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Pension Fund Governance: OECD Principles, Governance & Investment International Seminar on Pension Reform for Civil Servants and Complementary Pension Funds Brazilia, Brazil 1-2 October 2003 Russell Galer Financial Affairs Division Directorate of Financial, Fiscal and Enterprise Affairs Organisation for Economic Co-operation and Development OECD Guidelines For Governance of Pension Funds • Released October 2002 – Approved by OECD Working Party on Private Pensions after extensive discussion and debate • Complements prior and on-going work – Principles of Corporate Governance (1999, to be revised) – Fifteen Basic Principles (2000) – Detailed assessment criteria (on-going) – Protection of rights of members (Oct. 2003) – Other: Funding; Investment; Supervision (2003-2004) • Developed with help of Intl. Network of Pension Regulators & Supervisors (INPRS) Overview of Presentation • I. Why Guidelines on Governance? • II. OECD’s governance guidelines – Role of third parties • III. Role of governance in pension fund asset management I. Why Guidelines on Governance? • Good governance/management practices are important for all institutions – regardless whether an enterprise is a private or public entity – recent crises in corporate governance and esp. within financial institutions demonstrate the need for constant vigilance and a return periodically to fundamental concepts • Pension funds have unique agency problems • Pension funds can be complicated and operational functions extensive • Cost of failure in pension programs can be very high for members, the State, plan sponsors, and as funded programs grow, for capital markets Unique Agency Problems of Pension Funds • Limited redemption rights: – Occupational pension fund “shares” are not “traded”; Portability is limited. – Switching usually very restricted in personal plans (eg L.Am.) – Many members (across all countries) tend to be passive – even if they have a right to redeem or exit. • Direct political power of members may be weak – Member representation in fund governance is limited in many countries. – May be some exceptions with adequate worker/union representation. – Political voice may be indirect and mediated. – ** But members can be important part of fund governance • Mismatch of risk-bearing : – For DB plans, sponsoring employers are stakeholders (risk-bearers) that the fund governors/trustees/board may “accommodate” (Boots?). – In DC plans, employees bear investment risk, but others (governing board, employers/trustees) have decision-making authority, e.g., over aspects of investment portfolio & choice (Enron?). Pension funds can be complicated and operational functions extensive • Funding and contribution policy • Collection of contributions • Investment management of assets • Record-keeping (work histories; benefit accruals; investment-related records) • Actuarial analysis • Relations with plan members • Staff and service provider management • Legal/regulatory compliance • etc. • Effective governance practices play a central role in pension fund management – – Regardless of the type of investment management rules and regardless of the legal form of the pension fund (contractual, foundation, corporate, trust) – By clearly identifying functions and responsibilities, encouraging objective processes, establishing effective internal controls, and assuring transparency of communication II. OECD’s Guidelines on Governance: Scope and Structure • Governance Structure – Identification of responsibilities – Separation of operational from oversight tasks – Identification and the accountability and suitability of those with responsibilities • Governance Mechanisms – Appropriate internal controls (IT, reg. compliance, operational risk mgmt.) – Communications/transparency across the organisation and with service providers – Regular review, assessment and process for revision 12 governance guidelines • STRUCTURE • MECHANISMS • Identification of • Internal Controls responsibilities • Reporting • Governing body • Disclosure • Expert advice* • Redress • Auditor* • Actuary* • Custodian* Structure: Who is responsible for what tasks? • WHO? Clearly vest power in an identified governing body – Establish accountability of governing body to members and competent authorities; legal liability • DOING WHAT? Establish appropriate, clear division of operational & oversight responsibilities – Set forth legal form, governance structure and plan objectives in relevant documents (statute, by-laws, contracts, trust instruments, etc.) • ARE THEY CAPABLE? Ensure suitability of those with with operational and oversight responsibilities – Integrity; professionalism – Encourage use of experts/professionals if necessary to assure fully informed decision-making and fulfillment of responsibilities Governance – Internal Controls n Transparency of process, including effective lines of communication and reporting within an organisation and with external service providers n Appropriate risk management n Effective regulatory compliance programs n Regular testing, monitoring and updating of information technology systems and processes n Identification, monitoring, correcting/sanctioning of conflict of interest matters and of the improper use of privileged information Governance - External Parties n Pension funds should utilize specialized industry expertise where needed n Third parties may exert independent oversight of the governing body and internal operations, performing a crucial monitoring function External Parties (1) • Auditors and Actuaries • Independent, periodic auditing • Appointed actuaries for defined benefits • Whistle-blowing » Report noncompliance to governing body » Additional duty to report to competent authorities if governing body fails to take remedial action » Effectiveness depends upon: » - Robustness of professional standards » - The whistle-blowing standard External Parties (2) – Experience with whistle-blowing • United Kingdom – Excessive number of whistleblower reporting from trustees, auditors & actuaries – Q1 2003 – 79,889 complaints received – Rules under review – Should fund managers have whistle-blowing obligations? • Ireland – Useful experience (less than 100 reports annually, targeting significant abuses) • United States – Pre-’Enron’ intransigence to impose whistle-blowing obligation on accountants & auditors – Supervisory authorities increasingly use voluntary compliance programs » Self-reporting of violations lessens penalties External Parties (3) • Custodians – Legal separation of pension assets from those of governing body, plan sponsor, and the custodian itself – How effective are custodians? » Extent of activity (v. passivity) depends on extent of “directed trustee”, fiduciary or contractual obligations » E.G.: Recent US Mutual Fund After Hours Trading Scandal • Pension fund members – Need adequate disclosure to play significant role – Board representation – Rights of redress (courts/ administrative action, ombudsmen, etc.) Members & Governance • OECD/INPRS “Guidelines for the Protection of Rights of Members & Beneficiaries in Occupational Pension Plans • Aspects relevant to governance include – Disclosure & education of plan members – Rights of redress – Protections against employer/sponsor retaliation – Portability 3. Governance and Pension Fund Asset Management n Amounts, allocations and inv. performance of pension fund assets vary widely across OECD countries n Depending on many factors, such as: n Age of program n DB/DC n Nature of asset regulation n Depth/performance of domestic markets n Plan demographics n Impact on plan sponsor of funding and accounting rules n Sound Investment Management Requires Sound, Robust Governance in All Cases n - Regardless of rules (PPR, Quantitative), pension fund managers have substantial discretion over investments Two Basic Approaches to Regulation n Prudent Person Rule n Establishes a broad behavioural standard applied to the process by which inv. mgmt. decisions are made n Process-oriented n Quantitative Limitation Rules n Establishes numerical boundaries (ceilings, rarely floors) on investment by asset class n Assuming the limits are not excessively restrictive, there remains substantial discretion. In effect, only an initial broad asset allocation is set. n Hybrid cases? (e.g., Canada; EU Directive) Prudent Person Approach or Quantitative Limits? • Trending towards prudent person rule – Anglo-American jurisdictions – EU Directive – Tendency to loosening quantitative constraints • Which countries are more likely to more heavily rely one quantitative limits? – Less developed security markets and professional asset mgmt. industries – Mandatory systems with individual risk-bearing – Insurance-oriented systems • Are quantitative constraints alone sufficient? Prudent Person Rule n The basic rule: n “A fiduciary must discharge his/her duties with the care, skill, prudence and diligence that a prudent person (or expert) acting in a like capacity would use in the conduct of an enterprise of like character and aims.” n Behaviour-oriented; fund-specific n This rule often doesn’t stand on its own and various corollaries fill out the rule. n E.g., EU Directive Article 18 Procedural prudence n Compliance with PPR is judged by reviewing means rather than end results alone. The relevant questions focus on PROCESS: n Did the governing parties (trustee, board, fund managers) go about the business of managing the pension fund in a way that other similarly-situated, responsible, prudent parties would have? nIf, not, did they “proceed prudently” by diligently considering the reasons for departing from the norm – in light of the particular circumstances of the pension fund? n Some benefits of PPR: n Fund-specific n Accommodates shifting understanding of risk n Reliance on industry standards and best practices n Encourages use of professionals and experts. PPR Corollaries –examples [* = EU Directive] n *Act in best or exclusive interest or for sole benefit of members; act under duty of loyalty n Assure adequate liquidity corresponding to fund needs n *Diversify portfolio n *Avoid single-issue concentration n Avoid undue risk; balance security and profitability n *“Ensure security, quality, liquidity and profitability of the portfolio as a whole” n *Avoid or limit conflicts of interest and self-dealing n Limit/prohibit *loans, leverage, *derivatives n ‘Match’ nature of assets held with nature of liabilities (ALM) [*Directive technical provisions] n *Asset segregation/custody/trust/ring-fencing n *Create written investment policy QL Rules: “One-size-fits-all” asset allocation? n In effect, QLR set initial asset allocation parameters for all funds within the jurisdiction. n State determines initial asset allocation parameters n Compare PPR – governing body makes this determination n But are parameters too hot, too cold, or just right? n Too loose? If so, it constrains no one and is ineffectual n Too restrictive? Significantly constrains fund managers, disregarding particularities of each fund and limiting ability to use professional investment management expertise. n “Just right”? Constrains outliers, but may prevent implementation of unique, but responsible, strategies. n QLR itself is insufficient regulatory mechanism As a result, QLR jurisdictions use qualitative ‘corollaries’ n Italy: n -Sole interest of members; n -Investment policy; n -Diversification principle; n -Avoid single company concentration; -Efficient resource management (contain and minimize transaction and management costs); n -Governing body monitoring obligation; n -3rd party depository; n -Use of professional investment managers [Fondi pensione negoziali (FPN)] As a result QLR jurisdictions use ‘corollaries’ too n Poland: n -Sole purpose rule; n -Investment policy to include “investment rules and standards” and 3-year financial plan; n -Obligation to invest with eye to both security and profit efficiency; n -Self- investment prohibitions; n -Permissive delegation to external portfolio manager As a result QLR jurisdictions use ‘corollaries’ too n Slovak Republic [Supp. Pension Insur. Co.s (SPICs)] n -Principle of careful and rational persons; n -1-year and 5-year financial plan and investment strategy; n -Liquidity requirement; n -Self-investment prohibition; n -Independent custodian Why governance? n Investment management function alone is extremely complex. PPR and QLR approaches both leave substantial discretion to the pension fund’s governing body n Determine investment policy in light of overall risk preferences, anticipated liquidity needs, contribution expectations, and long and short term plan obligations n Establish asset allocation parameters of portfolio n Consider role of alternative asset classes n Consider investment style/techniques (passive/active; growth/value, etc.) n Investment manager selection (internal/external) n Individual security selection (stock-picking) n Conducting necessary transactions (buy/sell; best execution) n Consider fees and other costs n Monitor and review of performance (benchmarking, etc.) n Reassessment of overall policy Thank you.
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