Pension Fund Governance: Avoid the bear traps

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.

“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.

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.

Managing conflicts 

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.

“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.