Pension Fund Governance: OECD Principles, Governance by 6TD3CH


									           Pension Fund Governance:
         OECD Principles, Governance &

                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
  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
        – Integrity; professionalism
        – Encourage use of experts/professionals if necessary to
          assure fully informed decision-making and fulfillment of
        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
          » 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

• 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
n   Amounts, allocations and inv. performance of
    pension fund assets vary widely across OECD
    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.
   – 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
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

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’
 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
     n   -Self- investment prohibitions;
     n   -Permissive delegation to external portfolio manager
As a result QLR jurisdictions use ‘corollaries’
 n   Slovak Republic [Supp. Pension Insur. Co.s
     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,
    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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