Increasing scrutiny by financial directors of UK pension arrangements will promote fiduciary management as a future savings solution, as Nigel Birch explains
Fiduciary management has up to now been a solution designed to help defined benefit (DB) pension funds to meet their long-term funding objectives. Over the last four years, our research has described the continuous development of the fiduciary management model; indeed our first 2008 project was ‘The Evolution of Fiduciary Management'. This article describes how fiduciary management is emerging as a total work-place savings solution, directly targeted at providing finance directors and sponsors with bespoke and integrated solutions, not only for their DB schemes, but also for defined contribution schemes.
At times it has felt like fiduciary management is a solution with few friends. In the UK, pension funds are typically accessed through investment consultants. Fiduciary management incorporates services that in the UK are usually provided by the investment consultant, having the effect of ruling consultants out as both a friend and a sales avenue. Not only that, fiduciary management is focused on building a more efficient governance structure for pension funds. This has enabled some fiduciary clients to reduce the in-house resources required for effective management of the scheme. With this comes no new friends, and popular analogies involving turkeys and Christmas.
DB solutions for FDs
One friend that fiduciary management has won over, however, is pension scheme sponsors- more specifically finance directors. New regulation, market volatility, increasing liabilities and scheme closures have prompted a revolution in the role of finance directors in relation to pensions. They are looking for more formality, more rigour, more resources and more focus. In some cases, this happened many years ago, but in many others it is only happening now. Fiduciary management may hold a solution to their problems; focusing on solvency and balance sheet management, enabling effective use of investment risk, providing scale and resources, and strengthening the management of DB schemes.
In a 2011 qualitative research project, New Centres of Influence in Corporate Pensions, we found that finance directors have a wide range of responsibilities, and in the past pensions did not claim much of their attention. But this is changing.
We identified three layers of pension decision making:
• Pensions strategy. Finance directors are almost invariably deeply involved in pensions strategy (in 30 of the 43 companies we spoke to), by which we mean all the big decisions on scheme type and structure and covers forming policy on how and when to pay off any deficit in the DB scheme. These decisions are now typically taken at board or near board level, and invariably include the finance directors at the heart of the debate;
• Investment strategy. This is the next decision-making layer and is, in theory, the realm of the trustees. Here too we found finance directors significantly involved, especially with regard to the contributions they must make each year towards the deficit, a figure that is in turn influenced by investment performance. As a result, we found evidence that finance directors are heavily influencing trustee investment committees.
• Implementation and selection. This is the detailed decision-making level, which covers the implementation of investment strategy and selection of investment and other suppliers. Again this is, in theory, the job of trustees and, although there is little evidence that finance directors themselves are leading implementation and selection, in-house finance or HR teams were seen to be closely involved, so the corporate footprint is not entirely absent.
The involvement of the finance director at the investment-strategy level is generally driven by misalignment of views in relation to risk. While many factors determine a scheme's risk appetite, the size of the deficit and the proportion of active members, for example, are among the most important. Figure 1 illustrates how the quality of the sponsor covenant can influence risk appetite.
In low (or medium) quality covenant companies (and you would have to say that in these economic times, this segment is the majority), trustees very often take the position shown in box D in the matrix, whereas finance directors tend to take the position of box B. The differences between these two positions is the basis for much of the dialogue that takes place. Many finance directors are taking the lead in investment discussions to ensure that their on-going annual contribution is manageable for the company. After all, a strong company provides a more secure pension. This does not mean that finance directors are seeking to disenfranchise trustees. As finance directors have become lured into decisions in pensions, so they have interacted more with trustees. Relations are usually very constructive, discursive and non-adversarial, although things get strained when company covenant weakens. But many finance directors privately express their weariness with the trustee model.
As figure 2 illustrates, our view is that as DB schemes lose active members, they become more of a finance challenge rather than a HR one. Our research suggests that finance directors will continue to become even more involved in pensions.
In large companies with very large pension schemes, this will mean that FDs will rely on larger and better resourced internal teams to manage the schemes' assets, risks and liabilities, with the ultimate objective of meeting the schemes' long-term funding targets, while placing as smaller burden on the sponsor as possible. While this may be an option for the very largest of schemes that have the resources, this is simply not an option for mid-sized and smaller schemes that do not. Instead, finance directors of these companies may seek to gain access to the critical resources they need through partnerships with fiduciary managers. By leveraging a fiduciary manager's scale, expertise and resources, schemes can aim for box D of our matrix - controlled investment risk and manageable sponsor contributions.
A holistic savings solution
The last five years have prompted many finance directors to believe that DB pensions are no longer a sustainable work-place saving vehicle. The funding risks and cost to the sponsor are simply too much. This is resulting in a greater emphasis on DC schemes.
We predict that DC assets will surpass DB by 2022 and with the growth of DC comes increasing risk for the sponsors. These risks may seem less tangible than those associated with DB, predominantly due to the removal of funding, and thus contribution risk. These risks are predominantly those linked to performance, member outcome and governance.
As figure 2 shows, as DC risks are not obvious on the balance sheet, they are currently falling onto the shoulders of the HR department. We predict that finance directors will want to keep close control of all workplace savings functions.
While balance sheet and solvency benefits do not apply, the other important benefits, concerning governance, economies of scale, resources and expertise remain just as in demand for DC schemes. DC funds, especially trust-based arrangements, suffer from a lack of scale, which makes investment, administration and governance expensive. By partnering with a fiduciary manager with respect to both the DC and DB scheme, Sponsors could benefit from a joined-up approach.
Efficiencies can be gained through leveraging a fiduciary manager's resources and expertise, and by exploring ways to link the products and services required by the DC and DB schemes.