The practical side to governance

How does a fund practically implement outcomes-based governance in a DC environment?

During this time, a large portion of time has been spent on compliance and operational governance.  In addition, substantial time is spent focusing on fund returns without any focus on other matters (such as good decisions by members on leaving the fund) that translate these returns into good outcomes for members.  It is our view that, in line with overseas trends and best practice, Funds in South Africa should also focus more on strategic governance that assists individual members to achieve a reasonable retirement income.  (Refer to question 2 for an explanation of the difference between operational governance and strategic governance.)

The Importance of Setting the Objective of the Fund

The first step is to ensure that the fund objective is clarified.

A member’s retirement benefit can be expressed as a percentage of his/her income prior to retirement, for example a pension equal to 75% of his/her income.  This measure, known as the net replacement ratio (“NRR”) is an indication of the continuation of the member’s standard of living at retirement.  Many funds therefore set their strategic objective as a target NRR at retirement after a full working lifetime of an individual (35 or 40 years).  In setting the objective, the Trustees must consider the profile of the membership and the issues that impact on the members’ needs.  The question to answer is therefore: What percentage NRR would be appropriate and achievable for the membership of the Fund?

Importantly, Trustees, Manco’s and employers should focus on the likely range of outcomes and not a single figure.  The ultimate aim should be to ensure that the range of outcomes is improved, that the likelihood of “bad” outcomes reduced.

So why the focus on an outcomes-based governance approach?

Governance facilitates decision-making and its success should be measured to the extent that it facilitates focusing on the key objective of a fund (i.e. the NRR and the key factors impacting on that – hence you need a strategy for each factor to assist in achieving the NRR objective and reducing the range of outcomes)

As with any good medical consultation, the starting point for creating an outcomes-based governance framework is not to prescribe new medicine (i.e. fire your existing manager and hire a new one) simply because you fear the old prescription hasn’t worked, but to understand the nature of the problem and why it exists.

Historically, conventional approaches to defined contribution funds have focused only on investment returns and tended to look like this:

1. Identify the funding needs of the majority of the funds’ members. (i.e. performance target or net replacement ratio).
2. Find the investment solution and structure that can best address these needs. (i.e. life staging structure, asset mix, benchmarks, and manager selection)
3. Monitor the outcome and if it fails to meet the benchmark requirements over some pre-determined time frame (1yr, 3yr, 5yr), change the solution.

What the above approach fails to address is that the reality of why members fail to meet their retirement objectives lies with how members behave (or don’t behave) in relation to their retirement planning rather than how the investment solution is performing.

Let’s use a concrete example of the kind of preliminary “diagnostic examination” Trustees could apply to their fund to see whether this is true. The graph below shows an analysis of individual members from a sample of our Member Watch database (this database includes around 700 000 members). The “green” shading shows the proportion of members who are expected to achieve a net replacement ratio of at least 75%, the “orange” shading showing the proportion of members with an expected net replacement ratio of between 60% and 75%.  The “red” shading next to each age shows the proportion of members whose net replacement ratio is expected to be less than 60% (we use 60% because research tends to show that this is the minimum of a reasonable range that should be targeted). The projections are based on a set of generally used assumptions. (We do not set these out in detail here since we are just illustrating the principle.)

Note that the majority of members below the age of 30 appear to be sitting in the green area – suggesting that if they stick with a reasonable portfolio (such as a lifestage solution that the Trustees selected as the “default” solution), they have a reasonable probability of meeting their targets at retirement. In effect – this part of the patient is healthy and doesn’t need changing.

But as we move along the graph to the right where members are now in their late 30’s and 40’s, significantly more members are now in the other zones, with an increasing “red” bar showing the proportion of members expected to achieve a net replacement ratio lower than 60%.  This suggests that these members are likely to fall short of their targets. What’s going wrong here?

To answer the question, we actually have to drill down to understand why each member in the above statistics falls short.  An analysis of this will reveal if any of the below factors have resulted in an expected outcome for each individual member that is not ideal:

• Failure to preserve retirement credits from previous job
• Contribution rate too low
• Significantly larger salary increases for the member than the modeling exercise accounted for (since the ratio of the final benefits to end salary reduces as that final salary becomes significantly higher than the end salary initially projected)
• Was the default portfolio actually chosen or could the member be in another portfolio that would not appropriately address the funding requirement needs?
• Were these members previously invested in a solution that failed to get them to an appropriate level of funding at this point in time?
• Poor performing investment portfolios?
• High costs relative to the value of the particular item on which money has been spent
• A big difference between deemed “pensionable” salary and actual income. (This means the member has been living off a far higher income than the fund will be trying to generate for retirement.)

We know that many of the above issues are relevant and affecting members’ outcomes as demonstrated by previous research we have conducted showing that:

1. Preservation rates in South Africa are generally low
2. Large portions are taken as lump sums at retirement
3. Drawdown rates of members taking living annuities are in many instances too high to sustain a pension for life
4. Insufficient allowance is made for inflation when purchasing an annuity at retirement

These are examples of significant issues that impact on members’ retirement outcomes. But employers, Trustees and Mancos can and should do something about ensuring that these kinds of problems don’t occur for future members.

What process can be followed to ensure outcomes-based governance is applied?

In a survey conducted by Ambachtsheer, Boice, Ezra, and McLaughlin called Excellence in Pension Fund Management: What Is It? , the following issues were issues identified most often that resulted in a there being a shortfall in the fund performance:

• poor decision-making processes
• inadequate resources
• lack of focus or clarity in mission

In order to ensure that these issues are addressed in South Africa, the below control cycle essentially shows the process that should be followed to ensure that the key issues impacting members’ retirement incomes are focused on: 

Control Cycle for Strategy Development

The bottom line is you can’t keep doing the same things and expect a different outcome!  Clearly, a lot more needs to be done in the South African retirement industry to improve the outcomes achieved by members.  This means a different approach, one focused on improving the outcomes for members instead of focusing purely on returns, operational and compliance matters.

The control cycle overleaf highlights that:

1. They key consideration is the focus on the needs of and the outcome for the individual member.
2. People look to their employers for assistance with regards to their retirement, health and other employee benefits.  The role of the employer is therefore critical within the whole framework.
3. Employee benefits require that the employer and Trustees work together to most appropriately address these needs and improve the outcomes.  There are benefits for the individual member, the employer and society in general of doing so.
4. Successful employee benefit programmes require a holistic approach to be taken to see how the various elements fit together.  In doing so, overlaps are avoided, shortfalls identified and addressed and efficiencies created.
5. Sufficient measurement tools are necessary to determine whether the individual members are on track, the factors impacting the achievement of the objectives and the success of any intervention strategies.
6. It is essential to have a “feedback loop” as part of outcomes-based governance – this means doing a check on whether the implemented policies are achieving what they were created for. So if you have implemented a strategy whereby the employer has agreed to have individuals educated properly about the dangers of non-preservation or the kinds of annuities at retirement – is this then translating into better preservation rates and better decisions at retirement...

All the decisions made should be done against the criteria of which choice is most likely to give the best range of income replacement outcomes (i.e. we do not know what the future will hold, however the decisions made should be done to increase the likelihood of achieving a good retirement income for each member). This means that employers, Trustees and Mancos of umbrella funds need to focus on the key issues impacting the retirement outcomes of their members and the factors that affect the achievement of those outcomes.  These are as discussed in question one:

• Contributions;
• The allocation to risk benefits and expenses;
• Salary progression;
• Investment returns;
• The portfolios in which the individual is invested;
• Preservation of retirement savings;
• Conversion of retirement capital into an income.

To achieve a good income replacement, a whole series of factors as set out above need to come together:

• You need to contribute enough and your non-retirement funding contributions should not eat into the retirement funding.
• Your portfolios need to perform well.
• Expenses should be appropriately managed and members should be getting value for money.
• You need to be invested in the right portfolios at the right time.
• You need to preserve your retirement savings throughout your working lifetime.
• You need to appropriately convert capital into an income.  This applies not only the day you retire but throughout your retirement years.

Therefore governance itself should be assessed by the extent to which it focuses on, and facilitates attainment of, the above key factors. The above factors are the key strategic factors, and the ones Trustees and employers most need to focus on.  In addition, Trustees and employers need to constantly re-evaluate the benefit design of their employee benefit arrangements and review:

• whether member needs are being met
• evaluate how any shortfalls can be addressed

Consider this:

• Changing a fund manager, and in many cases an investment approach, always incurs a cost to the fund. And there is no assurance that this cost will be made up by improved performance by the new strategy.
• Changing the behaviour of HR departments and members costs little and is something Trustees, Manco’s and employers can and should do something about.

Ensuring appropriate allocation of resources and the extent to which additional support is put in place for members

An important issue in retirement funds is the extent to which structures are put in place to support members to help them achieve a reasonable retirement outcome.

Employers, Trustees and Mancos have a very important role to play to ensure that members in South Africa (who are generally not financially literate or who generally fall prey to behaviour aspects) are provided with the right support. A framework is required such that those issues that have the greatest impact on member outcomes attract the greatest trustee attention and governance budget

 In doing so, one should ensure that trustee meetings and decision-making processes are designed to ensure that the time available can be used most productively

In a DC environment - members bear the investment risk – to a large degree, many funds opt for MIC arrangements which allow members to opportunity to make their own decisions in respect of the investment strategy  applied to their fund credits i.e. Autonomy. The move to DC largely represents a move away from Paternalism on the part of funds and the employer, but is this in the member’s best interests? Do members really want the autonomy?

The evidence suggest otherwise with members making decisions that are short-term focused as opposed to long-term. There is then a need for “structured choice” and where still applicable “open choice”.

From a practical governance perspective, there is then a need for judicial oversight

Source:  Prof. GL Clark, University of Oxford, Presentation in September 2010 – “DC Pension Fund Design and Governance”

A framework is required such that those issues that have the greatest impact on member outcomes attract the greatest trustee attention and governance budget. In doing so, one should ensure that trustee meetings and decision-making processes are designed to ensure that the time available can be used most productively.

In making this decision as well as the extent and nature of the support those employers, Trustees and Manco’s should provide their members, a decision needs to be taken about the individual members’ governance capabilities to ensure a good outcome.  The below diagram illustrates the spectrum of an individual’s governance abilities and the extent to which additional support should be given to the members in line with these abilities. 

At the far right, members have the ability to make appropriate decisions.   To the far left, the opposite is true.  As one goes from right to left, more support, leadership and guidance is provided to members who are not able to make ideal choices.   In these instances the role of the employer, Trustees and Mancos can be significant in assisting members make the right choices.

In South Africa, many of the processes put in place by funds leave members to their own devices.  This essentially assumes that individuals are financially literate and are able and willing to make the right choices.  Unfortunately this assumption is generally incorrect in the South African context with members generally being more financially illiterate and evidence showing that they are generally making inappropriate decisions (i.e. members in South Africa generally fall into the left side of the above spectrum).  This then implies that more should be done to support members to ensure a good outcome

In achieving the above, a fund, Manco or employer’s governance budget and the roles and responsibilities depends on their experience, expertise and time available.  The less expertise and time available the more issues should be outsourced to ensure appropriate management.  In these cases, Trustees should ensure there is then appropriate review of the outsourced functions and its performance.

Appropriate structuring of Trustee meetings by applying outcomes-based governance

It is important to ensure that trustee meetings are structured to ensure that sufficient focus is given to the key issues impacting the achievement of the objectives of the fund.

Some key items can assist in facilitating this:

• Having a 3 year plan.  Here, all the key strategic issues are focused on in addition to the ongoing operational matters.  Such a plan ensures that the fund plots out its goals and plans appropriately ahead to ensure a long-term focus on the right things
• Ensuring that the trustee meeting is structured to facilitate discussions on the key factors impacting members’ net replacement ratios.  This can be built into the 3 year strategic plan and every future trustee meeting can, for example, focus on one of the key issues impacting net replacement ratios as a theme (so for example, the November 2010 meeting can be dedicated to the non-preservation factor, the February 2011 meeting to the annuitisation factor etc).
• Ensuring that trustee meetings aren’t consumed unnecessarily by operational matters that could be dealt with in the ongoing operations of the fund.  Importantly, the role of the board of Trustees is on the strategic operation of the fund.  One should avoid a situation where the board micro-manages the operational issues to such an extent that it becomes the focus of a trustee meeting.  Instead, a separate operational subcommittee could be established to deal with these matters and report to the Trustees at the regular trustee meetings instead.
• Ensuring that appropriate and information is included in agendas focusing on the key strategic issues.  Here, the information should centre around the fund’s objectives, the key factors impacting those objectives and whether the fund is on track in terms of its goals set out in its long-term plan.

Ensuring that the roles and responsibilities are clarified for each of the issues impacting the net replacement ratios.  Ensure that the structure is relevant to the time and expertise of board, and get appropriate advice and outsource functions where appropriate.

The Role of the Employer should be elevated in Outcomes-based Governance

Internationally as DC becomes more prominent, there is a realisation that the move has resulted in less employer involvement.  There have been calls for more employer involvement and there may be regulatory changes to facilitate this. 

“While employers are moving from trust-based to contract-based schemes [this is where the relationship is a direct one between the provider and member] to reduce their responsibilities, there are some indications that the regulators may wish to see employers take more direct responsibility for the oversight of contract-based schemes.” – (The Reluctant Investor, Pensions Institute)

In South Africa, there is a key role for the employer to play to ensure that the key strategic issues impacting retirement outcomes are focused on and addressed (this includes a prominent role in the provision of defined contribution pensions).  These include:

• reviewing the contribution rates and benefits, their appropriateness and competitiveness
• Measuring the return on investment (since retirement funding plays a crucial part in the employee value proposition).  Here, measuring employee satisfaction can provide a suitable proxy  (this can, for example, assist in identifying where areas need to be addressed such as sections of employees wanting more flexibility for the benefits to remain competitive)
• Assisting with member communication and education.  This is an area where the employer can make a significant difference (for example, making it compulsory for employees to attend a retirement induction, fund update or education initiative)
• Ensuring appropriate and targeted communication when an employee joins or leaves the fund
• Ensuring appropriate communication and assistance provided to dependants on death of an employee (often, families look to employers for assistance)
• Editorials – in staff communications / magazines on awareness / education of “planning for life”
• Contracting with firms for the advice and mechanisms to review such contracts with a set of criteria

The employer has an important part to play and should ensure it has a governance process that facilitates this and ties in with the scheme’s governance to ensure better outcomes for employees. 

The Importance of Targeted Communication in Outcomes-based Governance

It is vital that the role of the employer be elevated and focused on more in South Africa.  We believe that employers should, as part of their governance processes, establishing a benefit strategy committee (or some other review mechanism) that ensures that the retirement arrangements meet their objectives and remain appropriate for employees in the context of the total package of benefits provided by the employer.  Such a review mechanism should also focus on the link between the employer and the retirement fund and ensure that relevant issues are addressed.  By doing so the complete governance process (which includes the decision making of members, Trustees and employers) is enhanced and completed in a cohesive manner.

There is an increasing realisation that communication needs to be more targeted to ensure that members take notice of them and take appropriate action where necessary.

Occupational schemes put effort into providing information, including targeted communications, to scheme members.

Source : Defined contribution pension schemes : risks and advantages for occupational retirement provision, EFAMA

Targeting is about giving people information that they are likely to pay attention to because it relates to a relevant point in their lives

Employers and Trustees can use targeted communications to try to influence the behaviour of members who appear to be making mistakes.

Source:  Dealing with the reluctant investor: The Pensions Institute, 2007

Examples of targeted communication include:

• Annual projection statements showing whether members are on track in terms of their net replacement ratios (and how much additional contributions need to be made or the extent to which the member will need to retire later)
• Annual death needs analysis showing the level of death benefits provided to the fund compared to a specified benchmark to provide a sufficient income for dependents
• Communication to members who are expected to have a net replacement ratio shortfall
• Communication to members who are expected to have a shortfall of death or disability benefits relative to a reasonable benchmark
• Communication on exit demonstrating the impact to the member of non-preservation based on the individual’s actual information
• Communication before retirement showing the expected pension based on actual quotations from the market (showing pensions under different options)
• Retirement seminars prior to retirement
• Communication to members who opted a particular investment option that may be inappropriate (e.g. young members who have opted for cash, members who appear to be engaged in market timing etc)

The importance of education in an outcomes-based governance approach

An important aspect in retirement funding given the shift from DB to DC, as well as the rate at which individuals switch jobs (and hence are increasingly faced with decisions related to their pensions on what to do before, at or during retirement), is member education.  It is well-known that financial literacy in South Africa is generally quite low.  An important contribution Trustees, employers and Manco’s can make in this regard is to provide appropriate education programmes for members focusing on the key issues impacting their financial security

Initiatives to enhance the general financial capability of individuals through educational programmes are also being implemented and have been shown to deliver some positive effects, if only in the longer term.

Source : Defined contribution pension schemes : risks and advantages for occupational retirement provision, EFAMA

This is a key ingredient of a good outcomes based governance approach since, if successful, it can improve the long-term retirement income outcomes of members. 

The importance of measuring net replacement ratio positions and the factors impacting them – staying the course in an outcomes-based governance approach

There is a clear trend internationally that employers and funds are taking member behaviour into account in their governance and decision-making processes.  This ensures that outcomes are measured, success of interventions tested and amended where necessary to improve their effectiveness. 

As individuals are given greater control and responsibility, their decision-making ability is likely to improve over time through learning and familiarity. In the meantime, addressing the concerns about individual choice in DC schemes is likely to remain a key policy objective. Examining how individuals make choices and what can be done to help them make better choices when it comes to their retirement provision is also likely to remain an important area of further research.

Source : Defined contribution pension schemes : risks and advantages for occupational retirement provision, EFAMA

The Importance of Member Advice under an Outcomes-based Governance Approach

It is becoming more and more clear that communication and education for members is not sufficient (at least in the short to medium term) to ensure that members make appropriate decisions.  This is evident by the fact that members’ net replacement ratios achieved over the last few years have been significantly impacted by their decisions, despite the increasing communication and education.   Therefore, the provision for financial advice has become a very important component of an effective outcomes-based governance approach.

If Trustees, employers and Manco’s want to create an effective, outcomes-based governance framework, this kind of diagnostic that focuses on the key objectives and the factors impacting the outcome needs to be regularly applied – e.g. once a year. Without it, any other “governance” exercise could be seriously misguided.

Financial advice and automated pension decision tools can further add to individuals’ ability to make the right decisions.

Source : Defined contribution pension schemes : risks and advantages for occupational retirement provision, EFAMA

For members, understanding basic investment fundamentals and the confidence to make decisions are quite separate characteristics. Even where a member has a reasonable understanding of investment issues, putting this into action is a separate task. It is important not to underestimate the member’s fear of making the wrong decision. This we contend is a major factor that explains the concentration of members in the default fund, which further implies that additional information and communications, although very important, will not by themselves convert the reluctant investor into an active one. Our research suggests that what most members want is not more information, but rather to have an expert make the investment decision for them.

Source:  Dealing with the reluctant investor : The Pensions Institute, 2007

The approach that Trustees, Manco’s and employers can take here would vary on their beliefs on the governance abilities of the members of their retirement arrangement as set out in an earlier section (i.e. to what extent do members need advice and to what extent should we be more active in sourcing such support for our members?).  Some variations range from:

• Encouraging members to obtain advice.  This is a passive approach that is more linked to education.  Unfortunately, in practice the reality is that this approach has limited success in improving outcomes
• Allowing financial advisors to consult members at the office premises prior to exiting the fund. 
• The fund or employer contracting with a financial planning institution to provide their members with advice.  This is a more pro-active approach where a financial planning institution is contracted on a group basis to provide advice to individuals.  A service level agreement is put in place and the service is monitored and the appointment reviewed from time to time in line with the regular governance processes applied by funds and employers.
• With this approach, a governance process should be in place to put in place the most appropriate advisory house together with a review mechanism.  Factors to include in this process include:
  • Experience of financial advisors, size and depth of team
  • Quality of advice, quality of advice framework and philosophy
  • Tools used by advisors in providing advice and education to the member
  • How well the advisors understand the fund, objectives and operations
  • Attention to ongoing advice, annual reviews and reporting offered to members
  • Cost of advice and how this will be borne
  • Access to advisors services in all major geographic areas
  • Scale of services – can they cope with the number of members requiring advice

Financial Planning Tools for Members under an Outcomes-based Governance Approach

It is important that DC scheme members understand that the outcome from their scheme is risky and that different courses of action, in terms of contributions and investment strategy, have different distributions of possible outcomes. Stochastic modelling is the appropriate tool for estimating what these different ranges of outcomes are. These models use simulation techniques to illustrate not just the most likely outcome from the member’s strategy, but also the possible range of outcomes. For example, the model might show that a strategy has a 50% chance of achieving a pension of at least £10,000, but a 1-in-20 chance that the outcome could be £6,000 or less.

Source:  Dealing with the reluctant investor: The Pensions Institute, 2007

It is increasingly being recognised that members should be provided with adequate tools to assist them in their decision-making.  This assists in improving the retirement outcomes.

An example of a full comparison for an individual member, showing the impact of various investment strategies on her probability of being SORRI™ is shown below

Here, we can see that Strategy 2 minimises both the likelihood of being short in retirement relative to the member’s income for comfort requirements and income for necessities requirements.  It therefore assists the members in understanding the risks associated with the various retirement strategies. Importantly, it illustrates the impact of selecting each strategy – in favourable and unfavourable future economic circumstances – so that individuals can get a sense of the extent of the risks with each strategy.

Some other tools that can assist members in their decision-making include:

• online projections
• retirement planning tools
• budgeting tools
• bond calculators
• accumulation calculators
• risk profiling tools
• financial needs analysis tools

How does a Fund measure the achievement of its Strategic Goals?

In a defined contribution fund, there are numerous factors impacting on members’ retirement benefits and the measurement of the success of the fund (relative to its strategic goals) involves an analysis of each of these factors.  A strategy can then be implemented to address problem areas identified.  Such a strategy will include:

• Review the fund’s benefits (retirement age, contribution rates).
• Communicate and education members on their retirement savings plan to discourage inappropriate behaviour and manage members’ expectations of their retirement benefits.

It is important that the analysis of the factors impacting on members’ NRR’s be repeated on a regular basis to assess the effectiveness of the implemented strategy and to make the necessary adjustments to the strategy.

The process of measuring the performance of a fund can therefore be illustrated as follows.

The factors impacting on members’ NRR’s can be illustrated as follows:

The separate and combined effects of the above factors then result in a member’s retirement benefit which we refer to as the “net replacement ratio”.  (Essentially, the “net replacement ratio” is the member’s pension at retirement expressed as a proportion of his final salary at retirement.) 

An analysis measuring the above factors and their impact on the fund’s objectives assists Trustees and the employer to address the above issues on an ongoing basis.  Such an analysis can be performed using the same principle adopted in the old defined benefit retirement funds to assist Trustees and employers to meet their fund objective of ensuring their members will reach retirement with adequate retirement benefits.

However, this “net replacement ratio” can be extended to all aspects of the employee benefits program, including death, disability and health benefits (each one essentially adding to the overall “net replacement ratio” of a member to improve their overall financial wellness).  Importantly, when performing such an analysis cognisance needs to be taken of an individual’s total package since deemed pensionable salary is usually a % of the individual’s total income.  The analysis should therefore be a “total cost to company” analysis to ensure it focuses on the full picture and impact on the individual.

Essentially such an analysis provides employers and Trustees a benchmark statistic for each of the above aspects, including how general member behaviour impacts the ultimate net replacement ratios members can expect from funds. 

This givs Trustees, Manco’s and employers a good idea of how their fund compares to industry averages and can assist in answering questions as:

1. Are members on track to achieve reasonable retirement income outcomes taking their total income into account?
2. Is the benefit design meeting members’ needs?  Are there shortfalls?
3. What are our fund’s withdrawal rates?  Are these above or below industry norms?  Are there specific categories of members where it is out of line?  Why?
4. How do our preservation rates compare to industry averages?  In which areas can these be improved?  What can be done to improve these in our case? 
5. What are our cost ratios?  How do they compare to industry statistics?  Are the costs and benefits in balance?

6. How do our contribution rates compare with other funds?  What can we do to maximize the utility of the amounts being spent on our benefit arrangements?

7. Are our members / employees adequately insured in the event of death and disability?  Are there areas where improvements can be made?
8. What net replacement ratios are being achieved by our members / employees and what net replacement ratios can be expected to be achieved by our members / employees in future?  What can be done to improve on this? Have the steps that were put in place to improve this worked? Should a different approach be taken?
9. What investment choices are being selected by members?  Are they reacting to short-term market movements?  Are there categories where the experience is out of line of industry norms?  Do members understand their choices?
10. What retirement options are being selected by our members?  Are they purchasing adequate inflation protection?  Are they purchasing adequate longevity insurance?

11. Are the pre-retirement portfolios appropriate in light of what options members are taking at retirement?  Are the portfolios optimally integrated?

The outcome of such a diagnostic tool also assists in identifying areas where members may need additional assistance, in the form of retirement or other solutions, financial advice or improved communication.

Such diagnostic tools form a key part in the strategic management of a successful retirement and employee benefits arrangement, much like the strategic tools used by businesses in ensuring they meet their objectives and constantly review these in ever-changing environments.

... [analysing individual member behaviour and positions]... is also used at the scheme level by Trustees and sponsors to form a ‘bottom up’ picture of how each of their individual DC members is performing, and to identify distinct segments of the membership where tailored communications or other specific actions may be required. This information is relevant in identifying and managing many of the risks cited in the recent consultation on DC by The Pensions Regulator. Peer group comparisons can be made across companies, e.g. within an industry, as well as within a single company. This can be particularly useful to Trustees and scheme managers who wish to understand how their scheme is performing relative to others...

Source:  Dealing with the reluctant investor: The Pensions Institute, 2007

An example of such a diagnostic tool is set out below (which is an extract of an example analysis that focuses on the key issues and included in a Trustee meeting agenda):

From the example overleaf we can see that between 2009 and 2010 the expected net replacement ratio outcomes has reduced by 1.5% because lower contributions are being allocated to retirement (in the above example fund members can choose their contribution levels), a further reduction of 0.1% since the amount preserved has reduced over time and another reduction of 0.3% because members at retirement are taking more lump sums (the example was for a provident fund where members can take 100% of the benefit as a lump sum). 

The above analysis assists in focusing on the key issues (in this case contributions, preservation and annuitisation) and put further steps in place to improve the outcome.

How can a fund incorporate these principles in its investment strategy?

In the preceding questions, we considered governance as a concept, how it relates to Trustees and Manco’s achieving the objective of their retirement fund and then at the practical ways in which it can be applied. In this question, we briefly consider how Trustees and Manco’s can align governance to their investment strategy. We have already discussed the fact that DC funds now generally dominate the retirement fund landscape. So much of our discussion will therefore look at DC investment governance.

You will recall that in question 2, we discussed the two types of governance that are used in managing funds i.e. operational and strategic governance. Investment governance falls under the strategic sphere and it is here that Trustees can add value to members by applying their minds to the investment strategy of the fund. That is a good word to associate with investments...value-adding. So let’s consider what the valuing-add ways in which Trustees can approach their fund investment strategy. There are three primary drivers¹ for ensuring proper governance in a DC fund

Let’s take a look at how these three drivers impact the way that Trustees should look at their investment strategies.

Setting the budget...

Trustees and Manco’s need to decide on the investment governance budget that will reflect the time, expertise and collective commitment of the decision-makers. Broadly-speaking, a governance budget reflects the capacity to create value from effective actions. A fund’s investment strategy and style should match its governance budget insofar as both aspects being sensitive to the resources available for effective management.

Furthermore, a fund’s governance budget should be interlinked with the fund’s risk management strategy. The ability of Trustees and Manco’s to manage the risks that a fund faces is closely linked to the performance that a fund is able to enjoy. Looking at the of a governance budget, let’s consider what they mean in the context of a fund’s investment strategy:

Constraints to the Budget...

In their observation of funds in the UK, Clark and Urwin (2010)² found the following in respect of the above components of a governance budget. Their observations resonate with ours in respect of the South African environment:

• Time – given the increasing time-sensitive nature of investments coupled with the time constraint that many Trustees face - many Boards find themselves not having the ability to act on investment decisions or devote the time needed to adequately deliberate issues.
• Expertise – The expertise of most Trustees does not extend to the level of investment knowledge that is often required to be able to evaluate investment opportunities extensively. PF130 requires Trustees to obtain advice from experts in those areas where they do not necessarily possess the ‘expertise’ themselves.
• Collective Commitment – Here the varying levels of investment knowledge amongst the Trustees themselves can hinder the ability to make effective decisions in respect of the fund’s investment strategy.

It is important for Trustees to cultivate these key components to the level required. The issue of adequate level of knowledge speaks to the need for Trustees and Manco’s to receive the necessary training and perhaps consider the appointment of an investment sub-committee where appropriate.

Sub-committees can be useful in respect of the time constraint that most boards of Trustees face. However, it should be noted that appointing a sub-committee does not absolve the Board of Trustees from the collective investment decisions made by them or the agreement with decisions put forth by the investment sub-committee.

Below – we have diagrammatically illustrated the options available to Trustees and Manco’s in setting their governance budget for a fund: 

For those funds who have a low governance budget, it becomes important for Trustees/Mancos to appoint advisers who are skilled in asset allocation, have extensive knowledge of the various asset classes and can help the Trustees/Mancos set an investment strategy based on the fund’s objective. Furthermore, when Boards of Trustees/Mancos do not have the governance budget to be able to assess managers against the criteria needed, it is has become common to appoint a multi-manager who then takes over the responsibility of assessing managers and monitoring their performance. However, it still remains the Trustees’/Mancos’ responsibility to ensure that the multi-manager portfolios that are chosen are in line with the fund’s objective and that an appropriate review mechanism is in place.

For funds with medium governance budget, it is important that a proper analysis of the time and expertise available in the Board of Trustees is done to ensure that where appropriate experts are called upon and sufficient time – this will avoid instances of ‘governance slippage’.

Sitting out the noise...

For those funds who have a high governance budget and as a result devote considerable time to the deliberation of investment issues, the extract overleaf from Clark and Urwin³ (2010) succinctly puts across the need for Trustees/Mancos to be wary of hasty decisions:

“...it is often difficult to distinguish between short-term and long-term volatility in financial markets; there may be significant but unexpected costs in an immediate response to the under-performance of an asset manager or service provider, including the risk of penalising a successful long-term investment strategy.

Because markets are prone to unanticipated shifts in underlying causal relationships, only time can resolve whether recent events are part of market volatility within expected parameters or whether recent events portend a shift in market parameters – often referred to as regime shifts. We view the short-term – long-term dichotomy as the most difficult of four such issues referred to in Clark and Urwin.

The other issues were: beneficiary versus sponsor interests; agent versus principal interests; signal versus noise and the risk components of performance. Given these points, we observe that pension fund decision-makers have an extremely difficult task in correctly identifying the meaning of signals from the data monitored. Here, of course, expert judgement is crucial as is the collective capacity to process market information conceptually and empirically.

Institutions facing such dilemmas have a variety of coping strategies, including ‘ sitting-out ’ events until market trends are resolved. There are clearly significant but often unknown costs in misjudging the significance of events, costs in acting too fast and costs in ‘ sitting-out ’ events until market volatility stabilises.”

It is therefore imperative that decisions made in respect of changing investment managers etc are not done in reaction to short-term market movements.

Member Outcome - Allowing Choice?

In a DC environment, we now know that members are the ones who bear the investment risk. With this responsibility comes autonomy (as discussed in question 9) which takes the form of a member investment choice environment. But, there is a significant amount of evidence that leads us to believe that when given choice; members more often than not end up making choices based on emotions. To complicate this problem even further is the fact that you get different tiers of members ranging from 

Therefore, Trustees need to decide on whether they wish to allow members a wide range of choice i.e. a wide range of portfolios to choose from. Another reality is member apathy, this is where members exhibit a low level of engagement in terms of the investment strategy for their fund credits, in this kind of environment, and the most common solution has been to provide a default portfolio.

Here, funds should consider where individual members lie in terms of their financial literacy and their ability to make appropriate decisions.  As set out in question 9, default investment straetgies and a limited and well-structured choice framework will be very important where individual members are less financially literate.  This default, in conjunction with education and advice are important components to help improve the outcome for members.

An assessment of the fund and where its members lie on the spectrum set out in question 9 is therefore very important and will then inform whether the investment strategy and support mechanisms is appropriately matched to the underlying abilities of the members. 

The Link...

At the foundation of any investment strategy is the need to link to the overall objective and in the case of DC funds, it is the NRR (“net replacement ratio”) objective, overleaf we have put together a simplistic diagram illustrating the role investment governance plays in helping link the fund’s investment strategy to the fund’s objective. In setting the investment strategy for the fund, a Board of Trustees and Manco’s must take cognisance of the fact that their membership is heterogeneous. This means that there will be varying asset mixes that would be applicable to each NRR objective of a specific category of membership i.e. young member, middle-aged members, older member, financially well-off members, average-income members etc.

The use of an asset liability modelling exercise on a regular basis will help inform the asset mixes that will help members achieve their various NRR objectives. Once asset mixes are chosen, the risk/return objectives which helps Trustees monitor the portfolios chosen BUT with recognition of the short-term volatility inherent in markets.  

An example of such a structure for ABC Retirement Fund is set out below:

In the above example, the net replacement ratio for defined contribution members being targeted is 75%.  Here an asset-liability modelling exercise was conducted to ensure this is a reasonable target and the variability was also taken into account and translated into the “risk budget”.  In order to achieve this objective a lifestage strategy was employed and each lifestage portfolio has a real return target (for example, the high growth portfolio has a target of 5.5% per annum real return over the long-term).  If this is achieved over the long-term (and here the term needs to be specified in the fund’s investment policy statement) then the fund’s NRR objective will be achieved and assist in improving the outcome for members. 

As a result, the above fund measures the performance of the lifestage portfolios in line with the above objectives as well as looking at the risk associated in the achievement of those returns.  This ensures a focused approach on the key issues impacting the achievement of the ultimate NRR objectives.

Concluding Remarks

Investment governance clearly has a role to play in helping Trustees ensure optimal performance of the fund’s investment strategy. This aim of this question has been to highlight those principles which are key to ensuring good investment governance in retirement funds.

References

1 Towers Watson, Investment Governance – Enhancing the Value Chain, 2010
2 GL Clark & R Urwin,  Innovative Models of Pension Fund Governance in the context of the Global Financial Crisis, 2010
3 GL Clark & R Urwin,  Innovative Models of Pension Fund Governance in the context of the Global Financial Crisis, 2010