An argument has been made for DB schemes to copy corporate governance structures to boost trustees' accountability. James Phillips explores the idea
Good governance is absolutely critical to ensuring a scheme is run correctly and delivers the best outcomes for its members. Yet, with thousands of schemes and trustees, the approach to governance is a mixed picture.
Efforts are being made to understand what good governance really looks like, particularly by learning from best practice, and The Pensions Regulator is looking into the role of trustees in its 21st Century Trustee project.
Cardano, however, believes there is an easy solution that would both boost trustee boards' performance and refocus their attention on financial outcomes: mandating defined benefit (DB) schemes to adopt a governance model that parallels the approach taken in the corporate world.
The fiduciary manager has published a report, Mind the Governance Gap, which argues the trust-based scheme framework means trustees act as stewards of funds, and primarily act to pay pensions when they fall due.
This, in turn, means they may take more risk where they can be assured the sponsor's covenant will be able to support a downturn. Yet, if this downturn does materialise, the firm argues the trustees are not accountable for their decisions.
On the other hand, the corporate governance model is designed to ensure there is an accountability hierarchy, with the executive team accountable and hired by the directors, and the directors accountable to shareholders.
The report suggests this model should be replicated within trust-based schemes, whereby an internal chief investment officer or external fiduciary manager is the equivalent of an executive team. Then, trustees would be equivalent to directors, and the members and sponsors would replace shareholders.
The firm believes one of the core reasons trustees are fairly unaccountable is down to lack of a clear objective of trustee boards. The report says the current governance system does "not encourage robust risk management of financial outcomes".
Head of innovation Stefan Lundbergh says the existing rules do not encourage proper deliberation or accountability.
"There's no real accountability for financial outcomes among trustees," he argues. "It's more like we are justifying decisions by following a process, taking professional advice and so forth.
"With people acting according to the existing rules, things are not dealt with in a proper way. Why not apply tried and tested corporate governance models, take the good things out of there, and apply them to pension funds?"
While adopting a corporate governance model, firm objectives of setting strategy and managing the day-to-day executive team, monitored through key financial indicators, would make it much easier for all parties to consider how well the pension scheme is doing.
PS Independent Trustees managing director Wayne Phelan, who acts as an independent chairman on a number of boards which have adopted this kind of model, says having a clear chain of accountability leads to better member and sponsor engagement."Personally, I find it better because people are holding me to account," he states. "That's good because the moment you're in the spotlight, you feel like you've got to up your game. Frankly, a lot of the time, people don't recognise what is being delivered, so the more you can talk about it and demonstrate it, the more engagement you get."
In particular, Cardano argues the current set-up allows trustees and sponsors to take excessive risk and shun de-risking. The report states "only a small proportion" have embraced opportunities like liability-driven investing (LDI), and bad risk management has then led to higher deficits.
Lundbergh argues it is sometimes the sponsor that pressures trustees to adopt riskier strategies, but then refrains from taking responsibility, aside from paying additional contributions, if things go wrong.
"What has puzzled us a lot is that all the tools have been available, but pension funds have been very slow at taking them up," he states. "We were trying to figure out what the driver behind this is, and after a lot of thinking we came to the conclusion it is the governance gap.
"Since there is no clear accountability, there is also some sponsor influence. For example, the sponsor says 'maybe we can take a bit more risk because if it pays off we don't have to put in so many contributions'. On the other hand, if it doesn't pay off, the sponsor doesn't acknowledge that they encouraged the scheme to take risk and it then blew up."
Risk management should be a standing item on trustee boards, and a fixed strategy approach would help ensure trustees are aware of how to approach these decisions.
Phelan says having a firm plan or strategy also enables trustees to be more accountable, particularly for the chairman. Therefore, adopting a corporate governance model with a clear objective for the trustee board to have a strategy makes this much easier to measure.
"There are two elements to being a trustee," he states. "One is the operational side and everyone finds this really exciting: whether Fred was married to his wife or had another wife when he passed away or retired. But that doesn't turn the dial.
"It's the strategic things that are really important - the financial risks. How are the investments doing? What is the journey? What is the plan? What do you do if it goes off plan? There needs to be more strategic focus on this and not just the operational weeds."
Yet, London School of Economics (LSE) visiting fellow Simon Wong does not believe trustees necessarily have the skills needed to put in place a good strategy. This, he argues, is largely due to trustees overly relying on their advisers and the sponsor to suggest approaches.
"There is scope for pension funds to adopt a more private sector governance model," he argues. "Pension funds, just like the corporate world, must recognise that the directors or trustees need to possess relevant experience and skillsets. That is still missing to a considerable extent in the pension world.
"People in the boardroom at pension funds may not be up to the task, in terms of the understanding and deciding on increasingly complex investment issues."
Wong adds that this is particularly the case where members and sponsors both appoint their own trustees: "Those that have proportionate representation don't usually come together and say 'what will Mr X or Ms Y bring in terms of investment-relevant skillsets and how do we look at this in a holistic and coherent way?'"
The problem Wong sees is that even if a corporate governance model is adopted, this does not necessarily mean every board would have the skills to deliver on its core objectives.
Cardano's Lundbergh agrees such a model necessitates a wide range of skills on the trustee board, but argues that the accountability of that model would facilitate a culture change and inevitably boost the performance of trustees.
"Because we're human, we tend to react in certain ways, and relatively small changes to the system we work in can have quite a large impact," he says. "By making people accountable, you are also changing the behaviour and people start to do things differently.
"That will give us more robust financial outcomes or solvency for DB schemes. If you change it so you are actually accountable for the financial outcomes, all of a sudden you can say ‘there's a big elephant in the room, we need to deal with it'.
"If you go for clear accountability for financial outcomes, that's a dominant driver and it is going to change a lot of things in what people do."
The wider argument here is that, while Cardano believes this model would primarily strengthen accountability and improve financial outcomes, it would also bring benefits in terms of trustee expertise as well as boost other elements of governance trustees see as important.
A report by Sackers and Winmark, Effective Governance - the Art of Balance, published last month, found that trustees saw regular board meetings, administration processes and structures as the key parts of a good governance framework. Conversely, the diversity of trustees in terms of gender, ethnicity and age ranked as the least important.
But the LSE's Wong believes all of this can be achieved simply by making sure schemes have trustees of the right calibre and with a wide range of expertise.
"Everything flows from the right people," he argues. "Pension funds' activities, in terms of what trustees are tasked to do, are becoming increasingly technical, complex and sophisticated.
"You need a group of trustees that can work within this environment, and I feel we haven't made enough changes in terms of the composition of trustees and their skillsets to keep up with the changes in the investment and pensions world."
A corporate governance framework could ensure trustees have clear objectives for their fund in a precise long-term strategy. Yet the benefits that could flow from this may also depend on the calibre of the trustees.
The question here is somewhat chicken or egg. Is it a good governance framework that brings about exemplary trustees, or exemplary trustees who enrich a governance framework?
Defined benefit (DB) schemes that provide GMPs must revisit and, where necessary, top-up historic cash equivalent transfer values (CETVs) that have been calculated on an unequal basis, a landmark court judgment says today.
Regulators must act now to impose some "proper regulation" to stop another defined benefit (DB) transfer advice disaster, saysTim Sargisson.
Opportunities for defined benefit (DB) schemes to pursue investment approaches that help repair the UK’s economy cannot stand in the way of improving member outcomes, Aegon says.
More members transferred out of defined benefit (DB) pension schemes in October after September's record lows while values were surprisingly stable, according to XPS Pensions Group's Transfer Watch.
Joanna Smith says trustees will need to accurately identify if covenant issues are short-term affordability concerns, or the start of more material deterioration.