Essentials of good governance
Pension schemes are promissory arrangements frequently voluntarily entered into by employers to provide pensions and other benefits to employees. Where benefits are defined in relation to the pay or part of the pay of employees, as opposed to being directly linked to the value of contributions, the governance of the scheme by the trustees is primarily directed to securing the fulfilment of the defined benefit (DB) promise. In the UK, for example, trustees cannot themselves guarantee that pension promises made are delivered, for they are greatly dependent on the employer for funding and they are also at the mercy of external factors over which they have no control. However, if the scheme is well managed, everything else being equal, there is no doubt that members of the scheme benefit.
Any structure that is put in place to serve a purpose and protect an interest is as good, and only as good, as the extent to which the purpose is achieved and the interest protected.
The essentials of good governance of a pension scheme are the access to, and use of knowledge and skill, the exercise of care and judgement, and the integrity, dedication and effort of the trustees. But trustees cannot operate in a vacuum, they rely heavily on advisers, delegates and suppliers of services. Nor in the case of an ongoing pension scheme can the trustees succeed in their task without the essential goodwill and support of the employer. Just in case UK trustees think that life is going to get easier they will be aware of the formidable powers of the new pensions regulator replacing OPRA in April 2005.
Government is seeking to raise the game for trustees. Among the most important sections of the UK’s Pensions Bill aimed at improving the way schemes are run are those calling for “knowledge and understanding” by trustees in the key areas of law, investment, funding and administration.
The principles of governance have been developed for corporate entities over the last two decades. The following requirements come to mind:
q The obligation on owners of corporates to exercise active responsibility of ownership;
q Quality of organisation;
q Rigour of process and debate;
q Allocation and division of responsibility;
q Checks and balances;
q Clear delegation and reporting lines;
q Transparent accountability;
qRecognition and management of conflicts of interest;
q Succession planning and continuity;
q Register and management of risks;
q Business planning and budgeting;
q Security of physical and financial assets and intellectual property;
q Control of resources;
q Efficiency of operation and
avoidance of waste;
q Legal compliance;
q Prevention of abuse and fraud;
q Communication with owners
and other stakeholders;
q Maintenance of esteem and
q Defences against vexatious challenge and complaints.
Unsurprisingly, many of these points listed have a resonance in other business activities. To an increasing extent this list can be applied and adapted to develop the governance of pension schemes.
Good governance of a pension scheme begins with compliance with legal obligations, both under the scheme’s trust deed and rules or statute. While it is recognised that statutory obligations are sometimes counter-productive, despite the best intentions of the legislators, they cannot be ignored. The answer to bad law is legal reform and in the pensions field there are examples where legal requirements which have not worked well have been repealed or sensibly modified.
Good practice of a pension scheme invariably goes well beyond mere legal requirements. It seeks to ensure that the scheme is run as well and as efficiently as possible for the benefit of the members. Forethought is the best insurance but not a guarantee against unwelcome surprises and shocks.
Good practice is not static and evolves over time. What is sometimes perhaps unwisely termed ‘best practice’ may be the regarded as the state of the art at a given point in time but may rapidly become obsolete.
The requirements of every scheme are different. Areas where good practice should be applied by the trustees of pension schemes, as may be appropriate to their particular scheme, include:
q Management and forward planning of agenda;
q Education and training – raising skills and achieving a balance of skills;
q Maintenance of legal documentation;
q Proper conduct of meetings regularly held and management of scheme business at or between meetings;
q Clear use of powers of delegation;
q Effective control of scheme administration;
q Understanding of actuarial valuations and scheme funding;
q Determination of investment strategy and management arrangements of investments;
q Enhanced custody of assets;
q Annual reports and accounts;
q Effective use of advisers and suppliers;
q Control of scheme costs;
q Communication with members, particularly in defined contribution sections or schemes;
q Legal compliance review;
q Understanding the employer’s interests and objectives;
q Regular review of all advisers and delegates and of the working of the trustees themselves.
What matters above all for the governance of pension schemes is all round quality, that strength in one area is not offset by weakness elsewhere, and that quality is maintained.
Many trustees and employers are examining together the risks implicit in their pension scheme. They include the financial risks of underfunding resulting from poor investment returns, mismatching of assets and liabilities or simply from bad experience. There are physical risks from loss of data or records and people risks of all kinds. At the extreme there are risks of gross negligence or fraud.
Revelations or accidents of any kind or breaches of compliance may undermine confidence in the pension scheme and damage the reputation of the employer. This is particularly true at a time when pension schemes are in the spotlight as never before and confidence in the ability of many pension scheme arrangements to meet expectations is weak.
Conflicts of interest
Pension schemes in the UK are governed by boards of trustees who are usually appointed by employers or nominated by the membership. Their role as trustees is to adhere to the terms and rules of the trust, to safeguard members’ interests and to oversee the management of the assets of the scheme which are separate from the employer.
Yet trustees are wholly dependent on the strength and covenant of the employer for the future funding of the scheme. With the majority of DB schemes in the UK in deficit on an ongoing basis, and requiring additional funding of past service liabilities, the relationship between trustees and employers is being sorely tested. In particular, company management trustees are struggling with difficult conflicts of interests between their obligations to the scheme and to the employer.
In general, recent proposals, such as the Pension Protection Fund (PPF), to be brought in belatedly to provide limited compensation to members of pension schemes which have failed to meet their promises or are likely to fail are exacerbating the conflicts and making matters more rather than less difficult for trustees.
The structure of the trustee body is therefore vitally important to deal with the growing demands and complex situations that trustees have to face. To achieve the necessary balance and independence on the trustee board the member trustees have a vital role to play; and there is an increasing role for trustees who are demonstrably independent of the employer.
Identity of interest
Despite the conflicts which have to be recognised and managed there is much common ground between trustees and the employers. To keep costs under control, and for the maintenance of good order and reputation, good governance of the company’s pension scheme is as important to the employer as it is to the trustees. Companies naturally extol their pension schemes to show that they are good employers.
Likewise good governance is without doubt the best available safety net for trustees. Recognition and management of risks is the best way to minimise the chances of negative surprises. It instils confidence and esteem.
Recognising their separate function, it is particularly important that trustees can agree a common position with an employer on funding a DB scheme and on a mutually acceptable level of strategic investment risk, without wherever possible unjustifiably compromising their powers.
The limits of governance have been tested in some cases to a breaking point. There have been some appallingly difficult situations lately for trustees where typically the covenant of the employer is in doubt and where reasonable funding demands by trustees would imperil the employer as well as the future of the scheme and lead to uneven and untold consequences for actives, deferred and pensioner members. In these situations the impact of trustees’ decisions within classes of member is further complicated by recent changes in winding up priorities, ‘debt on the employer’ regulations for solvent and insolvent employers and by the uncertainties about the extent of protection from the Pension Protection Fund and other government measures. It must be hoped that this is a temporary problem.
Good governance may cost more initially. But economies which may be appear to save time and money in the short term can allow situations to lie dormant for years, only to surface with a vengeance sometime later. Resting on laurels brings its own dangers.
On the other hand, no one would deny that the tendency to over-engineer, or over-check or duplicate unnecessarily should be resisted. Some services to pension schemes simply do not offer value. It is good governance to weed them out.
No system of management is perfect. The reality of governance may not be as good as it is perceived either by those responsible for it or by third parties. It is always necessary to guard against the dangers of complacency, benign neglect or bad luck. There should be a culture of constructive self criticism to effect continuous improvement.
Good governance of pension schemes is achieved by a quality approach to all aspects of the management process. It has many parallels with corporate governance by requiring proper checks and balances, clear delegation, allocation of responsibilities and reporting, proper process leading to decisions, recognition and management of conflicts of interests, attention to communication and altogether robust structures in place to respond to challenges of all kinds.
Robert Thomas is a director at Law Debenture in London