There are plenty of things for trustees to worry about, but what demands the most attention?
he role of the trustee is increasingly to act as a risk manager. The Pensions Regulator is pushing this agenda hard and wants trustee to assess risks in an integrated way. But what are the main risks trustees should keep an eye on? The priorities will vary from scheme to scheme, but here are Engaged Investor’s top 10.
The Pensions Regulator highlights covenant risk as one of the three fundamental risks to manage. It has received less attention than funding levels and investment risk, but the Regulator’s guidance, Brexit, and high-profile insolvencies at BHS and British Steel have put it in the spotlight.
The very best time to consider covenant is precisely when you think you don’t need to
Darren Redmayne, the head of Lincoln Pensions, says the key to mitigating covenant risk is to be proactive rather than waiting for concerns to surface. “The very best time to consider covenant and put in place protections is precisely when you think you don’t need to,” he says.
“That’s when mitigation mechanisms can be negotiated that respond to covenant risks as and when they develop.”
Investment risk is another of the core risks identified by TPR. It is certainly not an unrewarded risk – as long-term investors, schemes rely on risky assets to generate return, and the cost of completely de-risking assets can be high.
To get a handle on investment risk trustees need to consider it in the context of covenant strength and funding levels. They must produce a statement of investment principles that reflects the risk their employer can tolerate and the returns they need to meet their pension obligations. Then they have to monitor their strategy to ensure it stays in line with the statement.
A one per cent fall in interest rates can push up deficits by about 20%
The potentially devastating effect of low rates has been plain to see since 2008. A one per cent fall in interest rates can push up deficits by about 20%, making the decision to cut rates from 5% to 0.5% in response to the financial crisis painful for many schemes. Because the yield on low-risk assets tracks rates closely, the lower they go, the more expensive it is to buy safe assets to match pension payments.
Hedging interest rates is relatively straightforward – schemes can simply buy low-risk assets such as gilts. But this is expensive, and demand outstrips supply, meaning many schemes are turning to swaps and repos to created synthetic liability-matching portfolios.
If members live longer than expected, schemes will have to pay out more in pensions. Every additional year adds about 3-4% to liabilities. Tools to manage longevity include buy-ins, buyouts and longevity swaps, which transfer the risk to insurers.
Shelly Beard, senior consultant at Willis Towers Watson, says: “For many schemes longevity risk is now one of their top three risks, and its significance will continue to increase as further investment de-risking is undertaken.
“Schemes should consider when longevity risk will be managed, otherwise they may end up with a single concentrated risk.”
High charges are a drag on investment performance and increase the financial burden on sponsors, which can ultimately contribute to scheme closures or company insolvencies.
The difficulty for schemes is that it can often be surprisingly difficult to find out how much they are paying for asset management: a lengthy exercise carried out by Railpen found the scheme was paying four times more than it realised.
Trustees should demand full disclosure and part company with any supplier unwilling to be totally transparent
Transparency Task Force founder Andy Agathangelou says the answer is simple. “Trustees should demand full disclosure of all costs, and part company with any supplier unwilling to be totally transparent. Remember that for some, opacity and obfuscation = opportunity.”
Fraud risk ranges from scammers who encourage members to transfer their savings into dodgy schemes, to the more usual cons, such as relatives claiming benefits of a deceased member. Fraud appears to be on the rise, with one in three schemes targeted last year, according to research by consultancy RSM – twice as many as in 2013.
Trustees should proactively engage with members at risk of pension scams, and work closely with their administrators to monitor their membership. Kim Gubler, director at KGC Associates, says: “Some administrators can offer quite sophisticated and continuous existence monitoring, without the need to write to the pensioner asking them to confirm they are alive.”
CONFLICTS OF INTEREST
Conflicts of interest abound in pensions and must be carefully managed. Financial directors often sit on trustee boards, which leads to conflicts when discussing issues such as covenant, and mergers and acquisitions. To manage this, trustees with a conflict of interest must leave the room when relevant issues are discussed.
Trustees should evaluate their advisers, and make sure they are aware of potential conflicts
Advisers and providers are also often affected. Many consultants now offer fiduciary management services or mastertrusts, for example, limiting their ability to give impartial advice on these markets. Trustees should evaluate their advisers, and make sure they are aware of potential conflicts.
There are several risks associated with environmental and social governance factors. Schemes could miss out on returns as firms with high levels of governance tend to do better in the long run.
A survey of academic reports by Deutsche Asset Management found that two-thirds of respondents identified a positive correlation between ESG and returns. Polluting, carbon-intensive or unethical firms are also in danger from future clampdowns.
Share prices of energy companies do not account for the fact that they will not be allowed to extract all of their reserves of oil and gas if governments stick to CO2 reduction commitments, for example.
Key to managing ESG risk is engaging with investment consultants, and the asset managers who vote on behalf of schemes. The Association of Member-Nominated Trustees’ Red Line voting initiative gives schemes a template to instruct asset managers how to vote.
DATA AND ADMIN ERRORS
Administration risks can range from data breaches to administrative errors resulting in payouts going to the wrong people, or for the wrong amounts. Administrative errors can lead to member losses that can be costly and complex to correct, so trustees should constantly monitor and review their administrators.
Responsibility for information security lies with trustees, who could be fined up to £500,000 for breaches
As the data controllers for schemes, the ultimate responsibility for information security also lies with trustees, who could be fined up to £500,000 for breaches.
So trustees should ensure they carry out regular data cleansing exercises and do their due diligence on suppliers, as well as those further down the supply chain.
Serious disruptions like floods, earthquakes, and fires can damage the infrastructure schemes rely on. KGC Associates’ Gubler says that trustees can minimise this.
She says: “Trustees need to be aware of how vulnerable any offshored services are to natural disasters.
“Of course, floods happen in the UK too, but these tend to be more infrastructure related, such as burst pipes. Service providers should all have robust business continuity plan in place and preferably be ISO 22301 certified.”