Originally corporate governance was introduced based on the concern that the power equilibrium within companies needs to be restored. In the US it was more concentrated on the power of the management, whereas in Europe the focus was more on the majority shareholder. Recent scandals in the US and Europe accelerated the movement and expanded the target group to the mutual fund industry.
But pension funds are not public companies or mutual funds. They are different, and even within the pension fund market totally different concepts as defined benefit (DB), defined contribution (DC) or even cash balance plans exists. So the governance should be specific too.
Corporate governance for pension funds or pension fund governance is a concept that covers many different aspects. In this context, we will not tackle the issues involved in the governance of the pension system nor how the pension fund complies with its fiduciary duty of being a shareholder.
We limit ourselves to the the governance of the pension fund itself. Who is responsible for what decisions? It means the process and structures adopted by the board of trustees in order to direct and manage the business and affairs of the pension plan with the objective of optimising the plan’s performance while ensuring that the plan is financially able to discharge its responsibilities. In short: ‘Is the business done properly and ... seen to be done properly’.
Within the pension fund industry the focus will be on the relationship between:
o board and the management/consultants/asset manager)
o plan sponsor and the members/beneficiaries
o board and the members/beneficiaries
o board and the regulator
Let’s now explore why pension fund governance becomes more and more the topic of the day. In other words: Why is pension fund governance on the agenda? The main reasons are:
o management of the ‘agency’ problem
o good governance improves the performance
o pension funds need to be exemplary
o the regulators are getting involved
o the member or beneficiary can’t ‘sell’.
Management of the agency problem: The most common problem areas are: the responsibility for monitoring the asset managers; asset allocation decisions; and the plan’s level of funding.The optimal governance structure is one in which the risk-bearer (the residual claimant) is also the decision-maker. So determination of the optimal governance structure requires the identification of that residual claimant and if possible granting him the decision control responsibility. It gets even more complicated as there are always joint residual claimants, and potential free-rider problems may occur. Besley and Prat argue that if decision makers do not bear the full cost of their decisions inefficiency can result(1).
Good governance improves the performance: If we believe the media the world of pension provisions is in turmoil. After the prolonged bull market, the reality of asset market fluctuations has once again taken hold and in some cases are threatening the security of previously cast iron pension guarantees. Only the most naive pension investor could ever have ignored the inherent risks in such investments, especially those with heavy exposure to equity markets.
However, recent experience makes clear that risk exposure is only in part due to factors such as macro-economic climate and breakthroughs in medical technologies. Equally, if not more important, are the decisions made by the management of pension funds to ensure the best returns for beneficiaries gained with a reasonable exposure to risk. Hence there is renewed interest in pension fund governance and the potential that offers to reduce the beneficiaries’ exposure to management risk.
Improving performance: That good governance improves the quality of the asset management and performance of the fund was proven by the study, ‘Organisation performance versus organisation design’(2) which statistically confirmed the assertion “behind every well run pension fund stands a governing board that knows his job”. The study found that “excellence shortfall” in the pension fund organisation had an average cost of 0.66% per annum and that good governance mattered most.
Pension funds need to be exemplary: and are pushing corporate governance as far as it concerns their equity holdings. More recently they were even more motivated by the regulator to continue and improve their actions on the issues as ethical, ecological, social standards and shareholder activism. Using the voting rights that go with the equity investments of the pension fund becomes a well accepted fiduciary duty and implies the documentation and publication of the voting policy.
The regulators are getting involved: And the final reason to tackle the governance issue is the concern of the regulator. In July 2002 the OECD released their “guidelines for pension fund governance”. Many countries followed and started looking into this matter. After the ‘corporate governance’ wave the ‘institutional governance wave’ is now launched.
The UK took the lead with the Myners Report that set the standard for UK pension funds, and recently the Dutch government started looking closer into it and promised detailed guidelines coming out soon. In many other countries the issue is on the agenda of the regulator.
The logic behind this evolution, is that regulation focused more and more on the ‘prudent expert’ principle and that as the regulator does no longer have the back up of strict quantitative rules he needs to be assured that the ‘prudent expert’ is really in charge of the pension fund.
Members can’t sell: When you are a shareholder of a public company or a mutual fund you will always be able to ‘sell’ your share as an ultimate decision to show your disagreement. Unfortunately this possibility does not exist for you as a member of a pension fund. The conclusion is that governance, even more than for a public company or a mutual fund, is an issue and only the players are different.
Of course there is no single universal model of pension fund governance. Where best practices are global, implementation will be local and specific. The landscape of pension funds is so diverse that based on the global principles the implementation will be different for small or large funds, company, sector-wide or public schemes and DC, DB or hybrid schemes.
But whatever pension fund we are talking of, they should apply the global principles of good governance, regarding the functioning of the board and transparency.
Where boards originally were set up to oversee pension administration, they must now spend a great deal of time discussing investment strategy. The main tasks of a board of a pension fund are no different then those of a public company. A board of a pension fund must be able to cope with the following responsibilities:
o seeing that the pension fund has the highest calibre CEO and executive team
o to make sure that the pension fund has adequate information, control and audit systems in place preventing and managing crises (risk management).
For the composition of the board not only those whom they represent are the key element for being appointed but the board as a whole needs people who master the different domains where they are responsible for. It’s important to define clearly the identity of the residual claimant: the sponsor or/and the members of the plan. If the composition of the board does not follow this principle, the ‘agency’ issues can become very important. An example: The sponsor may be tempted to misallocate the assets of the pension fund in a way that benefits the sponsor and jeopardises the fund’s performance; the classical example is the investment in large proportions in company stock.
To avoid these kinds of conflicts appointing professional experts who compliment the ‘caring laymen’ can be a solution. The expert should then act as a non-executive director. He can be of great value in making the board less dependant from plan sponsors, members, consultants and advisers.
The board is required to act independently as representatives of any interest. All decisions should be made solely in the interest of participants and beneficiaries! The board meets with outside advisers on any issue which may require clarification or independent opinion in order to assist the board in discharging its responsibilities. The board appoints and meets with the external auditors to review their findings. The board also appoints actuaries in order to obtain an actuarial report on the financial condition of the plan.
As far as the structure is concerned, we do not see any difference between a large pension fund with in-house asset management and administration services and another large company. The board should set up at least a remuneration and audit commitee to ensure itself that these two responsibilities are completely covered. For smaller funds that outsource most of the activities these responsibilities do not change, fees have to be checked and control and audit may not be overlooked when the pension fund delegates asset management or administrative services to third parties.
Transparency is the second pillar under good governance. The board has to work following their terms of reference which clearly identify its role on an overall bases as well as its role related to investment, pension administration audit and actuarial activities. A statement of investment policy is an absolute necessity.
Complete and timely information to the regulator, plan sponsors and members of the pension fund should be documented and monitored.
In fact, the governance of institutional investors, including pension funds, should, in principle, not be different from the governance of any public corporation.
If the pension fund industry wants to stay ahead of this evolution, it is maybe time to launch the debate with the regulators on pension fund governance and present to them the local ‘pension fund governance code’. I’m afraid that if the initiative does not come from the pension funds, the regulator will react and introduce pension fund governance by law.
Karel Stroobants is an independent director based in Brussels with mandates in Belgium and the Netherlands
(1) T Besley and A Prat, Pension fund governance and the choice between DC and DB; December 2002
(2) Excellence in pension fund management symposium, was organised by The Boice, Dunham Group, CEM Inc and Frank Russell Company