Over the past decade the risks associated with defined benefit (DB) pension arrangements have steadily moved up the worries list of corporate treasurers. While the exact form of corporate pension DB provision differs between jurisdictions, in most instances the challenges faced are similar. Increasing longevity, volatile markets and mark-to-market valuations of liabilities are all undermining the viability of DB funds. From a treasurer’s perspective, the associated uncertainty is having an increasingly detrimental effect on the wider health of the company despite repeated attempts to get to grips with this blind spot.
Overcoming the Governance Hurdle
At the same time, maturing pension fund liabilities mean that the long-term outlook for DB pension funds is becoming less murky. This is particularly true in the UK where many funds are now closed to both new and existing employees. The other good news is that the industry has made significant progress in identifying what needs to be done to solve the problem.
However, governance remains a major hurdle as most pension funds lack the in-house expertise to monitor the more complex investment and hedging strategies that are now needed. One effective route to overcome this fundamental challenge is fiduciary management. Pioneered in the Netherlands, fiduciary management is increasingly being embraced in the UK and other European countries as a means of ensuring more effective governance and a holistic investment approach to the management of a pension fund.
A Simple Concept
Generally speaking, it involves outsourcing components of the management of the pension fund to a fiduciary manager, but with a high degree of transparency so that the manager’s decisions can be easily scrutinised and control is retained by the trustee board. By adopting a fiduciary management approach trustees can focus attention on the key strategic issues that face the pension fund. It also puts the fund on a more sustainable path towards full funding (e.g. full buyout in the UK) by enhancing both risk management and capital efficiency.
What’s in a Name?
Confusingly for trustees and treasurers, fiduciary management comes under many names and guises. This reflects the fact that fiduciary management is essentially a continuum from partial to full outsourcing, with the exact level of outsourcing depending on the fund’s requirements and the provider’s offering. Regardless of the name, however, we believe there are a number of common features that characterise successful fiduciary management. They include:
- A holistic view of assets and liabilities – based on an in-depth analysis and understanding of the fund’s overall circumstances and objectives, undertaken in close consultation with the pension fund board and advisers.
- Customisation – being able to reflect the specific challenges of the fund.
- Asset allocation informed by real world investment and capital markets expertise – thus allowing the pension fund to exploit market opportunities and mitigate the fallout of heightened market volatility.
- Flexibility – catering for changing market circumstances and the evolving requirements of the fund.
- Explicit focus on the management of risk – through comprehensive and timely risk management information with a clear rationale for each risk position.
- A partnership approach – between trustee board, provider and advisers. This entails that that any potential conflict of interests are identified from the outset and managed effectively.
The Role of Treasurers
Clearly, the decision whether or not to adopt a fiduciary management approach is down to the trustee board, but we believe a fiduciary approach will assist the relations between trustees and the company as it provides a single transparent risk management framework so not only the trustees but also the sponsor can see and know the scale of risk being run on a day-to-day basis
Where trustees are considering fiduciary management, treasurers can assist by encouraging the trustee board to seek best practice in terms of the chosen fiduciary management approach. This means ensuring that the trustees look at a sufficiently large range of providers – not just the consultants they have traditionally worked with – to obtain the right fit for the fund. Treasurers can also help trustees ask the right questions, focusing in particular on the risk information and risk management capabilities they will gain, and avoid the trap of treating this simply as a manager of managers’ approach.
Some Practical Considerations
Beyond that, what are the key practical issues and concerns that trustees looking to implement fiduciary management need to address?
Role of the trustee board
It is important to stress that trustees retain ultimate control and responsibility for the investment strategy. However, they should be able to rely on their chosen fiduciary manager for expert input in terms of both the strategic direction of the pension fund and more ad-hoc market decisions around, for instance, whether or not to hedge currency exposure.
Role of external advisers
External advisers such as investment consultants play a valuable role in the traditional pension fund management model. Where pension funds have opted for a fiduciary management approach there is usually still a need for external advice, which can be provided by traditional consultants or specialist independent advisers. This independent third party will provide an additional layer of governance and help ensure full effectiveness of the fiduciary management arrangement.
Role of reporting
In the context of fiduciary management, the ability of the provider to offer comprehensive and integrated reporting is crucial as the investment committee/trustee board need to be at all times fully apprised of the fund’s strategy in order to exercise effective control.
Need for In-depth Due Diligence
Trustees need to be very clear on their objectives as they review the different fiduciary business models on offer and adopt the most suitable approach for their fund, taking into account factors such as:
- Level of sophistication of investment committee and wider pension board.
- The expectations of the role of fiduciary manager, including the level of educational support, advice and analysis that is required.
- Level of governance the trustees want to achieve.
Finally, as mentioned above, effective fiduciary management involves a long-term partnership. Consequently, as well as making sure that the provider really has the requisite capabilities and hands-on experience in solving a fund’s specific issues, trustees and their independent advisers need to ascertain that there is a real cultural fit.
Ever increasing complexity, the need for swift decision-making and a treasury-style approach in the face of volatile capital markets and funding pressures make fiduciary management an attractive proposition for a growing number of pension funds. We believe this trend will continue to accelerate as trustees seek to improve governance and achieve long-term self-sufficiency.
While fundamentally a simple concept, the actual implementation of fiduciary management requires careful consideration and in-depth due diligence to ensure the key criteria that characterise successful fiduciary management are fully met. Only then can trustees and sponsor be confident that a fiduciary management arrangement will deliver a sustainable long-term improvement in both governance and funding.
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