Pension Fund Regulation and Governance
“Pension Fund Regulation and Governance” refers to the series of procedures, rules, and mechanisms that help to ensure transparency and accountability in the function and regulation of pension funds, along with a further emphasis on mitigating principal-agent problems and providing security and returns to principals.
Pensions funds (PFs) are investment vehicles that serve far-reaching political, social, and economic functions. As economic entities, pension funds are an important instrument for the deployment of significant pools of savings and must therefore work to generate and provide substantial economic returns to their principals. As social entities, PFs provide principals with two important forms of security: one being in the tangible income that they disburse and the other being in the intangible psychological sense of security that they provide to principals, as a known source of future income. As political entities, PFs are vulnerable to the energies of political agents that bestride the tension between the short- and long-term considerations (Wong 2016), where short-term considerations include the temptation to draw on pension resources to fund immediate requirements and long-term consideration include the need to preserve capital for future years.
When executed properly and continually, good governance can have many positive effects for all stakeholders in the pension fund architecture (see Stewart and Yermo 2008). These benefits include a robust and well-entrenched sense of trust among all stakeholders; a reduced need for prescriptive and active regulation; and an easier and better-facilitated array of supervision mechanisms. Beyond this, good PF governance can also influence the level of corporate governance in the companies that PFs choose to invest in. Well-managed PFs are likelier to seek value for their investments through a more active and better-engaged shareholder policy, which can improve the level of fund stability and pension fund returns in the long-run (Wong 2016; Stewart and Yermo 2008; Clark 2004).
Given their far-reaching and multifaceted importance, it has become increasingly evident that PFs must have structures and endowments that facilitate good governance, accountability, and transparency (Clark 2004). Without such mechanisms, pension funds risk falling prey to the perils that jeopardize a great many fiscal institutions, including dissatisfactory performance and returns, poor investment decisions, internal and external conflicts, a loss of reputation and trust, and an inability to plan or prepare for shocks or long-term requirements (see Chohan and Jacobs 2017; Wong 2016).
This chapter proceeds by examining the complexities that arise in studying pension fund governance, the structures of good governance including boards and management, and then considers specific best practices to address commonly noted deficits in pension fund governance.
Complexities in Governance
The basic objective of the regulation contouring PF governance should be to minimize sets of conflicts of interest that can arise between members (principals) and fund managers (agents), in the course of generating returns and protecting the savings of the principals. These conflicts of interest are also referred to as “principal-agent” problems or “agency” problems (Clark 2004).
However, that basic objective of PFs is complexified by the fact that pension funds are not simple profit-maximizing institutions. Rather, PFs can have a series of objectives, including the protection of capital, the disbursement of cash flows across certain time-constrained functions, or the mandate to invest (or avoid investing) in certain forms or types of assets. The structures of governance and accountability of PFs must reflect this multiplicity of objectives.
A further layer of complexity is appended in realizing that pension funds are structured differently around the world, in terms of regulatory rules and regimes (Stewart and Yermo 2008). Their international heterogeneity has made it difficult for academics and practitioners to resort to generalizations in many instances, and the work of PF governance must be mindful of the unique circumstances of each country. That diversity notwithstanding, there are patterns that can be gleaned from cross-country studies, which begin to provide the rudimentary templates for consideration in PF design (see Stewart and Yermo 2008).
To this point, although the level of standardization between international PFs can increase, there is an inherent limit to how far this exercise can go because of the ultimate differences between (1) demographic and (2) economic requirements that underpin the regulatory framework for PFs in each country. Furthermore, in choosing the appropriate governance structure for PFs, it is important to factor in the financial ecosystem, both public and private, in which PFs will operate. This includes the depth of capital markets, the level of existing public regulatory oversight, and the levels of transparency demanded by other structures of accountability.
The Global Financial Crisis of 2008 was a critical event in galvanizing pension fund stakeholders towards governance reforms, for several reasons. First, it highlighted the interdependence of financial markets and the systemic risks posed to the entire system, which were previously overlooked due to their complexity. Second, there was a realization that inadequate accountability and poor governance, while possible to overlook in the immediate term, ultimately lead to a catastrophic destruction of value for principals. Third, the crisis helped to reassert the doubts about “laissez-faire” approaches to financial markets, whereby agents were simply assumed to work in the best interest of principles. Fourth, given the long-term oriented nature of PFs, there was also a realization that financial markets are dominated by a pervasive short-termism that is not conducive to the protection of capital over extended horizons of time, which further validates the need for robust governance.
There is also a demographic element that must be considered in PF regulation and governance. Many countries, particularly those within the OECD, face a looming crisis to the sustainability of their pension systems, caused by the accelerating aging of their populations. As a larger cohort of their populations leaves the workforce to join the ranks of retirees, the pension system begins to face ineluctable stresses. While some countries are proactive in addressing the sustainability of their pensions systems, other countries find themselves unable to do so due to the extremely politicized nature of pension systems, wherein more organized groups of aged voters prevent governments from making drastic changes to pension sustainability programs. Pension fund regulation and governance must be mindful of these complexities because they serve as the backdrop for which accountability structures must be designed and effectuated.
Boards as Mechanisms of Good Governance
Good governance in PF regulation must be founded on the notion that there is a principal-agent relationship that must be led by a sense of fiduciary duty and trust (Clark 2004). The governance of PFs involves the managerial control and regulation of the organization, which is premised on the accountability and oversight of management itself. It must therefore incorporate risk-based measures that are conscious of volatility and uncertainty over future time-periods as well. As a general rule, the more sophisticated the investment strategy of a PF, the stricter its governance and oversight requirements become. Similarly, the more complex the administrative arrangements of the PF’s plan, the tighter the operation oversight needs to be.
In this regard, it is important to recognize the central role that boards play in effectuating governance (see Ambachtsheer et al. 2006). Every autonomous PF establishes a board as its governing body, which takes responsibility for PF’s operation and oversight. As the ultimate decision-maker, the board maintains an overall responsibility for the PF’s strategic decisions, including holding a mandate for setting investment policy; choosing investment managers, platforms and other service providers; and reviewing fund performance at regular intervals. In this sense, the board of a PF serves as the equivalent of a board of directors in a corporation, which is ultimately responsible for creating shareholder value and protecting shareholder assets.
Governance research has shown that boards play a key role in ensuring both governance and good investment performance, and the two have found to be linked to such an extent that good governance can account for as much as 1–2% of addition annual pension fund return, if not more (see Ambachtsheer et al. 2006). The converse has also been found to be true, as PF performance declines when governance problems persist, including when there is a poor process for selection for board members, weak oversight, a lack of self-evaluation of board effectiveness, a lack of clarity between board and management on responsibilities, and problems related to compensation of both (see Ambachtsheer et al. 2007).
For PFs, the board may be categorized as the institutional type, the contractual type, or the trust type (see Rajkumar and Dorfman 2010). Their boards may be either internally or externally situated and as either single-tier or two-tier structures. The implementation of a single- or two-tier structured board represents a tradeoff between strengthening oversight and quickening the decision-making processes, and in this sense it represents a tradeoff borne of public value theory between “efficiency” and “democracy” (see Chohan and Jacobs 2017). The choice of board structure is often dictated by legal stipulations and broader PF regulation at the national level.
The institutional type turns the PF into an independent entity with a legal personhood and capacity and with an internal governing board. This model is found in OECD countries such as Denmark, Finland, Hungary, Italy, Japan, Norway, Poland, and Switzerland (Stewart and Yermo 2008). In most of these cases, pension funds have a single-tier governing board, and its members are typically chosen by the sponsoring employers and employees. Other countries have two-tier structures, as in Germany and the Netherlands, where a supervisory board is responsible for selecting and monitoring a management board, which in turn is responsible for all strategic decisions.
By contrast, the contractual type is premised on treating PFs as segregated pools of assets without legal personhood or capacity, to be managed by a separate entity. These entities are generally banks, insurance companies, or pension fund management companies. The contractual type is more prevalent in OECD countries such as the Czech Republic, Mexico, Portugal, Slovakia, and Turkey (see Stewart and Yermo 2008).
Finally, the trust type is prevalent in Anglo-Saxon countries such as Australia, Ireland, and Canada and blends characteristics of the institutional and contractual types. At its core lies the concept of “trustees” who have the legal title to pension fund assets, whose trust assets they must administer in the sole interest of plan participants along a trust deed which identifies those participants as the beneficiaries.
These diverse structures are nonetheless bound by common principles regarding the board’s role in governance, including acting in good faith, fiduciary duty, protecting principal interests, choosing agents, overseeing management decisions, outlining strategy, and reviewing fund performance.
Board members serve PFs best when they are experienced, well-respected, and nonpartisan. Nonpartisanship is crucial for dispassionate oversight (Chohan and Jacobs 2017), while experience and good reputations can provide political capital to PFs in instances where controversial or sensitive decisions need to be made (Wong 2016). For example, as mentioned earlier in discussing the impact of the Global Financial Crisis, many pensions funds faced a backlash from stakeholders for the staggering investment losses of the time. However, boards with high stature and recognition of their expertise were better able to maintain operations and market-competitive pay structures for their funds even in the face of such an economic shock (Wong 2016).
However, pension fund regulation is not an ambit solely relegated to well-functioning boards. Rather, they are but one element in the governance architecture, which also includes financial market regulators and pension supervisory authorities, as well as civil society and the general public. PFs must be proactive in their engagement with these accountability institutions, so as to assure market stability and the wider interest of their own principals and stakeholders. Some well-managed PFs take the initiative to proactively keep government overseers up to date so that those institutions will not feel a need to be intrusive in the longer-run (Wong 2016). Similarly, some pension funds launch communication campaigns to inform the general public about significant changes to their investment strategies, such as shifting to higher-risk asset classes with ensuing higher volatility in returns, and this is done to inform them in a preemptive way so that the possibility of stakeholders pressuring politicians to intervene in situations of market turbulence is reduced (see Wong 2016).
Deficits of Governance and Possible Solutions
Deficits of governance in pension funds
PFs can have a diversity in their stakeholder base, which may not be reflected in their boards or management. This creates a principal-agent problem insofar as sufficient representation of principals is left unmet
Boards can be proactive in incorporating members who reflect the diversity of their stakeholder base, and appoint managers who reflect that diversity as well.
OECD countries such as the Netherlands, Canada, and Sweden have begun to emphasize that boards should reflect diversity of stakeholders
Insufficient input of expertise
The complex nature of pension fund management requires a substantial input of relevant economic, financial, legal, and regulatory expertise, without which pension funds become increasingly exposed to risk of losses
1. Boards may acquire or appoint members and managers with requisite expertise
2. Boards may externalize the use of expertise through capable trustee organizations
The Australian model of Trustee Partners externalizes the expertise of trustee-related functions to a capable, specialist organization
Conflicts of interest
Various types of interwoven interests can reduce the transparency and accountability of pension funds
Measures such as implementing codes of conduct, ethical codes, and rules for fiduciarity help prevent and reduce conflicts
A growing number of pension schemes in OECD countries adhere to such ethical codes
Defined contribution (DC) plan
DC plans shift the risk from institutions towards participating individuals, which increases the risks to these individuals in the absence of strong governance mechanisms
1. Stronger pension authorities can bridge the gap in DC structures
2. Stronger management committees can mitigate the institutional-individual risk disparity
The European Union and the OECD are pushing for much stronger pension authorities, and encouraging more proactive management committees at large pension funds
Fragmented pension funds markets
Regulation, oversight, and supervision of pension funds is made more difficult when the pension sector is heavily fragmented
Governments may encourage the consolidation of pension funds, and private pension funds can proactively acquire fragmented entities
The Australian pension fund (“superannuation”) landscape, with the approval of government, has undergone consolidation that has allowed larger, more efficient players such as Sargon Capital to emerge, therein spurring cost-efficiencies and technical innovations within the Australian pension system
The highly politicized nature of pensions leaves pension funds vulnerable to interventions that can ultimately destroy stakeholder value
Politics cannot be eliminated from the pension equation in a democratic society, but accountability within the political architecture can dissuade excessive political intrusion
Legislative Budget Offices are a nonpartisan economic office that can produce analysis on pension conditions that may dissuade heavy-handed interventions by politicians
The governance of pension funds is crucial given their substantial role as economic, political, and social entities. However, the core process of PF regulation suffers from significant complexity and from challenges such as the aforementioned principal-agent problems. Strong governance mechanisms can create a robust and well-entrenched sense of trust among all stakeholders, a reduced need for prescriptive and active regulation, and an easier and better-facilitated array of supervision mechanisms. Conversely, weak governance mechanisms can lead to dissatisfactory performance and returns, poor investment decisions, internal and external conflicts, a loss of reputation and trust, and an inability to plan or prepare for shocks or long-term requirements. Boards play a significant role in effectuating accountability in pension funds, and with strong expertise, good reputation-management, and proactive engagement with management and stakeholders, they can act as powerful contributors to good governance. While their design might differ across the institutional, contractual, and trust types, they are bound by similar fiduciary responsibilities and are all expected to enhance the level of accountability in their institutions. The aftermath of the Global Financial Crisis of 2008 and lingering demographic trends reinforce the pressing need for stronger governance and accountability measures. The growing layers of complexity around pension systems will make this all the more true in years to come.
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