Russell Investments: Pensions Problem Lands on the CFO's Desk - Shamindra Perera
The economic downturn has highlighted the fact that defined benefit pension plans can be a millstone around the neck of many companies. Hence the rising popularity of fiduciary management which, as Shamindra Perera of Russell Investments explains to FDE, is more dynamic and responsive to changing market environments.
Most pension funds saw funding levels fall dramatically in 2008 and early this year. This has left trustees and companies alike asking questions such as: are pension funds carrying unrewarded and/or inappropriate risk in their portfolios? Are pension funds fully cognisant of the types and magnitudes of the risks in their portfolios at a holistic level? Are pension funds doing enough to monitor and manage the risks in their portfolio on an ongoing basis and are they doing enough to capture market opportunities on a proactive basis?
‘Fiduciary management addresses the current challenges faced by pension funds in a number of ways. In short, it entails the appointment of an expert to execute a pension fund’s investment strategy in the face of limited in-house resources and expertise. It enables trustees to focus on the first-order questions and issues by delegating the execution of the investment strategy to the fiduciary manager. By accessing the expertise of the fiduciary manager, it also allows pension funds to formulate and pursue a wider range of possible strategies, which in turn may make previously unattainable objectives more achievable,’ says Shamindra Perera, managing director of UK Institutional at Russell Investments.
Fiduciary management: passing fad or critical ‘end game’ strategy?
It is worth considering whether fiduciary management is a knee-jerk reaction to a crisis, in this instance to the recent decline in funding levels. The looming problem of liabilities from defined benefit (DB) pension funds long preceded the crisis in the financial markets. The events of the last two years have merely thrown the pensions issue into sharper relief.
‘The fundamental problem is that defined benefit plans are very expensive for companies to sponsor, especially relative to the perceived benefit among employees. You can compare it to a company making a product that costs more to produce than consumers are willing to pay. Pensions are in a similar position, which is not sustainable. The DB plan, once a part of a company’s toolkit for attracting and retaining employees, has become a financial burden, which can sometimes threaten the very existence of sponsors, hence the inevitable end game,’ says Perera.
‘A new stage of the game requires a new game plan,’ he adds. ‘Gone are the days when a pension fund faithfully stuck to a 60:40 equity bond allocation regardless of changes in markets, funding levels or affordability of sponsor contributions. When funds were smaller relative to sponsoring companies, their membership growing, liability profiles less mature and investment horizons very long, this was okay. But not now,’ he says.
‘Many companies recognise that their pension funds must be more responsive to changes in the financial markets and changes in their own circumstances and consequently more are considering fiduciary management,’ continues Perera.
Comparing pension fund management with business management
CFOs have not traditionally played a key role in deciding who manages pension funds or which strategy is used. These decisions are normally left to the fund’s trustees, but the tide is turning. Finance directors increasingly accept that the financial burden of the pension fund is very much their business.
‘CFOs face a problem with the unfunded liabilities of a pension fund, and as the pension fund grows relative to the size of the business they now see that problem as part of their responsibility. Regulations and accounting standards might be getting some blame for that problem, but they are really just exacerbating it, not creating it. The pension fund is more integral to the CFOs function now,’ he comments.
There are a number of telling differences between how corporations are run and how pension funds are run. For instance, companies don’t set a ten-year strategy and forget about it. Corporate strategy is dynamic and is revisited constantly in the face of changes in the market place, consumer preferences, competitors, suppliers, etc. Pension funds too need a dynamic investment strategy that responds to the fast changing marketplace and changing circumstances of the sponsoring company.
Outsourcing non-core but important business and production functions to experts that have both the scale and skill to perform those functions is not new in the corporate world and has a proven track record of enhancing profitability and shareholder value. Outsourcing can bring with it access to industry best practice across aspects of a company’s business that for most is difficult to replicate in-house. Moreover, it brings with it a level of accountability that can sometimes be lacking with in-house solutions. As such, the concept of outsourcing the function of executing an investment strategy of a pension fund to a fiduciary manager brings pension fund management into closer alignment with well-proven corporate practices.
‘The questions that get raised about the loss of control that accompanies outsourcing are not new either. Companies have dealt with this issue effectively,’ explains Perera. ‘Well-defined service level agreements and agreed upon metrics for performance measurement are tools that companies use to maintain control over outsourced processes.
Similarly, well-constructed investment guidelines and performance metrics allow trustees to retain control of their investment strategy, whilst outsourcing its execution to a fiduciary manager. Moreover, having a single entity that is accountable for the execution of the overall strategy can enhance rather than dilute the control trustees have. Releasing trustees’ time from the day-to-day decisions, which typically neither trustee bodies nor internal executives have the time and expertise for, will enhance their ability to monitor and control the big-picture fund-level risks.
‘Fiduciary management also provides a platform for bringing the trustees and company together,’ suggests Perera. ‘As the focus of the trustees shifts from appointing and monitoring investment managers (which the CFO is rightly not concerned with) to setting and monitoring strategy and understanding and monitoring risk at a holistic level, their agenda aligns more closely with that of the CFO and the company.’
Selecting a fiduciary management partner
Obviously, the success of fiduciary management depends on finding an appropriate partner with a proven track record.
‘Fiduciary management entails the marriage of two very different skill sets,’ says Perera. ‘On the one hand a fiduciary manager needs to be skilled in understanding a pension fund’s objectives, moreover the sometimes different objectives of the different stakeholders. It then involves the skill of guiding the different stakeholders through the tradeoffs implicit in different strategies they may adopt to pursue those objectives. This is the typical skill set of an investment consultant,’ he explains. ‘On the other hand a fiduciary manager needs to understand investment markets, not merely from a theoretical perspective but through the experience of making investment decisions and being accountable for those decisions. This is the typical skill set of an investment manager or investment bank,’ Perera adds.
For over 40 years Russell Investments has guided the investment of some of the largest pension funds in the world through its advisory services. For 30 years, Russell has also been managing multi-asset, multi-manager mandates for pension funds globally, being one of the largest multi-manager investment firms in the world with over £100 billion assets under management.
‘It is rare that a single firm can demonstrate best-in-class skills in both these areas. Moreover, the culture of an advisory firm is distinct from the culture of an investment firm,’ says Perera. ‘As such, the ideal fiduciary manager needs to not only demonstrate skills and experience in advice and implementation, but also the culture of consultative discussion, investment risk taking and accountability.
‘Subject to selecting a suitable partner, fiduciary management can alleviate internal limitations on expertise and resources and deliver an integrated asset and liability solution that ensures that the pension fund is managed effectively at the total fund level, while providing control where it matters, unambiguous accountability of investment decisions and efficient and dynamic implementation,’ concludes Perera.