OPDU Report 27 June 2010 - Annual Risk Conference Special Edition

DC Investment
Investment governance – enhancing the value chain
Paul Trickett, EMEA Head of Investment at Towers Watson

In recent years there has been growing awareness of the need for effective pension plan governance, not only in DB but also in DC pension arrangements. The term governance can mean different things to different people and in relation to different pension schemes. DC pension plans have been growing steadily in number, size, importance and sophistication over the last decade or so. As their size and importance has grown, so the level of governance and management oversight has been increasingly coming under scrutiny. The recent financial crisis further emphasised the governance challenge facing DC retirement savings plans.

In this article we explore the concept of governance in a DC context and the options available to fiduciaries in aligning their governance to investment strategy. We draw on some research¹ from the DB world and suggest how this may be adopted in a DC environment.

Defining governance

There are three main reasons for ensuring a DC pension plan has good governance:

• Risk management: making sure that the plan does not break the law or expose the sponsor, member or fiduciary to undue risk.
• Maximising the impact for the sponsor: ensuring that the plan sponsor gets a reasonable level of return on its pension spend. This will focus primarily on ensuring the employee or member gets a positive ‘experience’ of the plan.
• Maximising member outcome: ensuring the member gets the best possible outcome from the plan. Effective governance can significantly increase the level of a member’s retirement income.

It is worth noting, however, that these objectives are not without tensions. In many cases, DC plan fiduciaries may wish to assist members in terms of communication and financial education, for instance, but may be wary of the risk of being perceived to give advice to members.

The figure below outlines a basic framework by which we can define the potential governance of a DC plan.

The components of DC governance

We characterise two forms of governance:

Ensuring the plan ‘works’, for example:

Operational governance

Managing the basic day-to-day running of the plan and ensuring it meets with all relevant legislative and regulatory requirements. Activities covered under this would include the production of benefit statements and the payment of contributions.

 Value-adding governance

Ensuring the plan functions in the interest of its members and seeks to improve the member experience and retirement outcome. This may include helping members to make decisions, structuring a choice/default investment programme and managing the investment content.

The extent to which governance should include these value-adding aspects and what role fiduciaries believe they should take in governing a DC pension plan is a matter of considerable debate. There is probably no right or wrong answer to this question, but rather it depends on the fiduciary’s core beliefs, which are covered later in the article.

While the activities regarded as operational governance are critical to the smooth running of the plan, the allocation of governance resources to the value-adding aspects determines whether the investment solution creates or destroys value². As a result, we suggest that investment strategy should be tied closely to the value-adding governance capabilities of the plan. This implies that there is no single best practice model that is appropriate for all fiduciaries.

Governance is a combination of three factors – time, expertise and organisational effectiveness – and it is the available level of each and how they interrelate that defines the level of governance capability.

Within a DC pension plan, the individual member bears the investment risk and should therefore take responsibility for his own retirement savings. Most members are, however, unwilling or unable to make their own investment decisions and, even if they do, there is a practical limit to the governance that they can realistically apply to their own investment arrangements, particularly in terms of expertise. As a result, we believe there is a vital role in a successful DC plan for a plan fiduciary and that the fiduciary should seek to enhance the member’s governance capability to a more appropriate level.

Working the governance budget

Some fiduciaries will see merit in improving their governance arrangements by increasing the time they spend on investment issues, adding expertise and rethinking their organisational structures. This could include enhancing their engagement strategy to assist members in making the necessary decisions. However, it is unrealistic to suppose that all DC pension plans can, or indeed wish to, achieve the highest levels of governance needed to operate sophisticated investment solutions. The extent to which plans consider enhancing their governance arrangements to augment their members’ governance is dependent on the core beliefs of the fiduciary body, as shown above.

At one end of the spectrum of core DC beliefs, fiduciaries believe that their members are not willing or able to make the ideal choice and would benefit from being offered leadership and guidance in this process. This belief is likely to be reflected in a focused and structured range of investment options and a significant, proactive engagement programme.

At the other end of the spectrum of DC beliefs, fiduciaries subscribe to the concepts of choice and flexibility being available to their members. As such, the fiduciaries regard their role as one of facilitation. The investment range offered is likely to be wide in order to provide members with sufficient choice, while the engagement programme may be variable but more aligned to the provision of information.

Getting the right focus

If fiduciaries believe they have a role to play in augmenting the governance of the DC member, they should consider where best to apply this governance. We believe there are broadly three categories of members, based on their investment expertise and willingness to be engaged:

• The true-defaulters: members who do not have any financial expertise, have no interest in or engagement with their pension savings and are likely to remain entirely disengaged
• The guided-selectors: members who have the potential to be more engaged in their pension savings and have some financial knowledge to support limited decision making
• The self-selectors: members who are motivated and financially literate and are able and willing to take appropriate investment decisions.

By understanding the profile of their particular membership, fiduciaries are better able to focus their time appropriately. The true-defaulter group would benefit from a well-structured default investment strategy (and probably little overall investment complexity). The self-selector group would benefit from a high quality line-up of investment options, suggesting fiduciaries would need to focus on the design of the investment range and the selection and termination of the underlying managers. This group would also benefit from online tools to assist their planning and hence a comprehensive engagement programme would be desirable. Typically, fiduciaries have focused on these two parts of their membership. We suggest, however, that more time and expertise could usefully be focused on the guided-selectors, through enhanced engagement and ‘nudged’ investment options³. This does not necessarily mean adding investment complexity, but rather improving investment efficiencies that take account of particular member circumstances.

Building the investment solution

Given a plan’s governance capability, the question is then how that capability can best be spent and, in particular, how much of that capability can and should be spent on achieving investment efficiency.

If a default investment strategy exists, the likelihood is that the majority of the DC members and their assets will be invested in this strategy and, as such, this default should arguably be at the centre of the plan’s governance focus. Additional fund options for the relatively few self-selectors, whilst important, would typically be secondary in calling on governance time and resource. For both the true-defaulters and guided-selectors, a significant amount of value can be generated through effective asset allocation. This is generally not something that these members are able and willing to do themselves and hence fiduciaries can add value through the design and management of the lifecycle strategy. A DC plan should be conscious of the fees that its members have to bear. Fees detract from members’ retirement outcome and are also visible to members, who typically will have a low tolerance for what they might consider as excessively high fee levels. Given these considerations, should DC fiduciaries include active management within their investment solution?

Active or passive?

As mentioned above, we suggest that the plan fiduciary should be focusing much of its governance capability on the default strategy and, in that strategy, on seeking value from asset allocation. If there is any governance capability left over, the plan fiduciary can then consider whether it believes it can add value through the inclusion of active management. Furthermore, given the need for the effective change and/or blending of active managers over time, we suggest that plan fiduciaries only utilise active managers through a flexible structure, such as white-labelling. We suggest that most plans would benefit from significant use of passive strategies. These tend to be cost effective and less of a strain on governance budgets. We believe that it is important for fiduciaries to adopt an investment strategy that is consistent with their governance capability and does not overstretch the member’s investment expertise.

Investors should only take on investment risk if they feel there is a reasonable expectation of being rewarded for that risk, and investment governance is the mechanism by which investors make decisions to turn the risk into reward. Clearly, good decision making increases the chance of being rewarded (and vice versa) and, as mentioned above, many DC plan members are unable or unwilling to make these decisions. The plan fiduciary, therefore, needs to be clear on the extent to which they themselves are willing to influence investment decisions and in what areas (for example, asset allocation, degree of risk, manager selection, and so on).

As governance resources and core beliefs differ, we have identified three different investment models⁴ which correspond with DC plans’ different potential levels of governance. Each will have an ‘ideal’ investment solution, depending on the fiduciary’s core beliefs around their role and purpose.

• Cost minimiser: the objective is to manage all costs, with fiduciary time focusing on easily available investment returns. The plan’s relatively limited governance budget is directed instead to other areas such as member communication and/or administration. The investment solution is likely to be a small range of predominantly passive funds.
•  Diversity seeker: governance resources are sufficient to pursue some value creation opportunities. The focus would be mainly on improving beta diversity, with limited active management. The investment solution is likely to be mostly passive, but potentially with some active management. The core default strategy is likely to be a diversified blend of mostly passive, but some active, funds delivered through a white-labelled structure with a range of primarily passive funds available for self selectors.
• Diversity and skill exploiter: the third model has significant diversity and a high proportion of active risk. There is greater emphasis on identifying alpha opportunities and, as a result, the investment solution will be a combination of active and passive funds. The core default strategy may be a diversified blend of active and passive funds delivered through a white-labelled structure with an enhanced range of active and passive funds for self-selectors.

Given the accelerated growth of DC and the greater spotlight attention that it is receiving, we believe fiduciaries should be reappraising their DC investment strategies as current practice is often overly ambitious in terms of trying to identify successful active managers. Relatively few DC plans really have sufficient governance capability in place to exploit manager skill, both fully and effectively, across their investment solution.

Conclusion

With the continued rise in importance of DC pension provision, it is important that fiduciaries make effective use of their time and resource. In particular, they should be realistic about what they believe they can achieve in delivering their investment proposition to members. Many DC members would benefit from an enhanced level of engagement, supported by the fiduciaries. There should be a link between governance (member plus fiduciary) and the complexity of investment strategy undertaken in order to provide a value proposition.

Paul Trickett
EMEA Head of Investment
Towers Watson
0113 234 3222
paul.trickett@towerswatson.com 

www.towerswatson.com

White-labelling 

White-labelled funds are bespoke investment funds established and run solely for the use by a particular DC plan. For example, the fiduciary of the XYZ DC pension plan could set up a ‘Growth Fund’ or even a ‘XYZ Growth Fund’. Within this structure, the fund’s asset allocation or the underlying investment managers could be changed at any time by the fiduciary without an onerous communication and administrative exercise being required. White-labelled funds give the plan fiduciary greater control of investment strategy as well as additional flexibility in the management of its manager relationships. In a traditional DC approach, each member can select from a choice of managers. White-labelling allows the fiduciary to create funds that consist of a number of managers to provide members with efficient solutions.

We suggest that the full benefit to white-labelling is achieved when different managers, managing assets on a best-in-class basis, are brought together in either a single or multi-asset class structure. While this structure can be used with passive managers, it is particularly beneficial for active management or for combining active and passive strategies.