Investment - Articles - Fiduciary Management: learning from the Netherlands


 Andrew Slater, Managing Director, Ortec Finance
 Fiduciary management is touted by its proponents as the new paradigm for a pension scheme, in fact any institution, to manage its investments.  Fiduciary management is somewhat of an “anti-Ronseal” name in the sense that it does not really do what it says on the tin; however such qualities are not uncommon in investment.  Alternative names are being tried, such as implemented consulting, delegated chief investment officer, but fiduciary management is the one that appears to stick best.  While there are slight differences between the products and services offered by asset managers, consultants and pension funds this article will use fiduciary management for all.  Whatever the flavour the common themes are increased authority to the provider for decision making and some element of specifying the mandate by reference to the scheme’s liabilities rather than a market related benchmark like FTSE All Share.
  
 Cast your mind back and recall the buzz around 130/30 funds.  They were all the rage back in 2007, and overnight it felt like every asset manager’s marketing team had jumped on the bandwagon.  But it was clear they were never going to take off as they were a solution looking for a problem which did not exist.  However, fiduciary management is the opposite.  Fiduciary management is a solution to a problem that UK pension schemes are, in the main, only just beginning to think about. 
  
 Fiduciary management is a solution (a solution, not the solution) to how pension schemes adapt their investment governance – how they make investment decisions – to be fit for purpose in the 21stcentury.  Without decent investment returns no pension plan has a future.  The typical governance structure is a board of trustees which meet several times a year.  And there may be an investment subcommittee, perhaps spurred on by the Myners Report ten years ago.  The distinguishing feature for the vast majority of schemes, really all except the very largest, is that the operational activity of managing money is outsourced, and that the trustees make decisions based on the advice from external advisers.  This worked when the scheme was open to new entrants, the active population was growing and the equity market delivered reliable bull-market returns.  But we are now in a world of closed schemes, dwindling active populations and hence the bulk of the pension obligation formed of deferred pensions and pensions in payment.  The changes in the demographics are compounded by the inflationary effect of increasing longevity together with legislation which impedes the equitable sharing of the good news. 
  
 It is not just the liability side of the balance sheet that looks very different today than compared to even ten years ago.  The asset side has changed tremendously too.  There are many more instruments trustees can invest in, particularly in the derivatives market.  It is much tougher to make analysis to comprehend the risk-reward trade-off and decide how to allocate to seek return and mitigate downside.  And this is against a background where operational costs are increasing (complying with legislation is particularly onerous and with doubtful benefit) and capital is in short supply.  Put all these factors together and the cost of making a mistake in the investment process has never been higher and more difficult to rectify.  No scheme wants to de-derisk!  Get it right and you achieve self sufficiency with limited risk capital.  Get it wrong and the sponsor faces never-ending deficits.  Trustees walk a tightrope and need all the assistance they can get.  Hope and pray clearly is not a viable strategy. 
  
 Pension schemes are realising that current governance structures impede successful investment.  Since the dotcom bubble crash pension schemes have been seeking the silver bullet of investment.  Unfortunately such a silver bullet does not exist.  An analogy for scheme governance would be low-cost airlines and how they are naturally limited in what they can do.  If all your fleet is made up of Boeing 737s then transatlantic flights are just not possible.  The model of quarterly meetings and traditional asset managers will not allow successful implementation of the de-risking flight path that has carefully been constructed by advisers.  Instead, what you need is real time information (both assets and liabilities) and quicker decision making.  Decisions have to be made with an approach that covers all the angles together – assets and liabilities; asset allocation, contributions and sponsor covenant – rather than individually (holistic is the buzzword).  Implementation has to bring efficiency savings, for example through economies of scale.  Other governance structures have been proposed, for example bulk annuity buyout, but the high cost of their “delegate everything” approach may prevent mainstream acceptance as sponsors are unwilling or unable to provide the necessary capital.
  
 Fiduciary management is not a new concept; it was invented in the Netherlands ten years ago (the Dutch do think about pension scheme governance as a topic in its own right) and has evolved over the years.  The first manifestation, now superseded, was little more than the asset manager extending its services to include an asset-liability study providing advice, though not necessarily decision, on the strategic asset allocation.  But the service extension was warmly received by pension funds who were struggling to comply with new pension legislation (FTK) requiring them to operate akin to insurance companies.  The second wave came from the “pension delivery organisations”, the large pension schemes that were already running the investments internally.  They reorganised themselves so that the scheme and the investment operation were separated entities, with the latter continuing to run the scheme’s assets and also able to offer services to other schemes.  The third evolutionary phase is now underway.  Earlier phases brought quicker decision making but did not fully address matters of governance: how do trustees decide what to delegate, and having done so how do they oversee their fiduciary manager on an ongoing basis?
  
 Trustees need to consider whether the status quo can continue regarding how they manage their investments.  How are they going to obtain information on the assets to calculate exposures to BP (post oil spill), Japan (post earthquake) or what unfortunately comes next?  And how are they going to obtain information on the liabilities, and hence funding ratio, in a timely manner?  Waiting 18 months for the precise results of a triennial actuarial valuation will not assist a de-risking strategy whose opportunities can come and go within a month.  The solution is in the use of technology.  The membership and asset data that make up a pension scheme represents a huge amount of data which is worthy of being managed for its own sake.  But for too long the modus operandi has been to throw virtually all of it away, and with it much valuable information.  A fiduciary manager can bring access to the technology and people to ditch the traditional calendar time approach and to give access to accurate information in real time to support quicker decision making.  The alternative is for the scheme to build the infrastructure itself.  Doing nothing is really only an option for the smallest schemes, and they will purchase the technology eventually when they buyout.  The harsh reality is that pension funds need to tackle their prevailing skills and governance gaps that have for too long promoted herd instinct and rear view mirror decision making.  In today’s world of limited risk capital trustees need to control investment losses and control operational expense.  The sponsor’s chequebook will not be there forever.  It would foolish for trustees, who are economically agents of the sponsor, to behave otherwise.  Appointing a fiduciary manager goes a long way to bring a modern investment process.
  
 Fiduciary management is all about outsourcing.  Hence all the typical criteria apply that needs to be satisfied in order to determine whether the solution is beneficial.  This is the big lesson to be learned from the Dutch experience.  First, will the fiduciary manager help trustees become more effective and efficient?  Second, do trustees want to outsource the entire process or just components?  Third, if trustees decide to outsource how does it effect their decision making and oversight function?  And fourth, how do you make sure that the fiduciary manager understands the trustees’ needs and has the processes to address those needs so that trustees can let go when appropriate and intervene when required.  Switching between strategy revision and implementation of a current strategy is one area which has not been very well organised in the Netherlands.  Successful outsourcing depends on how well you stay in control without having to take day-to-day decisions.   For that you need independent reporting at a level that allows trustees to understand what goes on (without getting lost in details) and monitoring that the strategy and its implementation is still sound with respect to the objectives and risk constraints.
  
 The pension crisis is unlikely to be resolved with the same level of thinking that gave rise to it. Constructing a fiduciary management mandate is not easy; the scheme is looking for a partnership with the provider.  Trustees need to know what they want to buy before they go shopping, ie what is to delegated and how.  Nor is fiduciary management a fire-and-forget solution, there needs to be ongoing monitoring.  It can be done on behalf of the trustees by an in-house executive, or an independent advisor.  Such monitoring has its own challenges as it has to extend from the day to day investment performance to the long term policy decisions.  This is the third evolutionary phase underway in the Netherlands.  The advantage the UK has is that it can skip phases one and two and move directly to a tripartite governance arrangement of scheme, fiduciary manager and independent monitor.

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