Pension Funds Online

2007- A year of Challenge for Trustees: A Plain Mans Guide

There are aspects of the Pensions Act 2004 which only came into force on 6th April, 2006 but which introduce significant changes to the efficient functioning of Trustee Boards. In particular the revisions to the existing Member Nominated Trustee (MNT) requirements (or Member Nominated Directors (MND) where the trustee is a corporate entity) represent the start of a period of change and challenge for employers, administrators and trustees of trust based pension plans.

Member Nominated Trustees and Trustee Training

The Act requires that at least one third of trustees are member nominated (by active members and pensioners, with, for example, an election process) and removes the option for an employer to develop approved opt out arrangements. Existing opt out arrangements which have permitted employers to put forward their own proposals to provide members with input into the trustee function and the operation of the pension plan must be discontinued by no later than 31st October, 2007. Furthermore, it is envisaged that the mandated MNT proportion will rise to one half by 2009. This is a minimum requirement; for example, if there are five trustees, in total, then two must be MNT and from 2009 this would rise to a minimum of three. The non-MNTs, that is those nominated by the employer, would then represent only a minority of the trustees.

It follows that an employer who will by 2009 only be able to influence the appointment of up to one half of the trustees must be confident that these appointment decisions, under his control, are made wisely and effectively.

The Act also gave wide-ranging powers to The Pensions Regulator (TPR) who has proceeded to develop a Code of Practice including training materials (in particular a tool-box for interactive use over the internet) for trustees. TPR requires that all trustees must have an adequate knowledge and understanding to properly fulfil their role and be prepared to give of their time to acquire this knowledge through employer sponsored training or in other ways (TPR toolbox, for example). This initial training would normally take place over a prolonged period of time, typically between six months and one year. Regular refresher training will also be required.

Determining the Level of Contribution to the Pension Plan

In trust based defined benefit pension plans, the trustees now have considerable power over the rate of contribution to the pension plan and will need to bring, or develop, extensive negotiation skills or experience to the trustee deliberations. A thorough understanding of the value of the employer’s covenant and the pace of contribution to meet the emerging liabilities of the pension plan is required.

Reduced to its simplest terms, the ultimate cost of providing a given level of pension (and related) benefits, over time, can be reduced only through enhanced total investment performance of the invested assets or a reduction in the overall costs of administering the pension plan, or a combination of both of these actions. The trustee has overall responsibility to optimise the efficiency of the operation of the pension plan (for the benefit of all potential beneficiaries) and this will require his, or her, diligent application to the appointment and monitoring of the investment managers and administrator.

The trustee must be confident to be willing to discuss with their advisers the funding implications for the pension plan of a range of financial and demographic (including mortality) assumptions and understand the consequences of varying these assumptions. This understanding gives the trustee the grounding required to pursue what may become robust discussions (now, more likely, negotiations) with the employer on the appropriate level and pace of contribution to the pension plan. An actuary cannot predict, with any degree of certainty, the specific financial and demographic assumptions that will be borne out in reality. Rather there is a range of assumptions with varying degrees of likelihood to prove correct. The trustee must be able to understand the financial implications of choosing the assumptions and the probability that future actual experience will reflect them and the financial outcome if they do not.

The trustee must also be alert to the special role that they will have in any business acquisition, merger, reconstruction or events leading up to insolvency. Working with TPR and possibly the Pensions Protection Fund (PPF) in these circumstances may become a crucial aspect of the trustee’s duties. An understanding of the value of the employer’s covenant in these circumstances and the financial implications of possibly having to secure accrued benefits in the insurance market (including Section 75 debt on the employer issues) is essential.

Investing the Assets of the Pension Plan

Whilst the trustee can delegate his responsibility in relation to any matter, he cannot abrogate this responsibility. Accordingly, when appointing an investment manager, the trustee retains all responsibility for the subsequent investment performance of that manager. It follows that all trustees must possess a minimum level of knowledge in relation to investment matters. At least one, if not more, of the trustees should have in depth knowledge and experience. Often this will be the Chair of the Investment Committee of the trustees. The world of financial derivatives, commodities, hedge funds and the like should be as comfortable an environment, to this trustee, as that of bonds and equities.

The trustees are required to develop a ‘statement of investment principles’. This statement should record the types of investment that can be made, the level of investment return expected and the risk the trustees are prepared to accept. The spread of investments between classes of investment is also noted. This statement should be prepared with professional advice and shared with the employer sponsoring the pension plan.

Exercising Trustee Discretion and Conflict of Interest

The increasing responsibility and complexity of the role of the present day trustee is no better demonstrated than with the exercise of trustee discretion for example in the awarding of benefits in the event of retirement due to ill health. Rigorous processes must be developed to ensure the provisions of the pension plan are closely followed and an appropriate understanding of the financial consequences of granting such enhanced early retirement benefits must be maintained. Most pension plans will offer pension benefits following early retirement before Normal Pension Age. Such benefits would not normally be available before age 50 (age 55 from 2010) and often only with the agreement of the employer. The pension following early retirement will normally be calculated as the actuarial equivalent (in value) of the pension accrued to the date of retirement so that no financial strain is placed on the pension plan. When a member retires early on account of ill health, the immediate pension awarded will normally represent the full pension accrued to the date of retirement (without any actuarial reduction following early payment) and, in many cases, may also include credit for years of pensionable service to Normal Pension Age which have not yet been completed. Part of this pension would, of course usually be available as a tax free lump sum. The financial consequence of awarding such enhanced pension benefits where there is no impairment to expected longevity should be obvious.

A thorough understanding of the consequences of exercising the trustee’s discretionary powers is needed when dealing with the distribution of benefits available from the pension plan following a member’s death whilst in employment. Most trustees (or administrators on their behalf) will seek written expressions of wish from members as to how they would wish these benefits to be awarded should they die before Normal Pension Age. These expressions are however in no way binding upon the trustees who should act in their sole discretion in accordance with the trust deed and rules of the pension plan. There could be substantial inheritance tax implications if the trustees are not seen to distribute lump sum benefits, following death in service of the employer, in other than a wholly discretionary manner.

Furthermore, the trustee must be free of any real or perceived conflicts of interest and must act in accordance with the trust deed and in the best interests of the beneficiaries. MNTs should never consider themselves as representing a sectional interest (for example current employed members only or pensioners only) nor should they feel under pressure for their employment prospects or security in exercising their trustee responsibilities. Similarly, trustees appointed from senior management must put to one side their management or shareholder interests.

Good Governance and Internal Controls

The EU Pensions Directive requires each pension plan to establish internal controls to comply with local laws and the rules of the plan itself. These requirements were embodied in the Pensions Act 2004 and, taken with much earlier recommendations of the Myners Report of 2001, now represent good governance of pension plans and have been incorporated into the Code of Practice published by the TPR. The trustees must establish sound internal risk controls to ensure that they meet all of the financial, operational and regulatory compliance requirements to which the plan is subject. Good governance requires that these controls are regularly reviewed. Reference to the completion of a risk review and the regular monitoring of the controls should be documented in the trustees’ annual report to plan members.

Appointment of an Independent Trustee

It now becomes clear why in exercising its influence over the selection of the non-MNT part of the board of trustees, the employer must choose carefully and wisely. It is here that an independent professional trustee can offer a wealth of knowledge, skills and experience to the trustee board. In many ways the independent trustee can be compared with the role of the non-executive director to a company. The independent trustee will usually be the most experienced member of the trustee board and as such have appropriate influence in decisions taken with fellow trustees. The process for selection of the independent trustee must therefore be rigorous and be undertaken with all due professionalism and diligence.

A selection process which relies on personal friends, colleagues or contacts is unlikely to produce the desired result for this most important role.

Rather a clear definition of the employer requirements, developed through detailed discussions, followed by a thorough search of the market, knowing the skills and strengths of who is available, will produce a list of potential independent trustees that the employer may consider. Once appointed the employer may also wish to introduce appropriate monitoring of trustee performance and a range of relevant measurement tools should be developed having regard to the specific objectives of the particular pension plan.

Appointment of a trustee is a responsibility of profound proportions and not to be entered lightly but with appropriate care and forward planning, preferably with professional assistance, will amply repay the investment made.