Pension fund governance 1: expertise and organizational form · public and private standards. This...
Transcript of Pension fund governance 1: expertise and organizational form · public and private standards. This...
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.
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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.
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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).
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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.
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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.”
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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
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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.
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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) .
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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).
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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.
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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).
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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
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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).
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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
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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).
PFGovernance1(February 16th, 2004) 15
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
PFGovernance1(February 16th, 2004) 16
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
PFGovernance1(February 16th, 2004) 17
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.
PFGovernance1(February 16th, 2004) 18
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).
PFGovernance1(February 16th, 2004) 19
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
PFGovernance1(February 16th, 2004) 20
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.
PFGovernance1(February 16th, 2004) 21
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).
PFGovernance1(February 16th, 2004) 22
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
PFGovernance1(February 16th, 2004) 23
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.”
PFGovernance1(February 16th, 2004) 24
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
PFGovernance1(February 16th, 2004) 25
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.
PFGovernance1(February 16th, 2004) 26
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