Pension Act puts pressure on trustees

Pre-Maxwell, the role of the pension fund trustee carried a number of more or less implicit burdens, but these burdens were not set out explicitly in law.

Now, thanks to the 1995 Pensions Act – which builds on and extends the 1986 Occupational Pension Schemes Regulations – trustees, including the good many FDs who act as such for their companies, are being forced to think through their role in fine detail.

The 1986 Act began the process of sharpening thinking on this subject by formalising the structure for trustees reporting back to the members of funds. It also decreed that audited financial statements had to be available within one year of the end of the company’s financial year.

The 1995 Act, however, goes much further. The reporting time frame is reduced to six months (starting from the company’s year end), but more importantly, trustees are required to formalise and document a statement of investment objectives together with an outline of how those objectives are to be achieved. The Act goes on to state that the trustees have an obligation to appoint advisors and to monitor their funds performance to ensure that performance is “satisfactory”.

Both these last points address the relationship between the trustees and the fund manager and create some potentially serious problems, as is often the case when government tries to legislate in complex areas.

First, take the seemingly innocuous word, “satisfactory”. What, exactly, does it mean to say a fund’s performance is “satisfactory”, and in relation to what? This is where the statement of objectives becomes critical. On the one hand “satisfactory” takes its meaning in an obvious sense by reference to the fund’s performance in relation to the market. On the other hand, it is a truism in the investment game that returns are seen as possessing an intimate relationship to risk: the higher the risk, the higher your expectations of a return. So “satisfactory” also means something like “satisfactory, taking into account the level of risk the trustees consider appropriate for the funds in question” – which brings us back full circle to the importance of the statement of investment objectives required of trustees.

The way things work in practice is that trustees meet with their fund managers and are generally given a presentation as to the current state of their funds. Most UK companies now have external fund managers. Since there is a good deal of competitive pressure in the market, one can assume the fund managers concerned will be pulling out the stops to make even a mediocre or poor performance look like the solid road to success.

To set against the inevitable razzle and bias of this pitch the trustees can and should call upon their own team of independent specialist advisors.

These, as Eamonn Rice, a partner in Price Waterhouse’s European financial services practice points out, will consist variously of the company’s consulting actuaries, auditors, financial advisors and solicitors – most or all of whom will be able to provide an independent view of the fund management team’s actual performance.

It is worth noting that despite the prevailing fashion for “leaving it to the experts”, a small minority of UK companies still run their own, in-house pension investment teams. And, according to John Williams of the WM Company, a leading independent measurer of pension fund performance, these in-house teams are doing rather well by comparison with the national average. These days however, in-house is not considered to be the way to go, so the more usual situation will be one where trustees find themselves dealing with external fund managers.

The reason for the present trend away from in-house teams, as William Mercer investment consultant Andrew Green explains, is that the costs associated with acquiring the knowledge base and the infrastructure to manage an international spread of investments has become prohibitive for all but the specialists. “Investment is now a global activity, which means there are very high start-up costs to putting an in-house team in place – so the message to large companies has to be: if you don’t already have your own in-house investment team, don’t start now!” he says.

Picking an external fund managing operation inevitably involves the usual “beauty parade”, where trustees scrutinise the various teams’ past track record and try to assess the “feel good” factor generated by the rival presentations – before going into a huddle with their professional advisors, who probably helped to construct the short list in the first place. However, trustees should also be formulating their “statement of investment objectives” prior to any external assessment. Logically, it is useful to decide on your objectives before you employ a group of outsiders and charge them with the task of achieving those objectives!

Here again, though, one runs into a dilemma. For a number of reasons trustees will generally feel a certain amount of reluctance in formulating the objectives for their funds in too specific a manner. Yet if the statement of investment principles is just a bland “nothing” utterance, such as “the trustees will seek to achieve the highest return possible within a level of risk appropriate to the security of the funds”, the statement will do nothing to shed much light on anything.

Clearly, the more detailed it is, the more helpful it will be. The downside of a detailed statement, however, as Neville McKay, a partner in Coopers & Lybrands’ actuarial and benefits consultancy, points out, is that if it is too ambitious it can set additional constraints on fund managers.

This means a detailed statement could also work against the trustees by serving as a tailor-made excuse for fund managers seeking to explain below par performances – as well as laying the trustees open to criticism at a later date.

Nevertheless, McKay argues that unless the trustees set meaningful objectives, it is virtually impossible for them to do their job within the spirit of the new legislation. Without meaningful objectives, it is difficult to know whether or not those objectives have been reached. Some examples of statements that would enable performance to be measured against target without unduly constraining managers, he suggests, would be for the trustees to stipulate that the fund should outperform the median by x% over a three or five-year time frame; or that the fund should be more than 120% funded by reference to the Minimum Funding Requirement (MFR) at all times.

McKay also urges trustees to think about risk in terms that are broader than simply the perceived speculative nature of certain categories of investment. Risk can have many meanings, he says. It can also refer, for example, to the need to manage the fund in such a way as to minimise the chances of the trustees having to ask the company board for a top-up contribution over a certain level.

Having decided upon the level of detail appropriate to their circumstances, and armed with their statement of principles, the trustees then have the ongoing task of monitoring “satisfactory” performance. For most trustees, in practice, this comes back once again to attending presentations by external fund managers at the end of which there will normally not be much reason for any overt action – since by definition, performance has to be considered over the medium to long term.

The Edinburgh-based Morrison Construction, for example, recently went through the process of appointing external fund managers. Keith Howell, the financial director, and company secretary John Morrison, both trustees of the fund, point out that when it comes to performance, they are prepared to take the “long view”. He and his fellow trustees expect their fund managers to perform in the upper quartile as far as comparative results are concerned and, so far, they have. Even if this fell off a bit, he notes, the trustees would still tend towards the idea that they are in it for the longer term and would be inclined to give the fund managers the benefit of the doubt – at least for a while. Precisely how long would depend upon circumstances and upon the advice of its actuaries and investment advisors, and this is the position one would expect most company trustees to adopt.

However, some investment specialists feel the Act’s emphasis on the trustees’ role as monitors of fund performance could, on occasion, provoke too much intervention, particularly since it calls for them to specify how those objectives are going to be met in terms of strategy. John Williams points out that success or failure for fund managers is measured in very fine terms.

“Over the last year, for example,” he says, “US equities showed a 35% return, while Japanese equities showed virtually zero. Funds that were 1% heavier in US equities and 1% lighter in Japan would have picked up almost a whole percentage point on their bottom line.”

William Mercier’s Andrew Green says trustees need to remember the only thing they can affect is future performance – the past performance of their fund managers is set in stone. Pointing at the cyclical nature of much of investment management, he says trustees should remember if they fire a manager for poor performance, they could find themselves having ridden the downside of his cycle and then missing out on the subsequent upward cycle, which someone else will benefit from instead!

Because of the difficulties facing trustees, Green expects to see them increasingly turning to external consultants – as opposed to looking for advice from their company’s established circle of financial advisors.

“I think you will see a kind of ‘manager of managers’ role becoming far more common, with external consultants acting as a bridge between the external fund management team and the trustees,” he says.

Eamonn Rice adds that, in today’s complex investment market, the success of the trustee’s role ultimately rests upon the professionalism of the trustees and the amount of training which their companies are prepared to give them, usually through the company’s consulting actuary. “Trustees have to be able to form a reasoned assessment of the risks and returns implicit in investment strategies and this requires some formal training,” he says. “Fund managers have access to more and more risky products. You can’t, as a trustee, just look at upper quartile performance and say, ‘Right – that’s where our money should be’.”

Usually, he points out, the company secretary will find him or herself drafted in as a trustee, but merely being the company secretary does not, of itself, necessarily qualify anyone to be taking these decisions. However, if they are aware of the need for training, then they are at least getting there. “Over the last two or three years it has become much clearer that the trustee role is not an invitation to a gin and tonic club meeting.

They have some very key decisions to make!”