In defined benefit pension plans, a causal link exists between the performance of the pension fund and the benefits received by its members. If you don’t believe this is true, a quick look at the actions of employers through recent market downturns (2000-2003 and 2008-current) should change your view. While benefits for individuals approaching retirement may remain unchanged, the level of prospective benefits is being cut for the current and future workforce, and there continues to be movement to shift risk to plan participants.

Against this background of poor market performance, many multinationals are currently concerned with cost and risk. However, fund performance, and specifically fund performance relative to liabilities, is arguably the most crucial component that needs to be addressed to deal with these concerns.

Fund performance, as it relates to liabilities, is affected by a number of factors, not least of which is the skill applied by the various players who have a hand in the overall management of the fund. These include the governing fiduciaries (the governing board or entity that sets strategy and makes key decisions), the managing fiduciaries (the individuals who implement policies and manage and monitor fund operations) and the operating fiduciaries (the internal and external delegates who manage the portfolio of assets, handle information and reporting, and undertake day-to-day operational functions).

At each of these layers in the fund’s organizational architecture, skillful management requires both timeliness and quality in the decisions made and actions taken. Without these two components, performance will suffer. Decisions made without the appropriate due diligence can be defective. Similarly, where decisions are of high quality but take too long to reach or to execute, the fund frequently suffers because an opportunity has been missed or only partially captured. Nowhere is this more apparent than in the realm of investment decision making, where the number and complexity of available investment options and strategies has increased, regulatory expectations have become more onerous, and dynamic approaches to asset allocation are required for effective asset-liability risk management. Investment governance processes that may have been “fit for purpose” in the past are struggling to cope with current demands. This challenge is common to sponsors across all business sectors and geographies, and it was therefore not a surprise that enhancing fund performance was identified as a strategic option by the World Economic Forum. A key factor in enhancing fund performance, as indicated, is the decision-making framework.

Acting in time

Following the previous market declines in 2000-2003, with the introduction of mark-to- market accounting and funding standards, and faced with increasingly mature plans, many governing fiduciaries have been considering risk-reduction and efficiency strategies, and are serious about pursuing these objectives. However, the opportunity to move to lower risk at an acceptable “lock in” funding level has passed, as funding levels tumbled in the third quarter of 2008.

Exhibit 1

Source:Mercer's How does your retirement program stack up? - 2009

For example, the average funding level of around a third of US plans was over 100 percent at the end of 2007 (and probably 50 percent made it to this level during the previous 12 months). The window, however, was not open for long.

So what is an organization to do to ensure that its investment decision-making structure is appropriate given the changing landscape?

Partnering with advisors

Strategic investment options are increasingly complex, intensifying the knowledge and skill requirements for governing fiduciaries. Equally, advisors are challenged to communicate with their clients about highly complex instruments in a way that is understandable but not excessively simplified. Jargon that aids precision of communication among specialists can form an initial barrier to effective communication with governing fiduciaries. Dialogue between the governing fiduciary and its advisor to agree on information and communication format and style can help. There also needs to be clear trust between a fiduciary and a specialist that overall objectives are understood and that the information and advice delivered are relevant and appropriate given those objectives.

Getting the right focus

A typical approach to investing several years ago was to spend time choosing a general active investment manager who would outperform the market relative to a chosen mixed-strategy benchmark. However, research shows that 90 percent (or more) of the fund’s performance comes from the strategy decision (the balance between liability-hedging assets and return-seeking assets). These strategic decisions can be complex, and are often undervalued by governing fiduciaries when compared with the time investment in manager selection and monitoring. As a consequence, opportunities to generate value (or manage risk) can also be missed when governing fiduciaries don’t have the time or expertise to assess complex options. 

Articulating fundng, risk and performance targets

Governing fiduciaries need to measure fund performance relative to plan liabilities – not doing so will result in incomplete or inappropriate decisions.

Additionally, when making strategic decisions, many governing fiduciaries conduct the analysis based on accounting or local funding measures. Even though these measures are more mark-to-market than has previously been the case, some smoothing remains. These smoothing mechanisms can cause a disconnect between pension plan accounting, pension plan funding and what is really happening to the pension plan. Governing fiduciaries should focus on the underlying economics of the pension plan. In particular, an underfunded pension plan will need additional funding from future cash flows of the business, leaving less available for capital investment and dividend payments to shareholders. Additionally, for plans where assets are held predominantly in equities, resulting in an asset-liability mismatch, the pension plan risks are greater, which should result in a higher cost of capital. These are all factors that governing fiduciaries, working with the plan sponsor, need to factor into liability-based performance targets and asset allocation decisions.

Be clear about roles and responsibilities

Once the strategic decisions have been made defining appropriate funding, risk tolerance and performance target, detailed investment decisions should then be delegated to groups or individuals with the specialist skills or expertise to make those decisions. An investment committee might therefore be responsible for selecting investment managers, setting benchmarks, negotiating fees and refreshing investment allocations in line with the agreed-upon dynamic strategy. This role reflects the need for detailed investment knowledge and timely execution.

Clearly identify authorities for decision making

Frequently, knowing who has authority for decision making is unclear or misunderstood.  This in itself can lead to delays and negatively affect results, either because time is spent clarifying decision rights or because decisions are made improperly and must then be revisited. Terms of reference for boards and committees and role descriptions for individuals can help clarify decision rights and avoid delays.

Where an investment committee is in place, ensure that its authority for decision making has been formalized and clearly communicated. It will then be able to fulfill its role, executing strategy by taking advantage of opportunities with short windows of time without the need for referral to the full governing board.

If resources are scarce, consider outsourcing

Where resources (people, time or necessary skills) are not available or are stretched, governing fiduciaries should consider delegation to suitably qualified professionals. Any cost associated with this outsourcing is likely to be more than recovered by better capturing market, manager or strategic opportunities. Such an approach can simply mean that returns are maximized, but may also mean that the fund avoids taking unnecessary risks.

A particular example of the potential value available from outsourcing at least some of the fiduciary role are newly available derisking solutions, which tend to lock in gains to protect against downside market risks on a plan-specific basis. Such dynamic derisking solutions involve plan-specific funding level triggers coupled with pre-agreed decision mechanisms. In the absence of continuous financial disaster, these will allow a plan automatically to move toward a pre-agreed derisking target over a prescribed time scale. This more complete delegation releases the real decision makers to monitor effectiveness against the real-world objectives they are concerned about: security, sponsor and member outcomes, and benefits delivery. Most governing fiduciaries will not have the resources to monitor and execute all the components described above.

Conclusion

In conclusion, back in 1976, Peter Drucker noted that “pension funds themselves need knowledgeable, assertive governance mechanisms” in order to improve their standing and effectiveness. Times are moving on and governance is improving, with many employers more selective about improving governance where it will be most effective in meeting pre-agreed objectives.