For these guidelines, the definition of investment governance begins with describing the key elements of a system of decision-making and oversight used to invest the assets of a fund. Thereafter, the definition extends to define investment governance as this relates specifically to the management of reserve funds of social security institutions.
In institutional investment, “governance” describes the system of decision-making and oversight used to invest the assets of a fund. The responsibility for this role lies with fiduciaries such as the board and management who are faced with high-level issues (for which they will typically take responsibility) and more detailed implementation actions (where they are more likely to delegate to others and the fiduciaries’ role becomes monitoring those actions). Investment governance, in short, employs skills, resources and processes to create value for the social security institution.
The amount of expertise, financial resources, time (both internal and external) and fund operational effectiveness that an organization can devote to the governance process is limited. The amount of these elements that can be devoted to this process is known as the governance budget. The size of the governance budget will affect expected governance performance. A certain size of governance budget should be matched with an appropriate investment style and strategy. As more or fewer skills, resources and processes are made available, the governance budget may change over time, with implications for likely investment performance.
At its simplest, an appropriate governance budget is a precondition for an effective investment strategy, recognizing the limits imposed by fund size and committed resources including time and expertise. More generally, the governance budget is also a strategic instrument framed according to an investing institution’s ambitions in relation to its long-term investment mission and goals.
The challenge of governance is greater than dealing with the generic issues which affect all modern organizations. Social security institutions operate in global financial markets where the management of risk and uncertainty is crucial to the creation of long-term value. Governance can create and destroy value depending on the risk budget and the governance budget. The implications of this proposition are twofold: first, risk-taking against well-defined objectives is an essential ingredient in any well-governed financial institution; second, the extent to which risk-taking is a deliberate and managed activity depends upon the governance budget allocated to this function within the institution. Poorly governed entities rarely take risk planning seriously and wrongly economize on the governance budget, treating it – incorrectly – as a cost that limits net financial performance.
These guidelines on investment cover all aspects related to the progressive process of governance to be taken by an institution. However, we can identify four key, broad stages to the investment process itself. These four stages, briefly summarized below and developed in the individual guidelines, relate to: decisions regarding the investment strategy; building up an appropriate portfolio based on this strategy; implementation of the strategy; and monitoring and reporting of the process.
It is well documented that the strategic asset allocation of an investor accounts for the majority of returns. It is, therefore, an essential part of the investment process for this allocation to be thoughtfully structured and clearly defined. The strategic asset allocation is long term in nature and should reflect the investing institution’s investment beliefs, investment mission and goals, risk budget, return objectives, liabilities and funding policy, and risk tolerance, and the extent to which these may be impacted upon or constrained by non-financial factors. Risk tolerance should include consideration of the likely correlation between the financial well-being of the ultimate sponsor (the government/taxpayer) and the events which may cause a downturn in the assets of the social security institution. In addition to constructing a strategic asset allocation, a review of investment strategy may include asset liability modelling (where the liabilities may be inflation linked, for example), stress tests on key areas of risk to identify the main risk exposures, and reflections on diversification and hedging of selected risks.
Portfolio construction is the first step in the implementation of an investing institution’s strategic asset allocation. The objective of portfolio construction is to efficiently translate the goals of the strategic asset allocation into investment decisions. This process includes considering the investment mission, investment beliefs, governance budget, return target and corresponding risk budget, available investment choices and liquidity requirements. The portfolio should be sufficiently diversified using frameworks such as asset class, geographic region, risk premia and, possibly, thematic investments. The portfolio should be constructed using the most efficient investment possibilities available to achieve the desired return and risk objectives. Risks should be identified and analysis undertaken regarding how to manage (or “hedge”) risks that are deemed to be “unrewarded”. Liquidity considerations and the governance budget should play a part in determining whether the use of derivatives is an appropriate approach to managing risk. “Extreme” or “tail” risks which the board has identified as relevant when setting the investment strategy should be assessed in the context of portfolio construction. The portfolio construction may be dynamic by revisiting the asset allocation in light of changing market conditions. Clearly defined and shared investment beliefs, or working assumptions about the way the investment world functions, can improve the efficiency of decision-making for portfolio construction.
Implementation concerns applying the investment decisions made in portfolio construction by selecting specific investments. The investing institution should consider its expertise and governance capability when choosing whether to manage assets through an internal investment unit, through the appointment of external fund managers, or in collaboration with an external investment adviser. If active external fund managers are to be selected, the investing institution should have the resources, expertise and governance budget required to adequately research, select and monitor “best-in-class” managers or appoint an external investment adviser who has the capability to do so. Implementation should also emphasize selecting investments with maximum efficiency. This includes evaluating the value versus cost for each investment selected when constructing a portfolio. Value reflects the degree to which the investment objective is achieved. Cost is often represented by investment manager fees, which may be a significant drag on gross performance. Custody arrangements and the transitioning of assets are also key considerations when implementing an investment strategy.
Regular measurement and monitoring of key risks is essential to enable the investing institution to make timely and informed decisions, ultimately driving more efficient management of its assets. The board and management should have key metrics available to them, such as the overall asset distribution relative to strategic allocations, and the performance and risk of the overall portfolio and its underlying managers, as well as qualitative reviews of external fund managers, global markets and economics.
The investing institution’s ability to manage investment strategy dynamically depends upon its having a robust method for monitoring progress against the long-term strategy and the level of risk inherent in the portfolio. While investment strategy is typically set for the long term, there are times when dynamic or tactical allocations may be made to reflect current market opportunities or threats.
These investment guidelines reflect the specific issues relating to the management of reserve funds of social security institutions. They reflect the fact that the objectives relating to the investment of these funds typically differ, often significantly, from the objectives for the investment of supplementary benefit provision (often referred to as Pillar II provision). However, many of the principles of good investment governance – such as appropriate structures, decision-making and peer review, consideration of risk, reporting, etc. – apply to both social security reserve funds and supplementary pension provision.
These guidelines, however, do specifically reflect the differences between social security and other pension provision where this impacts upon governance processes and structures. The key differences are:
- Funding and financing of benefits. Whereas Pillar II arrangements are normally required to target full funding (where the present value of liabilities is covered fully by assets), social security reserve funds often have different investment objectives. This reflects the fact that such funds are often set up for different reasons than to fund benefits (e.g. to smooth future cash flow requirements) and that the state often acts as the “lender of last resort” for social security. Therefore, the majority of social security systems are, generally, partially funded. This situation has implications for the choice of investments and may lead to more onerous cash flow constraints for reserve funds due to the lower level of assets held. In addition, and more generally, funding objectives are more likely to be different for reserve funds and may focus on the ability to meet cash flow requirements (e.g. the fund may be required to hold assets at least equal to a certain multiple of monthly benefit payments) or simply to ensure “sustainable cash flows”.
- Investment regulations are likely to differ. While such regulations and limits may, on the surface, be less onerous than for Pillar II arrangements (e.g. investment in certain asset classes may be less limited), social security reserve funds may also be more subject to greater political influence on the investment of funds (see below). Social security reserve funds may also be required to invest in certain assets and may have more direct investment either in private or state-owned enterprises or in infrastructure projects. In such cases the value of the investment (and risks related to it) may not be easily verifiable, leading to challenges in the assessment of asset value and risk. Where investment restrictions are less onerous than for supplementary non-state pension provision, this greater investment freedom coupled with potentially more demanding cash flow constraints (due to a higher cash flow requirement as a percentage of assets held) should be matched by suitably well-resourced governance capabilities which are able to manage often sophisticated and complex investment arrangements while taking into account the obligations of the institution.
- Wider objectives and external constraints. Although reserve funds are often set up to allow the smoothing of financing requirements and anticipate future demographic changes, they may be seen as important strategic investors by external bodies. This may result in the imposition of certain investment choices or supplementary objectives (e.g. providing financing to certain sectors or buying government debt). In such situations, the role of the investment function to put in place appropriate governance procedures, and putting in place appropriate responses to such situations, is particularly important so as to ensure that the reserve fund meets its obligations in respect of those covered by social security.
- Reporting requirements may differ from supplementary non-state pension provision. Although requirements may be more onerous for supplementary plans, social security reserve funds have a public and political accountability which will influence the quality, content and frequency of reporting.