INTERVIEW Rethink: Global Pension Risk Governance A discussion with Aon colleagues Matt Clink, Jeff Clymer and Ian Hinton
How is pension risk management different for multinational companies than for those operating in a single country? The main difference for multinationals is determining which decisions are fine to be made in local silos and which are better managed with global direction or oversight. What s complicated is different countries have different financing and funding regulations, and different fiduciary frameworks. For example, the Dutch regulations take a risk-free view toward funding requirements, while the funding requirements in the U.S. tend to offer more flexibility. Corporate teams don t always have a good understanding of local regulations, risks, local bias that affects risk tolerance and solutions to manage risks in each country, all of which are needed to effectively manage pension risks centrally. In theory you re trying to have a cohesive global strategy. It is challenging to do that when the parent company neither has all the knowledge needed nor controls the fiduciary decisions in all of the countries. We can think of it as a governance gap when the preferred tradeoffs of risk and return at a local business level are very different from what the broader organization wants. 2
You described how knowledge management and coordination can make it difficult to implement a global approach. Why is it important to overcome these challenges to have a global approach? MC The ability to profit from risks is different across countries. Differing regulatory environments is one reason we see wide variation in investment programs. A global approach may help companies to allocate capital and risks more efficiently. Are you taking investment risk in the countries where you are most likely to profit from it? Are you choosing how much cash to allocate above statutory requirements or negotiated amounts in each country based on what will be most beneficial? Differing regulatory environments is one reason we see wide variation in investment programs. 3
It sounds like it can be tricky. How do most multinationals manage pension risk? Practices vary, but the common thread is that most focus on a few countries with the biggest obligations. In general, decisions are driven by local trustees and advisers to the trustees according to common practices. The problem with local discretion is that often creates an inconsistent approach to managing risks, which can drive higher cost of risk. We see some companies nominate corporate finance or HR leaders to the trustee boards. Our research suggests that roughly half the companies have a global committee and global guidelines to manage pensions. We have seen such committees focusing on global reporting, but a lot less so on proactive pension risk management. It is often a challenge simply to get information about pension risks globally, so getting aggregated information may be a big win. Most multinationals have aggregated information on an accounting basis, but that doesn t mean that they understand risks. Risk is not necessarily proportionate to the size of the plan either, as the regulatory environment drives a lot of the risk particularly when it comes to funding deficits. For example, in some markets it is considered acceptable to be underfunded on a solvency basis, whereas that may not work in other regions. Understanding the risks in each region can be challenging when there is not a consistent method for calculating risk exposures or even defining what risk is. Speaking of solvency, it is worth highlighting the challenges of terminology. The term solvency-basis in the U.K. is often used interchangeably with buyout basis, while in Canada it has a very specific meaning. 4
If that is how companies typically implement global pension risk management, how would you describe best practice in global pension risk governance? We have done two in-depth studies with the American Benefits Institute 1 of over 200 multinationals on how they make and execute strategic decisions on pension design, financing and operations. There are five simple questions we use to define "best practice": 1. Does the corporation have ready access to information about the plans it sponsors? 2. Does it have insights into risks and opportunities to manage them? 3. Has it established specific risk-management principles globally? 4. Does it have governance protocols and operational discipline to execute its riskmanagement decisions? 5. Does it monitor risks and opportunities? Our research shows that only 20 percent of companies so called best practice companies report effectiveness across all five measures. What is interesting is that these companies report significantly higher levels of confidence in their ability to manage costs and risks. I agree. Very few companies manage pension risks as well as they would like. It is certainly easier said than done. That said, there is a simple approach that we recommend: Define where you want to be over the next 5-7 years, measure where you are relative to that target and specify what needs to be done to get there. MC We have seen this happen even more effectively when the actuarial and investment teams are on the same page. For example, having the actuary participate in the quarterly investment meetings can make sure the key goals are understood well. 1 Aon s 2012-13 and 2015-16 Global Benefits Governance and Operations studies, conducted in partnership with the American Benefits Institute. 5
Let s get down to more specific examples of what this might look like. Are there certain countries that are better suited for taking investment risk or contributions above the minimum required amounts? Yes and no. Certainly the regulatory regime in a country influences those decisions, but it is hard to make blanket statements about what strategies are more effective in which markets. As an example, Dutch regulations penalize pension funds that invest in riskier assets by increasing their funding targets. In the U.K., many sponsors have closed defined benefit pensions for new participants and are increasingly freezing them for future accruals, and we see less appetite for riskier investment strategies because the economic value of the surplus they might create has no real value for the sponsors, and the trustees are keen to de-risk pensions. It also depends on the situation of the company. For example, companies often consider tax treatment, profitability of local operations, cash-repatriation opportunities and of course preservation of capital for business growth. What we are seeing in some cases and it is certainly our recommendation is once a company decides on an annual cash budget for pensions, it is important to allocate cash above any required contribution with a global view. Companies often consider tax treatment, profitability of local corporations, cash-repatriation opportunities and of course preservation of capital for business growth. 6
Can you give more examples of why a global approach might be different and beneficial? As another example, the fiduciary requirements for managing Dutch pension funds are quite onerous; in fact, companies often find it very difficult to fill trustee boards of the Dutch pension funds. On the other hand, financing Dutch liabilities say in Belgium or Luxembourg under the European cross-border pension legislation has all kinds of benefits for both members and plan sponsors. Indeed, companies like BP, Nestle and Sanofi have established cross-border funds that finance pension arrangements in multiple European countries under a single legal structure. However, locally there is an obvious bias against financing pensions in different countries. So a multinational organization really needs a global view to consider such arrangements. MC As another example, there may be financial and operational efficiencies to delegating the investment management to a third-party fiduciary manager. This is particularly true for smaller pension funds where the plan fiduciaries or trustees simply may not have the access or scale to achieve optimal diversification, expertise, time or resources to manage pension assets. We have seen examples where the corporate treasury has a clearly documented principle of delegating asset management for fiduciary providers as the means of executing global riskmanagement strategy in various local jurisdictions. 7
What are the key steps in developing a global approach to pension risk governance? To start with, it is important for companies to articulate either formally or informally their long-term position on pension design, financing and operations. It provides context for risk management decisions. The second step which I call a gap analysis is to understand where their pension plans are today versus where the company wants them to be. The next phase is to understand all the potential risk-management options at a local country level, which may include: Design changes such as closing defined-benefit pensions. Alternate funding options. De-risking and risk-settlement options. Operational options such as delegated or fiduciary solutions that enable seamless execution of the strategy. Finally, it is all about prioritizing decisions to take risks and opportunities where it is most profitable and which allocate capital efficiently. 8
When undertaking this type of approach, how do you manage the challenges of each country having local fiduciary rules? I often wonder if this is an excuse used by companies to not take action. Ultimately there is a lot of common interest between the company and the local fiduciaries. After all, the trustees primary responsibility is to ensure that the benefit promise made by the company is fulfilled, which requires that the obligation is fully funded and the assets are invested prudently. The company s position is not that different. The U.K. is a prime example. The buyout activity in the U.K. is on the rise because the plan trustees believe that the insurance promise has a stronger capital backing than the company covenant. That is not different from the company s desire to remove the liabilities from the balance sheet when it is economically attractive. It all comes down to having a long-term strategy, and then collaboratively working with the trustees within the local fiduciary framework to execute decisions. That is exactly right. One of my multinational clients has worked with us to develop a longterm view and a strategy, and has formed a collective advisory panel of trustee representatives from their largest pension plans. It makes a world of difference when it comes to getting things done. A global approach is most effective when there is common understanding and buy-in from both the corporate and the local fiduciaries in terms of strategy. This is different from having a small group from the parent company push out decisions without a good understanding of the local markets, legal structures and the business. The local fiduciaries shouldn t view the corporate headquarters as trying to undermine what they are doing, but rather that there are overall objectives that they are trying to work together to accomplish. This approach will likely yield better results than if the parent is simply reacting to proposals from the local offices. 9
What role do consultants usually play? This varies by situation. The consultant can often be effective as a facilitator across groups, and can also share information about what other organizations are doing, along with pros and cons of different approaches. The consultant may also be knowledgeable about how the various jurisdictions define risk and can help translate it to the parent in a consistent manner. Also, the global consultant can help project manage and implement the ongoing initiatives to manage risks in each local area; we see this working really well in practice. MC For the investments in particular, the consultant may have an opportunity to align the portfolio operations across regions to get the full benefits from the company s global scale. Consultants can be especially effective with this in an outsourced chief investment officer (OCIO) arrangement, which gives them flexibility to streamline many processes and simplify the management demands on the sponsor. 10
Any concluding thoughts? Technology is one thing we really haven t discussed. Technology platforms are increasingly playing an important role in managing knowledge and creating insights. Data and analysis can be created very quickly to help understand risks and make decisions that, a few years ago, used to take extensive time and resources. MC I would certainly echo that. Our fiduciary management teams in various countries execute dynamic de-risking strategies set by the fiduciaries of pension plans. Unfortunately, the markets don t move according to the trustees calendars. So, historically, by the time trustees made the decision to change the asset allocation strategy to, say, preserve the market gains by moving from equities to bonds, the markets had moved on. Think about the opportunity cost of this delay. We are using technology now to monitor asset and liability position on a daily basis so that we can make dynamic decisions on the dime. We ve covered a lot. In closing, if companies can organize themselves to understand risks and make efficient risk and capital allocation decisions globally, they will potentially see tremendous benefits. If companies can organize themselves to understand risks and make efficient risk- and capital-allocation decisions globally, they will potentially see tremendous benefits. 11
Legal Disclosures & Disclaimers Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc. ( AHIC ). The information contained herein is given as of the date hereof and does not purport to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information set forth herein since the date hereof or any obligation to update or provide amendments hereto. This document is not intended to provide, and shall not be relied upon for, accounting, legal or tax advice or investment recommendations. Any accounting, legal, or taxation position described in this presentation is a general statement and shall only be used as a guide. It does not constitute accounting, legal, and tax advice and is based on AHIC s understanding of current laws and interpretation. This document is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or circumstances. The comments in this summary are based upon AHIC s preliminary analysis of publicly available information. The content of this document is made available on an as is basis, without warranty of any kind. AHIC disclaims any legal liability to any person or organization for loss or damage caused by or resulting from any reliance placed on that content. AHIC. reserves all rights to the content of this document. No part of this document may be reproduced, stored, or transmitted by any means without the express written consent of AHIC. Aon Hewitt Investment Consulting, Inc. is a federally registered investment advisor with the U.S. Securities and Exchange Commission. AHIC is also registered with the Commodity Futures Trading Commission as a commodity pool operator and a commodity trading advisor, and is a member of the National Futures Association. The AHIC ADV Form Part 2A disclosure statement is available upon written request to: Aon Hewitt Investment Consulting, Inc. 200 E. Randolph Street Suite 1500 Chicago, IL 60601 ATTN: AHIC Compliance Officer Aon plc 2018. All rights reserved. 12
About Aon Aon plc (NYSE:AON) is a leading global professional services firm providing a broad range of risk, retirement and health solutions. Our 50,000 colleagues in 120 countries empower results for clients by using proprietary data and analytics to deliver insights that reduce volatility and improve performance. For further information on our capabilities and to learn how we empower results for clients, please visit aon.mediaroom.com Aon plc 2018. All rights reserved. The information contained herein and the statements expressed are of a general nature and are not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information and use sources we consider reliable, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. Contacts Matt Clink, CFA Partner matt.clink.3@aon.com +1.312.381.1216 Jeff Clymer, FSA, EA, MAAA Senior Partner jeff.clymer@aon.com +1.781.906.2242 Ian Hinton, FIA Senior Partner ian.hinton@aon.com +44(0) 20 7086 9139