Many multinationals have built up pension arrangements that can become complex when they are consolidated at group level. These frequently contain a mixture of defined benefit and defined contribution schemes. They may be invested directly or indirectly – for example, through insurance policies or investment funds – and may have a social security offset. They may also have different funding situations, including being underfunded. Benefit levels will also vary, typically to fit in with local market employee benefit practice.
Local rules for pension fund financing, such as minimum and maximum contribution rates or different approaches to the treatment of surpluses and deficiencies, can vary significantly, This has focused the attention of multinationals on the whole issue of ensuring cost-effective provision of pension plans. The more advanced multinational companies already exert a degree of control over local pension fund strategy and structures with such co-operation now being considered almost the norm. But the level of assistance varies from company to company.
The reaction of local pension funds to group control has been mixed. Some initially saw such control as interference. But multinationals that committed themselves to a programme of explanation, education, and the provision of resources within their multinational framework, managed to establish their credentials and are now seen as providing valuable assistance. Such groups are viewed positively as a resource to share experiences with, particularly in the increasingly complex investment arena.
Once benefit levels have been agreed, groups need to focus on a number of key issues to minimise costs. Here we consider defined benefit plans. Defined contribution plans, where cost savings accrue to increase members’ benefits rather than reduce scheme costs, have different requirements.
These are the five key ways of maximising returns and minimising costs, in order of importance:
q Developing appropriate investment strategies;
q Establishing an appropriate risk control framework;
q Establishing appropriate implementation processes: selection of investment managers; minimising transaction costs on changing managers; ensuring cost-effective custody arrangements; identifying ‘marginal’ value added activities.
q Developing appropriate monitoring procedures;
q Establishing best practices to ensure ongoing stewardship of funds.

Developing an appropriate investment strategy
Probably the most important aspect for multinationals is ensuring that subsidiaries have appropriate investment strategies. The equity/bond mix is usually regarded as the most important investment decision for any pension plan, but as investment strategies have developed they have tended to become more complex. Many European pension funds are considering increasing their equity content (except UK funds), diversifying out of their home equity market to a more pan-European or global base, considering the use of credits in bond portfolios and introducing alternative investments such as private equity, hedge funds and commodities. As a consequence, strategy debates have become more in-depth.
Surprisingly, considerable differences in asset allocation between various countries still exist. Most local subsidiaries use some form of asset liability modelling, but come up with different results. For example, the average UK fund has about 70% equity while the average Dutch fund has 40%. Yet both use similar modelling techniques and similar inputs for asset assumptions. Most multinationals have sought to achieve consistency in assumption setting, modelling methodology and output. This has led to some consistency in establishing an appropriate global framework and is the first step to consistent asset allocation.
In the past two years, pension funds have seen poor overall performance, with equities underperforming bonds. The extent of the underperformance is significant and has had an adverse effect on funding ratios around the world. As a result, many multinationals now want to see how they can better quantify and control the risk being run on a group basis.
Most multinationals will have looked at whether local plans are in surplus or deficit and whether a different group strategy would be appropriate; for example, by aggregating pension plans, rather than treating them as the sum of the individual plans. Such issues are complex and require extensive examination. It is inefficient to put money into a subsidiary pension plan that is in deficit, while enjoying a contribution holiday in another. The net effect could be a lower cash flow into the funds.
Local requirements, and the inability to consider pension provision on a cross-border basis, mean that such issues will remain. But the aim of minimising cash flow into the pension funds is important for companies, since it is difficult to repatriate money from funds with surpluses. Many groups have examined the question of controlling surpluses and deficiencies in subsidiary plans in a cost-efficient way. Such strategies tend to be complex and may result in some corporate overlay strategy.
However, whatever local constraints apply, ensuring the correct investment strategy is adopted is the priority.

Establishing an appropriate risk control framework
In our experience, few multinational companies have quantified risk in their pension funds on a global basis; or if they have, they have not at the same time been able to influence local investment strategies as a result of this analysis. While most conduct local asset liability modelling exercises, the results are difficult to consolidate into a coherent strategy. Many companies that collect their pension fund data for accounting purposes will have realised the significant effect the investment downturn in their pension funds’ returns will have on the balance sheet - and the potential cash flow implications - at a time when corporate profits are under pressure. Although the strategies of the biggest pension plans are likely to be examined in detail, those of some of the smaller plans may be scrutinised less rigorously. This could result in significant volatility of pension fund costs.
Multinationals with subsidiaries that have large pension funds have been grappling with this issue and are now developing sophisticated tools to minimise risk in a more coherent fashion. A consistent approach to risk management across all subsidiaries is one of the key areas where multinationals have benefited from open dialogue and debate. But although most pension funds have developed a good dialogue in the area of risk management, they have a mixed understanding of its implementation. Risk management includes ensuring efficient asset allocation in each of the local plans, implementing an appropriate risk budget, which would result in an agreed structure of the fund management arrangements, as well as putting monitoring procedures in place and ensuring the safe keeping of all assets.
Establishing an appropriate implementation process
In the early stages of assistance with investment arrangements, most multinational parent organisations focused on helping with the selection of investment managers and manager structures, such as active or passive management. For historical reasons, most multinationals still have a complex mix of local managers. They are now consolidating to achieve a smaller number of providers. Combining the assets of a number of subsidiaries can provide significant economies of scale and reduce costs. In practice, however, consolidation increases the asset pool size, resulting in more choices of provider and the ability to diversify. Consolidation therefore tends to risk rather than provide direct and instantaneous financial benefit.
Complex tax treatment has made it difficult for multinationals to find an appropriate structure to implement such policies. This is especially true for the medium and small funds that would benefit most from this type of arrangement.
The selection of investment managers probably remains the highest profile activity but still only accounts for a small proportion of time. Other activities, such as ensuring that strategy is consistent, that manager structures are appropriate and that proper monitoring procedures are in place, are more time-consuming – and probably less exciting – but equally important.
The larger pension funds have reached more advanced stages of maximising returns and minimising costs. Many are concentrating on minimising transaction costs when changing strategies or fund managers and are using specialist management expertise in these areas. They have also developed ‘best practices’ for ensuring cost-effective custody arrangements and are examining other value-added activities, such as stock lending, cash management and so on. While the additional returns or costs of such activities can be difficult to quantify, experience suggests that the more advanced funds that have focused on these areas have benefited, or at least that they have enjoyed a reduction of risk for a similar level of return.

Development of appropriate monitoring procedures
Many plan sponsors have developed systems for monitoring arrangements including structures, manager performance and fund performance. However, for multinationals with different structures, ensuring consistency and the ability to consolidate information on a group basis has been vital. They have made it a priority to ensure that benchmarks are appropriate and that review procedures and appraisal systems are implemented with proper rigour.
Although multinationals vary in their requests for information at group level and in their understanding of risk control issues, over the past few years they have successfully introduced procedures to ensure that there is an overview of total pension fund progress and have developed best practice procedures for monitoring subsidiaries.

Establish best practices to ensure ongoing stewardship of funds
There tend to be two distinct levels of pension fund oversight – largely dependent on fund size. There are those that are large enough to justify dedicated expertise and there are those that are smaller and whose investment issues are part of a manager’s overall responsibility. Developing best practice and sharing information are key factors here. Successfully structured funds have developed a more rigorous framework for decision-making to guide those with less day-to-day interaction with pension fund investment issues. By developing best practices, the group’s assistance can be less hands-on, while at the same time developing rules to ensure compliance and procedure s for seeking help when needed.
In our experience, the most successful group-subsidiary relationships have developed over time, where there is an emphasis on education and sharing of experiences. With disappointing returns and rising costs, pension fund sponsors will come under significantly more scrutiny. Higher returns that can be generated cost effectively and within a controlled framework will ensure a healthy provision of pensions in the future. This means sharing best ideas and learning from mistakes. There is also likely to be more emphasis on the quantification and control of risk from a corporate perspective, resulting in consistency of approach, structure and methodology.
Nigel O’Sullivan is managing director pensions insurance strategy group at Goldman Sachs International in London

Topics