The Pensions Regulator has published guidance on investment for trustees of defined benefit pension schemes. The guidance is divided into six sections, covering:
- Governance
- Investing to fund defined benefits
- Matching assets
- Growth assets
- Implementation and
- Monitoring.
Investment Governance
This section reminds trustees that they should ensure that they are familiar with the basic legal principles of pension scheme investment, as well as the investment provisions of their scheme’s governing documents. The trustees’ role is to decide investment strategy, though they should take professional advice in doing so.
Trustees are required to consult with the employer when preparing or revising their Statement of Investment Principles (SIP). This involves exchanging views and giving proper consideration to the employer’s perspective. However, trustees are not required to reach agreement with the employer, as they remain responsible for the investment strategy. However, TPR suggests that better outcomes are likely if trustees and employers work together collaboratively to develop an understanding of the investment and risk issues.
TPR provides a list of decisions to be considered, in descending order of likely impact on future outcomes, and recommends that these be included in the SIP. This consideration should enable trustees to decide which decisions they wish to make themselves and which they would prefer to delegate. In general it will be the lower-order decisions that get delegated. Governance arrangements should allow decisions to be taken in a timely manner by the appropriate people.
Some schemes use “fiduciary management” (also known as delegated consulting). This is a governance model which involves significant delegation of investment powers to the fiduciary manager. Trustees remain responsible for the stewardship of the scheme, including setting the overall investment strategy. TPR reminds trustees that they should carry out sufficient due diligence to ensure that their fiduciary manager has the appropriate skills and experience.
Trustees should consider the potential for conflicts of interest both within the trustee board and with investment advisers and managers. Conflicts of interest may arise also with fiduciary managers, where they manage the funds as well as advising on them.
Investing to fund DB
TPR encourages trustees to record their investment beliefs and then to reflect these in their investment strategy. Investment beliefs relate to how investment markets function and which factors lead to good investment outcomes and TPR provides a list of examples, such as:
- risk is necessary to achieve return but not all risks are rewarded;
- markets are not always efficient and there are opportunities for good active managers to add value;
- climate change could be a long-term risk for the scheme and has the potential to impact the scheme’s investment strategy.
Where trustees consider such factors to be financially material, they are required by law to take account of them in their investment decision-making.
Scheme investment strategy should take account of:
- the trustees’ investment objectives,
- the scheme’s risk capacity and their risk appetite,
- their funding strategy and the employer covenant (integrated risk management),
- how the level of risk in the scheme can be supported by the employer, both initially and in the future,
- the nature and expected timing of the scheme’s liabilities,
- cashflow requirements (to pay benefits).
Trustees should consider also how their target asset allocation and risk mitigation are expected to develop over time. This may involve setting triggers for future actions such as an increase in interest rate hedging or divesting from growth assets.
Asset allocation decisions tend to be made in the light of information provided by models used by the trustees or their advisers. TPR expects such models to be proportionate to the complexity of the risks concerned. However, as a minimum, TPR expects some scenario (“what if”) or sensitivity analysis.
Matching assets
Many schemes hold “matching assets” for the purpose of managing investment risk relative to their liabilities. These may include assets designed to:
- reduce the volatility of the scheme’s funding level,
- match a scheme’s short-term cashflow requirements,
- match an intended transaction, such as a buy-in, or
- match all of a scheme’s expected long-term cashflows.
TPR notes that many schemes now use liability-driven investment (LDI), typically including derivatives, to increase the level of matching achieved. However, matching assets may still involve some risks, such as credit risk and counterparty risk.
Growth assets
Investment in growth assets involves taking risks to target investment return. Trustees should understand how their growth assets are expected to generate return and the principal risks involved. TPR recommends that trustees consider each of the potential drivers of return and reconcile those with their investment beliefs.
Diversification is a key issue, first because it is a legislative requirement that investments be properly diversified but also because diversification can provide a given level of return with lower volatility and risk. Schemes’ investments should be diversified not only across the portfolio but also relative to the employer covenant.
The guidance includes a list of issues to consider when selecting a multi-asset fund.
Implementing investment strategy
The implementation of a strategy needs to be planned carefully, to minimise out-of-market risk and transaction costs. Trustees should consider also how their intended fund managers address operational risk, to ensure that this is satisfactory. These risks are relevant especially to alternative asset classes such as hedge funds and private equity.
Trustees should understand the arrangements in place to safeguard their scheme assets. This is especially important in relation to pooled funds. For example, many pooled funds are structured as unit-linked policies with a life assurance company. Investors in these funds are exposed to the risk that the company writing the policy may default, as well as the risks of the underlying investments. In addition, the use of investor platforms means the scheme may have contractual agreements with the platform provider, rather than the underlying fund, potentially weakening the scheme’s position in a credit default event.
The Financial Services Compensation Scheme (FSCS) may provide some protection, but it is a “last resort” arrangement and there are no definitive criteria for establishing the extent to which an occupational pension scheme is covered. The FSCS confirms coverage on a case-by-case basis.
TPR recommends that trustees review the managers’ fund documentation and obtain appropriate legal and investment advice.
Monitoring
TPR notes that monitoring scheme investments is a key part of integrated risk management (IRM). Trustees should monitor scheme investments alongside the employer covenant and the funding level. Trustees should also allocate their time for monitoring in a way that reflects the potential impact on their funding level. Therefore, monitoring strategy should occupy more time than monitoring fund manager performance against a benchmark.
The guidance encourages trustees to focus on the long term when monitoring investment strategy. If the investment strategy is failing to meet its long-term objectives, or if there are investment triggers in place which are not being met, trustees should decide whether this is likely to persist and decide what action might be appropriate.
When monitoring fund managers’ performance, the guidance recommends that trustees focus on their more risky or complex mandates and the larger ones. This concentrates resources on issues that represent the greatest risk to scheme performance.
Comment
Overall this is a helpful document, with several case studies included for illustration. Parts of it will not be appropriate for some schemes but all trustees should find the guidance useful.