Jeff Neate explains what fiduciary management actually means and how it can help pension schemes address the funding gap
Fiduciary management is now gaining momentum in the UK, but there remains confusion about exactly what it is, and what its benefits are. There are many flavours of fiduciary management, and a solution that is right for one scheme may be quite the wrong thing for another. Trustees who are considering fiduciary management for their scheme need to press providers to go beyond the marketing speak and take a proper look under the bonnet.
Fiduciary management is in essence a solution to the investment governance challenge that trustees face. But the nature of the solution can vary from an off-the-shelf product, to a strategic outsourcing partnership, right through to co-sourcing alongside an existing internal team. Towards the partnership end of the spectrum, fiduciary management is a way to devise a framework that sets, executes and monitors sophisticated investment strategies while putting trustees in control of their journey back to full funding.
Below we revisit the major challenge facing pension schemes and how, by selecting the right flavour of fiduciary management, trustees can build an effective governance solution.
The major challenge that defined benefit schemes face in the UK is one of funding: markets have not been kind and most schemes are a long way from where they would like to be. Trustees and corporate sponsors need to have a recovery plan in place to meet their long term funding objectives. This plan must set out the target funding level and the timeframe, as well as how the trustees plan to achieve it.
There are of course two ways to achieve a better funding level: additional contributions (cost) and investment returns that exceed the growth in the scheme’s liabilities (risk). Trustees must therefore set a realistic strategic investment objective — an outperformance target and a risk budget — that is consistent with their and sponsors’ risk tolerance. The result is a ‘flight plan’ that maps out the intended path for the funding ratio over time.
How to tackle it?
In practice, schemes need to find a balance between contributions and investment outperformance. Putting everything into gilts and annuities is not an option for any but a tiny minority of schemes. But whatever that outperformance target is, all parties will want to minimise the risk that is incurred in trying to achieve it. Today it is more important than ever to really work the assets to achieve the highest possible return per unit of risk. And that requires a sophisticated investment strategy.
This investment strategy should be designed to achieve the strategic investment objective through:
• A diversified mix of rewarded risks
Although some progress has been made over the past few years, risk analysis of most schemes continues to show a concentration of risk in interest rates, inflation and UK equities. But the outperformance target can be achieved with much less risk by hedging a significant part of the unrewarded interest rate and inflation risk in the liabilities. Then, in the growth portfolio, diversify across different underlying drivers of return, including assets like credit, non-traditional equities, and alternatives. The better balanced the strategic risk profile the more stable the path to full funding nirvana.
• Dynamic risk management
In the past, schemes have implemented their investment strategy statically with simple rebalancing rules. But what if one could take a more dynamic approach to managing the risk level and profile over time? That would mean positioning that takes to account medium-term economic scenarios and financial market conditions. In today’s environment of low returns, coupled with challenging strategic investment objectives, we believe that dynamism is essential. By thinking long-term and acting in the short-term schemes can benefit from medium-term trends and protect against downside risk in fast-moving volatile markets.
• Asset class mandates
Once the trustees have decided to invest in a certain set of asset classes, they must determine the best way to invest within each one. What is an appropriate investment universe and benchmark? Should the goal be to outperform the benchmark or to passively track it, or simply to target absolute returns? To what extent should there be diversification across managers to mitigate manager concentration risk?
Answering these questions is important for many reasons. For one, it avoids ending up with unnecessary concentrations of risk due to overlap between different asset classes. An example of this is hedge funds: unless you construct the mandate carefully, hedge funds can end up being little more than a rather expensive way to access a return and risk not dissimilar from the more traditional asset classes. For another, the market standard benchmarks can in some cases have really nasty risk concentrations. The high exposure to financials within sterling investment grade credit is just one example of this.
Experience and scale are the key to execution
It is one thing to design a more sophisticated investment strategy. The real challenge is the execution, which involves a much larger number of asset classes and managers than most trustees are used to. And on top of that, to get the best results it should be managed dynamically.
Executing this kind of strategy is a real challenge under the traditional investment advice model, and quickly becomes unwieldy. And that is true even for schemes with an engaged investment committee that meets monthly and acts decisively. So trustees who go down this road will need to upgrade their governance structure to ensure risk and cost-controlled execution.
What is really needed are experienced investment professionals working with sophisticated systems to monitor and analyse markets, assets, liabilities, managers, counterparties and custodians. The trustees need people working for them who have at-the-coal-face market experience and a willingness and ability to act in real time in the interest of the members.
Fiduciary management as a solution
For the very largest schemes, building an in-house team of investment professionals is a serious option. This is what we would describe as the purest form of fiduciary management. But most schemes are not nearly large enough to build a cost-effective and robust in-house capability. Fiduciary management provides an alternative: outsourcing some or all of the required functions to a provider whose core business is to execute pension investment strategies and inform, advise and report to trustee boards. In this partnership model, the fiduciary manager works together with a core in-house team or, for small and medium sized schemes, itself acts as the in-house team.
Trustees can delegate a lot of the day-to-day decision-making but we believe that they need to be careful that delegation does lead to a loss of control. The key is to choose thoughtfully which decisions to delegate and with what latitude, together with effective reporting and monitoring. Done right, delegation actually enhances trustees’ control by allowing them to focus more time on the strategic investment objective and the investment strategy, whilst at the same time monitoring delegated dynamic decisions and execution.
Does fiduciary management really add value?
Although performance should not be looked at in isolation, especially when considering fiduciary management, the chart provides some insight as to the value we have added for our clients in the UK. This performance is the result of a partnership between ourselves and each individual trustee board. It is our approach to fiduciary management, tailored to the specific needs and requirements of each scheme.
Written by Jeff Neate, senior client director UK, MN