The Dutch view collective defined contribution pension provision (CDC) more as a flexible sort of defined benefit (DB) structure than as DC, and are somewhat perplexed by the DB/DC binary choice that savers are faced with in the UK. Several schemes in the Netherlands have converted from DB to CDC over the past few years, among which has been KAS Bank’s own scheme.
In the UK press, much has been made of pension benefit cuts and intergenerational mismatch risk, yet there are many other risks to bear in mind. The good news is that custodians are able to offer support to such schemes through providing insight and transparency.
CDC’s flexibility to replace liabilities with benefit targets essentially migrates risk away from sponsors and dissipates it among the membership; transparency and oversight should therefore be top of trustees’ agendas to yield the best outcome for members. This is exactly what is happening in the Netherlands as a direct consequence of this shift.
Members recognise that they shoulder an increased burden of risk and, consequently, are demanding greater insight into how their scheme is run. This is leading to a paradox of more detailed and complex information reporting undertaken by custodians and administrators, which has to be understood not only by a lay trustee, but also by a lay pension scheme member. Annual reports, reinforced by information from custodian banks, have become crucial in ensuring efficient communication with the membership.
In order for transparency to flourish in a collective scheme, its structure must be balanced. Like country governance, best practice entails a separation of powers and activities, ensuring service providers’ accountability to the pension scheme, and the scheme, in turn, to its members. The custodian therefore acts as a counterweight and check on the activities of asset managers in terms of holdings valuations, risk and costs. In practice, this entails the custodian acting independently of asset managers and consultants in providing crucial and up-to-date trade information and risk metrics.
In a CDC scheme, this would include monitoring of both the scheme’s assets and the target benefits. Sitting in the centre of the trading infrastructure, the custodian is ideally placed to evaluate scheme holdings, in addition to the asset-versus-target benefit relationship, which will be highly interest-rate and inflation sensitive – one of the first lines of defence in terms of reducing scheme deficits is to remove indexation linkage for retirees.
Banks can offer support here by updating trustees on the swap market and inserting scheme funding level triggers to empower trustees to make informed decisions on de-risking or, indeed, re-risking to close funding gaps. Add to this the possibility for scenario analysis, such as inflation rates rocketing, a financial crisis or even a large terrorist attack, and its effect on scheme assets and there exists the potential to create a very robust risk framework indeed.
The quest for transparency has been echoed by regulators of late, who are busy trying to de-risk the wider financial system through several EU directives and policies on both sides of the Atlantic. Transparency, however, will come at a cost. Fortunately, CDC schemes will have scale on their side in having the ability to afford such robust systems, to hedge against inflation risk, and to have the size to keep these costs manageable. For example, schemes will wish to hedge risk through derivatives. However, under EMIR, onerous regulations on derivative trading will create a compliance cost. Custodians can help mitigate this, reducing cost and complexity by providing transaction reporting, independent valuation and collateral management services to pension schemes.
Economies of scale do not simply lower costs. Scale permits segregated mandates and investment directly in securities, enabling schemes to understand precisely the nature of their holdings and risks to members. This also allows for ESG monitoring and ensuring that the investment mandate is being adhered to. ESG, incidentally, is a favourite topic of scheme members in the Netherlands when scrutinising scheme activities. This is far more difficult to achieve when implementing a less-direct fund-of-funds strategy as recent and well-documented ESG mishaps that have emanated from pooled fund investments attest.
Trustees must acknowledge that this is a somewhat operational necessity when considering private equity or hedge fund investment, however; in this scenario custodians can provide look though capabilities to view end fund investments. Depositaries, obligatory for alternative funds due to AIFMD legislation, will also bring clarity to the important alternatives sector in providing oversight and helping to prevent Madoff-style investment scandals.
Based on the Dutch experience, therefore, any talk of CDC schemes as ‘lighter’ than DB for trustees should be quickly stifled; sponsors may be less involved in scheme affairs but members shouldering mismatch risk will demand their schemes be run in the best possible way. The need for independent, transparent management information and support has never been greater. Which just might be a job for the oft-overlooked custodian bank.
Carl Giannotta is sales manager for institutional investors at KAS Bank
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