Published: July 21, 2008
Multinational companies with employees worldwide are often faced with the predicament of having occupational pension schemes in different locations, resulting in disparate pools of assets and liabilities across the world. While few new schemes are defined benefit (DB) schemes and many older schemes are now closed to new members, DB schemes create ongoing challenges as the value of assets versus schemes’ liabilities fluctuates, creating new financial obligations for sponsor companies. There have been several high profile cases where controversy over a company’s occupational pension scheme has created significant problems during merger & acquisition negotiations and even caused these discussions to terminate. When the number of schemes which a company manages is multiplied, these issues become even more complex.
With most asset valuations relatively high compared with levels of liability, and therefore less external scrutiny by shareholders and other stakeholders in the business, now is the time to consider ways of enhancing ways in which the group’s schemes are managed to position the company for the future. In this series of articles, Northern Trust Global Investments (NTGI) considers ways of establishing a centralised approach to pension scheme management to improve governance, risk management and create tax efficient economies of scale.
As new and active DB schemes are gradually disappearing, it is perhaps tempting to consider these schemes as a ‘legacy’ issue, primarily a series of financial risks and obligations as opposed to a core element of a progressive employee benefits strategy. While the trustees of each individual scheme will generally make decisions over the investment strategy, risk management, governance and choice of investment managers, the sponsor company is responsible for financing the scheme and may in some cases manage a scheme’s assets. Furthermore, the sponsor company often brings substantial treasury expertise in managing financial assets and financial risk which can be very valuable to pension scheme trustees. Where there are multiple schemes, however, it can be difficult to share this experience across all the group schemes, so that the smaller schemes in particular are forced to seek these skills externally, at a cost to the scheme and therefore ultimately to scheme members.
These are among the reasons that multinational firms are increasingly recognising the potential benefits of a centralised approach to pension scheme management. In some cases, this can mean quite simple changes, such as implementing a single custodian to provide a global view over the assets held in each group scheme; in others, companies are seeking a more integrated approach across their pension schemes such as cross-border asset pooling. In the articles which follow, we outline NTGI’s Roadmap to Global Investment Management which provides a pathway through the stages of centralisation. We envisage that different companies will adopt various approaches so that while some firms would benefit from implementing Step One, others may progress through Steps Three or Four - and in the future, beyond. By adopting some of these strategies, sponsor companies have the opportunity to create not only a more efficient platform for managing DB schemes but also for developing more efficient defined contribution (DC) schemes. [[[PAGE]]]
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In the Introduction to this series, we identified some of the issues faced by companies with multiple occupational pension schemes in different parts of the world. In recent years, Northern Trust has been pioneering new approaches for companies with global pension schemes with considerable success working with some of the world’s most respected firms.
Each of the company’s pension schemes will have specific legal requirements according to its jurisdiction in terms of the role of the trustees versus the sponsor company, tax implications for the scheme and in some cases, accounting for scheme assets and liabilities. The disparate nature of companies’ schemes makes it difficult to gain an immediate view over the collective assets and how these are managed. But why do this? After all, pension scheme assets are not at the disposal of the sponsor company except under highly extraordinary circumstances, so why should Treasury seek to centralise its view, or even its management of assets?
Firstly, and perhaps most significantly, the sponsor company (usually within the remit of Treasury) is responsible for financing the company’s schemes, which can be a considerable issue for a scheme in deficit. DB pension scheme liabilities are amongst the biggest financial headaches for CFOs and treasurers; after all, what other financial obligation extends indefinitely, cannot be controlled by any particular action by the company and fluctuates continuously? (apart from one’s children, that is). If the assets are not being managed as efficiently and cost-effectively as possible, there is clearly a greater onus on the company to provide higher levels of funding, which is detrimental to other projects and may have an impact on shareholder confidence, debt requirements and the company’s credit rating. Consequently, Treasury needs to provide assurance to the CFO that pension scheme financing requirements are as predictable as possible, not only in the company’s major schemes but in all locations, and that the assets held in each scheme are being worked as hard as possible to fund future liabilities. [[[PAGE]]]
The discovery stage includes four key stages:
i) Understand the assets held by each scheme;
ii) Assess the detailed pension provisions of each scheme;
iii) Review the regulatory issues and market practice in each location in which the company has one or more schemes
iv) Benchmark the findings across schemes and potentially across companies.
While this would seem to be a detailed and initially labour-intensive exercise, it often leads to some surprises and opportunities for significant improvement which would not otherwise have come to light and forms a solid basis for enhancing schemes’ asset management.
i) Understanding the assets
The first stage in achieving visibility over the company’s schemes is to source common and up-to-date information on the assets held by each scheme and how these are managed. As Treasury has both asset management skills and the greatest interest in the financing needs of the pension schemes, it is generally the best positioned to undertake this process.
A logical starting point is gaining information on scheme assets from the custodian. Companies which have appointed a global custodian will be able to derive the information from the custodian bank; however, in many cases, each scheme will have appointed its own custodian, so asset information needs to be sourced individually from each scheme and collected through a ‘master record keeper’.
This process in itself will illustrate the value of a global custodian. For example, the overall cost will generally be significantly less than that of custodians appointed individually by each scheme and there is a consistent approach to reporting and information across group schemes can be sourced more readily. It can often be a sensitive issue to encourage scheme trustees to take on recommendations of their business partners made by the sponsor company; however, there are benefits for individual schemes, as a global custodian brings the advantage of lower costs. Furthermore, custody is generally a less sensitive area than decisions such as the choice of asset managers or asset allocation strategies.
Information which Treasury might consider collecting could include:
This information may not be easy to collate initially (in itself a reason to consider engaging with each scheme with a proposal to appoint a global custodian to act as ‘master record keeper’).
Having obtained this information, many companies have been surprised to see the differences which exist in the way in which each scheme is managing its assets. In the case of smaller schemes, for example, the investment management costs may be relatively high compared with larger schemes as they are not in a strong position to negotiate fees. Schemes may be holding the same or similar assets but as the holdings may be relatively small at an individual scheme level, transaction fees etc will be relatively high. [[[PAGE]]]
ii) Assess pension provisions
While schemes may have different asset allocation strategies, this will often be connected to the specific provisions of the scheme and the scheme’s projected liabilities. By understanding the relationship between the two (which potentially leads on to asset and liability modelling covered in the next section) Treasurers can understand better the rationale behind schemes’ asset allocation decisions.
iii) Review regulatory constraints and market practice
Another issue which will affect the asset allocation strategy is occupational pension legislation in the jurisdiction of each scheme. This, plus cultural issues and market conventions will impact on the way in which the scheme’s assets are managed. Furthermore, there may be pending or anticipated regulatory changes which could affect the scheme. Europe in particular is in the throes of regulatory transition which could have a significant impact on schemes.
iv) Benchmark schemes
Having collated all the necessary information, treasurers are then in a position to identify where potential inefficiencies, costs and inadequate asset performance exist. Furthermore, it is quite possible that this process will reveal discrepancies in benefit provisions which cannot necessarily be explained by different regulatory requirements and market practices. This is particularly the case when a company has inherited schemes through acquisition or schemes have been set up gradually over time as the firm has expanded its geographic footprint.
There are various likely conclusions to this process. In some cases (although in reality, a very limited number) the result will be that treasurers will gain an insight into the assets across all schemes and provide the necessary assurances to management concerning the way that they are managed. In others, there will be an increased awareness of the benefits of a global custodian to provide better visibility over the group schemes’ assets. However, in many cases, treasurers have discovered that through this initial process that there are significant efficiencies, cost savings and improvements in risk management which could be made, which when addressed, ultimately benefit trustees, scheme members and the sponsor company.
As we will see in the subsequent steps, companies have taken various approaches to this, from appointing a ‘golden circle of investment managers through to cross-border asset pooling. Furthermore, it should not be assumed that benchmarking the company’s schemes is a precursor to reducing pensions provisions - after all, for many companies, an attractive pension scheme can be an important differentiator in engaging and retaining valuable employees. However, this process can be significant not only in reviewing existing schemes but also in considering future pensions provisions, potentially even setting up a pan-European pension scheme, as described later.
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Having conducted a background study into the company’s pension schemes, treasurers and CFOs will wish to assess how appropriate each scheme’s allocation of assets is in relation to its liabilities. While some schemes will routinely conduct asset and liability modelling exercises, when looking across all group schemes, it is probable that these were undertaken at different times and using different assumptions. Consequently, some treasurers and CFOs will wish to conduct a comprehensive asset and liability study across all schemes based on a common set of assumptions and dates in order to permit a sensible comparison across schemes.
Asset allocation and manager performance
At the very least, this process is likely to result in the need to work with some schemes to improve their asset allocation and performance. One element of this is to consider whether individual schemes are making appropriate decisions about whether to adopt active or passive asset management strategies. Another is to look at fund managers’ performance and the fees which are being charged.
Although some treasuries will manage the assets on behalf of one or more of the company’s pension schemes, or work with the investment managers directly, this is certainly not the case for all companies. In many cases, the level of assets will not justify the cost of an internal asset management function but even for large schemes (or the composite of a company’s schemes) it is often difficult to insource a process such as asset management once it has been outsourced to external managers and in only a few cases is treasury likely to be able to take over asset management for all the company’s pension schemes. An example of a company which has made great strides in this is Nestlé, as featured in this edition of TMI, but few companies are in a position to establish their own asset management function.
Consequently, most companies’ schemes will have their assets externally managed, either partly or in most cases fully, on a single or multi-manager basis. A multi-manager strategy i.e. appointing different, specialist managers for each asset class or currency, potentially with an overlay manager if a liability driven investment (LDI) strategy is adopted, is often preferable as managers are appointed according to their speciality. Performance can also be benchmarked more readily for a single asset class. For treasurers and CFOs of the sponsor company, it is important to note inconsistencies in the benchmarking of fund managers’ performance and anomalies in the fee structure.
While the sponsor company cannot dictate which investment managers are appointed by the group’s schemes, there is valuable expertise, and potential economies of scale, at sponsor company level which can benefit schemes. Appointing fund managers and reviewing their performance is a time consuming process and many schemes do not have the time or expertise within the Board of Trustees to conduct this process with the required scrutiny or regularity to ensure that the scheme’s assets are managed in an optimum fashion, particularly amongst smaller schemes. This becomes even more apparent as schemes diversify their investments into non-traditional asset classes, such as property and other alternative asset classes, and then need to select suitable asset managers, but without the specific experience in the relevant asset class.
Treasurers can make trustees’ roles easier by identifying a preferred group of investment managers with which global pricing arrangements and a common approach to performance benchmarking have been negotiated, a so-called ‘golden circle’ of preferred partners. By working with this ‘golden circle’, schemes can accelerate the selection or review process for investment managers, take advantage of lower pricing than would otherwise would be available and receive assistance in benchmarking performance.
It is potentially beneficial to extend the concept of preferred suppliers to various different functions which support the company’s pension schemes, such as tax, legal and investment advice. The aim is not to compromise the integrity of the scheme or the arms-length way in which trustees need to act, but to assist trustees in their role by reducing the amount of time spent in selection processes, the overall costs to the scheme and an increased ability to benchmark performance and costs. [[[PAGE]]]
Risk management
While risk management is becoming increasingly important to pension schemes, particularly as they expand their asset allocation into areas such as currency management, interest rate products and even commodities, there may be better, and more comprehensive ways for schemes to identify, measure and manage their risk. Furthermore, as ultimately pension schemes’ risk is the risk of the sponsor company, it is important that the treasurer and CFO is confident that risk is being measured and managed in a consistent way across the group so that a global picture can be obtained. In many cases, the pensions industry has focused on tracking error as a measure of risk i.e. benchmarking against an index, measuring the standard deviation between the portfolio and index returns. Treasury professionals, who are accustomed to managing the company’s financial risk using a range of measures may wish to introduce methodologies such as sensitivity analysis and stress testing to establish the resilience of investment strategies and introduce absolute risk management measures such as Value at Risk (VaR) i.e. the market risk of the portfolio, calculated based on the maximum loss with a given probability, based on a confidence level of, say, 95% over a given period of time. Many schemes will themselves not have the tools to calculate or use this information effectively, but the sponsor company will frequently have risk management specialism together with the necessary technology to produce and explain these calculations for the benefit of the scheme.
It is often said that if you are running a risk, you should be paid for doing so, and pension schemes are no exception. Certain risks may not be hedged, but these should be rewarded or hedged if it can be done so cost-effectively, such as the currency exposure of assets and interest rate or inflation risk of liabilities. This is explained in detail by Bart Kuijpers and Sanjeev Kumar of The Royal Bank of Scotland in their article ‘A Framework for Pension Management’ in issue 143 (August 2005) of TMI which can be accessed at www.treasury-management.com.
Fiduciary management is a phenomenon which first began in the Netherlands, the result of more stringent regulations imposed in the aftermath of the bear market in equities from 2000-2003. These laws required pension schemes to adopt VaR-based risk management programs. As we discussed earlier, few schemes have the dedicated risk management specialism or technology to make these complex and iterative calculations. This has led to many schemes outsourcing the scheme management to third party, or fiduciary managers. Since then, the concept has extended into other countries as a potentially valuable way of outsourcing the financial management of the scheme.
Fiduciary management takes a variety of forms, from simply a multi-manager strategy (with which many schemes are already familiar) where the trustees interact directly with the fund managers, through to a complex solution where the fiduciary manager takes responsibility for interacting with fund managers, and puts in place reporting, risk management and performance monitoring procedures. Schemes will have different needs, so fiduciary management solutions are bespoke to every company. [[[PAGE]]]
Figure 2 illustrates an example of how a fiduciary management arrangement might work, but although there are differences, there are some common themes. Firstly, a multi-manager strategy is generally a common approach as it offers active management in an open environment without promoting the direct investment skills of the fiduciary manager. Another common element is the provision of services such a performance analysis, risk management and reporting.
The key advantage of this approach is that one expert provider takes responsibility for the entire management of the fund and can perform specialist functions which the scheme itself is unlikely to have the resources or technology to conduct. There is the potential for a conflict of interests if the fiduciary manager is also including their own investment product offerings as part of the solution; however, while a potential way of addressing this is to exclude these products, it may be undesirable to do so if they excel in a particular area.
The decision to outsource fiduciary management to a specialist manager can be made at individual scheme level or it may be appropriate to use this approach as a way of standardising the group’s schemes. Sponsor companies’ ability to convince trustees of the merits of this approach will vary, but there are universal benefits. Scheme trustees have the assurance that assets are being managed expertly with continuous performance measurement and with the right degree of control, reporting and the management of risk, without the need to make multiple appointments and manage these various relationships. The sponsor company can be confident that assets are being managed appropriately to the liabilities and that reporting is transparent and consistent, which ultimately helps the company as a whole to manage its risk.
A primary consideration when adopting a fiduciary management approach is the selection of the right partner to provide these services. This requires a detailed and rigorous process to establish potential providers’ expertise and the way that they recommend approaching fiduciary management of the scheme(s). The sponsor company can contribute significantly to the selection process by lending its skills in negotiation, solution structuring and project management to migrate to this model. [[[PAGE]]]
For many companies, not simply the largest firms, there is significant attraction in the prospect of centralising the pension scheme assets to improve governance, reduce overall risk and potentially make cost savings. Fiduciary management is potentially an attractive option for many schemes, in particular when the management of multiple schemes can be outsourced to the same fiduciary manager as part of a centralised arrangement. This can be taken one stage further, however, by commingling the assets from different pension schemes, from different locations, into a single offshore fund incorporating a diversity of asset classes in which each pension fund can invest. This is known as cross-border pooling.
This type of solution brings a range of advantages. Firstly, all the benefits of a fiduciary management arrangement exist, with the transparency of reporting, accountability and cost-effectiveness. Secondly, by commingling the assets, an economy of scale is created so the fund can implement a diversified investment strategy. These underlying funds will typically deploy a multi-manager approach, and with high values of assets frequently involved, there is the opportunity for preferential pricing and the ability to demand the best services.
The opportunity to set up commingled offshore funds is a relatively new one. Pension funds are generally tax advantageous and one of the issues in the past was that investing in this type of structure meant the tax treaties which applied between the country where the fund was domiciled and the investor countries often carried a ‘tax drag’ when compared to investments held directly by the pension fund. This was particularly the case when investing in equities where withholding tax is applied to dividend payments. However, detailed tax studies in recent years have revealed that the tax status of the underlying investor fund can be preserved by using certain vehicles and domiciles, opening up the opportunity to pool pension scheme assets in a tax- transparent way. For US schemes with schemes overseas, this position was ratified in a US Department of Labor advisory released in April 2008 which confirmed that U.S. ERISA DB retirement plan assets may now be commingled with those of non-US subsidiaries. In recent years, the Luxembourg fonds commun de placement (FCP), the common contractual fund (CCF) in Ireland and Dutch fonds voor gemenerkening (FGR) have all emerged as appropriate locations for cross-border pooled funds. [[[PAGE]]]
Inevitably, the first companies to take advantage of these opportunities have been the largest multinational corporations who had the scale and resources to devote to these projects. However, we are now seeing providers emerging who, in effect, provide an outsourced pooled solution. This makes it far easier for companies of all sizes with schemes in multiple locations to benefit from pooling irrespective of the value of the assets under management.
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Practical issues
In order to take advantage of cross-border pooling, a disciplined approach needs to be taken to its implementation. Engaging and seeking the support of all the relevant parties early on, including trustees of local schemes, senior management and the fiduciary manager are all vital. Going through the discovery phase in Step One above will provide crucial background and collateral and will smooth the implementation to a significant degree. Some of the major steps in the process of will include:
These steps can appear onerous and resource-intensive; however, providers of these services are starting to emerge who will provide fully outsourced implementation in addition to the ongoing management of a cross-border pooling vehicle.
The future
Looking ahead, we see greater deployment of both fiduciary management and cross-border pooling arrangements, and in many cases, fiduciary managers will be seeking to expand their services into pooling to offer more flexible and beneficial solutions to their clients.
Greater acceptance of cross-border pooling of pension scheme assets has also sparked more discussion about the opportunity not simply to pool assets across multiple schemes but to establish a single pan-European defined contribution pension plan (or indeed defined benefit plans, although it is now rare for new DB schemes to be set up). These were defined by the EU in the 2003 IORP directive. Such schemes would be domiciled in one EU country but employees across Europe, and potentially outside the EU, could participate and the plan would be underpinned with a single pool of assets. Bearing in mind the problems of fragmentation, replication of resources and inconsistencies when operating more than one scheme, the ability to establish a single scheme in Europe has significant attractions. As with all pensions-related strategies, the needs of members remain paramount and a pan-European scheme allows far greater flexibility for employees to work in different countries without affecting their pension provisions, which has been a growing issue for multinational firms.
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