The long-term is defined in much existing regulation: e.g. capital gains taxes, the risk weights of long dated bonds, or the setting of insurance risk margins from a ‘hedged’ base position within Solvency II. Within Europe, preferential rates of taxation with holding term and purpose has been widely used to provide incentives for specific forms of investment.
The long-term can also be defined in terms of business cycles. The usual typology is:
• the Kitchin inventory cycle of 3–5 years;
• the Juglar fixed investment cycle of 7–11 years (business cycle);
• the Kuznets infrastructural investment cycle of 15–25 years (building cycle);
• the Kondratiev wave or long technological cycle of 45–60 years.
So why don’t institutional investors live up to their long-term investing potential? Several complex and interlocking barriers hold them back: “Institutional investors increasingly rely on passive investing or indexing on the one hand and alternative investments (such as hedge funds) on the other. The former can discourage them from being active shareowners while the latter may involve shorter term, higher turnover investment strategies.
“Agency problems are another barrier to longterm investment. Pension funds in particular rely increasingly on external asset managers and consultants for much of their investment activity. However, they often fail to direct and oversee external managers effectively – handing out mandates and monitoring performance over short time periods which introduces misaligned incentives into the investment chain. Institutional investors also contribute indirectly to short-termism via some common investment activities, such as securities lending or increasing investment in exchange traded funds (ETFs). Investors may, therefore, be inadvertently contributing to speculative trading activities in the very securities that they own.
“Government regulation can also exacerbate the focus on short-term performance, especially when assets and liabilities are valued referencing market prices. For example, the use of market prices for calculating pension assets and liabilities (especially the application of spot discount rates) and the implementation of quantitative, risk-based funding requirements appear to have aggravated pro-cyclicality in pension fund investments during the 2008 financial crisis in some countries.”
Carolyn Ervin, OECD
Engaging with investors will reveal the typology and magnitude of demand and allow productive innovation. This is engagement with institutions rather than their advisers and intermediaries. Two of the principal long-term investor classes, pension funds and insurance companies, are severely restricted by prudential regulation, which is concerned principally with investor protection and fails to consider the benefits or the positive externalities associated with the activities curtailed or prescribed. Removal of the impediments, overwhelmingly regulatory in nature, that prevent these investors from pursuing their preferred investment habitats is a priority.
Institutional investors, particularly pension funds, are poorly served by fund managers and investment advisers, whose advice is conflicted and often short-term in nature. These firms often have an interest in promoting the short-term, expedient and complex. Extending explicit fiduciary responsibility to them will greatly assist their institutional clients to fulfil the long-term elements of their tasks.
Infrastructure issues
The paper covers many different forms of investment: green and sustainable, infrastructure and SME finance. This is not helpful as the differences between these can be large and material. Much of SME finance demand is not long-term in nature.
The competitive tender processes of infrastructure finance make this investment very different from the standard investment management model. The high costs and low probability of success of these infrastructure bid processes are deeply problematic for insurance companies and pension funds. With standard investment, the pension fund or insurance company is concerned with the evaluation of an investment proposition presented to it.
The risk profile of these investments is also unlike that of traditional investments. With traditional investment, risk grows with time. The concerns of institutional investors over consistency of political commitment and regulatory stability are similar in nature. However, the concerns over procurement and construction costs for infrastructure, the high failure rate of new and small companies, and uncertainties over the viability of green and sustainable investments at scale and in the face of ever-more efficient technologies add new dimensions. Here, risk is loaded onto the short-term rather than growing with time.
Fair value accounting and possible changes
Fair value accounting involving regular mark-to-market has had a nefarious effect on investor behaviour. It needs a radical rethink, not ex-post compensation, particularly in the accounting of long-term institutions, which should be exempted from the market consistency regime, as already are the illiquid loans of banks (which may be classified as “held-to maturity” and valued on an amortised cost basis).
Managing assets
For assets, the question at heart is the function of the securities held. For a dealer they are a finished product, available for sale. For an insurance company or pension fund, they are an input towards the finished product, the future cash flows that are the policy or pension. The selection and management of these assets is the production process of the insurance company or funded pension scheme. Mark-to-market, when combined with risk-based solvency regulation, can disrupt this, badly. This results in strategies that satisfy the regulations in force, rather than optimise the production process – institutional corruption. This is costly to the consumer – it is short-term in extreme.
The issue is compounded by the use of liquid traded securities, which themselves contain liquidity premia. Liquidity has a cost: if it did not all assets would be liquid. Liquid securities are the those which are least informative as to fundamental value and largely irrelevant to the value of these securities in use. Using discount rates derived from bond market rates to estimate present values is entirely without theoretical support. No insolvency court could be expected to admit these values as creditor claims. The admitted claim on a long-term liability will not be the the amortised cost of that liability, which depends upon its issuance terms.
Comparing discounted present values for liabilities with market prices for assets (“mixed attribute” accounting) breaches elementary measurement theory, which would require us to use the same measure for both objects being measured, and would require the measure to be invariant over time.
Proposals for pension scheme valuation and accounting, which may be trivially extended to long-term insurance policies, are contained in “Keep your lid on” (6). This would be entirely consistent with the amortised cost method recognised in the IAIS Insurance Core Principles. The legal foundation of the IFRS has been questioned by a group of leading pension funds and institutional investors and a formal legal opinion7 obtained that these standards are not consistent with the UK concepts of prudence and a true and fair view.
Incentives for better long-term shareholder engagement
Solutions to the tragedy of the commons indicate how incentives may be designed to promote shareholder engagement, and involve control rights8 or dividend policy.
The key insight here is that those members whose claims are most remote in time should, ceteris paribus, dominate the decision process. The youngest member of a pension scheme has the pension rights that are most remote in time. This is not those who have held their claims the longest, but those whose claims have the longest remaining time to performance. Control and dividend rights based upon past holding periods may reward the historically committed shareholder, but they may do little, or nothing for the future behaviour. Share repurchases, which raise agency issues, and are motivated by short-termism, concern us.
The EC programme that emerges from this consultation will likely be important and even formative in many markets.
1 http://www.finnov-fp7.eu/
2 The seminal paper is Lawrence Lessig’s “Institutional Corruptions” . In particular, we would draw attention to Malcolm Salter’s recent paper: “Short-Termism at Its Worst: How Short-Termism Invites Corruption… and What to Do About It”
3 The measurement of housing consumption has been the subject of extensive discussion in the context of consumer price indices – see www.statsusernet. org.uk
4 And may indeed involve saving way beyond the time of death: the case of Benjamin Franklin’s bequests to Philadelphia and Boston are examples: see the Codicil to the latter’s will.
5 ibid
6 http://www.lapfforum.org/TTx2/press/ifrs-opinion
7 In this response, we frequently consider voting rights as control rights. However, control rights are a far broader concept and encompass governance structures. As Jean Tirole notes in the introduction to chapter 10 of his work: The Theory of Corporate Finance: “Covenants can only go so far in determining a firm’s future course of action. New information accrues and circumstances that were not clearly conceptualised at the onset arise after the initial funding has been secured. The firm therefore needs a governance structure that will elicit the parties’ information and act on it to select a range of short-term and long-term decisions over which the parties may have dissonant preferences: day-to-day management, choice of personnel, refinancing and dividend distribution, investments and mergers and acquisitions, and so forth.”
Comments