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1 August 2011 CFA Institute Journal Review

How Should Pension Funds Pay Their Own People? (Digest Summary)

  1. Natalie Schoon

How should pension funds pay their own staff? The author looks at two approaches to implementing a pay-for-performance plan that is similar to that used in the corporate sector. Using the example of the Canada Pension Plan Investment Board, he highlights the potential importance, complexities, and inconsistencies of the various types of pension plan pay schemes.

It is generally accepted that pension funds should use their position as large investors to influence corporate pay structures. How they should remunerate their own staff, however, is discussed less. Although difficult to define for the investment function of a pension fund, an effective pay-for-performance plan similar to that used in the corporate sector can be established. The main challenge is how to set the targets for performance, which can be done using one of two approaches: real market results or expectations market results.

Measuring performance using real market results is a forward-looking approach based on the purpose of a pension fund, which is to invest productively, administer efficiently, and advise wisely. Specific key areas need to be addressed when determining the targets to measure performance: the definitions of investing productively, administering effectively, and advising wisely; the effectiveness of the governance process; the maximization of scale and resources; and the attraction and retention of staff.

The expectations market approach is a backward-looking approach and compares the currently expected value with the historical cost. The only significant input to this approach is performance against an appropriate benchmark, where outperformance results in an increase in performance-related pay and underperformance results in a reduction. The future value of an investment is based on risk-adjusted expectations regarding, for example, future interest payments, dividend payments, growth, and capital repayments. For public investments, the future value should be reflected in the current market value. For private investments, a proxy can be calculated. These expectations, however, may not be realized, and research shows that investor expectations are often incorrect. Other challenges associated with this approach exist, such as how to determine the relevant benchmark, how to adjust for risk, and the conversion of gross into net returns.

The author reviews the Canada Pension Plan Investment Board’s (CPPIB’s) performance-related pay plan and shows that the two approaches—real markets and expectations market—are not mutually exclusive. Although CPPIB’s plan is a significant improvement over that of many pension funds, the current results of the CPPIB’s plan also reveal that too much emphasis is placed on the less-reliable expectations market approach. For example, the bar for payout adjustments under CPPIB’s long-term bonus scheme is a four-year return over 0 percent. Recently, the short-term bonus scheme applied a multiplier to bonuses during a period when returns underperformed a reference portfolio. Despite these apparent imperfections, the pay innovations may serve as a model for other pension plans developing incentive pay structures.

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