Introduction

If you are reading this book, you are almost certainly a trustee or board member. Or perhaps you are considering becoming one. Maybe you are an adviser looking for tips on how trustees think about the complex issues you advise on, or you are a board member of a pension fund, endowment or foundation. Irrespective of your level of expertise and profession in the industry, why should you read this book, and which problems are we attempting to solve here? More importantly, how should you use this book and apply it to your own practice for the benefit of your fund and its long-term performance?

The basic premise of this book is that trustees have a crucial role to play in the long-term success of pension funds and other long-horizon asset owner organizations: sovereign wealth funds, endowments and foundations. Trustees are able to make to a real and meaningful difference when it comes to sustainable pensions for millions of pensioners in the coming decades. For a trustee this may be a powerful, but at the same time scary, idea. In the past decade, the very low interest rates have dramatically increased the cost of meeting future pension payouts, beyond all expectations. The time that you allocate and the level of knowledge that you need to demonstrate have probably increased disproportionately over the years as a consequence of the increased regulation. The stakes for your personal reputation are higher than ever. You understand the importance of doing this job well. You are aware that you matter for the thousands and millions of future pensioners who depend on your choices for their future retirement. As a trustee you have both a large responsibility and a large opportunity regarding the investments you oversee. Given that you are at the beginning of the investment chain it is imperative to understand what contributes to investment success and what detracts from it. This matters all the more because the margin of error is steadily narrowing. Consider, for instance, that in the year 2000, trustees would have expected equities to earn 10% per year, whereas today, they would be more than happy to expect half as much.

It is easy to get lost in the complex landscape of investing. Understanding and overseeing what really matters is key. This book benefits anyone who is seeking to ask the right questions in the boardroom, and is looking for a guide that will help them in setting the agenda in ways that allow for effective and relevant decision-making. This book is also intended as a potent counterbalance to the highly skilled management of the investment organizations that trustees face. Above all, this book contributes in a very pragmatic way, as we review and consolidate years of academic research and case studies on day-to-day implementation, translating these into inspiring examples and actionable alternatives that are of practical use to trustees worldwide. We systematically integrate the important perspectives into the five parts of this book. In Chapter 14, all perspectives are brought together in a way that assists trustees in determining where they stand right now, and what is needed to move to the next level in the pursuit of investment excellence. Reading this chapter first will help you to read the book in a more goal-oriented manner.

As a trustee, having oversight and pushing the right buttons is difficult. We have come to this conclusion based on years of extensive practical and academic experience, in combination with our own research and the ample available evidence. We are fairly confident in saying that there is a lot to be gained from learning how to do this correctly. We feel that trustees should take an active role in this process on behalf of the beneficiaries they represent.

Trustees are often highly competent individuals who are relatively new to the situation in which they have to govern a pension organization. It can take quite some time before they grasp the task in its entirety, appreciate its complexity and fully understand what really matters and what does not. Trustees are more often than not in the process of "learning on the job," which creates a risk of them only having a partial understanding of the issues at hand. Such a risk is manageable and may even be tolerable when financial markets are calm and the political environment is stable. Unfortunately, at this time, the opposite is true. We are witnessing abrupt and profound shifts in the political and technological landscape; and given generally low solvency, the margin of error is small. This book aims to bring the reader up to speed fast. Moreover, we hope it will stimulate a structured conversation within the fund, where views can be shared and exchanged in order to assess the current state of the fund, and possibilities to improve it can be determined.

We argue that there is a substantial governance "bonus" to be harvested. We believe that by transforming any weak pension organization into to an excellent one, additional annual long-term return gains of 1%-2% can be achieved.1 Of course, the potential gain depends to a large extent on the starting situation of the plan. Exhibit I.1 below specifies a number of sources of higher returns, splitting them in two parts: avoiding negative contributions to returns and intensifying the use of positive contributions.

EXHIBIT I.1 Bonus to be harvested when moving up from mediocre to excellent on the scale of excellence.

The potential gains of moving up on the scale of excellence depicted in the table above are crude and will differ from fund to fund. This table zooms in only on the financial side of things, but there also are other issues at hand that may drive success: How do you cope with environmental, social and governance () matters? What is your policy on climate change? We are witnessing a shift in the expectations of beneficiaries and other stakeholders. Not having a sound answer to these questions or hiding behind a narrow definition of fiduciary duty may come at a high cost in terms of the license to operate the fund.

Quite a few of the sources of improvement are accessible to almost all funds, regardless of their size. They all require well-applied knowledge and understanding from the board of trustees and investment committee. Essentially, the message here is to plug any leaks and avoid avoidable mistakes. Some of the sources are scale-dependent and depend on the availability of a "proprietary" investment organization that can, for example, harvest the risk premia available in illiquid assets in a cost-effective way. To a large extent, in both cases the board and the board investment committee play crucial roles in driving the fund into the direction of excellence-or vice versa. Therefore, the quality, knowledge and, most of all, drive of boards matter-a lot.

Doing 1-2% better is a considerable amount in a world in which expected returns for well-diversified portfolios are somewhere in the range of 3-6% in nominal terms. We estimate that harvesting 80% of this bonus requires only a limited amount of work once you understand the drivers and put in place the right groundwork. For example, it involves getting your beliefs right and making sure that they are consistently translated into the investment process. It involves designing an investment process that helps to achieve your fund's goals and tackling the main known governance issues. We believe that there are five activities that together can create "excellent investing;" we discuss them at a later point in time. We feel these are the roughly the same for every fund, even though pension funds come in all shapes and sizes. Our experience is that the same issues pop up around the globe. As the answers to these common issues may vary slightly due to cultural or regulatory circumstances, we will address such differences in size and structures (and their consequences) wherever necessary and appropriate.

The central message throughout this book is that the board is key in achieving long-term investment excellence. The board, however, is not the party managing the investments, but the party that is meant to be in charge of the design, strategy, monitoring, and improvement of the "machine" that delivers the output. This requires a specific set of perspectives, which we summarize as the right altitude, the right distance, and the right horizon. Altitude: Does the board look at the total fund setup and its outcomes from a helicopter view? Can it achieve a critical distance towards itself? Horizon: Has the board organized itself in such a way that it can look forward and backward at least over a 5-10?year perspective? Can it do so even if that time span is longer than the individual's timespan as a member of the board? And distance: Is the board able to maintain the right distance from the execution of the investment management-is it close enough to be able to fully carry out its responsibility, yet not so close that it is taking operational decisions that should be taken by the executive?

Excellent pension funds strike the right balance between altitude, distance and horizon. They do not get caught up in the vast forest of investment strategies, nor do they get drowned by oceans of financial data. They are not distracted by mathematics and investment industry jargon. Often, too much attention is paid to the (sometimes highly technical) detailed investment side (i.e. doing things right), while important issues remain unanswered (i.e. doing the right things). Excellent pension funds and especially their trustees, therefore, know when and how to take the fiduciary...