It's time to talk The urgent need for dialogue to strengthen governance of UK pension schemes

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1 It's time to talk The urgent need for dialogue to strengthen governance of UK pension schemes A report from the Economist Intelligence Unit Sponsored by Goldman Sachs Asset Management

2 About the research It s time to talk: The urgent need for dialogue to strengthen governance of UK pension schemes is an Economist Intelligence Unit report that asks whether the trust-based system of defined benefit pension scheme governance remains fit for purpose in the current legal, financial, regulatory and demographic environment for private sector occupational schemes. It is sponsored by Goldman Sachs Asset Management. Debbie Harrison was the author of the report and Rob Mitchell was the editor. The Economist Intelligence Unit bears sole responsibility for the content of this report. The Economist Intelligence Unit s editorial team executed the online survey, conducted the interviews and wrote the report. The findings and views expressed in this report do not necessarily reflect the views of the sponsor. Our research drew on two main initiatives: We conducted a survey of 143 UK pension trustees in autumn Respondents represented a wide range of scheme sizes and types, as well as a variety of different roles on trustee boards. To supplement the survey results, the Economist Intelligence Unit also conducted a programme of qualitative research, comprising a series of indepth interviews with trustees, advisers and other participants in the pensions environment. About the author Debbie Harrison is a Senior Visiting Fellow at the Pensions Institute, Cass Business School, where she is a researcher and co-author of three recent pension reports. We would like to thank the many people who helped with this research and who, for reasons of confidentiality, did not wish to be named. In addition we would like to thank the following organisations for their co-operation and assistance: Aon Consulting Capital Cranfield Trustees Citigroup EPIC Investit Lane Clark & Peacock Law Debenture National Association of Pension Funds Pension Fund Partnership Pensions Adviser Review Pinsent Masons PricewaterhouseCoopers Railways Pension Trustee Company Sacker & Partners SEI TUC Watson Wyatt The Economist Intelligence Unit

3 Executive summary The Pensions Act 2004 has placed the role of the trustee under the microscope. The majority of the UK s private sector defined benefit (DB) schemes are in deficit. The trustees of these schemes must now work with employers to meet the Statutory Funding Objective and put in place a recovery plan to clear scheme deficits, typically within ten years. Conflicts over funding may oblige company-nominated trustees to withdraw from the board in order to fulfil their commitments as directors. And member-nominated trustees are under pressure to achieve the requisite individual levels of knowledge and understanding demanded by the Act. At the same time, the investment environment has become vastly more complex over the past few years. Asset allocation is no longer a question of equities, bonds and cash. There is now a huge range of investment strategies Faced with the growing and alternative assets for trustees complexity of the regulatory to consider, including hedge and investment environment, funds, private equity, derivatives there is a real imperative both and absolute return products. for education of trustees and The investment universe has for better dialogue between undoubtedly become harder to trustees and their advisers. navigate as a result, but it has also created powerful opportunities for schemes to generate better returns and manage risk more effectively. It is essential that trustees gain an understanding of what these innovations can offer. Faced with the growing complexity of the regulatory and investment environment, there is a real imperative both for education of trustees and for better dialogue between trustees and their advisers. This report turns the spotlight on scheme governance and trustees management of these key relationships both between trustees themselves and between the trustee board, the employer, the investment consultant and the asset managers. Trustees recognise that these relationships can no longer operate in isolation. Instead, there needs to be an approach whereby frequent and open dialogue occurs as a matter of course between all parties. This is an argument that resonates among trustees questioned for this report, 50% of whom believe that the relationship between the trustees, the investment consultant and the asset managers could be more inclusive than it is at present. The areas identified by this report that require the greatest scrutiny include the following: Trustee-employer relations. The 2004 Pensions Act identifies the employer covenant as one of the crucial issues for trustee understanding and analysis. On the whole, trustees questioned for this survey rate their knowledge of this issue, along with that of their fellow trustees, fairly highly. A significant minority (39%), however, say that they spend little or no time discussing the covenant at their trustee meetings. Given that the strength of the employer covenant can change quickly as a result of new corporate activity, funding requirements or changing financial performance, this is a worrying finding. Relationships within the trustee board. Fiftyfour percent of respondents say that the relationship between the pension scheme and sponsoring company works well or very well, but that leaves a sizeable minority who believe that the relationship is less successful. Qualitative research conducted for this report suggests that conflicts of interest are reportedly forcing the resignation of many companynominated trustees, depriving affected boards of 2 The Economist Intelligence Unit 2007

4 both specialist financial knowledge and a channel of communication with the sponsor. Well-defined and documented governance processes are vital to maintain communications and manage conflict between trustees and sponsor, but these are lacking on many boards. Trustee-investment consultant relations. Relationship management and performance measurement is at the heart of good scheme governance under the Act. Yet most schemes have only rudimentary methods for measuring the performance of their investment consultant, despite their critical role in the selection of asset managers and their influence over asset allocation decisions. Survey respondents demonstrated little confidence in the ability of investment consultants to recommend innovative investment strategies and tools, such as derivatives and alternative assets, with only 35% of trustees rating their consultant as good or very good in these areas. Trustee-asset manager relations. Almost 50% of trustees in the survey sample (and 65% of membernominated trustees) say that they would like the asset manager to be involved at an earlier stage in investment decisions a finding that reflects a marked trend towards closer dialogue in the trustee-asset manager relationship. Asset managers in turn must address trustee gripes that their communications are often unclear and fail to address the needs of specific schemes. Trustee knowledge and training. In general, trustees feel that they have a good knowledge of areas such as the implications of the statutory funding 1. The current model: Fractured relationship between key stakeholders Sponsor company Conflicts of interest and resignations of company trustees can undermine dialogue between sponsor and trustees Trustees may lack good knowledge and understanding of the sponsor s corporate structure and risk position Pension trustees Investment consultants may lack resources to research current investment trends thoroughly and so be unable to recommend more innovative approaches Trustees may not conduct systematic performance measurement of the investment consultant Investment consultant objective and the employer covenant. They are less confident, however, about topics such as the use of derivatives and current trends in asset management, such as liability-driven investment. Sixty-five percent say that they need more training in the former, and 56% indicate that they need more training in the latter. The clock is ticking for trustees of the UK private sector DB schemes, many of which are already closed to new employees, with a growing minority now closing to all future accrual. To manage the increasing complexity of their responsibilities, trustees recognise they also need to change the current model by which they manage their principal relationships (see chart 1). Asset managers may have only limited communication with trustees and lack understanding of the needs of specific schemes Trustees may lack knowledge of current asset management trends and fail to create opportunities to question asset managers about them Asset manager The Economist Intelligence Unit

5 The trust-based approach to scheme management Introduction Trustees questioned for this report say that the system is not in crisis. Despite mounting pressures, survey respondents remain dedicated to their jobs, with 82% saying that they would take on the role again (see chart 2), although this figure drops slightly to 67% among member-nominated trustees. When asked if they thought that the balance of responsibility between trustees, investment consultants and asset managers was working, most respondents gave a positive response. 2. Would you take on the role of pension trustee again, knowing what you know now? (% respondents) Yes 82 No 11 Undecided 6 Source: Economist Intelligence Unit survey. But for company pension schemes in the UK to survive the next ten years the period during which most schemes will have to meet the new Statutory Funding Objective (SFO) trustees will need to achieve more professional standards of business conduct. They will have to enter into closer dialogue with employers and set up more robust systems for measuring the strength of the employer covenant. They must learn to manage conflict with fellow trustees as well as hired providers. They need to build stronger relationships with their primary advisers and learn how to measure more effectively the value these advisers add to the scheme. And they should ensure more substantive interactions with asset managers. Despite the demands that trustees now face, 62% of those questioned in the survey believe that the trust-based approach to scheme management works either well or very well (see chart 3). A slightly lower proportion, 52%, believes that the traditional tripartite advisory structure between trustees, investment consultants and asset managers is also still fit for purpose as currently structured. The survey and qualitative research, however, revealed 3. In general, how well do you think the following aspects of the current approach to running defined benefits schemes work in practice? Very well Well Quite well Needs improvement Badly Don t know/unable to answer The relationship between pension funds and the sponsoring company The trust-based approach to scheme management The advisory structure (in particular, the reliance on the investment consultant) Division of responsibility between trustees, consultants and asset managers The current role and function of asset managers Involvement of asset managers in fund-specific issues Source: Economist Intelligence Unit survey. 4 The Economist Intelligence Unit 2007

6 specific areas of weakness within the trusteeemployer relationship and within traditional advisory relationships. 1. Trustees and the corporate sponsor The Pensions Act of 2004 introduced the statutory funding objective (SFO), which requires schemes to have sufficient and appropriate assets to cover their technical provisions. In cases where there is a deficit, trustees must draw up a recovery plan that should set out how they intend to meet the SFO through a combination of funding from the employer and from investment returns. The Pensions Regulator (TPR) has indicated that it will investigate recovery plans where the recovery period is greater than ten years and most trustees will aim to clear scheme deficits more quickly than that. Qualitative research for this paper found that employers are generally willing to support trustee funding demands but, in return for this commitment, they want to be more involved with the investment strategy. In some cases, they may demonstrate an interest in more robust and innovative strategies, such as alternatives and liability driven investment (LDI), that will mitigate risk and enhance performance. Where appropriate advice is taken, improved investment returns in the context of a risk mitigation strategy will be a win-win for trustees, who will achieve the SFO more quickly, and for employers, who can expect to pay lower contributions. Some employers, however, will take a more cautious approach towards alternative assets and other innovative investment strategies. Managing the relationship with the corporate sponsor has become a vital issue for the trustee board. Among respondents to the survey, 54% think that the relationship between pension schemes and sponsoring companies works either well or very well. But that leaves close to one-half that feels less confident about the quality of the relationship. Eighteen percent say that the relationship works quite well, 14% say that it needs improvement or works badly, and a further 13% say that they do not know. This Managing the relationship with last figure suggests that a sizeable the corporate sponsor has become minority of trustees lack the skills a vital issue for the trustee board. or information to monitor sponsor Among respondents to the survey, relations effectively. 54% think that the relationship During the recovery period, between pension schemes and the tensions between trustees sponsoring companies works either and sponsor will mount. Where well or very well. the defined benefit deficit is significant relative to the sponsor s balance sheet, trustees will require special contributions and high levels of regular funding from the employer. This will reduce the company s profits and may restrict its freedom to distribute dividends, arrange new loans, and engage in corporate activity. 4. In the next three years, what changes do you expect to be made to the scheme of which you are a trustee? Already in place Closure of defined benefit scheme to new members Increase in employer contributions Substantial change in asset allocation Expected in next three years Closure of defined benefit scheme to existing members Source: Economist Intelligence Unit survey. The Economist Intelligence Unit

7 Trustees who fully understand their sponsor s corporate structure are in a much better position to make funding proposals for agreement with the employer from a position of strength. David Poynton, head of credit analysis at Lane Clark & Peacock. What is the employer covenant? The employer covenant refers to the ability and willingness of the employer to pay sufficient advance contributions to ensure that the scheme s benefits can be paid as they are due. The need for higher contributions Trustees surveyed for this report are very aware that they will need higher employer contributions, with 43% saying that they expect an increase in the next three years (see chart 4). Interestingly, interviews with the chairmen of the trustee boards at several large and mid-sized schemes revealed that substantial funding from the sponsor was likely to be traded for the trustees agreement that the scheme should be closed to future accrual. In extreme cases, increased employer contributions could call into question the viability of the company as a whole. Some of the older manufacturing companies will go bust as a result of trustee action, says one independent trustee interviewed for this report. If you had a scheme with 100,000 pensioners and deferred members, and just 2,000 active members, you might be justified in demanding an injection of capital that would push the employer into insolvency. Tough as this decision would be, nevertheless it could be argued that it was in the pension scheme members best interests, even at the loss of 2,000 jobs. A thorough understanding of the employer covenant is critical in the current legal and regulatory environment. Consultants who specialise in covenant assessment urge sponsors to develop an open dialogue with trustees to ensure they have the information they need to make informed decisions. Trustees who fully understand their sponsor s corporate structure are in a much better position to make funding proposals for agreement with the employer from a position of strength, says David Poynton, head of credit analysis at Lane Clark & Peacock. Most survey respondents say that they are confident in their knowledge of the employer covenant, with 78% saying that they have either a good or very good knowledge of this issue (see chart 7). Likewise, there is widespread recognition of the significance of the employer covenant, with 61% saying that it is very important to their scheme. Surprisingly, however, a relatively high proportion do not spend time on the issue during board meetings, with 39% saying that they devote little or no time to discussing it. For many trustees, assessing the employer covenant will be a new requirement, and it may be that the high number of respondents who say they spend little time on the issue can be attributed to the lack of experience trustees have to date of managing this issue. A 2006 governance survey from The Pensions Regulator found that almost 40% of UK trustees were failing to review their sponsor s credit rating. Mr Poynton stresses, however, that informed, independent knowledge of the credit standing of the employer is critical to the decisions that trustees make. An appropriate response could be for trustees to commission a credit appraisal of their sponsor every three years to coincide with the triennial valuation of the scheme together with annual updates to take account of any significant changes in the risk profile of the sponsor, he explains. He adds that in the absence of a comprehensive independent analysis of the creditworthiness of their sponsor, trustees may encounter two challenges. First, they will find it difficult to assess the level of contributions that it is fair to expect to be paid into the scheme, and second, they will be unable to decide upon the level of equity risk premium that it is prudent to allow for, as the amount of risk that can be taken within the funding and investment strategy depends 6 The Economist Intelligence Unit 2007

8 on the ability of the sponsor to underwrite that risk. Patrick Disney and Andrew Slater, head of institutional business development and director of institutional strategy respectively at SEI Investments, also stress the importance of an understanding of the employer covenant to guide investment strategy. The selection of the asset managers, the benchmarks they are set, and the amount of risk they should take will reflect closely the employer s ability and willingness to meet the funding schedule, they say. 2. The trustee board For the current trust-based approach to scheme management to remain successful, decision-making must take into account the views of all trustees, whether company, member-nominated or professional. An overwhelming majority of trustees 86% agree strongly that their views count and are heard on their board, sounding a strong note of confidence that decisions on UK trustee boards are driven by consensus rather than a strong individual or clique. Despite the lengthening list of pressures they face, trustees are also fairly comfortable with the amount of time they have available to dedicate to their duties. When asked how much time they would ideally need to spend compared with the amount they currently spend, 65% think the allocation is about right, and only 10% say that they would require double the time or more. Among member-nominated trustees, who as volunteers must typically juggle their duties with fulltime jobs, a slightly lower proportion of 50% say that they would ideally need about the same time as they currently spend. Although the time allocation and decisionmaking processes appear to be functioning well, the possibility of conflict between the company and the Case study: Marconi The 2005 acquisition by Ericsson of most of Marconi provides lessons for all trustees who face negotiations during a corporate action, such as a takeover or merger. While the deal struck with the Marconi pension scheme was unusually complex and innovative, the case highlights trustees requirement for expert pensions advice during negotiations as well as the wider range of funding arrangements that employers can use to support a scheme strategies that are comparatively new to the UK pensions landscape. Marconi s March 2005 annual report revealed a FRS17 deficit of 109m the difference between the scheme s assets of 2.4bn and liabilities of 2.5bn. Ericsson did not intend to take on the pension liabilities, leaving them instead with telent, the new name for the Marconi business that remained after the sale. The issue for the trustees was that, as a corporate sponsor, telent was very small relative to the liabilities of the scheme and, therefore, might not be in a position to provide substantial funding should this be required in future. The deal struck by the trustees, with the help of The Pensions Regulator s clearance process, was that there would be an immediate payment of 185m out of the sales proceeds to the pension scheme. In addition, 490m was set aside in an escrow account held under a trust separate from telent and the pension scheme. Should the scheme become fully funded on a buy-out basis, the excess money would go to telent. Otherwise it would eventually be passed on to the scheme. The deal shows how important it is for the trustees to understand any significant changes to the employer covenant and to seek expert advice on the funding and contingent guarantees required to maintain scheme security, says Michael Berg, a partner at Lane Clark and Peacock, the actuarial consultancy, which was not party to the Marconi deal. Trustees need to know what constitutes a reasonable demand in the circumstances, and this can involve a complex balancing act. While it may be correct in certain circumstances to make demands that have the effect of scuppering a deal, such action might not be in the interests of the scheme members where this results in the loss of potentially significant new funding to the scheme. From Marconi, adds Mr Berg, we can see that, where the covenant is seriously weakened, the trustees can look for substantial additional funding, sometimes well in excess of the FRS17 deficit, and here it is highly relevant to consider the scheme liabilities relative to the sponsor s business. It is also important that trustees are making decisions based on up-to-date assumptions, particularly in relation to mortality. The Economist Intelligence Unit

9 trustees remains a real threat, and this can create problems within the trustee board itself. There is no clear picture on the scale of trustee resignations but, according to one high profile independent trustee, company trustees are quitting in droves because the requirements of a trustee to secure the highest funding from the sponsor clash with the directors obligations to shareholders. The directors remuneration may be performance-based and linked to profits and the share price, The traditional approach of which makes it doubly difficult to equities and bonds is now less channel profits into the pension likely than ever to meet future scheme. liabilities, and company trustees Claire Altman, an associate at may well have some of the Sacker & Partners, a law firm that expertise needed to help guide specialises in pensions law, notes funding away from anachronistic that standing down as a trustee asset management solutions. is something that should be done only in extreme circumstances. If a conflict is likely to cause difficulties for an individual or the trustee board, she says, that person may need to abstain from any vote or absent themselves from the relevant discussion. She adds that trustees might consider appointing an independent chair for the board, and recommends that decisions and actions should be documented to facilitate investigations at a later stage. In cases where company trustees resign, it is essential that the remaining trustees ensure a close two-way dialogue with the corporate sponsor. Trustees should take account of the position of the sponsor, explains Allan Course, client director at Capital Cranfield Trustees, and seek to ensure the employer s agreement in the way the scheme is run. According to one independent trustee interviewed for this report: In some cases, a sub-committee of the parent company board is charged with the task of negotiating with the trustees, while in others the finance director is in attendance at the trustee board or the sub-committee meeting, although not in the formal role of a trustee. Trustee boards need more experts, not fewer While it might be prudent for the finance director and chief executive officer to step down from the trustee board in some circumstances, their absence can also leave a gap in the trustees collective financial knowledge at a time when such expertise is crucial. This is especially true given the complex investment environment in which schemes now operate. The traditional approach of equities and bonds is now less likely than ever to meet future liabilities, and company trustees may well have some of the expertise needed to help guide funding away from anachronistic asset management solutions. Trust boards need more experts, not fewer, said an independent trustee. A sensible way forward would be for company trustees to step down from certain meetings. It is important to have a protocol for this before conflict arises. Well-defined processes to manage conflict are lacking on many trustee boards. According to the September 2006 survey of governance by The Pensions Regulator, 70% of schemes did not have in place a process to manage conflicts of interest. The Pensions Regulator urged trustees to address this issue and will be looking for signs of improvement in the 2007 survey. Where conflict does arise, it is not necessarily a bad thing, according to one chairman of a trustee board. I want all the information on the table, he explains. I don t mind conflict and it s better to deal with it face to face than to establish a more contorted channel of communication between the trustee and company boards. 3. Trustees and the investment consultant Trustees have two main sources of capital to achieve a fully funded position on a SFO basis. The first, discussed above, is the sponsoring employer, which is legally obliged to make good any deficits in the scheme to ensure the accrued benefits can be paid. The other main source is the fund itself and here, the 8 The Economist Intelligence Unit 2007

10 5. Please indicate whether you agree or disagree with the following statements. Agree strongly Agree slightly Disagree slightly Disagree strongly Don t know Schemes have a pressing need for external expertise It is important that asset managers are included at an earlier stage in the decision-making process The relationship between trustees, investment consultants and asset managers should be more inclusive than currently Source: Economist Intelligence Unit survey. asset allocation and the investment strategy can be optimised to help secure the desired return within an appropriate risk management framework. More than half of respondents have either already made a substantial change to their asset allocation or expect to do so in the next three years (see chart 4). In an investment climate characterised by volatile equity returns, relatively low interest rates and the availability of a wide range of assets and investment strategies, the need for clear and informed investment advice has never been greater. The survey results demonstrate that trustees have a strong awareness of the need for external expertise, with 85% agreeing that this is the case (see chart 5). Of course, pension scheme legislation has required trustees to seek external investment advice for many years. The question is how the trustees relationships with consultants and asset managers are changing in the current environment. The relationship between trustees and their investment consultant is a crucial one in determining an asset allocation and investment strategy appropriate in relation to the sponsor s covenant. Overall, trustees who took part in the survey say that they are satisfied with the service they receive from their consultant, with 76% confirming that their consultant has either a good or very good understanding of their scheme s needs, and 74% giving a similar rating to their consultant s quality of advice (see chart 6). There was less confidence, however, in the ability of investment consultants to recommend innovative investment strategies and tools, such as derivatives and alternative assets, with only 35% of trustees rating their consultant as good or very good in that area (see chart 7). All we get [from the consultant] is information on the core asset classes equities, bonds and cash, reports one chairman of a trustee board. Our consultant does not talk to us about hedge funds, for example, so we do not have the confidence to go there. Another chairman of a trustee board reports similar problems. I ve been an independent trustee for over ten years but have yet to hear how products and strategies like derivatives, interest rate swaps and hedge funds work in a way that makes me feel I can 6. How would you rate the following aspects of the service you receive from your investment consultant? Very good Good Average Needs improvement Poor Don t know Understanding of your scheme s needs Quality of advice Objectivity of advice Source: Economist Intelligence Unit survey The Economist Intelligence Unit

11 7. How would you rate the advice that you receive in the following areas from investment consultants? Very good Good Average Needs improvement Poor Don t know Changing asset allocations Selection and monitoring of managers Willingness to challenge the status quo Current trends in asset management, eg, liability-driven investment Use of innovative investment strategies and tools, such as derivatives and alternative assets Providing access to external experts to deal with new problems Source: Economist Intelligence Unit survey. recommend them. Without that understanding I feel I would be in the wrong to recommend a commitment. These comments reflect a growing concern that investment consultants do not themselves always have the resources and research capacity to keep up with the fast-moving investment universe and so tend to play it safe with the assets The question for trustees, and, in some cases, fund managers then, is how to gain access to with which they are familiar. With the knowledge they require if thousands of hedge funds and consultants do not have expertise private equity firms from which in certain areas. One possibility, to choose, for example, it is discussed in detail later in this perhaps not surprising that many report, is that they should enter consultants do not feel confident into more fruitful dialogue directly in being able to recommend these with asset managers. more innovative strategies. The question for trustees, then, is how to gain access to the knowledge they require if consultants do not have expertise in certain areas. One possibility, discussed in detail later in this report, is that they should enter into more fruitful dialogue directly with asset managers. The elephant in the corner With the investment consultant taking a primary role in asset allocation and in the selection of asset managers, there is a clear imperative for trustees to have in place an independent monitoring process that sets robust targets and provides effective measurement of the consultant s performance. Qualitative research, however, indicates that few trustees have implemented an efficient process for this important aspect of scheme governance. Consultants direct the spotlight on the asset manager but never turn it on themselves, notes one independent trustee. Chris Edge, chief executive of EPIC Investment Advisers, an independent investment consultancy, agrees that there has been a tendency for investment consultants to escape scrutiny in the past. Traditionally, it was the asset manager who faced the most rigorous performance measurement, but the Pensions Act 2004, adopting many of the views of Paul Myners, states that all primary advisers must be measured. Implementing this requirement can be problematic, however, as there is no readily available mechanism by which trustees could establish appropriate performance benchmarks for investment consultants, ask the right questions and understand the answers. It was, if you like, the elephant in the corner at trustee meetings on governance. When trustees do attempt to measure the performance of the consultant, as is required in the regulations, the process used is frequently very rudimentary. Trustees say they have monitored the investment consultant, says one research 10 The Economist Intelligence Unit 2007

12 consultant, but when you probe deeper, you find they have based their assessment on whether the consultant turned up on time for meetings or whether the reports arrived on time. Roger Brown, an independent consultant on the selection and assessment of investment consultants (formerly of Blacket Research), says that trustees have a real need for independent evaluation of the service that consultants provide. To judge the value of the consultant s advice and selection, Mr Brown examines the performance of the shortlisted managers and compares this with the manager universe as a whole. This exercise enables the trustees to determine the value the consultant has added through its selection process compared with a random selection of fund managers. In many cases, his analysis has revealed that the performance of shortlisted managers was no different from a random choice. If the consultant has not added value, says Mr Brown, the firm would need to be able to explain this underperformance and set out how it intends to remedy any perceived weaknesses in future. If it can t do this to the trustees satisfaction, then it may be time to consider changing the consultant. Mr Brown also analyses the trustees ability to make a positive final selection by comparing the performance of the selected manager with that of the other shortlisted firms. He found a striking improvement in the results from trustees boards that have a dedicated sub-committee to deal with investment issues, where the superior knowledge and understanding of investment issues leads to a significant improvement in manager selection decisions. 4. Trustees and the asset manager Under the traditional tripartite advisory model trustees, investment consultant, and asset manager the consultant takes the dominant role, agrees strategy with the trustees and then appoints the asset managers required to carry out this strategy. Many asset managers in the UK have long desired a closer dialogue with the trustees and consultant at an early stage, arguing that they can bring specific investment expertise to the table that the consultants may lack. At present, 42% of trustees say that the role and function of asset managers works either well or very well (see chart 3). This indicates that there is considerable scope for improvement in this relationship. In terms of how it can be improved, 49% of respondents said that the asset manager should be involved at an earlier stage in the investment discussions (see chart 5). This means, for example, that asset managers could communicate directly with trustees on a more regular basis, not just when they present their performance data to the trustee board. In addition, trustees must ensure that they create additional opportunities to ask questions of asset managers. By ensuring that a two-way dialogue is in place, it is more likely that asset managers will be able to gain a better insight into scheme-specific requirements and, in return, trustees could make their selection based on a better understanding of the range of asset management strategies on offer. Certain asset managers in the UK are well-placed to offer By ensuring that a two-way investment consultancy (although dialogue is in place, it is more not actuarial advice), and some likely that asset managers will be are hiring ex-consultants with an able to gain a better insight into actuarial background to improve scheme-specific requirements client relations and product and, in return, trustees could make development. They are rebadging their selection based on a better their services, notes one understanding of the range of asset investment consultant. Manager management strategies on offer. of managers already incorporates a consultancy element. In this context, it is interesting to note that, just as asset managers (and investment banks) are developing consultancy services, the consultants are developing manager of manager services. This trend suggests that both professions recognise the need for a more integrated consultancy/ asset management model. The Economist Intelligence Unit

13 Asset managers vary considerably in terms of their ability and desire to form closer relationships with trustees. In general, however, qualitative research for this report found that the majority of managers have much to learn about communications skills before trustees will be prepared to engage in a closer dialogue. Professional and independent trustees, member-nominated trustees and even the chairs of trustee boards all reported dissatisfaction at one time or another with manager presentations. These can be obscure and overly complex, according to interviewees, delivering the information the manager wants the trustees to hear and being evasive in other areas. The same criticism was levelled at investment banks, which, according to the survey, are also forming closer relationships with trustees. I have been researching pensions and investment issues for 30 years, says one member-nominated trustee on an investment sub-committee, yet I still come out of meetings with asset managers feeling confused and irritated. Manager reports also come in for criticism, with one interviewee describing them as completely unintelligible to trustees. Asset managers need to demonstrate a far deeper understanding of the schemes they serve and the corporate sponsor s ethos and circumstances, which is an aspect of relationship management that traditional consultants have generally managed very well. Asset managers should take care to ensure that the products they offer are tailored to meet the specific requirements of individual schemes. Asset managers and investment banks could be doing more to make insurance and derivative structures available that are specifically tailored and priced for trustees needs, notes one investment consultant. They have fantastic solutions but often fail to make them scheme-specific. 12 The Economist Intelligence Unit 2007

14 Trustee knowledge and understanding The Pensions Act 2004 stipulates the requirement for trustees to demonstrate knowledge and understanding of pensions law and issues related to the funding of the scheme. In general, trustees questioned for this report are fairly confident in their knowledge, although they also highlight areas where they feel they need further training. Respondents say that they have a strong understanding of the implications of the Statutory Funding Objective for their scheme, with 72% of respondents saying that their knowledge is either good or very good in this area. They are also reasonably confident in their grasp of the employer covenant, with 78% professing good or very good knowledge in this area (see chart 8). Trustees are less confident in their understanding of current trends in asset management, with 40% saying that their knowledge in this area is either average, in need of improvement or poor, and substantially less confident in the use of derivatives, with 64% giving themselves a similar rating. As is often the case with self-assessment surveys, individuals have tended to rate their own knowledge more highly than that of their peers, with 47% rating their fellow trustees knowledge of current trends in asset management as good or very good, and just 18% giving them the same rating for their understanding of the use of derivatives (see chart 9). Given the widely accepted need for schemes to 8. How would you rate your knowledge and understanding of the following? Very good Good Average Needs improvement Poor Employer covenant (the financial strength of the sponsoring employer to ensure it meets its obligations to the pension scheme) Implications of the statutory funding objective for your scheme Current trends in asset management, eg, liability-driven investment Bulk annuity buyout market (product designed to switch the risks from an employer s pension scheme to its chosen life office) Use of derivatives, such as interest rate swaps Source: Economist Intelligence Unit survey. 9. How would you rate your fellow trustees knowledge and understanding of the following? Very good Good Average Needs improvement Poor Don t know Employer covenant Implications of the statutory funding objective for your scheme Current trends in asset management, eg, liability-driven investment Bulk annuity buyout market Use of derivatives, such as interest rate swaps Source: Economist Intelligence Unit survey. The Economist Intelligence Unit

15 10. In which of the following areas do you feel you need more training? (% respondents) Use of derivatives, such as interest rate swaps Current trends in asset management, eg, liability-driven investment 56 Statutory funding objective 42 Employer covenant 31 Statement of funding principles 27 Overall role and responsibilities of the trustee 25 Recovery plan 22 Statement of investment principles 20 Source: Economist Intelligence Unit survey. explore more innovative investment strategies to meet future liabilities, there is a pressing requirement to close this gap in trustees knowledge. It is essential for trustees to understand trends in asset management, explains a pensions lawyer interviewed for this report, otherwise they are in danger of ignoring a suitable strategy or investing in a manner that is unsuitable for the scheme. Trustees themselves recognise this need for better information, particularly on innovative investment strategies. Sixty-five percent of respondents say that they feel they need more training on the use of derivatives, such as interest rate swaps, and 56% say that they need more training on current trends in asset management (see chart 10). There is also a recognition that training issues in general are important to the scheme, with 87% of respondents indicating that training is either very important or relatively important. While training is ultimately the responsibility of trustees who, after all, must demonstrate to the regulator that they have attained the required levels of knowledge and understanding, the investment consultant also has an important role to play in this area. When asked what would most improve the value of the service provided by their consultant, the most 65 popular response was training of trustees, selected by 33% of respondents. As other sections of this report make clear, there is also a role for asset managers to play in ensuring that trustees keep up with innovations in investment strategy. More generally, trustees and their pension executives should be open to ideas from outside providers. Only allowing their current providers to teach them will limit the growth of their knowledge. In addition, an investment sub-committee can be a useful vehicle for nurturing expertise about current asset management trends, although it may only be appropriate at larger schemes. These two developments better communication from the asset manager and a focus group for investment issues on the part of the trustees could help to strengthen the relationship between trustees and their asset managers, as well as improve returns. Collective versus individual knowledge One aspect of the Pensions Act that has drawn criticism has been the focus on individual knowledge of trustees without a corresponding requirement for the assessment of the board s collective knowledge. On a company board, you would not expect the sales director to be an accountant, notes one independent trustee. Good governance calls for a diversity of skills and for the sum of the whole to work. In other words, just as a good company is run by a team of directors, each with their specialist areas of knowledge, so it is the collective knowledge of trustees rather than that of specific individuals that matters. The importance of collaboration and shared knowledge is something that comes across strongly in the survey results, with 89% of respondents agreeing that decision-making tends to be consensus-driven. Several consultants and independent trustees, however, question the ability of lay trustees, both member- and company-nominated, to conduct a thorough self-assessment of their own performance. A lot of trustee boards are complacent without realising 14 The Economist Intelligence Unit 2007

16 it, believes one benefits consultant. They say they are all doing well in terms of their performance as trustees but they have no relevant benchmark against which to measure their performance. Rise of the educated amateur The demands on individual trustees to demonstrate knowledge and understanding may be a factor that will reduce the supply of member-nominated trustees in future. Among those questioned for this survey, 60% said that they would still have become a trustee had they known what was in store, leaving 20% who said they would not and 20% who were undecided. These figures do not translate into a major exodus of member-nominated trustees, but they do indicate that the supply may dwindle as these positions come up for review. You can t expect member-nominated trustees to be experts, says one benefits consultant, but that is what the Regulator appears to require. Smaller schemes in particular are going to have a tough job in future finding willing volunteers. This trend may have an unanticipated impact on the make-up of trustee boards. The enthusiastic amateur is being replaced with the educated amateur, believes one independent trustee. This will change the nature of the lay trustee by moving the job up the management scale. Member-nominated trustees will increasingly be drawn from middle management. The Economist Intelligence Unit

17 Conclusion Trustees questioned for this report broadly agree that the current advisory structure and trust-based approach continues to work, despite the greatly increased pressure that they face in the light of scheme deficits and a complex Even if trustees successfully regulatory and investment implement all of these changes, the environment. Our survey reveals coming years will test the current an impressive level of commitment advisory structure and trust-based and altruism on the part of approach to its limits. But by taking member-nominated trustees continuous steps towards closer in particular. There is no doubt dialogue and a better exchange of that many trustees feel a moral information, trustees at least have responsibility to members in terms a chance of ensuring the survival of of future pension arrangements the current model. and jobs, both of which are at risk where the deficit is significant relative to the sponsor s balance sheet. But despite this overall endorsement of the current model, the coming years will be challenging ones for trustees. They will need to ensure that they are getting the right advice at the right time from their consultants and asset managers, monitoring the strength of the employer covenant, as well as maintaining a fruitful dialogue with the scheme sponsor irrespective of whether the sponsor is represented on the trustee board. In practical terms, this means that trustees must move to a set of relationships that are far more inclusive than is typical for most schemes at the present time (see charts 1 and 11). They must assess the effectiveness of their relationships with key advisers on a regular basis, as well as ensuring that channels of communication remain open with the scheme sponsor. They should conduct an assessment of their own individual and collective knowledge and, in areas where they feel they lack expertise, they should seek information either from the investment consultant or, increasingly, from the asset manager, with whom a two-way dialogue is increasingly sought. Trustees should also ensure that performance measurement remains top of the agenda, particularly when it comes to the investment consultants on whom they will frequently rely for advice and 1. The current model: Fractured relationship between key stakeholders Sponsor company Conflicts of interest and resignations of company trustees can undermine dialogue between sponsor and trustees Trustees may lack good knowledge and understanding of the sponsor s corporate structure and risk position Pension trustees Investment consultants may lack resources to research current investment trends thoroughly and so be unable to recommend more innovative approaches Trustees may not conduct systematic performance measurement of the investment consultant Investment consultant Asset managers may have only limited communication with trustees and lack understanding of the needs of specific schemes Trustees may lack knowledge of current asset management trends and fail to create opportunities to question asset managers about them Asset manager 16 The Economist Intelligence Unit 2007

18 Appendix It s time to talk recommendations on investment issues. Finally, they should put in place processes to manage conflict on trustee boards. Should the issue of the resignation of a company trustee arise, they are then more likely to avoid losing valuable sources of expertise. Even if trustees successfully implement all of these changes, the coming years will test the current advisory structure and trust-based approach to its limits. But by taking continuous steps towards closer dialogue and a better exchange of information, trustees at least have a chance of ensuring the survival of the current model. 11. Model of the future: the key to inclusive trustee relationships Sponsor company Institute systematic monitoring of employer covenant Monitor levels of collective and individual knowledge and understanding and seek dialogue and training to fill gaps Pension trustees Agree mechanisms for resolving conflicts of interest on the trustee board Involve asset managers in substantive, schemespecific dialogue Asset manager Investment consultant Agree and implement performance measurement for investment consultants The Economist Intelligence Unit

19 Appendix It s time to talk Appendix In autumn 2006, the Economist Intelligence Unit conducted a survey of 143 UK pension trustees. Our sincere thanks go to all those who took part in the survey. Please note that not all answers add up to 100%, because of rounding or because respondents were able to provide multiple answers to some questions. How would you rate your fellow trustees knowledge and understanding of the following? Very good Good Average Needs improvement Poor Don t know Employer covenant (the financial strength of the sponsoring employer to ensure it meets its obligations to the pension scheme) Implications of the statutory funding objective for your scheme Current trends in asset management, eg liability-driven investment Use of derivatives, such as interest rate swaps Bulk annuity buyout market (product designed to switch the risks from an employer s pension scheme to its chosen life office) In general, how well do you think the following aspects of the current approach to running defined benefits schemes work in practice? Very well Well Quite well Needs improvement Badly Don t know/unable to answer The relationship between pension funds and the sponsoring company The trust-based approach to scheme management The advisory structure (in particular, the reliance on the investment consultant) Division of responsibility between trustees, consultants and asset managers The current role and function of asset managers Involvement of asset managers in fund-specific issues The Economist Intelligence Unit 2007

20 Appendix It s time to talk From which of the following do you currently seek, or would you consider seeking, advice on your pension scheme? Currently seeking advice Would consider seeking advice in future Would not seek advice Legal advisers Investment consultants Asset managers Accountants Actuarial consultants (separate from scheme actuary) Independent trustees Professional trustees Pensions regulators Investment banks How would you rate the advice that you receive in the following areas from investment consultants? Very good Good Average Needs improvement Poor Don t know Changing asset allocations Selection and monitoring of managers Willingness to challenge the status quo Current trends in asset management, eg liability-driven investment Use of innovative investment strategies and tools, such as derivatives and alternative assets Providing access to external experts to deal with new problems How would you rate the advice that you receive in the following areas from asset managers? Very good Good Average Needs improvement Poor Don t know Changing asset allocations Willingness to challenge the status quo Current trends in asset management, eg liability-driven investment Use of innovative investment strategies and tools, such as derivatives and alternative assets Providing access to external experts to deal with new problems The Economist Intelligence Unit

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