Implementing your investment strategy, including considering operational risks, the security of scheme assets, asset transitions, liquidity and collateral management.
Issued: March 2017
What you need to do
- Understand the risks associated with implementing an investment strategy, including operational risk, so you can manage these risks and organise appropriate due diligence processes.
- Understand the security of your assets so you can decide if asset security risk levels are appropriate and take action where necessary.
- Ensure that the risks and costs of asset transitions are effectively managed.
- Understand your scheme’s exposure to collateral movements (if any) so you can develop and maintain a collateral management plan.
As well as setting the investment strategy for your scheme, it’s important to consider how that strategy can be implemented. This includes consideration of operational risks, security of scheme assets, asset transitions and liquidity and collateral management.
We expect you to understand, and mitigate where appropriate, the principal risks associated with implementing your scheme’s investment arrangements.
Identifying, understanding and mitigating implementation risks can be complex. We recommend you take an approach proportionate to the risks concerned. You may want to consider assistance from your adviser and investment providers.
Operational risks associated with the management of the scheme investments can arise from the operations of the custodian(s), investment manager(s), derivative counterparties and scheme administrator(s).
Our code of practice 9: internal controls, sets out how occupational pension schemes should satisfy the legal requirement to have adequate internal controls in place, which should manage operational risk within the scheme.
The degree of operational risk associated with managing the scheme’s investments is likely to depend on factors such as the structure and complexity of the scheme investments and counterparties used. For example, the use of derivatives gives rise to greater operational risks.
You should have a prioritised strategy in place to manage and mitigate operational risks proportionate to their significance in the context of your scheme’s overall investment-related risks. It’s good practice to document and regularly review your strategy, including the mitigations in place against the risks identified.
You may wish to consider the need for operational due diligence before appointing any third party involved in managing your scheme’s assets, and as part of your ongoing monitoring of operational risks. This may include due diligence processes by you, your investment manager(s), investment adviser, legal adviser and/or specialist providers.
Footnotes for this section
-  The legal requirement is set out in Section 249A(1) of the Pensions Act 2004.
Operational due diligence
Operational due diligence includes assessments of a third party’s awareness of their own operational risks and what controls they have in place to identify, manage, monitor and report on them. If you do not believe the third party’s operational risk framework is adequate, you’ll need to decide whether to put in place additional mitigations or avoid working with them.
The level of due diligence undertaken should reflect the significance of the risks associated with the third party’s operations. In many instances, such as in relation to regulated investments in mainstream asset classes, it is sufficient to seek input from your investment adviser as part of the third party selection process. The third party is likely to have pre-existing analysis covering operational risks that you and your investment adviser can review to assist with making this assessment.
Some operational risks are especially prevalent in alternative asset strategies such as hedge funds and private equity investments, which are often subject to less regulation than traditional securities. You may consider it proportionate to seek a greater degree of assurance regarding such investments. Where the risks are particularly significant, you may find it appropriate to use a specialist operational due diligence provider to understand and manage the level of operational risk to an acceptable level.
Understanding the security of your assets
As a trustee, you have a duty to ensure your scheme's investments are held securely. You therefore need to understand the arrangements in place to safeguard your scheme assets.
To do this, you will usually need to know who the custodian(s) of your scheme’s assets are, and their roles and responsibilities. Normally, at least some of the assets are held by a custodian, although only larger schemes with segregated mandates are likely to have appointed a custodian directly. A segregated mandate is a fund run exclusively for the pension scheme where the portfolio is tailored specifically for the needs of the scheme. Read further guidance on holding scheme assets securely.
Where your custodian participates in securities lending activities, you should ensure the terms of engagement with the scheme permit these activities and consider the financial benefit to the scheme. Example 10 within the guidance accompanying our code of practice on internal controls provides an example of this issue.
The use of pooled funds can bring greater risks to asset security, compared with making the equivalent investment via a segregated portfolio.
For example, many schemes make pooled investments by taking out a managed fund policy with a life assurance company (so-called 'life funds'). Investors in life funds are exposed to the risk that the company writing the policy may default, in addition to the risks of the underlying investments. Other types of pooled funds may also expose investors to unexpected credit risks.
In addition, the use of investor platforms to access funds means the scheme may have contractual agreements with the platform provider, rather than the underlying fund, potentially weakening the scheme’s position in a credit default event.
Mechanisms exist to provide investors with protection against these risks. Investors in regulated funds benefit from the requirements of their regulatory authorities. For example, the regulatory framework for life assurance companies seeks to prevent them from defaulting, and some providers of life funds put in place additional protections for their policyholders.
You need to understand the type and level of investor protection applicable to your investments. This is especially the case where investments are made in unregulated funds, where the level of investor protection is generally lower than for regulated funds and the risk of loss higher.
Establishing the level of protection that different scheme assets would have in the event of fraud, malfeasance or other adverse events is not straightforward. You may not always be able to definitively establish the extent to which your scheme’s assets are covered.
The Financial Services Compensation Scheme (FSCS) may provide some protection, but it is a ‘last resort’ arrangement and there are no definitive criteria for establishing the extent to which an occupational pension scheme is covered. The FSCS confirms coverage on a case-by-case basis.
There are mechanisms that may cover some or all of a scheme’s assets outside the FSCS, and these will depend on the structure of the scheme’s investments and how they’re held. You may wish to include questions on asset security when tenders for new investments are issued, and seek contractual commitments from the provider to keep that information up to date. It’s likely that you will need to take advice to establish the levels of cover and risk the scheme remains exposed to. You can then decide whether you’re comfortable accepting that level of risk, or if you need to make changes to the scheme’s investments or the contracts governing the investments, in order to reduce the level of risk.
Footnotes for this section
-  Regulation 4(3) of the Investment Regulations.
Negotiating additional protections
You may be able to negotiate bespoke terms with your investment manager to better protect your scheme’s investments. These could cover, for example, the manager’s liability for non-investment losses such as operational errors. If you are investing in a pooled fund, the terms may also cover the pooled fund’s investment mandate.
You can document these terms in a formal investment management agreement, or a side letter to the fund documentation. This is particularly relevant to investment in unregulated funds.
We consider it good practice for trustees to review the managers’ fund documentation, obtain appropriate legal and investment advice, and explore negotiating investor protections with the managers in light of that advice.
A review of the documentation should ensure you are aware of the main features of the fund’s investment mandate, so you can understand the principal risks inherent in the portfolio. It should show which investments are allowed and which investments the fund will typically be invested in. These may not always be obvious from the fund’s title.
The documentation may also set out the liquidity arrangements for investing in the fund. The fund may deal weekly, monthly, quarterly or even less frequently. In addition, the fund documentation may permit the investment manager to impose additional liquidity constraints, eg in times of market stress. You should familiarise yourself with the arrangements and how they can be applied.
Example 15: negotiating additional protections
The trustees of ABC Pension Fund undertake a selection exercise for a UK equity manager. They decide to appoint XYZ Asset Management, and to invest via a pooled fund, having obtained proper advice on how appropriate the investment is. The trustees note that, under the rules of the pooled fund, up to 20% of the portfolio may be invested in non-UK equities. They are fine with this, because the manager has explained the rationale for this during the selection exercise.
Upon further reading, they note that the fund documentation allows the manager to use derivatives for efficient portfolio management (EPM), and for other purposes.
They are familiar with the use of derivatives for EPM and risk reduction. However, they wish to know more about potential other uses of derivatives allowed in the portfolio.
The manager tells them this is standard wording and it applies across the manager’s pooled funds, some of which make extensive use of derivatives as a core part of the investment process. However, the manager doesn’t intend to take advantage of this wording for the UK equity fund, which is currently run on a straightforward basis. This does not reassure the trustees, as the manager could change their approach at any time, which the trustees may not be comfortable with.
The trustees ask their lawyer to review the documentation and to discuss matters with the investment manager, who reconfirms that the manager only intends to use derivatives in the UK equity fund for efficient portfolio management purposes. However, the manager agrees to enter into an additional agreement, confirming the manager give the trustees due notice of any change in approach. The trustees will then have the option to accept the change or transfer out of the fund.
Learning points: You need to be aware of what your funds invest in and how they’re managed. This may not always be obvious from the label on the fund, and it may require research and input from your advisers to understand this. If you’re not happy with the freedoms a fund’s documentation gives the investment manager, it may be possible to negotiate additional investor protections.
You need to be aware of the operational and market risks involved during asset transitions, such as those that arise from changes in investment strategy or changes of investment manager. You need to assure yourself that there are appropriate mitigations in place to address the risks of trading. Ordinarily, your investment adviser and/or investment managers can assist in implementing asset transitions. However, for more complex transitions it may be helpful to appoint a specialist transition manager.
The costs involved in transitioning investments can be significant. It’s important to consider these costs and the ways you can mitigate and manage them when making your investment decisions. Often, the explicit (visible) costs in a transition can be far less than the overall costs. You may wish to take advice about the transition options available to you.
Common mitigations against transition costs include:
- in specie transfers, where the assets are simply reregistered rather than traded
- pre-funding, which reduces the time investments spend out of the market
- trading investments in stages to reduce the negative impact that buying or selling at a particular point in time may have if market conditions are unfavourable
You need to assure yourself that there are appropriate reconciliation and reporting arrangements in place, eg between investment managers and administrators. You should also ensure that third parties are transparent about the costs involved, so you know these are appropriate.
The need for collateral management arises from the use of derivative instruments, eg those used in LDI arrangements. Derivatives can require security, in the form of cash or eligible assets, to be transferred from and to the scheme, in order to manage the counterparty credit risk arising from changes in the value of the derivatives. As well as placing liquidity and eligibility requirements on the scheme assets, this gives rise to operational risk.
When a scheme invests in pooled funds the fund manager normally undertakes routine collateral management within the funds without requiring collateral movements between the scheme and the fund. However, in the case of leveraged LDI funds, the manager can request additional collateral from investors, or may pay surplus amounts back to investors, if market conditions have changed.
You should consider, with your advisers, what your scheme’s collateral needs may be in changing market or regulatory conditions and ensure the scheme has suitable assets available to meet them. We would encourage you to consider a number of potential scenarios and assess their implications for the investment strategy.
You need to put in place and maintain an effective operational plan to ensure a smooth experience if assets are needed at short notice for collateral calls, for example if you have segregated or leveraged pooled LDI arrangements. This can include ensuring clear processes and communication channels exist, keeping up-to-date signatory lists and understanding the documentation requirements of the investment providers in advance.
Trustee toolkit online learning
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