Tuesday, 28 June 2011

A time for thick skins and challenging minds

When I started work in the 1960s, and throughout most of the rest of my Shell career, the basis of my remuneration was comparatively simple. I did a job. That job had a value to the organisation expressed as a "Grade" and that Grade had a salary range attached to it. I was paid within that salary range and then if I moved to a higher graded job I was paid more. Occasionally - very occasionally - I received a modest bonus perhaps roughly equivalent to one month's salary. In addition I benefited from being part of a Defined Benefit Pension scheme to which I contributed, as did my employer. The receipts from this scheme were of course deferred until I retired and started to draw my pension - essentially this retirement benefit was remuneration deferred from my employed days. This was the traditional model common across the world of work and reflective of the then tradition of most of us having only one employer over our lifetime - and of an assumption of a duty of care on the part of the employer not just during the working years but into retirement. In the last couple of decades this model has broken down and whilst it still exists the changes in social and business attitudes of modern times have profound implications for pension fund trustees.

As I have written here before the closure of DB schemes to new entrants is in part recognition that the modern "compensation" package with, for some, its much higher and non-pensionable bonus element does not need to value pension provision so highly as in the past. It must also be true that in a period of high unemployment young people, especially graduates, are grateful for having a job offer at all - the lack of the provision of a Final Salary pension in their package is unlikely to be an issue. And for today's employers the paying of remuneration now, and with a high performance related element, seems much preferable to the creation of the long-term financial burdens that the provision of pensions for employees involves. It is also the case that the norm now is for individuals to have more than one employer over their working life - many more in most cases. Surely the norm for the future will be fully transferable money purchase pensions schemes rather than the DB (or DC for that matter) scheme based on a "single lifetime employer" assumption. So what is the Trustee role when a company decides to close a scheme to new entrants i.e. to change the basis of its compensation offer? I would argue that it is minimal. Trustees should certainly question a sponsor as to whether such a decision is in any way a weakening of the sponsor covenant. But that it about it - the Trustees duty of care is to scheme members and by definition an employee outside the scheme is not a member.

But, of course, it is not just the closure of schemes to new entrants that is underway at the moment. Take, for example, Unilever's recent decision to close its final salary DB scheme to further accruals. Although pensioners and those close to retirement age will not be affected (or will only be slightly disadvantaged) for the employee in mid career the decision must have come as a bombshell - after all this is a company that made over £5billion profit last year. As the Pensioners' Alliance Chief Executive said "This is pretty bad news for someone at Unilever who is in their mid 40s and had expected a certain level of Pension". Indeed it is! As recently as October 2010 the Chair of Trustees of the Unilever Fund said to the fund's members, in good faith I'm sure, "… it is our ongoing belief that Unilever has a strong commitment and ability to support the [Pension] Fund into the future"!

It is in circumstances like those at Unilever that the role of the Trustee becomes crucial and the need for independence of thought and attitude becomes paramount. Similarly if a Private Sector scheme decides to follow its Public Sector cousins and opt for the use of CPI rather than RPI for annual increment increases for pensioners, as some quite large schemes have done recently, the Trustee must challenge the rationale for the change and ask for alternatives to be considered. Easier said than done if you have a powerful sponsor determined to make a change.

Arguably the role of the Pension Fund Trustee has never been more important than in these febrile times. Thick skins and challenging minds required!

A Trustee’s role in a Fund’s investment strategy

A not uncommon reaction from friends when it emerged that I was a candidate to be a Pension Fund trustee was “I didn’t know that you were interested in investment, Paddy?” The implication was that the big deal for a trustee was involvement in the management of the Fund’s Asset portfolio – that’s where the action was. A couple of slightly cynical acquaintances even said when I was elected “Well that should help you sort out your personal investment portfolio” and when I said that I didn’t have such a thing they looked at me with amazement – must be the friends I keep! That maintaining and increasing fund value is a key role of a trustee I happily accept but for me to immerse myself in the minutiae of investment tactics - I don’t think so.

So what is the role of a non-professional trustee on a DB scheme’s Board with regard to investment? I think that above all it is to look at the subject from a fairly high level strategic perspective. The liability side of a Fund’s standing at any one time changes fairly slowly and is very assumption based. For example longevity and discount rate assumptions are just that – assumptions. Because they deal with future events, and because by definition the future is uncertain, they cannot be seen as factual - but all too often they can become unrealistically regarded almost as hard data. So, for example, discount rates based on bond yields can steer pension fund asset allocations towards bonds in an attempt to reduce volatility and improve the future prospects of the funding level - however this can be at the cost at the cost of potentially producing much lower long-term asset returns. The risk is that assumptions, which are very soft data, can distort asset allocations which can even lead to a delusionary perspective of the health of a fund. We all operate in the present and for some Trustees there may be a bias towards caution. If a Fund’s valuation at any one time can be seen to be more predictive of a healthier future by increasing the proportion of the liability driven element in the asset side this can be attractive to a risk-averse Trustee.

So in looking at investment strategy the Trustee does need to understand liability assumptions and not be over-influenced by them. Clearly a vehicle which locks in returns with a high degree of certainty - for example by using bonds with their dependable cash flows - can be useful for part of the portfolio. If this part of the asset base is notionally allocated to the meeting of current and short and medium term pension payment obligations that can be enticing. The rest of the fund can be allocated to investments with a longer time horizon - principally Equities in most cases. It is at this level of abstraction that I think Trustees should be operating – the principles of portfolio structuring taking due regard of the actuary’s liability forecasts. But it is worth remembering that every pound that is locked up in a liability driven investment vehicle is a pound that is not available, except at a cost, for other asset classes. There is a trade-off between on the one hand locking in returns and on the other hand keeping all the investment options open. And as is always the case the Actuary should be challenged – not to disagree with his assumptions but to request him to disagree with himself by running sensitivity analyses!

The Trustee’s role then is to avoid the detail of investment decisions, to try not to second guess the investment managers and to review performance at a fairly high level of summation. This means, ironically, that although Pensions conferences can be valuable for Trustees (more should go to them) many of the exhibition displays at these conferences by the investment community are not really for them. Trustees should not really be engaging in conversation with the earnest investment managers in their smart suits and with an impressive City addresses on their business card! What is, however, in my view firmly in the domain of the Trustee is to reflect that he is not only concerned with the metrics of the Fund’s investment but also with its integrity. The difficulties that some big name DB schemes have got into in recent years has tended to disguise the fact that most DB schemes remain adequately funded with good sponsors and reasonable prospects of discharging their liabilities over time. These funds are very significant players indeed in the world of finance and investment and they can also be a force for good in it. So for funds to invest ethically and especially to make investments in the new “social investment” asset class is something that Trustees should in principle support.

The changing role of the Trustee as DB schemes mature

Twenty years ago the Pension Fund of which I am a Trustee had 44,315 members of which 34% were Actives, 51% Pensioners and 15% Deferred members. Today the Fund’s total membership is numerically almost identical – 44,482 - but this membership is split very differently. Only 14% are Actives, 66% are Pensioners and 20% are Deferreds. Every Pension Fund is different but the trend in mature funds away from Actives to Pensioner members, of both types, is clear. In Shell in the UK the factors included a changing business model which meant a significant reduction in labour intensive business sectors and an increasing tendency to contract out areas of the business to third parties for whom there was no Pensions liability. This trend will continue and the situation where Pensioners represent close on 90% of the total membership of the Fund is not many years away. If a Defined Benefit scheme is closed to new members or closed to future accruals for its Actives (neither is currently the case for Shell) then the significance of the Pensioner membership as a percentage of the total will increase further. What are the implications for Funds, from a Trustee perspective, of this radically changing membership composition?

Trustees of mature funds, in which the number of members receiving pensions far exceed those still working, must take account of these changes both in the “hard” aspects as well as the soft. By hard I mean issues to do principally with the sponsor’s covenant and with funding ratios. When Pensions Funds were first set up in most cases on day one of the fund’s existence 100% of the membership were Actives. Gradually, of course, this changed and at some point the fund’s annual contribution receipts (Employer and Employee contributions related to Actives) became overtaken by the outgoings – the benefits paid to Pensioners. From this point on the nature of the Fund began subtly to change. No longer was the Fund primarily a tool for attracting and retaining staff. Instead it became an increasing actual or potential burden on the sponsor – there is no need to recall here the dramatic effect this had on some famous sponsors with, in some cases, the Company’s Pension Fund turning into an albatross which imperilled the whole business! The scandal of these cases was that we are not talking about an overnight event which suddenly turned a well-funded Pensions scheme into one with a hugely negative funding ratio. What we are talking about is culpable neglect on the part of Trustees who did not see the signs of a deteriorating position, or of Sponsors who didn’t do anything about it. You can model fund membership composition changes and test this on the future financial health of the Fund in “what if” scenarios – there is no excuse for Trustees who do not insist that this happens.

The “Soft” issues to do with the change in the balance between Actives, Deferreds and Pensioners include Board composition, communications and the general perspective of the fund that Trustees should have. Pensioner members will want to be able to rely on Trustees to protect their interests – not that these are especially complicated. In essence Pensioners need reassurance that their fund is being properly managed so that the income stream on which their retirement is predicated is reliable. When changes occur – for example if schemes close their doors to new members or stop further accruals for Actives – this is a good time to reassure Pensioners that their own positions are unaltered. A practical way of showing that the Trustees understand the changing nature of the Fund would be to give Pensioners greater representation on Boards. And a mature DB scheme becomes much less an element in employee compensation, and as such a responsibility of the Sponsor’s Human Resources Department, and much more takes the character of a stand-alone investment business for ex staff providing benefits to which, of course, they are fully entitled! The relationship with the sponsor also changes in a subtle way. In the past the Pension Fund’s funding by the Sponsor was a pragmatic way of keeping employees happy. Now it is a duty and a legal obligation but without any concomitant benefits of employee loyalty or staff retention. Loyal and contended staff can add to the bottom line – loyal Pensioners make no such contribution!

Trustees have a duty of care to all of their Fund’s members and must not discriminate between the member classes. But this doesn’t mean that they should be unaware of the member composition changes that are underway – many of the priorities of a closed mature fund are likely to be very different from that of a Fund with a high proportion of Actives and which is still open to new members.