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Russell Galer Financial Affairs Division Directorate of Financial, Fiscal and Enterprise Affairs Organisation for Econom

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

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Russell Galer Financial Affairs Division Directorate of Financial, Fiscal and Enterprise Affairs Organisation for Econom

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  1. Pension Fund Governance:OECD Principles, Governance & Investment International Seminar on Pension Reform for Civil Servants and Complementary Pension FundsBrazilia, Brazil1-2 October 2003 Russell Galer Financial Affairs Division Directorate of Financial, Fiscal and Enterprise Affairs Organisation for Economic Co-operation and Development

  2. 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)

  3. 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

  4. 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

  5. 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?).

  6. 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.

  7. 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

  8. 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

  9. STRUCTURE Identification of responsibilities Governing body Expert advice* Auditor* Actuary* Custodian* MECHANISMS Internal Controls Reporting Disclosure Redress 12 governance guidelines

  10. 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

  11. Governance – Internal Controls • Transparency of process, including effective lines of communication and reporting within an organisation and with external service providers • Appropriate risk management • Effective regulatory compliance programs • Regular testing, monitoring and updating of information technology systems and processes • Identification, monitoring, correcting/sanctioning of conflict of interest matters and of the improper use of privileged information

  12. Governance - External Parties • Pension funds should utilize specialized industry expertise where needed • Third parties may exert independent oversight of the governing body and internal operations, performing a crucial monitoring function

  13. 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

  14. 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

  15. 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 • Pensionfundmembers • Need adequate disclosure to play significant role • Board representation • Rights of redress (courts/ administrative action, ombudsmen, etc.)

  16. 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

  17. 3. Governance and Pension Fund Asset Management • Amounts, allocations and inv. performance of pension fund assets vary widely across OECD countries • Depending on many factors, such as: • Age of program • DB/DC • Nature of asset regulation • Depth/performance of domestic markets • Plan demographics • Impact on plan sponsor of funding and accounting rules • Sound Investment Management Requires Sound, Robust Governance in All Cases • - Regardless of rules (PPR, Quantitative), pension fund managers have substantial discretion over investments

  18. Two Basic Approaches to Regulation • Prudent Person Rule • Establishes a broad behavioural standard applied to the process by which inv. mgmt. decisions are made • Process-oriented • Quantitative Limitation Rules • Establishes numerical boundaries (ceilings, rarely floors) on investment by asset class • Assuming the limits are not excessively restrictive, there remains substantial discretion. In effect, only an initial broad asset allocation is set. • Hybrid cases? (e.g., Canada; EU Directive)

  19. 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?

  20. Prudent Person Rule • The basic rule: • “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.” • Behaviour-oriented; fund-specific • This rule often doesn’t stand on its own and various corollaries fill out the rule. • E.g., EU Directive Article 18

  21. Procedural prudence • Compliance with PPR is judged by reviewing means rather than end results alone. The relevant questions focus on PROCESS: • 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? • If, 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? • Some benefits of PPR: • Fund-specific • Accommodates shifting understanding of risk • Reliance on industry standards and best practices • Encourages use of professionals and experts.

  22. PPR Corollaries –examples [* = EU Directive] • *Act in best or exclusive interest or for sole benefit of members; act under duty of loyalty • Assure adequate liquidity corresponding to fund needs • *Diversify portfolio • *Avoid single-issue concentration • Avoid undue risk; balance security and profitability • *“Ensure security, quality, liquidity and profitability of the portfolio as a whole” • *Avoid or limit conflicts of interest and self-dealing • Limit/prohibit *loans, leverage, *derivatives • ‘Match’ nature of assets held with nature of liabilities (ALM) [*Directive technical provisions] • *Asset segregation/custody/trust/ring-fencing • *Create written investment policy

  23. QL Rules: “One-size-fits-all” asset allocation? • In effect, QLR set initial asset allocation parameters for all funds within the jurisdiction. • State determines initial asset allocation parameters • Compare PPR – governing body makes this determination • But are parameters too hot, too cold, or just right? • Too loose? If so, it constrains no one and is ineffectual • Too restrictive? Significantly constrains fund managers, disregarding particularities of each fund and limiting ability to use professional investment management expertise. • “Just right”? Constrains outliers, but may prevent implementation of unique, but responsible, strategies. • QLR itself is insufficient regulatory mechanism

  24. As a result, QLR jurisdictions use qualitative ‘corollaries’ • Italy: • -Sole interest of members; • -Investment policy; • -Diversification principle; • -Avoid single company concentration; -Efficient resource management (contain and minimize transaction and management costs); • -Governing body monitoring obligation; • -3rd party depository; • -Use of professional investment managers [Fondi pensione negoziali (FPN)]

  25. As a result QLR jurisdictions use ‘corollaries’ too • Poland: • -Sole purpose rule; • -Investment policy to include “investment rules and standards” and 3-year financial plan; • -Obligation to invest with eye to both security and profit efficiency; • -Self- investment prohibitions; • -Permissive delegation to external portfolio manager

  26. As a result QLR jurisdictions use ‘corollaries’ too • Slovak Republic [Supp. Pension Insur. Co.s (SPICs)] • -Principle of careful and rational persons; • -1-year and 5-year financial plan and investment strategy; • -Liquidity requirement; • -Self-investment prohibition; • -Independent custodian

  27. Why governance? • Investment management function alone is extremely complex. PPR and QLR approaches both leave substantial discretion to the pension fund’s governing body • Determine investment policy in light of overall risk preferences, anticipated liquidity needs, contribution expectations, and long and short term plan obligations • Establish asset allocation parameters of portfolio • Consider role of alternative asset classes • Consider investment style/techniques (passive/active; growth/value, etc.) • Investment manager selection (internal/external) • Individual security selection (stock-picking) • Conducting necessary transactions (buy/sell; best execution) • Consider fees and other costs • Monitor and review of performance (benchmarking, etc.) • Reassessment of overall policy

  28. Thank you.

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