Pension Scheme Governance in a Risk-Focused World

A new study published by BNY Mellon, the global leader in investment management and investment services, in association with Cass Consulting presents a framework to help trustees better navigate the complexities of today's risk-focused world.

New, more complex, more illiquid asset classes, the incorporation of derivative overlays and new regulations have all combined to produce an exponential increase in the governance burden on trustee boards.

The study, by Cass Professor of Asset Management Andrew Clare and Cass Visiting Fellow Chris Wagstaff, is entitled 'Pension scheme governance in a risk-focused world'. It proposes a transparent framework for a risk-based performance monitoring process. If adopted, such a framework would greatly enhance and strengthen pension scheme governance, according to the study.

Given the now widespread use of derivatives in pension scheme portfolios, the paper also proposes an alternative, more robust governance structure for monitoring derivatives portfolios, focussing on the often overlooked operational risks.

This structure envisages the establishment of a direct relationship between the scheme and the custodian that holds its derivative assets - very much in the spirit of the 2001 Myners Report recommendations for strengthening governance standards for pension schemes.

The study examines trustees' motives for investing in less liquid and often more complex, 'bond-like' asset classes and goes on to propose a valuation approach that could be integrated into the monitoring framework that is being proposed.

The paper also argues that it is possible to improve pension scheme governance by making use of simple checklists that should enable trustees to monitor key investment and operational risks of the scheme.

Chris Wagstaff argues that: "Checklists play a vital role in many complex processes, not least by minimising the possibility of human error and by systematising the monitoring of key risks. However, just as checklists play a critical role in the aviation industry in keeping us safe in the air, the use of a checklist does not in itself qualify someone to fly a plane. Similarly, while it should be considered good governance for a pension scheme trustee to regularly run through a well designed checklist of key investment and operational risks to be monitored, it is not sufficient in itself to improve the efficiency of the governance process, despite the clear benefits and negligible costs of doing so."

In constructing the investment and operational risk checklists, the study identifies the minimum levels of knowledge and understanding that trustees require today to monitor the vast array of scheme risks efficiently. The study proposes that the widespread attainment of this minimum level of knowledge and understanding would greatly improve scheme governance.

Professor Andrew Clare comments: "The operational infrastructure which comes with integrating derivatives into an investment portfolio may seem dull, but it is both very necessary and very complex. In fact, it's a bit like the plumbing in our homes: nobody notices or cares about their plumbing until a pipe bursts, or their boiler breaks down. The bottom line is that trustees really need to pay more attention to the plumbing supporting their derivative investments."

The report can be downloaded at the link below.