Dispelling the mysteries
‘For many beneficiaries and the public at large, pension funds are most mysterious organisations.” Whether or not you agree with this conclusion by an academic, it is certainly true that the structure and the running of pension plans has attracted low attention in the past, even by many insiders.
However, the interest in pensions governance issues is rising in Europe. In five years’ time, good governance of pension funds will be a generally accepted (and, hopefully, also widely implemented) concept across Europe. This is one of the easier predictions to make over this period!
Already, pensions governance issues pop up in every corner of Europe, and the reasons are manifold. Just a few spotlights:
q Governments and social parties are taking a stronger interest in the running of the pensions industry. For example, the Myners Review, commissioned by the UK government, resulted in a long list of proposals on how to improve the decision-making process and enhance the professionalism of trustee boards. New studies in other countries reach similar conclusions.
q The European Commission has taken steps towards a wider acceptance of the ‘prudent person’ principle, as opposed to strict quantitative rules in pension investment.
q There is a trend towards funding of pension obligations, segregation of assets and outsourcing of investment management in Europe. In this process, there is a question about the governance structure that immediately arises: how best to run a pension fund that is a separate legal and financial vehicle?
Good governance of pension funds is not only of academic interest. When problems emerge, such as a deteriorating solvency position, the decisions of pension boards and management come under scrutiny.
But first, what exactly is ‘pensions governance’? It is more than administration and management. In general terms, it deals with the direction and control of pension funds. It is worth distinguishing the governance of single pension funds (the micro level) from the governance of national pension systems (the macro level). In this article, I will concentrate more on the former – although the two levels are, of course, strongly interlinked. (Workers’ participation on pension plan boards, for example, is an area where politics and industrial relations play an important role.)
The concept of ‘pensions governance’ is derived from ‘corporate governance’. The awareness of ‘corporate governance’ was originally driven by US public sector pension funds (most prominently CalPERS) in the 1980s. In the 1990s, it spread all over the world. The direct driver for this movement was, of course, the attempt by institutional shareholders to enhance shareholder value in the companies they invested in. In this process, company management has often been beaten up by pension funds for sub-optimal performance, lousy governance or ‘unethical’ behaviour.
However, one can argue, what is true for companies must be true for pension funds, too, or even more so. Therefore, in explaining the concept of pensions governance, I like to go back to a good definition given by the OECD of corporate governance, since it is equally applicable to pension funds: “Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation … and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance.”
The governance of pensions does, of course, depend on the specific legal and regulatory framework in each country. There are major differences across Europe – for example, in the different role of supervisory bodies. There is also a great variety in legal vehicles used for pension funds:
q pension foundations, used, for example, in Switzerland, Benelux and the Nordic countries;
q trust-based pension funds, as known in the Anglo-Saxon countries;
q corporate forms, such as mutual assurance companies or co-operative associations;
q other contractual arrangements (under labour and/or contract law), for example, direct pension promises by companies or asset-backed solutions in Germany.
Confronted with all these differences in regulation and vehicles, one is tempted to speak of very different and still quite separate ‘pension cultures’. However, there are, economically speaking, strong commonalities in pension funds. Basically, they are a basic pensions promise, the objective of strong investment returns, the aim for high security of pension assets (or risk control, in modern parlance) and the requirement of compliance with law and plan rules.
Another key characteristic of pension funds is great variety of people involved in the decision-making. However, somebody needs to be ultimately in charge. Using American terminology, we can call them the ‘governing fiduciaries’, that is, a board of trustees, a pension foundation board or a supervisory board of some form.
It is at the level of governing fiduciaries, where the bulk of responsibilities for good governance in a pension funds lies. In practice, however, we encounter a series of constraints on ‘good’ decision-making.
q Time: company executives and staff are often busy people while pensions issues tend not to be top priority;
q Expertise: there is often limited expertise on the board while pension issues get increasingly (technically) complex – just think of all those new asset classes;
q Resources: often limited and lacking experience;
q Interests: on top of this, interests of the various parties involved can be conflicting;
q Advice: when consultants’ advice is taken, trustees are often still left with difficult trade-offs;
q Change: pension funds operate in an environment of continuous change (corporate, regulatory, markets, instruments, etc);
q Upsets: having to deal with totally unexpected situations for decision-makers, including a plan sponsor in financial trouble.
Given these constraints and potential troubles, decision-makers need to be very clear in their minds about what they are doing. Let’s call these best practice principles for pension plans:
q Clear objectives;
q Understanding of the framework for decisions (law and rules, but also the interests, risks and incentives of the different parties involved);
q Good structure and process in decision-making and communication; clear allocation of responsibilities;
q Professionalism of decision-makers.
It is all about process and structure, but it is still ‘prudent’ people who have to make decisions. The moment you leave a strongly prescriptive environment, the degrees of freedom for governing fiduciaries increase.
Pension investment decisions typically are long-term decisions made under great uncertainty for a large number of people – and they are decisions of increasing complexity. Therefore, there has recently been a move in Europe towards ‘technical competence’, to supplement general ‘prudence’ of board members and management.
The EU Commission draft pensions directive speaks of ‘competence’ and ‘appropriate professional qualifications and experience’.
In the Netherlands, the regulator has introduced new competence and suitability tests for pension board directors.
In the UK, the Myners Review effectively introduced the ‘prudent expert’ concept to trusteeship.
In this process, we are likely to see a greater use of non-executive directors on pension plan boards to add external expertise and experience and promote objectivity and reassurance. In effect, the Myners Review considers the use of independent professional trustees a ‘helpful and positive development’.
All this talk about process and professionalism may sound a bit formalistic. However, getting governance right helps avoid a lot of problems. When looking at risk management in pension funds, governance risks are arguably the most important ones to manage. But even more, good governance frees time and energy for better ‘substantive’ decisions, and this should in the longer term result in better financial results, too.
The impact of good pension fund governance is obviously difficult do measure. There are very tangible and important intangible benefits to it. American studies show a benefit of 0.50–0.66% (as a percentage of pensions assets). This equals a rough 10% better benefits or lower contributions.
The scientific evidence here is obviously not yet very strong, but an average benefit of 15–20% benefit of ‘good governance’ is not untypical for corporate governance studies. Such estimates are supported by anecdotal evidence. As a result of this increasing awareness, fiduciary expertise is in demand, and not only in critical situations. This is certainly our own experience as professional trustees or pension fund directors in over 200 pension plans.
The corporate governance trend will not stop short of pension plans.
Despite all the differences in regulation, pension fund governance issues are, in the end, very similar across Europe. Best practice principles are ‘global’ – effective application is ‘local’.
Good governance is not just a formality but is of substantial importance to the financial results of pension funds: lower risk, greater security, more efficiency and better long-term performance.
Over the next five and more years, we are likely to see more extensive scrutiny of good or bad governance of pension plans, not only by academics but also by shareholders, members, regulators and the media. The demand for ‘fiduciary expertise’ will clearly rise.
Georg Inderst is director of The Law Debenture Pension Trust Corporation in London