When a pension scheme is well governed it can maximise returns within an appropriate risk budget, provide a positive experience to its members and comply with its legal requirements. It can also pursue opportunities which may arise, such as using buy-ins and buy-outs, which by their nature might require the ability to act quickly. Running a scheme well requires the right team, effective structure and good process. As running pension schemes has become more complex, ensuring a scheme is well governed has never been more important.
What is Good Governance?
According to The Pensions Regulator (TPR), good governance requires trustees to set up a process to identify, evaluate and manage risks on an ongoing basis. By establishing and operating adequate internal controls this can enable trustees to manage risks associated with their scheme. In essence, good governance means that trustees are aware of the hazards associated with a pension scheme and take actions to reduce those risks using the best practice framework identified by TPR. Good governance can also involve planning ahead to think through how to manage specific large risks if they occur.
To govern well, a scheme needs to ensure the resources, structures and processes that constitute scheme governance are interlinked.
Pension scheme managers and trustees have to manage multiple demands, from devising investment strategies to reducing funding deficits, managing interest rate risks and determining long-term goals. Yet hazards identified by TPR under the category of operational procedures and technical systems often contain "hidden risks" which in our view, continue to be neglected. Thus, governance gaps can be created.
The following hazards have been identified by AMX as the type of risks that can often overlooked by trustees and consultants due to a general lack of transparency over their existence and the impact they can have on returns.
Five key areas where improved operational capabilities can support good pension scheme governance are:
- Mitigating trade errors. Errors made while buying and selling assets can reduce investment returns and cost investors significant amounts over time. A standardised process, formally set out with portfolio managers, can be used to spot trade errors with a contractual requirement to refund end investors.
- Fund liquidity management. As many as four in ten European high-yield bond funds would not have enough liquid assets immediately available to meet investor withdrawals in the event of a market shock, according to the European Securities and Markets Authority (ESMA)*. There has been a spate of liquidity crises recently, raising questions regarding whether the correct governance procedures were followed whilst selecting and monitoring assets. Ongoing monitoring of fund liquidity is vital to ensure that the liquidity of underlying assets matches that of the fund and its redemption terms.
- Effective treasury management. Excess cash in a portfolio may often be left in a custody account, garnering little or no interest. By using an efficient automated cash management strategy, trustees can ensure that assets held within portfolios are maximising financial returns for scheme members. Just making small adjustments to the treasury function can result in 0.10-0.20% increased returns to members on some funds.
- Cost and tax management. Managing costs and reclaiming tax is clearly important. However this doesn't always occur and can lead to a large drag on returns. For example, despite the UK and USA having a joint tax treaty in place, fund managers with US investments, using OEIC and SCIAV structures, can be subject to tax charges of 30% of the returns paid out in the form of dividends. Using tax transparent fund structures, such as Irish-domiciled Common Contractual Funds (CCFs) allows the ability to ‘look through' to the tax status of the investor, understand the withholding tax implications of investments and make the most of tax treaties (where available) to minimise this cost.
- Working with counterparties. Managing counterparty risk is important because a fund's assets are not always held with the manager - some are moved out of the custody account and into those of third parties. If these entities go into administration, these assets could be lost or hard to reclaim. Each counterparty should be robust. They need to have a strong credit score, be fit-for-purpose and have good process management. There should also be a process to manage the relationship if conditions change.
When a scheme is well-governed, not only can it mitigate risks more effectively, but it can take advantage of many opportunities. It is important to note however, that the definition of good governance is frequently evolving and there is no "one size fits all".
Good governance is not a set-and-forget exercise: one has to constantly keep monitoring the emergence of new risks, such as climate change, in order to develop effective tools required to manage them. A platform with robust operational infrastructure can improve governance by providing an independent risk oversight function, providing an objective assessment of potential issues and improve transparency, thus supporting trustee decision making.
Ultimately, as aptly stated by David Fairs, Director of Regulatory Policy at The Pensions Regulator, "Good governance and the management of investment risk in pensions schemes is fundamental to providing savers with a good retirement".
Nick Horsfall is managing director of AMX