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Pension Revolution: A Solution to the Pensions Crisis

Pension Revolution: A Solution to the Pensions Crisis

Keith P. Ambachtsheer

ISBN: 978-0-470-08723-7 January 2007 368 Pages


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Praise for Pension Revolution

"When Keith Ambachtsheer puts his keen mind to work on a problem, watch out! Here he exposes today's fragile arrangements for the most serious social dilemma of our times--financing retirement. Then he provides a compelling and powerful set of solutions. His writings are essential reading for all who care about the future of American living standards."
--Peter Bernstein, founder and President, Peter L. Bernstein, Inc., and author of Capital Ideas and Against the Gods

"This book describes one of the most ingenious inventions in the history of mankind: pension funds offering credible promises about old-age income. It reads like a thriller: how can well-governed pension funds be created in an imperfect world in which mortals wrestle with foibles and moral shortcomings? One of the world's leading experts on pensions searches for the answer--and finds it."
--Lans Bovenberg, Scientific Director, Network for Studies on Pensions, Aging, and Retirement, Tilburg University, The Netherlands

"Pension Revolution exposes the inadequacies of current pension systems and persuasively makes the case for the fundamental changes that are needed. It is essential reading for both the pension industry and policymakers."
--Elizabeth Bryan, Chair, Investment Committee, Unisuper Management PM Ltd, Australia

"Most analyses of complicated issues deal with complexity by simplifying or only looking at one piece-part, and, in doing so, provide limited value. In stark contrast, Keith Ambachtsheer boldly wades into the complexity in Pension Revolution to come up with a valuable integrative solution. He is a most welcome revolutionary!"
--Roger Martin, Dean, Joseph L. Rotman School of Management, University of Toronto, Canada

"We have known Keith for over ten years, and consistently over that time, he has constructively and comprehensively challenged conventional wisdom. He has done this so effectively that many of his initial thoughts have now become universally accepted norms. Such is his energy however that he continues to push the boundaries of pension and investment thinking."
--Peter Moon, Chief Investment Officer, Universities Superannuation Scheme Ltd, UK

"Pension Revolution not only explains the shortcomings of the existing pension system and the underlying design features that have resulted in the current pension upheaval. It also offers thoughtful and creative suggestions for prospective pension design. A must-read for anyone interested in the future of retirement finance."
--James Poterba, Professor of Economics, Massachusetts Institute of Technology and a member of the TIAA-CREF Board of Trustees

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Preface: Peter Drucker’s Pension Revolution: Here at Last xxiii

Introduction: Why a Pension Revolution Now? xxvii

The Trouble with DB Plans xxvii

DC Plans Are Not the Answer Either xxviii

Expert Pension Co-ops xxix

TOPS Tipping Points xxx

PART ONE The Pension Revolution: Touchstones

CHAPTER 1 Are Pension Funds ‘‘Irrelevant’’? 3

An ‘‘Unreasonable’’ Actuary? 3

Exley’s Four Irrelevance Propositions 4

So What Is Relevant? 4

Responding to Exley 6

Relevant Pension Funds: Building the Case 6

Managing Retirement Income Risks 7

Leveling the Informational Playing Field 7

Getting the Execution of the Idea Right 8

CHAPTER 2 The Pension Revolution—Are You a Believer Yet? 9

A Revolutionary Reordering of the Pensions Firmament 10

From Fuzzy Pension Deals to ‘‘Risk-Sharing Co-ops’’ 10

Toward Pension ‘‘Business Models’’ That Work: The Risk Issue 11

Toward Pension ‘‘Business Models’’ That Work: The Scale Issue 12

The Pension Governance Issue 13


Two Role Models 14


SunSuper 15

Great Treasures? 15

CHAPTER 3 After the Perfect Pension Storm: What Now? 16

From Vegas to Oxford: In Search of Answers 16

Do Nothing or Something? 17

The Corporate Context: Two Basic Choices 18

New DC Plan ‘‘Business Model’’ Also Needed 19

The Industry/Public-Sector Pension Context 19

The ‘‘Fair Value’’ Question 20

Better Public Pensions Policy 21

CHAPTER 4 Beyond Portfolio Theory: The Next Frontier 22

Investment Theory’s Next Frontier: The Academic View 22

Investment Theory’s Next Frontier: Two Further Considerations 24

The Next Frontier: ‘‘Integrative Investment Theory’’ 25

CHAPTER 5 The United Airlines Case: Tipping Point for U.S. Pension System? 29

The United Airlines Case 29

A Good Question and Two Very Different Answers 30

ERISA’s ‘‘Sole Interest’’ Rule 31

Lessons from Abroad 32

Searching for ‘‘Supreme’’ Answers 33

The UAL Case in Context 34

CHAPTER 6 Peter Drucker’s Pension Revolution After 30 Years:

Not Over Yet 36

Two Unfashionable Themes 36

Politico-Agency Issues 37

Pension Contract and Risk Issues 39

Investment Beliefs 40

Pension Fund Governance 40

Still Much Work to Do 41

CHAPTER 7 Winning the Pension Revolution: Why the Dutch Are Leading the Way 42

The Globe’s Number One Pensions Country 42

Culture, Compactness, and Leadership 44

Regulatory Leadership 45

Research Leadership 46

A Remaining Challenge: Solving the Organization Design Puzzle 46

What About the Other Pensions Countries? 47

CHAPTER 8 Pension Reform: Evolution or Revolution? 48

A Pension ‘‘Tipping Point’’ Indeed 48

What Should Happen? 49

Pension Reform in the United States 50

Pension Reform Elsewhere 51

Pension Reform: Evolution or Revolution? 52

PART TWO Building Better Pension Plans

CHAPTER 9 Can Game Theory Help Build Better Pension Plans? 57

Pension Games 57

Why do Pension Game Switches Occur? 58

Who Are the Stakeholders and What do They Want? 59

Sources of Risk in Pension Schemes 60

Mitigating Micro Risks 60

Can We Mitigate Macro Risks? 61

Is Investment Risk Worth Taking in DB Plans? 61

Can Game Theory Build Better Pension Plans? 62

CHAPTER 10 If DB and DC Plans Are Not the Answers, What Are the Questions? 63

From Answers to Questions 63

Ultimate Pension Questions and Their Consequences 64

Underwriting Pension Mismatch Risk: Any Volunteers? 64

Should Pension Mismatch Risk Be Minimized? 66

Pension-Delivery Institutions 67

Benchmarking Traditional DB and DC Plans 67

The Way Ahead 68

CHAPTER 11 Human Foibles and Agency Dysfunction: Building Pension Plans for the Real World 69

Some Fundamental Questions First 69

Back to First Principles 70

Human Foibles 71

Agency Issues 72

Counteracting Human Foibles 73

Minimizing Agency Costs 74

TOPS, Employers, and Public Policy 75

TOPS and DB Plans 77

CHAPTER 12 DB Plans and Bad Science 78

Science and the Design of Pension Contracts 78

The TOPS Contract 78

Taking on Investment Risk: Implications 79

Is Investment Regime Risk Insurable? 80

Intergenerational Bargaining 81

Robust Course-Correction Mechanisms Required 82

The Flawed DB Model 82

Bad Science 83

CHAPTER 13 Peter Drucker’s Pension Legacy: A Vision of What Could Be 84

Two Handshakes to Remember 84

The Melbourne Message 85

TOPS: Neither DC nor DB 86

TOPS and Investing 87

TOPS and Governance 87

TOPS and the Real World 88

The Drucker Visit 89

PART THREE Pension Fund Governance

CHAPTER 14 Reinventing Pension Fund Management: Easier Said than Done 93

A Paradigm Shift? 93

Novelties of Fact 94

Novelties of Theory 94

Pension Industry Responses 96

Crossing the ‘‘Innovation Chasm’’ 97

CHAPTER 15 Should (Could) You Manage Your Fund Like Harvard or Ontario Teachers’? 99

Four Things in Common 99

Legal Foundations: Solid or Not? 100

Governance and Management: Understanding the

Difference 101

Investment Beliefs: Theirs or Yours? 102

Investment Processes: Like Wall Street? 103

Should You Manage Like HMC or OTPP? 104

Could You Manage Like HMC or OTPP? 104

CHAPTER 16 ‘‘Beauty Contest’’ Investing: Not Dead Yet 106

‘‘D´ej `a Vu All Over Again’’ 106

Why ‘‘Beauty Contest Investing’’ Is Ugly 108

Integrative Investment Theory 108

Investment Beliefs 109

Managing from the Inside Out 110

CHAPTER 17 Eradicating ‘‘Beauty Contest’’ Investing: What It Will Take 112

The Ugliness of ‘‘Beauty Contest’’ Investing 112

A Two-Pronged Eradication Strategy 113

What Corporations Must Do 114

What Investing Institutions Must Do 114

A Debilitating Pension Fund Governance Problem 115

Light at the End of the ‘‘Beauty Contest’’ Tunnel? 117

CHAPTER 18 High-Performance Cultures: Impossible Dream for Pension Funds? 118

Thinking and Acting Like Goldman Sachs 118

New Research Results 119

Specific Governance and Management Challenges 121

In Conclusion 122

CHAPTER 19 How Much Is Good Governance Worth? 124

Governance Quality and Organization Performance Should

Be Related 124

A Road Map for the Journey of Discovery 125

The Pension CEO Score and NVA Metrics: The Data 126

Pension CEO Scores Meet NVA Metrics 127

Further Insights 128

The Value of Good Governance 129

PART FOUR Investment Beliefs

CHAPTER 20 The 10 Percent Equity Return Illusion: Possible Consequences 133

Consequential Miscalculations 133

Why 10 Percent Doesn’t Work 134

Painted into an Awkward Corner? 136

Consequences 137

CHAPTER 21 Stocks for the Long Run? . . . or Not? 139

A Debate with Jeremy Siegel 139

How Investment Theory Became Investment Practice 140

What Is Wrong with These ‘‘Proofs’’ 141

What if ‘‘Reality’’ Is Not a Random Walk? 141

Investment Regimes, Dividend Yields, and ERPs 143

The Post-Bubble Blues Decade 143

CHAPTER 22 ‘‘Persistent Investment Regimes’’ or ‘‘Random Walk’’? Even Shakespeare Knew the Answer 145

The Ambachtsheer-Siegel Debate Revisited 145

History on Our Side 146

The Investment Returns Story: How to Tell It 147

The ‘‘Investment Regime’’ Game: Spot Today’s Well Before

It’s Over, and Tomorrow’s Before It’s Gone on Too Long 148

‘‘Regime Spotting’’ versus ‘‘Random Walk’’: Which Is More

Useful? 149

Contents xv

Theory on Our Side, Too 150

Fellow Travelers 150

CHAPTER 23 The Fuss about Policy Portfolios: Adrift in Institutional Wonderland 151

Tempest in a Teapot . . . or Not? 151

Duality in Finance: A Brief History 152

Financial Duality in Pension and Endowment Funds:

Building the Conceptual Framework 153

New Insights from the CEM Database 154

Enter Organizational Dysfunction 155

Decisions by Default 156

CHAPTER 24 Shifting the Investment Paradigm: A Progress Report 157

The ‘‘Policy Portfolio’’ Debate Continues 157

A Lens to See the World 158

Why the ‘‘Old’’ Lens Distorts 158

A Varying Equity Risk Premium 159

A New Lens 160

A Higher Level of Thinking 161

Glimmers of Light 163

CHAPTER 25 Whose ‘‘Investment Beliefs’’ Do You Believe? 164

Writing an ‘‘Investment Beliefs’’ Statement 164

Inferring Beliefs from Actions 165

Measuring Predictive Ability 166

What about Market Timing and Strategic Asset Allocation? 167

Expected ERP Powerful Predictor 167

Enter Woody Brock 168

In Conclusion 169

CHAPTER 26 Our 60-40 Asset Mix Policy Advice in 1987: Wise or Foolish? 171

Why Roll the Clock Back 20 Years? 171

Leibowitz’s Immunization Campaign 172

Investment Beliefs in 1987 173

Investment Beliefs in 1997 173

The Right Kind of Active Management 174

Wise or Foolish? 175

CHAPTER 27 ‘‘But What Does the Turtle Rest On?’’ A Further Exploration of Investment Beliefs 177

‘‘But What Does the Turtle Rest On?’’ 177

The Efficient Markets Hypothesis: Fact or Fiction? 178

The Three Strikes against the EMH 179

Economists and ‘‘Operationally Meaningful Theorems’’ 180

The Adaptive Markets Hypothesis 180

The AMH’s Five Practical Implications 182

The AMH and Integrative Investment Theory 182

CHAPTER 28 Professor Malkiel and the New Investment Paradigm: Raining on the Parade? 184

Raining on the ‘‘New Paradigm’’ Parade? 184

The Bases for Malkiel’s Skepticism 185

An Alternative Conclusion 186

Winning Evidence 187

The ‘‘Good Governance’’ Boost 188

We’re Both Right 189

CHAPTER 29 The ‘‘Post-Bubble Blues Decade’’: A Progress Report 190

Another Nail in the IID Coffin 190

Why Non-IID Logic Wins 191

Investment Regimes in the Real World 192

What Seems to Actually Be Happening? 193

Some Actual Numbers 194

The Bottom Line 195

PART FIVE Risk in Pension Plans

CHAPTER 30 Rethinking Funding Policy and Regulation: How Should Pension Plans Be Financed? 199

The Devil in the Details 199

How Many Course-Correction Tools? 200

Making Financing Decisions: In Whose Interest? 201

An Analytical Framework for Assessing DB Plan Financing

Decisions 202

‘‘Rational’’ Explanations 203

Four Principles to Fund By 204

CHAPTER 31 Funding Policy and Investment Policy: How Should They Be Integrated in DB Pension Plans? 206

Principles to Fund and Invest By 206

What Makes DB Pension ‘‘Contracts’’ Risky? 208

Should DB Funding Target Calculations Assume That More

Risk Means More Return? 208

Is Current ‘‘Accepted Actuarial Practice’’ Unacceptable? 209

What Is an ‘‘Acceptable Level of Certainty’’? 210

Surplus Ownership 211

Cleaning Up Our Act 212

CHAPTER 32 Resurrecting Ranva: Adjusting Investment Returns for Risk 213

Resurrecting RANVA 213

RANVA in 1998 214

Measuring RANVA in the Real World 215

The 2000 to 2004 Experience: Lessons 216

Remaining Barriers 217

CHAPTER 33 Adjusting Investment Returns for Risk: What’s the Best Way? 219

Resurrecting RANVA 219

The ‘‘Cost of Market Volatility’’ Approach 220

The ‘‘Cost of Insurance’’ Approach with Risk Buffers 222

The ‘‘Cost of Insurance’’ Approach with Put Options 223

PART SIX Measuring Results

CHAPTER 34 Pension Plan Organizations: Measuring ‘‘Competitiveness’’ 227

Pension Plan Organizations and ‘‘Legitimacy’’ 227

‘‘Provider of Choice’’ for Which Services? 228

Benchmarking Pension Services 229

Costing the Benefit Administration ‘‘Business’’ 229

The Benefit Administration Cost Equation 231

Build or Buy? 232

CHAPTER 35 Measuring DC Plans as ‘‘Value Propositions’’: The New Imperative for Plan Sponsors 233

Silk Purses from Sows’ Ears 233

Measures of ‘‘Prudence’’ 234

The ‘‘Own-Company Stock’’ Phenomenon 234

Understanding DC Plan Total Returns 235

DC versus DB Plan Cost Performance 237

Other DC Plan Performance Metrics 239

‘‘Value Proposition’’: Yes or No? 239

CHAPTER 36 Measuring Pension Fund Behavior (1992 to 2004): What Can We Learn? 240

A Well-Endowed Database 240

Current International Investment Policy and Implementation

Style Differences 241

Ten-Year Investment Policy and Implementation Style

Trends for U.S. Funds 242

Did Active Management Add Value? 243

The Selection ‘‘Alphas’’: Good News and Bad News 244

Is There Also a Payoff from Actively Managing Pension Fund Costs? 247

Two Important Lessons Learned Thus Far 249

PART SEVEN Pensions, Politics, and the Investment Industry

CHAPTER 37 Whither Security Analysis? 253

Bubble, Bubble, Toil and Trouble 253

Fortune Trashes Wall Street 254

Is Better Regulation the Answer? 255

Reversing the Financial Food Chain 256

What Is Security Analysis, Anyway? 257

Even Good Security Analysis Needs Context 257

Effective ‘‘Buy-Side’’ Structures 258

In Conclusion 259

CHAPTER 38 Pension Funds and Investment Firms: Redefining the Relationship 260

Who Are the Simbas of the Pension Investment Kingdom? 260

The Money Flood 261

A Question of Governance 261

Enter the Anthropologists 262

A Call to ‘‘Excellence’’ 263

What Do ‘‘Excellent’’ Pension Funds Look Like? 264

A Supplier-Driven Market 265

The Tiny Equity Risk Premium Factor 265

‘‘New Paradigm’’ Pension Funds: What Kind of Investment

Services Do They Want? 267

New Pension Fund–Investment Firm Partnerships 270

Could You Be a ‘‘New Paradigm’’ Player? 271

CHAPTER 39 The New Pension Fund Management Paradigm: Feedback from Financial Analysts 272

Test Driving the New Paradigm 272

Pension Politics and Economics 273

Pension Plan Governance 276

The New Pension Fund Management Paradigm 277

Putting the Paradigm in Practice 278

Performance Measurement 281

Did the Yardsticks Move Forward or Backward? 282

CHAPTER 40 Reconnecting GAAP and Common Sense: The Cases of Stock Options and Pensions 283

Closing the Information GAAP 283

When Are Employee Stock Options ‘‘Expenses’’? 284

The Common-Sense Solution in Action 285

Current Pension Accounting Rules Defy Common Sense, Too 285

Sensible Pension Accounting Rules 287

Common Sense in Action 288

Carpe Diem 289

CHAPTER 41 Is Sri Bunk? 290

SRI and Zen 290

What Is ‘‘Socially Responsible Investing’’? 290

A Slippery Slope? 291

Sustainable Investing 292

Assessing the Sustainability of Dividend Growth 293

From Saying to Doing: A Case Study 294

Redefining the SRI Revolution 294

CHAPTER 42 Alpha, Beta, Bafflegab: Investment Theory as Marketing Strategy 296

Giving Alpha and Beta a Rest 296

The Beautiful Art of Language 297

The Myth of ‘‘Absolute-Return Investing’’ 298

Investment Theory with the End in Mind 298

The Critical Role of Fund Governance 299

Pension Revolution 300

CHAPTER 43 The Turner Pensions Commission Report: A Blueprint for Global Pension Reform 302

Pension Wisdom from the United Kingdom 302

Turner’s Recommendations 303

The Power of Integrative Thinking 303

Blueprint for Global Pension Reform 304

NPSS Governance, Management, and Investment

Options 307

Moving Forward 308

CHAPTER 44 More Pension Wisdom from Europe: The Geneva Report on Pension Reform 309

Eight Hands, Four Economists, and One Point of View 309

Powerful Pension Policy Implications 310

Labor Markets and Human Capital 311

Optimal Risk Sharing 312

Optimal Pension Fund Organizations 313

A Powerful Pension Vision 314


CHAPTER 45 PERS and the Pension Revolution: Active Participant . . . or Passive Bystander? 317

Alyson Green’s New Job 317

History of Workplace Pensions 319

The 1976 to 2005 Period 319

Governance–Organizational Issues at PERS 320

Finance–Investment Beliefs 321

Pension Contract–Risk Issues at PERS 321

Is a Higher Contribution Rate the Answer? 323

More Drastic Action Indicated 324

Spreading the Pain Evenly 326

Is Risk-Sharing an Essential Pension Plan Feature? 327

Getting from Here to There 329

Devising an Action Plan 329

CHAPTER 46 Advice for Alyson Green: How PERS Can Join the Pension Revolution 331

Case Discussion Summary from October 25, 2005 331

The PERS Situation 332

The PERS Debate 332

In Conclusion: A Call to Arms 335