Market-Neutral: It's All About Alpha (not Beta!)
IN PRINT ARCHIVE CIR Summer 2001
|Pension plan governance models|
|Fiduciaries responsible for pension plan governance have focused on the management and integrity of the fund. New pressures are expanding expectations.|
|by Barry McInerney|
Today, the most prevalent model of pension plan governance targets a number of key issues:
* Compliance with legislation and regulation and minimum funding requirements.
* Establishing the asset mix and risk tolerance through the statement of investment policies and procedures.
* Monitoring of the fund, investment management structure and the performance of the investment managers in relation to stated objectives.
* As occasions arise, the demands of special situations such as partial wind-ups, the ownership of surplus and solvency issues.
The focus has been on the fund for good reasons. The performance of stock markets, the periods of concentration in the Canadian market and the relative performance of bond versus equity markets have presented a number of tests in the recent past. In the future, the prospect of single-digit returns and maturing pension plan membership will present further challenges in balancing the growth of assets against liabilities as they come due.
The board of directors is responsible for obligations associated with the administration of a pension plan and the investment of its assets. To ensure the required time, knowledge and skill are brought to pension plan governance, the administrator usually delegates some or all of these tasks to a pension, benefits and/or investment committee--the so-called managing fiduciaries. These committees in turn usually delegate specific administrative and investment activities to external agents (such as investment managers and custodians), and internal personnel--the operating fiduciaries.
THE JOINT FORUM
A stated objective of the proposed regulations for capital accumulation plans is to provide similar and harmonized regulatory protection to members. The regulations would cover all types of plans where the members have a degree of discretion over the investment of their accounts.
Since a number of sponsors of group registered retirement savings plans (RRSPs) established these plans in the belief that they would not attract the weight of regulation of registered pension plans, adoption of the proposals will certainly affect their governance and management. If the regulatory requirements are practicable, this could be a safeguard for some. The direction of case law indicates that group RRSP sponsors could be subject to legal challenges from dissatisfied members.
Many sponsors of registered DC plans should review their information and education policies. In December 1999, William M. Mercer Limited published a Survey of Defined Contribution Plans, covering 206 DC plans of various types. The survey found that a significantly high proportion of DC plan sponsors did not provide investment education to their members.
The regulators are concerned about the range and balance of investment choices being provided and the adequacy of information about these investments, in the absence of prospectus disclosure. The Joint Forum, looking at the U.S.'s Employee Retirement Income Security Act of 1974, calls for a level of disclosure (including continuous disclosure) which will enable informed investment decisions.
For enhanced investor protection, the Joint Forum recommends that, where no prospectus is provided, the sponsor ensure contracts with a third-party provider or investment manager to allow the plan administrator or employer to pursue an action on behalf of members for any misrepresentation about the investments.
The proposal also recommends that sponsors communicate a description of the types of fees that may be charged to members' accounts and information on the annual operating expenses of each designated investment alternative.
RISING EXPECTATIONS OF DB SPONSORS
A certain degree of the interest in DB governance stemmed from the spotlight on corporate governance in general, and developments in a number of countries. In Canada, a landmark was the 1994 publication of the Dey Report, Where were the directors? The most recent successor of Dey is the Interim Report of the Joint Committee on Corporate Governance, Beyond Compliance: Building a Governance Culture, published in March 2001. That report raises the possibility of a new governance responsibility for pension plans: as institutional investors are they in any way responsible for improving the corporate governance of those companies in which they invest?
To deal with current and emerging governance demands, boards of directors and pension committees may find it useful to set a framework within which to make and monitor decisions. The framework can be one of three levels of pension plan governance:
1. The core model of legislative compliance, with the emphasis
on the fund.
LEVEL ONE GOVERNANCE
* Managing fiduciaries focus on policy implementation. Operating fiduciaries focus on analysis, evaluation and monitoring.
* Tasks are delegated down the governance food chain, with reporting and information flowing back up.
* Tasks are delegated, but not responsibility.
* Due process and evidence of due process will achieve a result that is appropriate.
Within these governance structure roles, responsibilities and reporting lines are defined to ensure proper plan administration is maintained on an ongoing basis. This generally involves:
* developing, authorizing and documenting mandates for the various fiduciaries and stakeholders;
* keeping committee members and internal delegates up to date on legislative, regulatory and best practices developments;
* developing, authorizing and documenting procedures to implement the mandates (such as regular committee meetings); and
* monitoring the overall structure and ongoing activities.
Level one pension plan governance revolves around core fiduciary responsibilities. For DB plans, this means ensuring there are sufficient funds to cover the pension promise, filling in the necessary forms, reporting to the regulators, commissioning actuarial valuations and maintaining an up-to-date statement of investment policies and procedures. For DC plans, level one governance activities involve offering a suitable range of investment options and educating members on their best use. For DB and DC plan sponsors, it also involves evaluating the ongoing suitability of the investment managers.
For many pension plan sponsors, the effort and cost associated with elaborate pension management systems are not justified. A core fiduciary responsibility of a pension plan sponsor is to keep expenses down.
LEVEL TWO GOVERNANCE
This model enhances the links between benefit, funding and investment policies. A governance model that looks at the whole plan takes into account, for example:
* The extent to which funding and investment risks can be managed together. This involves linking asset mix policies with risk-based funding targets. Contributions can then be increased or reduced as assets fall short or exceed the target. Investment policies would also be recalibrated to ensure large deficits or unusable surpluses do not arise.
* The sponsor will periodically re-examine the overall mission statement of the pension plan. Why was the pension plan set up in the first place? Is it still doing the job it was intended for?
* In this model, the rationale behind the benefit policy will drive the strategic communication decisions.
* The examination of administration goes beyond the accuracy of the benefit calculations, to monitoring the providers, their fees and the service levels being provided to members.
The whole plan framework facilitates integrated risk management, which is now becoming an integral part of overall corporate governance. The Saucier Report on enhancing corporate governance states, "We recommend that the charter of every board explicitly include the responsibility to ensure that policies and processes exist to identify and monitor principal business risks."
The report notes that risks arising from financial operations have traditionally been the purview of the audit committee. Audit committees, it is recommended, should also monitor other types of risk: strategic, operational, leadership, partnership and reputation.
Integrated risk management entails the application of good business principles to the pension system--good governance and good management.
But financial risk will usually be a central concern. With single-digit returns and new accounting rules, DB pension plan sponsors are focusing on investment risks because of the potential impact of investment volatility on financial statements. The risk mitigation strategies are fairly straightforward:
* diversification across and within asset classes--and outside the concentrated Canadian market;
* linking asset strategy to the liability structure;
* balancing growth and value managers;
* developing a hedging policy to mitigate currency risk;
* managing higher foreign currency exposure; and
* adopting rebalancing policies to reduce asset mix drift.
A governance model that looks at the whole plan matches the asset policy with the structure of the plan liabilities--the profile of the beneficiaries.
A whole plan governance model will also seek productivity improvements in administration and cost-effectiveness in spending. Sponsors will explore various avenues of cost reduction too:
* Securities lending.
* Directed commissions to benefit the fund, rather than the investment manager. Recaptured commissions should equal 0.02% of a pension fund.
* Passive management.
* For multinationals sponsoring plans in a number of countries, a preferred provider arrangement can result in lower fees.
LEVEL THREE GOVERNANCE
Plan sponsors should make an active policy decision about where they want to be on the governance spectrum. The mechanics--roles and responsibilities--will fall out from there.
Barry McInerney leads the investment consulting practice of William M. Mercer, Incorporated in New York City.