Every single organization that sponsors a funded retirement savings plan or pension plan for its employees, whether it be a defined benefit plan type or defined contribution plan type, must deal with the selection and monitoring of the investment managers of its funds. This is an important decision to get right and keep right because so much of the plan’s funding depends on it.
The fundamental pension plan funding equation is Contributions + Investment Income = Benefits Paid + Expenses Paid, and for many mature plans their investment performance drives the majority of the funding of benefits and expenses. Get it wrong and plan sponsors are on the hook for very high contributions for long periods of time.
So how do most sponsors assess investment managers?
Most use past performance since it is the easiest way to assess someone’s ability. Using past performance helps in a number of ways: achieving investment objectives, adherence to investment philosophy, and insight into team dynamics.
Investment objectives: Each pension fund has target investment objectives such as inflation plus 2.0%, a benchmark index return plus 1.0%, the fund’s going concern discount rate, etc. These objectives help establish a good yardstick to determine if a manager has achieved its stated objective. When an active manager fails to achieve its objectives over a reasonable period of time over which it should, then it is time to move on.
Adherence to investment philosophy: Past returns and models that breakdown returns into component returns also shed a light on how managers actually invest their money. Are they value or growth investors in terms of style? Are they large-cap or small-cap in terms of security selection? Do they favour certain industries or geographies (developed versus emerging markets)? Looking at past performance tells the truth about how managers actually invest.
Team dynamics: Third, past performance shines a light on team dynamics since stronger teams have consistently high positive returns and are remunerated very well. Strong teams stay together and weak teams with poor investment track records tend to see people leaving, indicating poor leadership, lack of a team culture, unadopted philosophies, etc.
…does not equal future performance
However, many investment consultants and managers warn sponsors over and over again that past performance does not equal future performance. Why do they say that and how much weight should a plan sponsor place on past performance given it is so helpful?
There are three reasons for not relying solely on past performance: it is not always indicative of skill, future risks are not the same as past risks, and, given that it is viewed as a bet, all other things being equal, a sponsor could drop a manager just as they are about to take off.
The first two reasons (skill and future risks not equaling past risks) need to be explored further. Sometimes a manager is good but has had poor security selection, poor industry selection, or their style has not been in favour of late. If so, the plan sponsor needs to determine if things will get better or not. Normally, an investment consultant can break down a manager’s return to help explain where good or bad performance is coming from. These discussions are important and need to be understood. These conversations also help to assess if future risks could very different from past risks. Normally, these are longer conversations and involve getting a handle on macro-economic issues and geo-political assessments. For global investing, they do become important considerations.
Therefore, past performance can provide comfort and insights into how investment managers have performed and are the easiest thing to understand, but some factors such as actual skill level and assessment of future risks need to be considered before making any changes.
Your turn: Has past performance been a good indicator of your investment manager’s ability? Use the comment box below to let us know what you think.
About the Author
BiographyMore Content by conduentblogs