Objectives, Governance & the International Experience

What is the true objective of a retirement fund?

Purpose & Objective cont...

Retirement funds in their basic form exist to honour a benefit obligation to a beneficiary. The manner in which the benefit obligation is honoured gives rise to the various forms of retirement funds.  There are defined benefit (‘DB’), defined contribution (‘DC’) and hybrid arrangements (i.e. combination of DB and DC benefit structures). DC arrangements are now the most common arrangement for employers in the private sector, whereas DB has become less prominent.  For this reason, we will focus our attention on the factors that are relevant to achieving the objective of a DC fund and then briefly discuss those factors relevant under the DB scenario.

Defined Contribution Funds

DC funds are arrangements where contributions¹ are paid into the fund and subsequently invested in the market. These contributions, together with accumulated returns, are then available to provide a retirement income, either directly or by purchasing an annuity.

The next question is then - how does one gauge if he/she is on the path to securing a reasonable retirement income under this form of a retirement fund? The answer is a Net Replacement Ratio (‘NRR’). A NRR is an individual’s gross income after retirement, divided by his or her gross income before retirement. It measures an individual’s ability to maintain his/her pre-retirement standard of living in the post-retirement phase. The appropriate target varies from member to member depending on their circumstances – the best a fund can do is target an ideal level appropriate to most members and a level of 75%² is widely propagated as an ideal target for many members to aim to achieve (individual funds may however have a different target depending on what can be afforded in terms of contributions as well as the allocation of contributions between retirement and risk benefits). This ratio broadly assumes that the member would have little or no debt at retirement and would not have to incur the same expenses as in the pre-retirement phase. Projections can be done to help funds ascertain if their members are achieving suitable replacement ratios taking into account their current contribution rates, inflation and term to retirement.

The NRR is influenced by several factors which include the following:

Together, these factors help determine the potential NRR that an individual will have at retirement. However, it is important to note that all these factors are interlinked and so what you would find is that even if one factor is considered ‘adequate’, it may not be enough for an individual to achieve a satisfactory NRR as the other factors would bring down the NRR if they are not also effectively managed.  Let’s briefly look at what these factors mean in the context of the NRR: Together, these factors help determine the potential NRR that an individual will have at retirement. However, it is important to note that all these factors are interlinked and so what you would find is that even if one factor is considered ‘adequate’, it may not be enough for an individual to achieve a satisfactory NRR as the other factors would bring down the NRR if they are not also effectively managed.  Let’s briefly look at what these factors mean in the context of the NRR:

Factors impacting NRRs

Contributions
As explained above, in a DC fund, contributions are typically paid on a monthly basis. These are subsequently invested in the market according to the investment strategy either chosen by the member³ or the Fund⁴.  The levels of contributions that are made are important to the NRR that is achieved at retirement. If contributions are set at an adequate level, contributions can grow (depending on the investment strategy) and benefit from the compounding effect thereby ultimately contributing to a higher NRR.

Contributions should be set at levels that allow members to save an adequate amount towards retirement.

Number of Contribution Years
The number of contribution years refers to the period for which an individual saves for retirement i.e. the accumulation phase. Typically, the longer the period, the better the chance that an individual has in order to achieve a reasonable NRR as he/she would have made a considerable amount of contributions to his/her fund.

Individuals need to be encouraged to save from as early on as possible in their working careers.

Costs – Risk Benefits & Expenses
In order to effectively run a fund, there are certain costs that need to be borne by the fund such as audit costs, administration costs, regulator levies and so forth. In addition to these, funds usually offer ancillary benefits such as death and permanent disability benefits – the risk premiums associated with these types of insurances are referred to as risk expenses. If costs and risk premiums are not managed appropriately, a situation could arise where an inappropriate amount of the total contribution is directed towards meeting the fund’s costs and risk expenses.

It is therefore important for Trustees to remain cognisant of the costs borne by the fund, weigh up the costs to the benefits provided by spending on those items, to ensure that the net contribution allocated to retirement savings is as high as possible.

Salary Progression
Salary increases (i.e. salary progression) also play a big role in determining the NRR that a member will have at retirement. Contributions to retirement funds are usually based on a percentage of salary which means that as a member’s salary increases, his/her retirement contributions also increase. Therefore, the higher the salary the larger the amount allocated towards retirement. However, it is important that we also consider investment returns when looking at salary progression. The reason for this is that the investment returns earned by the portfolios that contributions are invested in need to keep pace with a member’s salary growth to maintain his/her NRR.

In addition to this, it is important that members are educated about the gap that is created when retirement savings are based on pensionable salary and not their total income (or package). Individuals become accustomed to living their lives based on their total income. This difference results in many individuals not reaching their desired retirement savings amount. Contributing to this is the manner in which individuals are remunerated these days. Most companies have adopted the trend to variable remuneration meaning a salary plus incentives such as bonuses, 13^th cheques, share options etc. These forms of remuneration are not accounted for in an individual’s retirement savings plan and hence this also contributes to the shortfall in income at retirement and a gap in expectations. Employers should consider employee benefit arrangements that help their employees with holistic planning which takes into account the various forms of remuneration.

It is therefore important that members understand the difference between pensionable and gross salaries and that fund-related benefits are not based on their total income.  Employers and funds should ensure that appropriate mechanisms are in place to target a reasonable total replacement ratio based on total remuneration.

Investment Returns
Under a DC arrangement, the benefit that an individual receives upon retirement or withdrawal is calculated as the sum of accumulated contributions plus net investment returns. Investment return has a more significant immediate and direct impact to an individual under a DC arrangement than a DB arrangement as the employer does not guarantee the benefit. It is important for Trustees to have a good understanding of their membership demographic, which means understanding that risk appetites and needs vary across the membership. This will inform the Trustees’ decision on the types of investment portfolios to offer their members as well as whether to offer member investment choice (MIC) or not. We will go into further detail on how investment governance should be carried out, in Section 3 of this booklet. 

Another point worth considering is that even with the best investment strategy, if members continue to cash in their benefits on exit, the effect that good investment returns have on members’ NRRs is negated once the benefit is cashed in. Non-preservation is the next factor that we will discuss and it will become clear why it is an imperative that Trustees ensure that adequate interventions/mechanisms are put in place to educate members about the ramifications of non-preservation.   

Trustees need to ensure that the investment strategy is set taking into account the membership demographic as well as other key factors.

Losses due to non-preservation
Preservation in the context of retirement funds means that when a member leaves a fund prior to retirement, he/she does not elect cash. Instead, he/she opts to transfer the benefit due to him/her to either their new employer‘s fund, to an approved preservation fund or alternatively to an approved retirement annuity. Conversely, when a member elects to take his/her benefit in cash upon withdrawal, this is referred to as non-preservation.

What is the impact of non-preservation on NRR? Below, we have included a diagram⁵ that shows this impact.

Non-preservation is one of the main issues resulting in members not achieving the generally targeted NRR of 75%.  Increasing preservation should therefore be a key focus for Trustees and Manco’s in conjunction with discussions with the employer (insofar as creating mechanisms to encourage preservation).

It is important that members understand that the system of saving for retirement is long-term in nature and that non-preservation impedes their ability to achieve a reasonable NRR.

Annuity Factors at Retirement
At retirement, members need to decide on the type of annuity they need to purchase that will give them the income they require in order to sustain themselves in retirement.  There are various types of annuities i.e. living annuities, with-profit annuities, level annuities and inflation-linked annuities. However, in order to choose the correct annuity, there are various factors that need to be considered:

• Income needs (taking into account expenses)
• Dependents
• Spouse/s
• Health Status
• Amount of money at retirement that the member can annuitise

There are also a number of risks that need to be considered, which include amongst others, inflation risk and longevity risk. So for instance, a member can aim to save such that he/she will be able to buy an inflation-linked annuity at retirement. This type of annuity helps mitigate inflation and longevity risk.

It is important that members are educated at least 5 years prior to retirement about the above factors to ensure they are equipped to select the most appropriate annuity for their needs

Defined Benefit Funds

In a DB fund, a member who retires and qualifies for a pension will receive an income flow from the employer-sponsored pension fund from retirement until death. The benefit in this environment is therefore effectively ‘promised’ and the responsibility of funding this benefit ultimately rests with the employer (although one needs to be cognisant that individual members and pensioners are also exposed to risks here if the employer is unable to finance the pension promise – the extent of risk sharing also depends on things like the fund’s pension increase policy and affordability criteria).

The annual benefit is typically calculated based on a number of factors – the member’s final or average salary, the length of service within the company as well as age and mortality factors. From a funding perspective, the ‘promised’ benefit is dependent on a number of factors aside from those listed above; these include the mortality of the pensioners and the investment return earned by the fund. Therefore if investment markets experience a significant downturn for an extended period of time, the Fund runs the risk of being under-funded. In this situation, the employer is responsible for providing the financing needed to bring the Fund up to a position of financial solvency.

Factors impacting Financial Soundness & Ability to meet Benefit Promise

Employer Contribution (Balance of Costs)
Under a DB arrangement, the employer is required to contribute at such a rate so as to cover the costs of future service liabilities accruing, the costs of insuring risk benefits, and the cost of the Fund’s administration fees and incidental expenses.  The rate therefore varies according economic outlook and demographic profile or changes in benefit structure.

Investment Returns
Under DB arrangements, the Trustees need to ensure that investment returns earned through the investment strategy meet the liabilities (i.e. the promised benefits).

Actuarial risk is defined as the risk of being unable to meet liabilities as and when they fall due.  Any investment strategy adopted must seek to maximize investment return, subject to an acceptable degree of risk, with risk being defined as the actuarial risk.  Ensuring adequate matching between the Fund’s assets and the Fund’s liabilities (by both nature and term) will minimize this actuarial risk.

Non-preservation
The effects of non-preservation are as outlined under the DC scenario.

Longevity
As mentioned above, under DB arrangements pensioners are paid a pension from the Fund until they die. Therefore it is important for the Fund to account for the risk that longevity presents to the funding level of the Fund. What this means is that if pensioners live for a longer period than anticipated then the fund will have to pay their pensions despite having not accounted for the extra payments.

Benefit Structure
This refers to the manner in which benefits are structured in the Fund – some of the relevant questions that are appropriate here are:

• Do the benefits meet members’ needs?
• Does the pension increase policy take into account inflation and other relevant factors?

Whenever changes to the benefit structure are contemplated, it is important that the Trustees realise that this then affects the investment strategy of the Fund (insofar as - does the current strategy help the fund meet it revised liabilities, given the changes in benefits?).

Liability Structure
The benefit obligations (as defined in the rules of the fund) are the liabilities of the Fund and so when valuing the liabilities of the Fund, it is important to understand the age profile of the Fund as this determines the liabilities that the Fund is responsible for honouring.  

Hybrid Funds

These types of fund are a mixture of DC and DB elements and so the factors that we have just discussed in the previous pages are relevant to this scenario.

Using Governance in Achieving the Objective

So we have gone through the objective of a DC, DB and hybrid fund, we will now look at how governance becomes an enabling mechanism through which Trustees can achieve their objectives in running the business of the fund.

What is the virtue of having governance structures in place for a retirement fund?

The Role of the Board of Trustees

In the first question, we discussed the objective/purpose of a fund. By understanding the objective, we can now discuss the role of the Board of Trustees in helping the Fund achieve its objective i.e. reasonable NRR (DC) or meeting benefit obligation/ensuring financial soundness. A Board of Trustees is appointed to serve as the fiduciaries to a retirement fund. What does “fiduciary” mean in the context of a retirement fund? Put simply, it means that those individuals who are appointed as Trustees have a duty to ensure that the retirement fund is run in accordance with prevailing legislation, managed cost-efficiently and in the best interests of the beneficiaries. Broadly speaking, the role of the Trustees⁶ is as follows:-

• Set a clear mission for the Fund (this would be done in context of the objective of the Fund);
• To define a strategy for meeting the objective;
• To monitor the Fund’s success in achieving the objective.

In running the business of the fund, there are operational and strategic aspects, some of which include the following issues as outlined in the diagram below:

^{*This would involve liaising with the employer to ensure that any benefit changes contemplated are within the 'spend' allocated by the employer to its retirement fund in the context of the employer's Total Rewards System.
**Insofar as the kinds of decisions being made by members on withdrawal, retirement, investment portfolio switching.}

To drive the Operational and Strategic aspects, Trustees must ensure:

To meet the above requirements, some of the main issues Trustees should consider:

• Ensure adequate competency levels for all Trustees – this can be achieved through training courses, as well as keeping abreast of legislative and retirement fund industry developments;
• Ensuring adequate internal controls are implemented in the fund;
• Ensure quality of fund records;
• Remember that where Trustees have outsourced a function, they remain accountable for the services provided by external providers.

What is Pension Fund Governance?

“Sound pension fund governance is as essential to sound pension fund performance as sound corporate governance is to long-term corporate performance”⁷

In July 2002, the Organisation for Economic Co-operation and Development, representing its thirty member countries including the United States, adopted the OECD Guidelines for Pension Fund Governance.  These guidelines followed on the heels of the OECD’s Fifteen Principles for Pension Fund Governance adopted in November 2000. Insofar as the details of board management are concerned i.e. board competency, board composition, acquiring expertise from third parties and so forth - we have delved into this at previous Hot Topics sessions where we considered the impact of PF130 on pension funds⁸.  In this session, we will concentrate on how the principles contained in the documents outlined in PF130 can be practically applied.

An explanation provided by OECD succinctly puts across the concept of governance in the retirement fund environment:

“The governance of private pension plans and funds involve the managerial control of the organisations and how they are regulated, including the accountability of management and how they are supervised...”⁹

The Board of Trustees are ultimately responsible for the strategic decisions that are made in respect of the Fund. Governance enables Boards of Trustees to clearly define the role and responsibilities’ of the various parties that involved in the running of the Fund.

When the roles and responsibilities are not defined, Trustees tend to get involved in operational issues that should be left to internal management staff or external service providers¹⁰ and this leaves them with less time to deal with issues that affect the fund strategically. 

In South Africa, we have observed that Trustees tend to focus their efforts more on the operational aspects of the fund as opposed to focusing greater time on the strategic aspects. This could be a function of the legislative and compliance environment in which we operate in and the fact that in a DC environment the focus should be completely different from that of a DB arrangement (and that current legislation and approaches still tend to use the same approaches that were in place for DB funds – e.g. ensuring that assets equals liabilities in terms of the member balances and in the fund accounts but ignoring the issues impacting members’ long-term NRR’s).

The Governance Dilemma

Governance matters in pension funds because members entrust their savings into the hands of others i.e. their Board of Trustees. In South Africa, retirement funds were valued at approximately R1, 620 trillion in the FSB’s 2006 annual report¹¹. Coupled with this is the fact that the reach of retirement funds extends beyond the realm of the retirement fund itself. Trustees need to manage the interests of various stakeholders (see diagram below for the various parties who represent the stakeholders to the Fund).  Having to deal with the interests of these various parties introduces conflicts of interest that Trustees need to deal with.

Governance principles can assist Trustees in managing the various interests with the main purpose still being to make decisions in the best interests of members. So for instance, if a Fund adopts an investment policy that considers SRI¹² investments - local businesses, offshore businesses as well as charities are some of the parties who are likely to indirectly benefit from this investment by the Fund.

Another stakeholder not included in the above diagram is future generations. Given the nature of retirement, the outlook is primarily long-term. It is therefore important that Fund policies take cognisance of the impact they will have on future generations.  The actions taken now by Funds via investment strategies will influence the future environment and hence how it looks (and costs) for future generations.  This then links in with wanting to ensure that the Fund’s approach is sustainable because it influences what the future liabilities are.  Therefore, the way you invest today will be one of the factors that have an impact on your future liabilities.

Understanding the Member...

“A ‘universal’ solution may not provide much more than a basic or minimum benefit for those who might expect much more.”¹³

In the DC environment, there are a number of issues that Trustees need to take cognisance of – one of which is the general assumption that members operate on a rational basis and that the decisions they make are based on rationality. From our Member Watch series¹⁴, we have been able to observe that members do not always act on a rational basis. So, Trustees need to understand the profile of their membership – this means acknowledges that there are varying ages, levels of financial competence and commitment among members. This will inform their decisions around allowing autonomy and showing paternalism which then become relevant.

Applying Governance Principles

So we have gone through the role of Trustees in a Fund and contextualised why pension fund governance is important. So, the next question to then tackle is how the principles of good governance should be applied?

Remember that governance mechanisms at their basic level are designed to help Trustees evaluate their ability to put in place interventions, make decisions and run a Fund in a way that links to the objective of the Fund.

We consider this in detail in section 3 of this booklet. But before that, in the next question we look at the international arena and the trends that we are seeing in respect of pension fund governance.

What are some of the trends internationally in terms of governance?

The International Landscape
DC arrangements have continued to dominate the retirement fund landscape and so, much of the trends that we are seeing overseas are aimed at DC pension fund governance.

In the DC arrangements in the global space, members are often given autonomy in respect of the investment of their fund credits. However, the consequences of the financial crisis have prompted questions about the average member’s financial competence and investment decision-making ability.  A premium has been placed on good fund governance. 

Observations

• Many countries have sought to incorporate governance into their regulations – in the UK, see for example the Codes of Practice promulgated by the Pensions Regulator;
• Current models of DC governance commonly rely on single investment management firms or insurance companies selected by employers to provide management and over-sight functions associated with governing boards.  With these models, those then given the responsibility (the investment/insurance firms) do not have a stake in the welfare of the pension fund and its beneficiaries:

 “In the US, large investment firm often take responsibility of DC delivery; in the UK contract-based¹⁵ DC provision has similar issues; while in Australia it is arguable that there are moral hazard problems¹⁶ in both industry funds and master-trusts.”¹⁷

• In order to remedy the above problems, governance recommendations include:
  • Evaluation of the decisions taken by the governing entity in respect of the implications of these decisions for member’s wellbeing;
  • The governing entity, it members and employees are held accountable to the Fund’s beneficiaries.
• There is recognition that trust-based schemes offer solutions to the above problems, given that the role and responsibilities of board members. However, given that this is not the only model available and coupled with the increasing complexity and obligations in the DC space, employers have generally sought simpler solutions through individual saving contracts and so forth.
• There is definite focus on ensuring that communication to DC members is done regularly and in a manner that helps members make considered investment choices.  In the third section of this booklet, we look some of the strategies that can be employed to help members in this regard.

Taking a blow...

The global financial crisis delivered a notably blow to retirement funds. In the international space, many employers had to resort to closing their DB funds to new entrants¹⁸ and on the DC side, funds endured significant devaluation to their assets. Many DC retirees were faced with substantially lower retirement benefits than they had anticipated. 

The financial crisis had a lagged effect on sovereign funds and we are now witnessing a scaling back of social benefits and so the role of private-sector occupational funds has become even more pronounced. In the U.K, Pensions Minister Steve Webb announced that businesses would have to enrol employees automatically in a pension plan beginning in 2012 as part of the government's bid to close the gap in Britain's provision for old age.

Also in the UK, the Pensions Regulator recently published a report (4 November 2010) by the industry-led Investment Governance Group¹⁹ (IGG) which looked at the governance of DC pension funds. The report contains the IGG’s best practice guidance for defined contribution (DC) pension schemes, reflecting the growing importance of DC provision and that good governance is at the heart of a well-run pension scheme.  In addition to this, the Pension Regulator released a report of the National Audit Office on the investment governance in the UK Pension Protection Fund. The six principles released by the IGG cover the key areas of investment decision making and governance that are important to the health of a DC scheme.

The stages of investment governance can be categorised as follows:

Stage I: Governance structurePrinciple 1: Clear Roles and Responsibilities
Principle 2: Effective Decision Making

Stage II: Investment choices and monitoring
Principle 3: Appropriate Investment Options
Principle 4: Appropriate Default Strategy
Principle 5: Effective Performance Assessment

Stage III: Communications
Principle 6: Clear & Relevant Communications

We have included the principles as quoted from the Pension Regulator’s site, these are listed overleaf:

Principle 1: Clear roles and responsibilities

Principle rationale
This Principle aims to help decision makers lay firm foundations for the process of investment governance. It advocates that schemes have defined and documented roles and responsibilities for each element of the investment governance chain, ensuring each party, including members, are clear as to the role they are expected to play in the process.

DC Principle

Principle 1: Clear roles and responsibilities
Roles and responsibilities in relation to investment decision making and governance are clearly defined and communicated to interested parties

‘Best practice’ guidance for DC decision makers

• are those responsible for investment governance and they must decide which responsibilities are allocated to which roles within the operation of the pension plan. A decision maker can be an employer, trustee, provider, adviser or member representative
• should record the roles and responsibilities of each stakeholder, including delegations of responsibilities, in an investment governance plan or as part of the Statement of Investment Principles (where one exists)*
• should make all decision makers and scheme members aware of the allocation of responsibilities among the decision makers , particularly those responsibilities which members must take on in relation to their own pension planning
• should identify and document any conflicts of interest together with a plan to manage those conflicts where appropriate
• should agree a policy on responsible ownership, to the extent that it is practical in the context of the funds offered or under consideration, monitor its implementation and report on it to interested parties, including members and member representatives

Principle 2: Effective decision making

Principle rationale
This Principle builds on Principle 1. It aims to ensure the process is effective through sound decision making based on quality and timely information and reference to relevant regulatory requirements and guidance.

It also advocates decision makers adopt a proactive approach to their decision making, building in regular assessment and reviews of the people and processes within the decision making structure, and making improvements where appropriate.

DC Principle

Principle 2: Effective decision making
Decisions relating to investment governance are taken on a fully informed basis and the investment governance processes are sound.

‘Best practice’ guidance for DC

Decision makers should:

• have or acquire the relevant knowledge, understanding and skills to take decisions, which may be based on advice from those reasonably expected to have the necessary expertise
• make available sufficient time and resources for making investment governance decisions
• develop an investment strategy and options which are within their governance capabilities
• exercise sufficient control to allow them to adapt and develop their strategy as circumstances and market conditions require
• be sufficiently familiar with scheme documentation, regulatory requirements and supporting guidance to enable them to observe these principles and carry out their duties in accordance with the requirements set out in these documents
• regularly assess the effectiveness of the investment decision making and governance process with reference to investment performance including net of fees, make improvements to the process as appropriate and report to interested parties (including members)
• regularly review the management of any external investment advisers, their contracts and their remuneration
• produce guidelines for the selection and removal of investment managers and for any alteration to the range of investment options/funds and apply them consistently

Principle 3: Appropriate investment options

Principle rationale
This Principle requires decision makers to provide investment options that take account of a range of risk profiles and needs within the pension scheme membership. It also aims to ensure pension scheme members receive the appropriate level of fund choice to meet their needs, without being overwhelming or restrictive.

DC Principle

Principle 3: Appropriate investment options
The investment options provided take account of a range of member risk profiles and needs and are designed appropriately

‘Best practice’ guidance for DC

Decision makers should

• offer an appropriate default strategy (see Principle 4)
• consider the number of funds (as components of the investment options or as standalone entities) to be made available and how the number on offer might impact the ability of members to make effective investment decisions
• offer an adequate range of investment options given the expected risk tolerances and requirements of scheme members, including the likely format and structure of their retirement benefits, and consider how these options may change as they approach retirement
• consider:
  • the way investment options are classified and described with a view to making it easier for members to make appropriate choices (eg through the use of a core fund range or listing funds by risk rating of asset type)
  • the operational characteristics of funds including dealing frequency and liquidity
  • the costs, including management fees and other fund expenses
  • the security and stability of the firm(s) providing investment management services and products
• ensure that the investment options/funds offered have appropriate names, clear investment objectives and relevant benchmarks ensure that investment fees/costs are reasonable and competitive given the performance expectations of the fund

Principle 4: Appropriate default strategy

Principle rationale
This principle determines a sound investment strategy principally for those members who prefer not to take an active investment decision.

DC Principle

Principle 4. Appropriate default strategy
An appropriately designed investment strategy is offered for members who prefer not to make a choice

‘Best practice’ guidance for DC

Decision makers should

• ensure the default strategy meets the requirements described in Principle 3
• allow appropriate time for design, review and monitoring of the default strategy as compared with other investment options
• ensure there are clearly defined strategic objectives for the default strategy in terms of the levels of risk and returns inherent in achieving the desired outcomes for members
• ensure the membership data on which the default strategy is based is as robust and detailed as is practical
• ensure the design of an appropriate default strategy considers, as far as is possible, the needs of the broad membership, including:
  • risk and return (net of fees/costs)
  • its position in relation to all other investment options
  • members’ expected term to retirement
  • members’ attitude to risk
  • the expected format and structure of their retirement benefits
• ensure that investment fees/costs are reasonable and competitive given the performance expectations of the strategy

NB: The Department for Work and Pensions' guidance on 'Offering the Default Option for Defined Contribution Automatic Enrolment Pension Schemes' will be published in 2011. This will set out further detail for design and monitoring of default options in DC arrangements

Principle 5: Effective performance assessment

Principle rationale
The aim of this Principle is to ensure decision makers monitor the performance of investment options, including the default strategy, and take appropriate action where necessary

DC Principle

Principle 5: Effective performance assessment
The performance of investment options is monitored.

‘Best practice’ guidance for DC

Decision makers should

• regularly assess the default strategy against its strategic objectives
• regularly assess the performance of each investment option, and the constituent components of the default strategy, against its stated performance objectives
• consider removing any investment option which is not expected to perform well against its objectives
• spend an appropriate amount of time and resources reviewing and managing each investment option
• monitor the suitability of any investment wrapper and be prepared to swap to other arrangements when appropriate
• report performance including net of fees, risks and any alterations to members (expanded in Principles 1 and 6)

Principle 6: Clear and relevant communication

Principle rationale
The aim of this Principle is to provide pension scheme members with clear, relevant and timely information so they can:

• make an informed choice relevant to their circumstances about which fund(s) to invest in
• understand their personal responsibility for their pension plan, the choices they have available and how these affect the value of their fund and retirement income.

DC Principle

Principle 6: Clear and relevant communication to members
Clear information on the investment options and their characteristics that will allow members to make informed choices is provided

‘Best practice’ guidance for DC

Decision makers should ensure scheme members receive effective and relevant communications. Such communications should

• be tailored to the expertise of the members, using plain language and an appropriate format to engage their interest and further their understanding
• state the investment objectives, benchmarks and fees for all funds together with the risk/return characteristics of each fund in such a way as to enable members to make a meaningful choice between them (including explanation of the risks and implications of making these choices)
• provide or signpost tools, seminars and further information that can help members to understand the basic tenets of investment strategy including, most particularly, the interaction between risk and return
• provide or signpost tools to help members to appreciate that the contribution levels, term to retirement, net investment returns can all affect the size of the fund which will be available to them to provide a retirement income
• provide members with regular and consistent performance reporting, net of fees, on the investment options available to them
• provide members with timely investment information relevant to their term to retirement and the decisions they will need to make to secure an income
• set out clearly the options which will be available at retirement emphasising the importance of shopping around and how members can seek advice and guidance
• provide members with access to the scheme’s Governance Plan, or equivalent document

Innovation in the Face of Crisis...

The financial crisis has revealed innovative ways in which funds are now dealing with their challenges, these include:

• The adoption of rigorous Trustee selection procedures with market-based compensation.  This allows for the close scrutiny of Trustees’ performance and is aimed at enhancing professional competency of Trustee boards.  You will recall that we discussed Trustee remuneration at our last Hot Topics session²⁰; it is still a contentious topic in South Africa as well as the UK. However, recognising the constraints that many Trustees face in respect of time, expertise and collective commitment, it is thought that this process of Trustee selection enhances the governance budget.²¹
• “Funds have been introducing  decision protocols involving greater clarity of the fund’s mission and strategic goals; an appropriate resource budget for each element in the investment process; the application of a priori beliefs; the discipline of a risk budget; and a fit-for-purpose line-up of managers with ‘ buy and sell ’ thresholds for appointment and retention. By this assessment, UK best-practice funds have recognised the merits of matching their governance budgets with their risk budgets. This has been accomplished in a variety of ways, with rather different models of trustee responsibilities and the composition of boards. In a couple of cases, best practice has involved the use of a two-tier decision-making structure, with a highly competent investment function headed by a CIO tasked with clearly specified responsibilities and accountable to the investment committee.”²²
• In their study of the UK pension fund environment, Clark and Urwin (2010)²³ found that the following four responses by best-practice pension funds deserved recognition:
• • Intensification – increased board attention and the mobilisation of additional resources to deal with exceptional circumstances;
  • Priority setting – using ‘ dashboards ’ to signal (green, amber and red) the importance of issues and hence the time that should be devoted to those issues inside and outside of board meetings;
  • Risk management – quantitative discipline, qualitative overlay and greater independence of risk assessment from the investment management process;
  • Expansion of the belief structure of the board and its management team – where more complex market conditions can only be coped with more complex (deeper) beliefs.

Some of the other trends we found from the international research conducted will be set out in question 9, where these are applicable to SA and how they can be practically applied. Having now looked abroad at some of the trends/events taking place in respect of improving the governance of pension funds, let’s now turn our attention to our local environment.

References

1 Contributions can either be paid by the employer and employee or solely by either party.
2 Although a NRR of 75% is taken as the norm, it is important to note that NRR is dependent on an individual’s circumstances. Members should be encouraged to this into account in their savings regime.
3 Under a Member Investment Choice (MIC) arrangement, members can elect the investment strategy to be applied to the investment of contributions.
4 For some funds, there is a singular investment strategy that is applied to the investment of contributions.
5 This diagram was included in Issue 1 of the Member Watch series. If you require a copy of this issue, please contact your fund consultant.
6 Stewart, F. and J. Yermo (2008), "Pension Fund Governance: Challenges and Potential Solutions", OECD Working Papers on Insurance and Private Pensions, No. 18, OECD publishing, © OECD. doi: 10.1787/241402256531
7 John Par, President, Cortex Applied Research Inc, Canadian Trading Management Time, February 1995
8 The specificities of PF130 were covered at a previous Hot Topics session – “Good Governance & a Legal Update” (3^rd Quarter of 2007). Please request a copy of this booklet from your fund consultant should you require this information.
9 Stewart, F. and J. Yermo (2008), "Pension Fund Governance: Challenges and Potential Solutions", OECD Working Papers on Insurance and Private Pensions, No. 18, OECD publishing, © OECD. doi: 10.1787/241402256531
10 Stewart, F. and J. Yermo (2008), "Pension Fund Governance: Challenges and Potential Solutions", OECD Working Papers on Insurance and Private Pensions, No. 18, OECD publishing, © OECD. doi: 10.1787/241402256531
11 FSB Website: ftp://ftp.fsb.co.za/public/pension/Reports/PFAR2006.pdf
12 Socially Responsible Investing (SRI), also known as sustainable investing, socially-conscious or ethical investing, broadly describes an investment strategy which seeks to maximize both financial return and social good (which encompasses many aspects).
13 Professor GL Clark, “DC Pension Fund Governance”, University of Oxford, September 2010
14 If you wish to obtain copies of the various issues of the Member Watch Series, please request these from your fund consultant.
15 Contract-based funds consist of a segregated pool of assets without legal personality and capacity that is governed by a separate entity, typically a financial institution such a bank, insurance company or a pension fund management company. The governing body of a fund set up in the contractual form is usually the board of directors of the management entity. 
16 Moral hazard in the context of pension funds arises where those tasked with managing the fund in the best interests of its beneficiaries (i.e. fiduciaries) do not do so. So the fiduciaries do not take the necessary risk-mitigating actions when required and so forth. This is basically because they do not bear the costs of their actions and so they do not devote the attention needed to properly carry out their responsibilities.
17 GL Clark & R Urwin, DC Pension Fund Best-Practice Design and Governance, September 2010
18 Following the poor performance of the investment markets during the crisis, many DB fund went into deficit. Given that the employer is the guarantor under a DB arrangement, many employers took the decision to close their funds to new entrants.
19 The IGG was set up to encourage industry ownership and promotion of the Myners’ Principles and to take account of the characteristics of DC and the differences between trust-based and contract-based schemes.
20 Hot Topics session – “Taking Stock Post-World Cup: Trends, Governance & Communication” (3^rd Quarter of 2010). Please request a copy of this booklet from your fund consultant should you require this information.
21 “Governance is a finite and measurable resource, and the size of this resource – the governance budget – is associated with planned and expected performance” – GL Clark and R Urwin, Innovative Models of Pension Fund Governance in the Context of the Global Financial Crisis, 2010
22 GL Clark and R Urwin, Innovative Models of Pension Fund Governance in the Context of the Global Financial Crisis, 2010
23 GL Clark and R Urwin, Innovative Models of Pension Fund Governance in the Context of the Global Financial Crisis, 2010