Governance Q&A

July/August 2010

The Questions

A. Trustees responsible for both defined benefit and defined contribution arrangements face different governance challenges for each type of scheme. How can they balance these difficult demands?

B. Conforming with pensions legislation is a vital part of governance. Are pensions over-regulated?

C. What are the most common risks that you can see arising from failures of governance (for either DB or DC)?

Nick Boyes, Alexander Forbes Trustee Services

A. The ability to step back and take a considered approach is paramount in ensuring that issues are addressed in an appropriate manner, and with due weight to the various components. It is up to the chair of the trustees to set the agenda and this provides the opportunity to ensure that the DB and the DC sections are both given proper consideration.

One approach might be to put the DC section higher up the agenda, rather than as an afterthought, as can often be the case. A carefully thought out business plan can help to ensure that not only the common ground is planned out, but also those aspects particular to one section or the other are given proper consideration on the agenda.

B. Pensions regulation has a tendency to suffer from the law of unintended consequences. Laws and regulations are generally designed to address perceived ills, but the actual impact can spread beyond the original target. Consider the situation with unauthorised payments, for example.

The smothering effect of the current regime could be reduced, however, and some flexibility introduced and prescription removed. This would have to be accompanied by the provision of better financial education so that people are aware of the need to make adequate provision, and just how far the scheme offered by their employer will meet their needs in retirement.

C. They say that the devil is in the detail, but there is a risk that trustees focus too closely on the minutiae of running a scheme, and pay too little attention to the strategic considerations, such as the appropriateness of the default fund for DC members, or the ‘journey plan’ for DB schemes’ long-term funding.

Trustees can sometimes show reluctance in seeking professional advice for fear of increasing the costs to the sponsoring employer. While understandable, it is important to recognise those occasions when this expenditure can add value, and minimise the risk of potentially costly governance failures.

Julie Walker, Barnett Waddingham

A. One of the ‘not-quite-truisms’ in pensions is that DB schemes retain all the risk and DC schemes shift all of the risk onto the member. In reality both types of arrangement present governance and risk challenges, and both need to be given equal priority.

Typically, where a DC arrangement operates alongside a DB arrangement, the DC arrangement comes very far down the priority list. Whereas ongoing funding, investment and valuation requirements keep DB trustees focused on governance issues, DC trustees can be lulled into thinking of the DC arrangement more as a ‘set of administrative processes, centred on a monthly contribution-due date’ rather than as a significant area of responsibility.

Trustees can usually rely on their administrators (and auditors) to implement appropriate internal controls but responsibility for investment options, and for helping members make informed decisions regarding their options, remains with the trustees.

Trustees need to ensure their calendar also includes regular DC investment performance monitoring and that they are regularly reviewing the investment options they offer.

B. ‘Pensions’ is a whole range of fields, all governed by separate, but overlapping, regulations. I recently read that around 850 separate pieces of pension legislation had been introduced in the last few years and I wasn’t at all surprised!

If most pensions professionals are also acting as part-time compliance officers and most scheme trustees don’t have the technical background to fully grasp their regulatory responsibilities, it may be time to re-think, or ‘simplify’ the regulatory framework.

C. The most common DB risk is that the right members receive the wrong benefits, or the right benefits but at the wrong time because there has been a failure in data quality or administrative arrangements.

If trustees are willing to invest in data improvement in line with the latest record-keeping guidance, improvement of member data should go a long way towards getting the right benefits to the right members.

Paul Thornton, Gazelle Group

A. The demands of good governance for DB and DC are different but comparable and it is important that trustees do not allow defined benefit issues to displace proper governance of DC benefits.

In DB it is well understood that the covenant risk is an issue and that investment and funding strategy need careful attention. In DC these issues do not arise but the equivalent issue is that the members are reliant on good investment returns and administration to achieve good pensions. The design of default funds and the measurement of investment outcomes are therefore absolutely crucial. The danger is to assume that once fund choices and fund managers have been designed and selected the scheme will provide good results. However the outcomes will reflect not only the design of investment choices but also the success of member choices.

B. The welfare of individuals is at stake and the complexities of pension provision make it essential that members of pension schemes are protected. The real issue is whether the regulations are well designed and not simply bureaucratic. It is generally regarded as preferable to have principles-based rather than rules-based regulation, but this then places demands on those involved to use good judgement in interpreting the principles appropriately, ie it requires good governance.

C. For DB the biggest risk from failure of governance is that the risks undertaken are excessive relative to the ability of the employer’s business to handle them. The temptation is to run higher than desirable levels of investment risk, potentially leading into even deeper water. In DC the big risk is that the pensions eventually delivered are inadequate. This could be from a combination of inadequate employer contributions, inadequate member contributions or poor investment outcomes. One obvious area of concern is the design of investment choices, but much of the risk can be attributed to inadequate member understanding of the importance of proper contribution levels and thoughtful investment choices.

Alan Grant, JLT Benefit Solutions

A. Trustees have a responsibility under the Trustee Knowledge and Understanding requirements to be appropriately equipped to fulfil their duties and responsibilities – and these will in some cases be different for DB than for DC. The accuracy and completeness of data for a DC scheme is arguably of more immediate importance than for a DB scheme. The timely and accurate contribution deduction, payment and investment is fundamental to ensure that a DC member receives the correct level of benefits.

DB schemes face similar issues but perhaps not as immediate but good governance now would ensure that data is captured early and therefore reduce the risk of it not being available at a later date. However the underlying principles for operating effective internal controls are in the main equally applicable to both types of scheme.

B. We all need a little regulation now and again! Despite valiant attempts over the years to “simplify” the regime there seems to be an acceptance that the nature of pensions is that “it’s complicated”. The industry does seem to be blighted with legislators who are determined to develop rules and regulations that appear to be designed to test the most mathematically minded of practitioners and yet leave the end user with little if any confidence in the UK pensions system. Hopefully the change of government is our opportunity to move towards a “simpler” if not “simple” pensions regime.

C. Things can and do go wrong, but we can take steps to reduce the chance of errors or loss. Even if errors do not cost money, they generally cost in time. Poor governance can lead to incorrect benefit payment, the failure to make payments or contributions when due, loss of knowledge if there is a failure to keep proper records or if there is no adequate succession planning. Then there are reputational risks: what if the administration team is not performing, or if poor communication material is leading to members not understanding their benefits and therefore to making ill-informed decisions.

Rachel Brougham, Mercer

A. Balance is the operative word. To date it has been common for trustee boards with DB and DC sections to focus more on DB funding issues. But as DC sections grow in membership and asset size, we are seeing more trustees shift their focus towards DC.

Trustees need to assess their DC specific knowledge and understanding. Engaging with the employer to understand its objectives for the DC section is another essential early step.

Trustees might choose to dedicate a fixed element of agenda time to DC specific matters, or may alternate the focus of each meeting with DB matters. Setting clear objectives for both arrangements will allow the board to agree and prioritise the action needed to achieve both sets of objectives.

B. It is not unreasonable to point to increasing levels of pensions legislation over the last 20 years as being partly responsible for the state of UK pension schemes now. Increased regulation in this sense has reduced flexibility and increased financial burden for employers.

Regulatory demands have increased in recent years but that doesn’t mean these demands are not proportionate to the responsibility. It is not a responsibility to be taken lightly and ultimately, the governance related regulation is there to help as well as to protect trustees as they undertake their duties.

C. The purpose of scheme governance is to ensure the success of the scheme, which ultimately means benefits for members. The overall risk therefore is that poor governance results in a failure to deliver those benefits.

A failure to govern the financials effectively now could result in too little in the pot to deliver DB benefits.

Relationship management is extremely important; failure to manage effectively the key relationship with the sponsor and to monitor its covenant poses a significant risk to DB schemes because of the implications that has for benefit security. For DC schemes a failure to communicate the role members need to play in planning for their retirement can result in disappointing levels of benefits.

Des Hogan, Summit Global Investor Services

A. Investment strategies vary greatly even within DB and DC schemes, posing varied governance challenges. With the rise of DC as the primary model for company schemes and more dynamic DC investment options being chosen, trustees are realising that they hold similar levels of responsibility for the DC default fund as they do for their DB scheme.

Trustees of DB and DC schemes need to recognise when a change in investment manager or a strategic adjustment is required. They must monitor performance, risk and investment managers’ compliance with the mandated strategy. They should also ensure that they are receiving value-for-money for managers’ fees. Recent developments in technology have made it possible to gain almost immediate insight into what is happening within investment funds.

B. Trustees already face difficulties in adhering to existing regulation but the market fluctuations over the last few years have highlighted the need to make even greater improvements. This would suggest that pension schemes are not over regulated. The problem is that pension schemes lack control mechanisms. The traditional tools available to schemes are not user friendly, tend not to come from independent sources, are paper based, expensive and can require a significant investment in time before any gains towards governance can be made.

C. Lessons from the last recession have shown that a lack of governance and oversight can have detrimental effects on pension funds. The time delay before delivery of crucial investment fund information, such as extreme movements or over exposure in certain asset classes, meant that pension schemes were forced to make critical decisions too late to address the problem.

Too few schemes have considered the use of monitoring tools that automatically audit daily investment activity and deliver an immediate warning when risk threatens the fund. These enable the scheme to agree appropriate action much earlier and implement a best-practice governance structure.