Investment - Articles - Fiduciary Management: Addressing the Governance Gap

 By Shamindra Perera, Head of Fiduciary Management, Russell Investments

 The recent financial crisis led to ballooning pension deficits, causing much confusion and anxiety. This has left trustees and companies alike asking questions such as: are pension funds carrying unrewarded and/or inappropriate risk in their portfolios? Are pension funds fully aware of the types and magnitudes of the risks in their portfolios at a holistic level? Are pension funds doing enough to monitor and manage the risks in their portfolio on an ongoing basis and are they doing enough to capture market opportunities on a proactive basis? The answers to these questions, and the problems that lie behind them, must be considered by actuaries in order for the market to move forward. 

  

 Fiduciary management addresses the current challenges faced by pension funds in a number of ways. In short, it entails the appointment of an expert to execute a pension fund’s investment strategy in the face of limited in-house resources and expertise. It enables trustees to focus on the first-order questions and issues by delegating the execution of the investment strategy to the fiduciary manager. By accessing the expertise of the fiduciary manager, it also allows pension funds to formulate and pursue a wider range of possible strategies, which in turn may make previously unattainable objectives more achievable.

  

 The current governance structure is at the root of the problem

  

 The decline in equity markets, the decline in discount rates, the widening of credit spreads, the drying up of liquidity, the increase in correlations between asset classes and other financial market related phenomena, are commonly listed as the cause of the problems that face most pension funds post the financial crisis.

  

 However, simply attributing the increase in pension deficits to such factors misses an important point. The declines in funding levels were the result of decisions made by trustees regarding exposure to these risk factors. Some of the risk exposures in pension funds were unintended and some of the intended risks were inappropriate. A discussion of what risks are appropriate for a given pension fund is beyond the scope of this article. It aims to draw attention to the importance of risk management, which is indeed the cornerstone of investing.

  

 So what has governance got to do with risk management? As governing fiduciaries, pension fund trustees, in collaboration with together with their actuaryand investment consultant, have the ultimate responsibility for setting the appropriate risk budget for their pension fund. In particular,trustees need to spend more time on understanding risk and setting strategy and less time on implementation of strategy and risk management, which can be effectively delegated. Moreover,there are strong arguments in support of having more ‘real-time’,proactive and expert management beyond the traditional trusteedecision making process governed by quarterly meeting cycles. Theinability to make timely and proactive investment decisions haveexacerbated the problem caused by inadequate risk management:both attributes of poor governance.

  

 Mind the Governance Gap

  

 The first step to undertaking this transformation in governance isknowledge of the governance gap itself. It appears however thatthis knowledge is not widespread as evidenced by a survey in 2009,to look into current decision-making structures of UK definedbenefit (DB) pension funds. 200 interviews were carried out withpension fund managers, internal CIOs and trustee chairs spanningdifferent fund sizes. The survey sought out participants’ views onthe effectiveness of their current structures and their knowledgeand thoughts on fiduciary management, an alternative governancestructure aimed at addressing the governance gap.Some observations from the survey were unsettling, if notentirely unexpected, specifically:

  

  

  

  

 Sound decision-making structures and practices should improve the chances of investment success. There is room for enhancement in the decision-making structures of many UK defined benefit pension schemes.

  

 Fiduciary management: passing fad or critical ‘end game’ strategy?

 It is worth considering whether fiduciary management is a knee-jerk reaction to a crisis, in this instance to the recent decline in funding levels. The looming problem of liabilities from defined benefit (DB) pension funds long preceded the crisis in the financial markets. The events of the last two years have merely thrown the pensions issue into sharper relief.

  

 The fundamental problem is that defined benefit plans are very expensive for companies to sponsor, especially relative to the perceived benefit among employees. You can compare it to a company making a product that costs more to produce than consumers are willing to pay. Pensions are in a similar unsustainable position. The DB plan, once a part of a company’s toolkit for attracting and retaining employees, has become a financial burden, which can sometimes threaten the very existence of sponsors, hence the inevitable end game.

  

 A new stage of the game requires a new game plan, and gone are the days when a pension fund faithfully stuck to a 60:40 equity bond allocation regardless of changes in markets, funding levels or affordability of sponsor contributions. Previously, when funds were smaller relative to sponsoring companies, their membership growing, liability profiles less mature and investment horizons very long, this was acceptable – but not now.

  

 Many companies recognise that their pension funds must be more responsive to changes in the financial markets and changes in their own circumstances, leading to the rise in popularity and understanding of fiduciary management.