In his 2001 paper, Institutional Investment in the UK: A Review, Paul Myners highlighted the need for trustees to ensure that they are appropriately and professionally advised when making investment decisions that will affect the membership of defined benefit schemes. He wrote that "Decisions should be taken only by persons or organizations with the right skills, information and resources necessary to take them effectively."
Unless you are an investment expert, it is essential that you take professional advice when deciding on scheme investments. And decisions are becoming harder all the time as it becomes more difficult to compare different funds. As Myners said:
So-called ‘peer group’ benchmarks, directly incentivising funds to copy other funds, remain common. And risk controls for active managers are increasingly set in ways which give them little choice but to cling closely to stock market indices, making meaningful active management near impossible.
The main elements in Myner's review include:
- Trustees should set out an overall investment objective for the fund, in terms which relate directly to the circumstances of the fund, and not to some other objective, such as the performance of other funds.
- Trustees should normally be paid.
- The attention devoted to asset allocation decisions should fully reflect the contribution they can make to achieving the fund’s investment objective.
- Decision-makers should consider a full range of investment opportunities across all major asset classes, including private equity.
- The fund should be prepared to pay sufficient fees for actuarial and investment advice to attract a broad range of kinds of potential providers.
- Trustees should give fund managers an explicit written mandate setting out the agreement between them on issues such as the investment objective, and a clear timescale for measurement and evaluation. Fees paid to managers should include the costs of information, research or transactional services used by the manager.
- In consultation with their investment manager, funds should explicitly consider whether the index benchmarks that they have selected are appropriate. Where they believe active management to have the potential to achieve higher returns, they should set both targets and risk controls that reflect this, allowing sufficient freedom for genuinely active management to occur.
- Trustees should arrange to measure the performance of the fund and the effectiveness of their own decision-making, and formally to assess the performance and decision-making delegated to advisers and managers.
- In defined contribution schemes, when selecting funds to offer as options to scheme members, trustees should consider the investment objectives, expected returns, risks and other relevant characteristics of each such fund. Where a fund is offering a default option to members through a customised combination of funds, trustees should ensure that an objective is set for the option, including expected risks and returns.
The principles may seem little more than common sense. In a way they are – yet they certainly do not describe the status quo. Following them would require substantial change in decision-making behaviour and structures.
The review recommends that the Government should examine after two years the extent to which the proposals have been successful in changing behavior.
Taking the above into consideration, stakeholders should be asking tough questions of your pension fund managers and trustees, such as:
- How ‘managed’ is the fund – does it simply follow the herd or track an index?
- How often do you review the asset mix? Does it accurately reflect the current economic and financial risks and guard against disaster scenarios? Does it reflect the plan's liabilities?
- Where did you incur losses over the last fiscal year and what measures did you undertake to mitigate against these losses?
- Are the trustees fully cognizant of all the risks that underpin every investment activity, including the ones of private markets and absolute return strategies in public markets?
- Did you invest in ABCP, CDOs or CDS? If so, who was responsible for these investments and how are they held accountable for the performance of these investments?
- Is the pension plan's funding status independently verified and reported on a timely basis? Does the plan have a funding policy and is it publicly available?
- Is there a comprehensive and integrated governance framework for the fund and the plan which clearly outlines the roles and responsibilities of government supervisors, committees, board of directors, actuaries, administrators and pension fund managers?
- Are the performance benchmarks, including the ones for external alternative investments and internal absolute return strategies, clearly defined, explained in a public document and do they reflect the risks and beta of the underlying investment portfolio?
- Related to the previous point, are pension fund managers properly compensated using the appropriate performance benchmarks for each investment activity making up the composite index? Is the compensation aligned with the interest of the beneficiaries?
- How appropriate are the benchmarks to the objectives of the scheme and its members?
- How is risk measured and more importantly, how is it monitored and managed? Are there appropriate stop losses and controls to mitigate against significant losses?
- How exactly is risk mitigated for each investment activity, including alternative investments and absolute return strategies? How is it mitigated at the investment activity level and at the fund level?
- Are risk-adjusted returns reported for the pension fund as a whole and each underlying investment activity?
- How relevant is the description of risk to the beneficiaries?
- How well governed is the pension fund? Does independence exist between those who determine performance objectives and those who manage the fund on a day-to-day basis?
- Are there clear responsibilities and accountabilities for each investment and administrative activity governing the fund and the plan? Is there clear separation of duties between investment professionals and finance professionals that value the investments?
- Do you have internal expertise to allocate to external fund managers, including external hedge fund managers? How does your performance rate against that of the median fund of hedge funds or multi-manager fund?
- What are the qualifications of the person(s) in charge of allocating to external managers and what is the benchmark used to compensate this person and the team? Does this benchmark accurately reflect the risks and beta of the underlying portfolio?
- Are all risks and benchmarks of internal and external investment activities properly documented in public documents easily accessible to all stakeholders? If not, why not?
- Do you use external administrators to rely on valuations of external managers? If so, did you perform a due diligence on these administrators and is it properly documented?
- Are valuations of alternative assets and complex derivatives independently verified and audited? If so, by whom and how are they accountable to stakeholders?
- Are requests for proposals for external managers, vendors and consultants publicly available and independently verified?
- Are all costs associated with the pension fund, including administrative fees, external manager fees and all other costs publicly reported on a timely basis?
- Are there timely independent performance and operational audits to make sure that the trustees and fund managers are following industry best practices and are managing the funds in the best interests of the key stakeholders?
- Are there timely fraud audits performed by independent certified fraud examiners (CFEs) to mitigate against fraud?
- Is the fund fully transparent? In particular, are board minutes publicly available and does the fund publicly report performance of all internal and external investment activities on a timely basis?
- Are human resource activities properly monitored and independently audited? In particular, are changes to key investment professionals public and well explained? Are turnover rates in the pension fund made public and there appropriate exit interviews for any employee or investment professional that was dismissed or who voluntarily left?
- Does the fund take measures to foster a culture of openness withing the organization, making sure that all employees are actively engaged? Do you take genuine steps to retain your employees through competitive and fair compensation and a culture that promotes learning and personal growth?
- Importantly, are there sound whistle-blowing policies that are independently verified by certified fraud examiners (CFEs) to ensure that employees who speak up against fraud or mismanagement are protected under the full extent of the law?
- Finally, does the pension fund subscribe and actively implement employment equity standards for all potential candidates, including visible minorities and disabled persons? Is the fund's employee diversity independently verified in an HR audit and publicly available?
Transparency was one of the key Principles outlined by Myners in parallel statements targeting both DB and DC funds. His suggestion for DC schemes, for example, was that a strengthened Statement of Investment Principles (SIP) should take into account:
- who is taking which decisions and why this structure has been selected;
- each fund option’s investment characteristics;
- the default option’s investment characteristics, and why it has been selected;
- the agreements with all advisers and managers; and
- the nature of the fee structures in place for all advisers and managers, and why this set of structures has been selected.
Transparency means more than full disclosure by a pension scheme to its members. Just as members of a DC pension scheme need to know what their investment options are to make an informed decision, their trustees need to become aware of all of the pitfalls inherent in the modern investment landscape.
For example, trustees need to fully understand that the role of custodian has outgrown its traditional function as a caretaker and facilitator of assets and now encompasses many additional services with built-in costs. Do trustees know how much their manager is invisibly charging for FX transactions? Do they know if their cash management rates are competitive? Do they know how much they are paying for investment accounting, or for performance measurement? If the answer to any of these questions is “no”, they are failing to fully address the Principle of Transparency, and in an important way they are abdicating the leadership role expected of them by their scheme members.
Finally, take the time to read Dr. Susan Mangiero's article, Pension Risk Management: The Importance of Oversight.
Dr. Mangiero states the following:
Plan trustees need to assess their comfort level with the status quo by asking questions such as: What risk factors currently affect portfolio value and returns? How is risk mitigated, if at all? And is the risk management strategy uniform across investment strategies and outside money managers?A little later on, she adds the following:
What was the reasoning behind a particular part of the risk management process? How was the decision made to use derivatives or to forgo their use in lieu of an alternative approach?
What is the current compensation arrangement by job function and objectives and does it reward speculation?
Who has the authority to change trading limits? How are money managers hired and fired as a function of their reported risk-adjusted returns? What risk metrics are deemed appropriate and why?
Process means little without comprehensive documentation that spells out answers to these and many other pertinent questions.
The current investment environment requires better pension fund governance. All stakeholders benefit when pension funds are fully transparent about their investment, operational and administrative activities and when accountabilities are properly assigned and monitored.
As I have stated before, the risks of remaining complacent on pension fund governance is too high. All stakeholders of public pension funds deserve full transparency, full accountability as well as independent performance and operational audits of their pension funds.
Stakeholders need to ask some tough questions to their pension fund managers and trustees or hire the independent consultants to ask them on their behalf (make sure they are truly independent consultants with no conflicts of interest). The above questions are among the more important ones and a good starting point for reviewing the activities of any pension fund.
Important note: I would urge those of you who want to learn more to visit the governance section on my blog by scrolling down the right-hand side. There you can find documents on industry best standards on pension fund governance, including the Clapman Report and Institutional Investments in the UK Six Years On.