Pension Funds Online

Ten challenges facing pension scheme trustees in 2009

There are many reasons to believe that 2009 will be every bit as tough as 2008 for pension scheme trustees. Final salary pension schemes started the year with a collective deficit of £194.5bn compared to £19.6bn at the end of 2007. Pension funds are being hard hit by the financial turmoil and many of their sponsors will be fighting to keep afloat during what is expected to be a severe contraction of the economy.

With the recession forecast to deepen in 2009, trustees should be prepared for a significant increase in workload as they grapple with the ongoing impact of market turbulence. Two of the biggest and most obvious issues confronting schemes are funding levels and the weakening financial stability of sponsoring employers. At the same time, the Pensions Regulator is hardening its position with regard to the governance of schemes, heaping more pressure on trustees at this testing time to adopt best practice principles.

In such a context, this could be a year in which pension fund trustees' rigour will be put to the test. Negotiation skills could be a huge asset to have as trustees might have to fight forcefully to ensure schemes are adequately funded. The challenges trustees could face are likely to come in diverse and unexpected ways. The following ten points are areas trustees should pay particular attention to: 

1. Check how strong a grip the pension scheme has on promised assets

If pension funds have been promised security on assets, trustees should check just how solid that security is, as the recession has increased the likelihood that they may need to exercise their claim to those corporate assets.

For example, the sponsoring company might have set aside a commercial property that it owns as a security on assets for its pension fund. Trustees should check the value of that property because chances are that its value will have fallen significantly over the last year. They should also look into the terms and conditions to see if the pension scheme is the only claimant or if there are potentially other parties who have rights over that asset.

Poor documentation could allow another party to trump the pension fund's claim so it is important to ensure that the scheme's interest is written in black and white in the first place.

2. Revise the recovery plan if the employer's covenant substantially declines

In 2009, as the recession undermines the trading of many companies, the employer covenant could see a sharp decline, revealing the risk that an employer will be unable to meet a funding shortfall. Trustees should be prepared to revisit the existing recovery plan to address the shortfall.

In the face of a soaring deficit, trustees will need to come up with a practical solution. When reviewing recovery plans, trustees need to be realistic about any increase in the amount they ask the employer to contribute so that it doesn't jeopardise the company's solvency. Alternatives, such as extending the recovery plan, might be a better compromise in some cases.

Trustees should also bear in mind that the Pensions Regulator will have to be notified of any changes to the recovery plan.

3. Enhance the monitoring of business partners

The Lehman Brothers incident showed the risk of having a business partner or a counterparty going under. Trustees may want to step up the monitoring of business partners whilst diversification across counterparties and collateralisation will also help mitigate counterparty credit risk.

Trustees should also envisage the possibility of more active monitoring or even auditing their business partners. When choosing investment managers, it is important to ensure that they have effective risk management processes in place and that their investment strategies are transparent. In addition, trustees could build up a contingency plan to work out what they should do if any business partner or counterparty gets into financial difficulty.

4. Perform due diligence investigations of hedge funds

The Madoff scandal shows that you cannot take external advisers' recommendations at face value. It is important that trustees review that advice and draw their own conclusions on hedge funds. With a lack of transparency subsisting in the hedge fund industry, trustees should take responsibility for actively requesting information which is not fully disclosed.

There is a need to be more thorough in ensuring that the investment strategies and products actually employed by hedge funds and the risks they take on are in line with their prospectuses.

5. Watch actions by the employer which could require mitigation and/or clearance from the Pensions Regulator

2009 could see a surge in the number events, such as mergers or changes in solvency of the sponsoring employer, for example, which could be materially detrimental to the ability of schemes to meet their liabilities.

It is likely that more sponsoring companies will have to agree bank refinancings and the outcome of these negotiations could have damaging effects on the financial position of their pension schemes. Trustees will need to get information on these negotiations with banks as early as possible as they are likely to be tough for the sponsoring employer and there could be potentially serious ramifications for the pension scheme.

6. Check whether technical provisions are prudent going forward, given the employer covenant

Trustees should check that the estimate of the assets needed for the scheme to be fully funded is prudent enough, given the employer covenant. The technical provisions, which set the target level of funding in the scheme, should give confidence that the scheme benefits are secure against the risks faced by the scheme.

At the same time, trustees should recognise that absolute security might, in practice, be undesirable if it implies that employers have to commit to unsustainable contributions, which could threaten the viability of both the sponsor and the scheme.

Making sure that the information used to determine the employer covenant is accurate will allow trustees to make more reliable judgements about the right level of technical provisions to aim for.

7. A switch from equities to debt - assess how this will impact the scheme

Employers may become keen to dampen their pension fund's volatility by moving into bonds, for example, but may be less keen on committing the money early on to plug the gap in returns. What conditions will the employer try to impose on such a switch?

Employers might promise trustees that they will make good any shortfall as long as they can ensure the deficits do not get any bigger, but trustees will need to get a firmer assurance before committing to a strategy that could mean lower long-term returns.

More generally, trustees should look at their investment strategy in a more holistic and integrated way. The scheme's investment risk profile should take account of the employer's covenant, the scheme's funding (assets and resources) and governance.

8. Plug the knowledge gaps

The sharp fall of the stock market is pushing pension schemes to seek out alternative growth investments, which will involve shifting their investment strategy and approach to risk. For example, commodities were being promoted as a good method of diversification - but the fall in the value of these assets has simply left some schemes with poor performance spread across more asset classes!

Diversification could lead trustees to venture into complex asset classes offering more attractive risk-return characteristics. It is important that trustees fully understand the technicalities implied by this process in order to be able to properly question the quality of experts' advice and ensure that investments are made in compliance with schemes' long term objectives.

Technical knowledge of investments is also essential for selecting the right investment managers and can prove invaluable in rendering the decision-making process more effective in the tight timeframe which market volatility demands.

9. Evaluate the costs of a clearance application

Trustees should be careful when considering a clearance application with the Pensions Regulator as it can easily cost several hundred thousand pounds once the input of all parties is considered.

Sponsoring companies could be tempted to apply for clearance as an insurance measure to avoid the Pensions Regulator issuing a contribution notice rather than because they actually believe their pension scheme is at risk. Trustees should be wary of a sponsoring employer who suggests that the scheme should chip in and help bear the costs.

10. Reassess the attitude towards conflicts of interest as part of a wider overhaul of governance

Conflicts of interest are not new but they are being aggravated by the economic downturn. The Pensions Regulator's view on the matter is unmistakable: it wants pension schemes, their employers and their advisers, to be open about those conflicts and to manage them carefully, avoiding them where possible.

This financial crisis has again raised awareness of how dangerous it can be to neglect governance. Many financial services companies are having to admit that their boards have not functioned as envisaged by the UK's corporate governance framework. Non-executive directors, in particular, have been blamed for failing to constructively challenge the company's management approach. Just as companies will be trying to repair their governance structures, there are lessons that pension funds, too, should be drawing from the crisis.

On the regulatory front, one could expect the Pensions Regulator to campaign more vigorously on governance. So far the Regulator has been restricting itself largely with laying down guidelines of good practice, but if more schemes are transferred to the Pension Protection Fund, the Pensions Regulator could well become more interventionist.

In view of this, trustees should act more proactively to overhaul the governance standards of their schemes. Aside from sparing them a potentially difficult conversation with the Regulator, higher standards will also translate into more effective decision-making, which can be highly desirable given the small margin for error that the declining funding levels allow.

With all eyes on trustees, 2009 will be a year in which the role of trustees becomes more challenging than ever before.

www.trusteegaaps.com

David Johnson has worked in pensions for almost 35 years, holding senior national and international responsibilities with one of the largest global pensions and human resource consultancies. He has acted as an adviser to many groups of trustees as well as being a personal trustee and a director of trustee companies. He is a qualified actuary and was previously Chairman of the Association of Pensioneer Trustees and President of the Society of Pension Consultants. He is currently an adviser to the government-sponsored Pensions Advisory Service.