The legal position in delegating asset manager selection has to be seriously considered and the consequences weighed up by investors
Trustees, foundation boards and investment committees need to consider their legal position if they decide to delegate to professionals the decision to hire and fire the asset managers.
The UK’s experience of the ‘prudent man’ principle of investing is the most extensive in Europe. It provides useful guidelines for other markets which are likely to be required to adopt this approach if the current proposals for a pension funds directive are implemented.
‘Prudent man’ is broadly defined in British law and requires trustees to invest pension scheme money with the same care and diligence they would apply if it were their own capital. More specifically, the trustees have to draw up a statement of investment principles (Sip) with the aid of a professional adviser who is appointed by the trustees and not the sponsoring employer. This sets out the investment aims and, in the case of a defined contribution (DC) scheme, the member’s investment choices.
However, even in the UK, the legal position of trustees who wish to delegate the investment management to a manager of managers is not clear. Under the Pension Act (1995) all trusteeship duties carry specific civil and criminal sanctions but each of these can either be legally delegated to a professional or the trustees can insure the risk. Except for one: the investment management. For this – the most risky of responsibilities – trustees retain full liability.
This is not to say that poor performance will land the trustees in jail but rather that the trustees need to be able to demonstrate they have taken appropriate and prudential steps to ensure the investment arrangements are in the best financial interests of the scheme members.
Trustees therefore need to consider what type of manager structure, manager review process and implementation procedures best demonstrate good investment governance. They must also consider the extent to which their investment advisers should become involved in the implementation of the asset management strategy. In particular, under a manager of managers arrangement, the trustees need to feel confident that they are permitted to ‘delegate’ the control over the hiring and firing of the underlying asset managers to the MoM provider.
Under the act the trustees must retain responsibility for their decision. Pension lawyers state that there is no specific legal definition of ‘delegation’. However there is a distinction, which the act appears to make, between delegation and abrogation or abdication – both of which imply, in lay terms, that the trustees have washed their hands of the entire responsibility.
So how does the trustees’ responsibility for the investment management apply to multi-manager and manager of managers structures? Historically, the trustees of UK pension funds which have adopted a segregated multi-manager structure have retained control over which investment managers actually run the assets. The formal appointment and agreement of terms in this case is between the trustee board and the individual asset managers.
In the US it is possible for the plan sponsors and the asset manager to be partners or co-fiduciaries in the investment process. This process incorporates the services provided by both the investment consultants and the investment managers.
However, in the UK, with a manager of manager service, such as that offered by Northern Trust, Frank Russell, SEI, and Esher UK, among others, the trustees effectively subcontract the decision over who manages their assets to a third party. Here the formal appointment is between the trustee board and the MoM provider, but the trustees have no direct control or agreement with the sub-managers who run the assets.
Providers of MoM argue that there is no conflict of interests here and that to delegate to a third party with demonstrable professional skills is a clear discharge of the trustee’s responsibility under the Pensions Act. However, the act does not include any specific regulation which formally allows trustees to outsource the job of appointing the asset managers.
Given the growing interest in MoM strategies, it is important to clarify this issue. One possibility is for the trustees to waive the right to have discretion over the investment manager appointments set out in the trust deed.
Another is for the MoM provider to be registered as a discretionary manager under the appropriate regulator. In the UK this would be the Investment Management Regulatory Organisation (IMRO), which is part of the Financial Services Authority. NTGI, for example, has Imro authorisation. Under the Pensions Act trustees are within their rights to delegate the responsibility for investment management to an IMRO-registered investment manager.
The regulators may also consider whether it is appropriate to make an amendment to the Pensions Act. Fortunately there is a precedent for this set by global custodians and this may provides a useful analogy for MoM services. Global custodians use a complex network of sub-custodians. Under the original wording of the act, trustees were held responsible for the sub-custodians even though they had no control over their appointment and dismissal. This regulation was changed subsequently to allow trustees to establish a formal agreement solely with the chief custodian.
The chief custodian in turn undertakes responsibility for the sub-custodians and may act as guarantor in some but not all world markets. Where the custodian cannot offer a guarantee – for example in high risk markets – it sets out its responsibility and the limitations of its liability in the letter of appointment with the trustees. A similar formal agreement could be reached between MoM managers and trustees if the act were amended to permit this. The agreement could make particular reference to specific briefs where higher risks are to be taken – for example, satellite managers whose performance is likely to prove very volatile.
The documentation of the asset management agreement is particularly important for trustees of DC schemes. Until recently DC schemes and plans were not subject to the same level of scrutiny as their defined benefit (DB) counterparts but this is changing as they undertake a growing responsibility for private pension provision in European markets.
In particular, trustees are aware that unlike DB schemes, DC schemes do not pool risk between the employer and employee nor between different generations of members. The performance, therefore, has a much more immediate impact on member satisfaction. It also raises concern about the responsibility of trustees to members who are unhappy with their fund’s performance.
In the US members of DC schemes have taken trustees to court where they felt the they had failed to discharge their investment responsibilities satisfactorily. The implications for European trustee and foundation boards are, therefore, potentially very worrying.
In the UK if the members complain performance is unsatisfactory as a result of trustee negligence, they can take the case to Occupational Pensions Regulatory Authority (OPRA), the Pensions Ombudsman or, in the case of group personal pensions, to the Financial Services Authority Ombudsman. However, all of these authorities said that ultimately such a complaint would be question for the courts to decide. Precedents in the US indicate that the courts will support the trustees only if they can demonstrate good investment governance systems are in place.
Debbie Harrison