The UK is a divided market for pension funds and while many argue it is well-regulated, others say it is overly restrictive.
In truth, both sides are right. The regulations put in place since Pensions Act 1995, the regulatory response to fraud at the Mirror Group pension fund following the death of Robert Maxwell in 1991, have succeeded in averting further scandals but have arguably hastened the demise of defined benefit (DB) schemes.
Consensus is not common but, after death and taxes, most professionals would agree that the only guarantee is heightened pensions regulation.
This is borne out by such measures as the regulator’s code of practice for defined contribution (DC) schemes as well as the last Budget, which proposed radical reform. In the light of such unpredictability, what are schemes doing to make sure they don’t fall foul of regulatory bear-traps?
A change of focus
Most professionals agree that corporate sponsors are struggling with the burden of DB pension funds and that trustees are looking to reduce costs.
Adviser fees are now under closer scrutiny – which is a good thing, according to Judith Donnelly, a partner at the law firm Clyde & Co – and improving governance is one way to achieve this.
At a glance
• UK pension funds are increasingly focusing on an integrated risk management approach following new regulatory guidance.
• Funds are delegating in order to make better informed and faster investment decisions and to improve funding levels.
• Professional trustees will assume a greater role due to a dearth of willing and able member trustees.
“The introduction of statutory duties for trustees to know what they’re doing, and also for internal controls made a big difference, ushering in a new era of governance,” says Donnelly. “Although, these are hard for the regulator to police, they were extremely effective in focusing minds. They also spawned a whole industry, with lots of consultants putting together governance reviews and training programmes.”
The increased use of professional trustees is indicative of the heavy lifting they are required to do and this is having a major impact on governance, adds Donnelly.
Remco van Eeuwijk, UK managing director, at MN believes the most significant development has been the focus on an integrated approach to investment. This brings covenant risk into the mix, which is important as it provides a holistic view of all risks and where they interact.
“You cannot now have a suitable investment strategy without understanding the covenant,” says van Eeuwijk. “As a result we’ve seen more engagement in challenging schemes about recovery plans and questions about whether they have considered all the risks involved.”
A new way of thinking
These forces have been seen as responsible for driving the growth in a new response to raising governance standards over recent years – the appointment of delegated consultants or fiduciary managers.
The regulator’s approach has shifted the focus from investment management that concentrates on assets, to investment management that focuses on the funding level – assets and liabilities, says Sorca Kelly-Scholte, head of client strategy and research EMEA, Russell Investments.
“If the trustees’ fiduciary responsibility is to secure the benefits, then fiduciary management is about fully sharing that responsibility than is the case with traditional, asset-only oriented asset management.”
One Russell survey found that the primary motivation for 81% of respondents considering or adopting fiduciary management has been the belief it will allow them to respond more quickly and effectively to rapidly changing markets. And this is a reasonable assumption since funds have often been accused of moving too slowly to take advantage of investment opportunities and markets have undoubtedly become more complex.
Sponsors have also been watching funding levels improve since 2009-10 and may be keen to limit any potential deterioration as they approach full funding.
“You might argue that the volatility of markets is the key driver influencing continued reviews of governance, and the sense that with the end-game in play for many funds, they need a better gameplan for dealing with that market volatility,” adds Kelly-Scholte.
The growth of fiduciary
There are other governance related reasons that make fiduciary management appealing, such as a reduced governance burden on trustees and better access to specialist expertise. But a desire to make better and quicker decisions and to achieve a better funding position seems to be dominating the thoughts of pension boards.
The fiduciary management market covers a relatively small portion of UK DB assets – around £58bn (€71bn) or 5% of total assets according to the 2013 KPMG survey.
This has been growing at 20% a year since 2007 and is anticipated to pick up in 2014 as the first wave of early adopters have reviewed their decision and there have been no reported horror stories.
Those who are interested but who have hung back have been concerned by a loss of control and perception the trustees could lose touch with investment decision-making.
Governance focus: Nacro Staff Benefits Plan
• Chair of trustee board, Nacro Staff Benefits Plan, UK
• £27m (€33m) assets and annuities of £10m
• 1,600 members, half deferred and half pensioners
• Deficit of £12m-14m mark
• Recovery plan to 2027
Following a restructuring in 2010, the Nacro Staff Benefits Plan decided it was high time it reviewed its investment governance.
Its Gilt holdings had allowed a sizeable slice of risk to be taken off the table through the buy-in of a substantial proportion of existing pensioners’ benefits.
“We had been focused on the conventional arrangement of trustees, consultants and fund managers and we felt we were a disadvantage in a fast moving market,” says Paul Whitehouse, chair of the trustee board.
The scheme moved quickly, got a good rate but a chance encounter opened the door to a new governance structure. “We were cold-called by a fiduciary manager and as a result we decided to pursue the concept and invited tenders,” explains Whitehouse.
The initial lineup had four contenders plus the scheme’s existing investment consultant, but their approach is an object lesson in understanding your client.
“Our consultants came out with a very negative approach, suggesting we didn’t want to do fiduciary management, but offering very little as an alternative,” says Whitehouse. “This was a mistake on their part, because they ruled themselves out of a sensible discussion on the matter. Had they offered a plausible alternative or suggested they might implement more quickly, they may have had a chance.”
With the incumbents discounted, the board visited the two shortlisted providers. The trips were instructive as there was a unanimous instinct about one of the contenders.
“The relationship with a fiduciary manager is based on trust and the fit between the scheme and provider and how they will work together.
“With P-Solve, we each felt there was a consistency of message and they were open about how they would deal with the scheme from the beginning to the end. It just felt right.”
The clincher was the transition itself. With around £30m (€37m) to move into return-seeking assets, the trustees were concerned about market risk. One provider told them they would transition in a week, but the potential for capital destruction is unpalatable at the best of times, but unthinkable when your sponsor is a charity.
P-Solve’s softly, softly approach might take longer – in the end about six weeks – but it satisfied the board the company understood their needs.
Nacro’s scheme has been closed to new entrants for 15 years and new accruals for around nine. The buy-in gave the scheme some freedom to target maximum return on the assets within their risk appetite and has pursued a 90% return seeking and 10% matching fund.
Though it’s only a little over a year since the move was made, the Nacro board is satisfied.
“The outcome is that we are much better informed about the state of investments and feel more in control,” says Whitehouse. “We trust P-Solve to do the things that are required without having to oversee every issue ourselves. Our last board meeting agreed and we continue to be pleased with our progress.”
The process from the decision to review to appointing a fiduciary took four months. Despite the current growing trend, Nacro didn’t use a third-party consultant to vet shortlisted providers and Whitehouse isn’t sure what another adviser might have offered the scheme.
“This is much more about a relationship where you hand over complete control – within a policy framework – you can be confident the provider is capable.
That does not mean the other companies are better or worse [at fiduciary management], but in the end it’s a judgement call and we feel we were proved right.”
Since appointing P-Solve, some large consultants have approached the scheme and offered to review its choice of fiduciary manager, but Whitehouse isn’t convinced about their potential contribution.
“I’m not entirely sure what reviewing the fiduciary manager would achieve. If they hit the benchmark we’ve set them, then they have done what was asked of them. If they don’t, you have the choice to move or stay where you are.”
Cost is also a concern – fiduciary managers are no different from any other provider where fees are concerned, but the biggest worry for many has been conflicts of interest.
Although, the majority of mandates have been won by implemented consultants switching an existing investment advisory client into a fiduciary mandate, this has been under pressure recently.
The KPMG report showed that 91% of full delegation mandates were from schemes of less than £250m in 2013 and that 75% of these were won by implemented consultants. However, there are increasing numbers of larger mandates and specialists like MN and SEI claim to see interest from larger funds.
The issue of conflicts may in fact have been managed by trustee boards doing their own due diligence but latterly there has been an explosion in third party advisers – generally those who don’t offer implemented consultation – willing to advise schemes on the appointment, review and ongoing monitoring of a fiduciary manager.
In a year, this cohort of advisers has grown from a handful to perhaps as many as 18 or 20.
But even if there are checks and balances, there are misalignments inherent in the relationships that must be managed, says Bart Heenk, managing director of Avida International, an international pension governance advisory firm. “There is increasing demand for institutionalising power in the fiduciary. Professional trustees are being appointed to beef up the services of the fund, and risk managers are being placed alongside to ask the difficult questions.”
Although there have been moves to address the conflict of interest that arises where consultants migrate clients to fiduciary, Heenk has other concerns about the misalignment of interests.
“There is a misalignment of interest as consultants are more likely to sell complex products because they allow you to charge higher fees,” he continues. “This is not true only for fiduciary managers, but all consultants, who are incentivised to keep things complex. Pension funds should not invest in what they don’t understand, but it’s not necessarily in the members’ interests to keep things simple.”
Heenk believes the regulator would scrutinise these conflicts more if it was not so preoccupied with DC pensions. But Anne Kershaw, associate director at Muse Advisory believes the regulator is indifferent as to how a scheme implements its strategy.
“It’s all about the implementation, not strategy or risk management,” says Kershaw. “It is relevant which model you choose to implement it and the regulator should not care as long as you follow due process. In fact, the regulator would tend to agree.
Governance focus: The Pensions Trust
• CIO, The Pensions Trust, UK
• 36 DB and one DC scheme
• Assets: £6bn (€7.4bn)
It’s not only small schemes that need to raise the bar when it comes to governance. There is a danger of developing bad habits or missing out on better ways of doing things.
The Pensions Trust at £6bn (€7.4bn) assets under management is no weakling (IPE placed it thirty-first in the UK in the latest IPE Top 1000) running 36 DB schemes and a DC arrangement branded as Smarter Pensions.
Its trustee board sits above an investment committee that has five sub-committees reporting to it all serviced by an eight-strong investment team.
That represents a lot of moving parts and in early 2013 the trustees decided it was time to run a rule over the investment process and appointed Avida International to give it a healthcheck.
Pensions Trust was given a clean bill of health, but some advice on how to shed a few pounds. The most important recommendation was to split what it calls the governing fiduciary (determining strategy), the managing fiduciary (implementing strategy and hiring and firing managers) and the operating fiduciary (the day to day running of money) into three separate roles.
Currently, the investment committee fulfils the governing fiduciary and the managing fiduciary component, says chief investment officer David Adkins. But it was recommended that the managing role be devolved to others.
“We are working to the goal of having the investment committee govern the fiduciary element, setting the overall objectives but delegating the management fiduciary to a number of entities, not just the internal investment team.”
These entities are Cardano and AllianceBernstein (for DC assets), each of which has a quasi-fiduciary role.
“Ultimately, we’re looking for better risk return outcomes through more rapid decision-making,” says Adkins. “We did a case study on the selection of one of our asset classes, through the time it took from the original idea to the actual funding, the iterations and dialogues with the investment committee and subcommittees, and we found it taking too long.
“So more rapid decision-making, taken by the corporate investment professionals with the right qualifications, to end up with better risk return outcomes.”
This represents a considerable cultural change for the scheme, placing authority with the investment team which currently lies with the investment committees.
As a result, Adkins is working through a four-stage process devised to determine how the investment team might take on the responsibilities of a fiduciary.
“We’re currently at stage zero, which we have just finished implementing, to get the internal team structured in such a way as that it can receive mandates from the committee or the board, but then there’s further work to be done.”
The investment committee understands the existing skillset in the team and what would be required if it was to delegate more in certain areas.
The board has yet to decide what mandates it might pass to Adkins’s team, though three have been identified: global equities, alternative assets, and liability hedging.
“We think we have the existing capability to take on global equity mandates, but we would need additional resources on the other two,” says Adkins. “We’d also almost certainly need to set ourselves up structurally for FCA authorisation for alternatives and liability hedging, as we’d be entering into regulated investment activities.
“For the global equity mandate, we don’t need that. Where necessary, we can get by, by getting sign-off from our investment advisers, who themselves are regulated.”
The team is already split into looking at liquid – anything that can be turned into cash inside six months – and illiquid alternatives – including infrastructure and distressed debt mandates– but nobody on the investment team has the power to hire and fire managers.
If Adkins gets the go ahead, the world will be their oyster as far as options are concerned, but the new structure could deliver decisions in months instead of years.
“You don’t want to rush into things, and need to do the proper due diligence, but if you want access to the best capital market ideas, such as infrastructure debt, we’re competing with the likes of insurance companies who typically have faster decision-making processes,” says Adkins.
So, Adkins has passed the first stage and the second is under debate but he believes this will be agreed and implemented by the end of the year.
Then there will be more discussion, says Adkins, as consensus must be reached about implementing stages two and three. These not only involve delegation of duties but the opening up of new asset classes
“I’m not convinced there is agreement that we should get FCA approval. But, we have built consensus so far in our discussions, so I imagine this year we will be breaking it down into stages that suit the committee to allow them to pause and consider at each point.
“When you’re taking a large number of people with you, that approach tends to work best, so right now I’m just concentrating on the next stage.”
“As a regulator, our view is that schemes tightly managing their liabilities and assets is a good thing,” says Andrew Warwick-Thompson, executive director for defined contribution, governance and administration at The Pensions Regulator.
“I want to see schemes have an understanding of the economic reality of the deficit and manage it down in an orderly fashion. If fiduciary management can play a part in that, that is for the scheme to decide.”
(Not) going Dutch
Warwick-Thompson seems happy with the current trajectory of the pensions industry in general and welcomes the announcement of collective DC (CDC) in the Queen’s speech. “Anything that creates more choice and opportunities to provide better pensions for members has to be a good thing,” he says.
The Netherlands may offer a template for governance innovations like fiduciary management, third-party monitoring of fiduciaries and even CDC. But, it would be wrong to believe practice and experience there is exerting any great influence over best practice discussions in the UK.
The UK is a mature market and the same lessons have been learned as in the Netherlands and the US to an extent, but in a UK context, says van Eeuwijk at MN.
“People are following a similar path, but there is not a lot of cross-border sharing of lessons,” he says.
“Independent monitoring of managers is long established in Holland, but is not necessary if you have a strong board of trustees. The reason that most of the new activity in the UK has been in a monitoring capacity is because it was realised someone needed to review decisions that had been made before.”
Better governance, better trustees
There is less agreement on the issue of on-going monitoring of appointees. Fiduciary managers argue that strong trustee boards will be able to ask difficult questions of those providers in front of them, while those offering monitoring claim trustees don’t know the right questions to ask.
Joanne Kellerman at the DNB in the Netherlands has emphasised the importance of genuine diversity of opinion on pension fund boards, but this is in a different market context.
In the UK, diversity his historically come from the involvement of lay trustees and member nominated trustees (MNTs) have their champions. The last Labour government sought to increase a requirement for MNTs to make up 50% of trustee boards instead of the current figure of 30%. But this too has its problems, says Jennie Kreser, a partner at Silverman Sherliker.
“Schemes already cannot fulfil MNT numbers. They are having a real struggle,” says Kresser. “Clients are afraid the MNT process is a waste of time that for all intents and purposes you can kiss it goodbye.”
The industry should accept greater involvement of professional trustees, adds Kresser, but not simply fee-charging independents: “We need someone on the board who is properly qualified and by that I mean a properly examined trustee. Much of DC remains contract-based, but those with some trustee structure will be feel a growing push for increased professionalism. The need to understand investment is as great or greater than we have had with defined benefit.
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