogeneity of trustee competence? • Is the “representative” model of the UK pension trustee system consistent with high-quality, efficient decision-making? • Is the trust institution appropriate for the governance of 21st century pension funds given the need for financial innovation? • Has the trust institution come to the end of its usefulness? 14 Pension Fund Trustee Competence

22. 21. Further reading • Clark, G.L. 2000. Pension Fund Capitalism. Oxford: Oxford University Press • Clark, G.L. 2004. Pension fund governance: expertise and organizational form. Journal of Pension Economics and Finance. 3: 233-53 • Lerner, J. et al. 2005. Smart institutions, foolish choices? WP11136. Cambridge MA: National Bureau of Economic Research • Merton, R.S. and Z. Bodie 2004. The design of financial systems: towards a synthesis of function and structure. WP 10620. Cambridge MA: National Bureau of Economic Research. Pension Fund Trustee Competence