Should you have an independent director on the board of your pension fund? What is their role and contribution? How to best deal with them?
These are questions typically asked when people hear about the services of independent trustees. The answers you get vary widely from plan to plan, and country to country. This is not really a surprise, because not too many people have experience of them.
Firstly, the concept of independent trusteeship is only established in two European countries, the UK and Ireland, where occupational pension funds are constituted as ‘trusts’. The share of sizeable pension funds using them lies somewhere between 10-20% (no exact figures exist).
Secondly, the rules in relation to the composition of pension boards vary widely across Europe. Some countries, like Switzerland, simply do not allow outsiders at board level. In other countries, it would be possible in principle, but there is often no tradition, or little desire, to do so.
Thirdly, politics may stand in the way. For example, where you have an equal number of employers and employee/union representatives (a ‘paritarian’ model, as in the Netherlands), there is hardly space for a neutral voice.
In practice, a number of governance models coexist. Some pension plans/sponsors are happy to share fiduciary responsibilities with outsiders at main board level. Others use independent experts as members of their investment/advisory committees. A third group of funds prefers to operate with outsiders purely on a principal-agent basis, ie, where advisers are there to give advice but not to make the decisions. This may well extend into higher-level decision-making such as asset allocation or manager selection.
What are the benefits of independent trusteeship? Proponents are quick to explain the logic. It is the equivalent of corporate non-executive directors, applied to pension funds. And non-executives are an increasingly established ingredient of good governance worldwide. The actual service providers emphasise a number of advantages:
qIndependence. The outside directors can take an objective and impartial view. They are able to build bridges in case of strongly conflicting interests of the various parties involved, eg funding and contributions issues;
qProfessionalism. Pension plan directors are typically not the ultimate experts in the broad range of (regulatory, investment, actuarial, operational, etc.) issues involved. A professional trustee is involved in pensions issues full-time and can lead co-trustees especially through very technical issues. Better decisions are the result;s
qCost-savings.Professional trustees can build on the experience made with other funds. Also, they may be instrumental in finding the most suitable advisers and negotiate better terms for the plan.
The inclusion of one or more outside directors should enhance the standards of governance of pension funds, both in form and content.
There is also a view that is less enthusiastic about external plan directors.
q Many corporate sponsors hold that pension benefits are an internal affair, best controlled by the company’s HR department. They are not keen on any outside interference in the decision-making;
q A sceptical view is often taken also at the other end of the spectrum, by workers’ representatives. They fear that independent directors could be biased the wrong way, in particular when the employers are in the driving seat in terms of their appointment;
q Other critics express reservations on the value-added of external directors. Do they really make a difference? One prominent observer looked at the asset allocation of UK pension schemes with independent trustees, and noted “that their investment strategies are just as risky as everyone else’s”;
q Some people feel there are already too many different parties, including all the advisers and delegates, involved in pension funds. External directors may not only add to the costs but also to potential conflicts.
In fact, even corporate trustees find it difficult to quantify the benefits of their involvement: there is a lack of general discussion in the pensions world contrary to the intense discussions about non-executives on company boards. Furthermore, no proper academic cost-benefit analysis of the use of independent trustees seems to exist.
One aspect would come to the forefront: that professionalism and independence are not synonyms. If there is a lack of skills and experience, there are various ways of bringing them in. However, even a high-calibre board may gain from the ‘control’ of independent non-executives.
In case you make the decision for the inclusion of an external director on the pension plan board, what are the critical factors to consider?
The first point to clarify is the purpose, and it needs to be clearly communicated to all parties involved, including the members.
Are you looking for any particular area of expertise or for a generalist? Do you feel more comfortable with hiring an established corporate trustee (ie, a company that offers trustee services) or are you interested in a particular individual that can bring in new ideas?
In the past, independent trustees were mostly called in to perform the role of a legal watchdog to make sure the trustee board does not make any expensive mistakes. A lot of the demand was generated by special circumstances (eg, sponsor insolvency, winding-up of pension scheme) or simply from lack of skills and experience by amateur boards. More recently, however, individuals with investment or financial expertise have been called in, in the hope they can help steer the fund through volatile markets conditions.
Although independent trustees are called in under the banner of good practice, the appointment process is often not very transparent. Who appoints? Who pays? What is the selection process? Who is the independent director accountable to?
Rights and duties of the independent trustees may be given by law and, more specifically, by the constitution of the fund. Important areas need to be specified, such as the length of office, termination, powers in extraordinary circumstances (eg, corporate takeovers). In addition, operational points such as the expected attendance of meetings, membership of internal committees, communication flows, should be agreed on in advance.
Governance guidelines increasingly call for a regular and systematic assessment not only of all advisers/delegates but also of the trustee board itself. How should this work in the context of pensions? Self-appraisal of the board or appraisal by the stakeholders? Should the inside director assess the external, or vice versa?
Pay is another controversial area, of course. Whatever the compensation of other board members, professional trustees need to be paid in order to make their job worthwhile (in particular corporate trustees with overheads). They typically get an annual fixed fee (like corporate non-executives) or hourly fees (like professional advisers), or a combination of both.
A major issue for this particular industry is the imbalance of risks and return. Risks are high and potentially unlimited, while returns are mostly moderate and fixed. There is little upside for doing a great job. However, when things go wrong, the buck stops with the board, and the independent trustee shares all the risk.
Interesting incentive issues need to be tackled in future. Take investment as an example: if it is true that strategic asset allocation is the key decision to make, why is it that those in charge are only paid a small fee compared to specialist fund managers (whose stock selection has a much smaller impact on the overall outcome of the pension fund)? If you thought performance fees for investment managers were a complex subject – finding an appropriate incentive mechanism for directors and consultants is incomparably more difficult.
Georg Inderst is an independent consultant based in London