By segregating functions, tasks are allocated across different parties, enabling effective checks and balances.
Governance has increasingly been regarded as a critical issue in recent years, also for pension funds, and is an area of heightened focus for regulators. Sound governance is considered essential for protecting the interests and entitlements of participants. An administrative separation of powers (a so-called “trias pecunia”) should form part of this governance framework, yet in practice this appears to be occurring less frequently.
Many pension funds use (large) banks to hold their liquid assets and investments. These investments mainly consist of equities, bonds, investment funds, and derivatives. In this capacity, the bank acts as a custodian—literally, a “safekeeper.” However, the custodian does not merely hold the investments, but also performs the actions associated with custody. These include, for example, the settlement of dividends, the reclaiming of withholding tax on dividends, and the settlement of coupon payments.
Too much under one roof
Over recent decades, custodians have further expanded their services to pension funds to include, among other things, investment administration. This expansion encourages pension funds to place their entire assets with a single custodian, as it eliminates the need to consolidate multiple administrations across different custodians. An additional advantage for custodians is the deeper and more enduring relationship with the pension funds concerned. Once investment administration has been placed with a single custodian, it becomes increasingly cumbersome for a pension fund to transfer the custody of its investments to another custodian. The custodian will typically argue that such a transfer complicates its service provision, as it would no longer have a comprehensive view of the total assets.
Where significant amounts of capital are involved, it is essential to manage conflicting interests and to segregate functions. An (independent) investment administration is not only necessary to ensure proper reporting, but also to enable effective controls over parties to whom activities are outsourced (such as the custodian).
Responsibility for critical activities—such as decision-making, safekeeping, control, recordkeeping, and execution—should therefore be clearly separated. In practice, particularly the latter four functions are now largely concentrated with a single custodian. In most “ordinary” businesses, it would be unthinkable to outsource administration to the same bank with which the company conducts its financial transactions; yet in the pension sector this has become common practice. By introducing a clear segregation of functions, responsibilities are distributed and essential controls can be performed. This helps minimize the risk of errors with potentially significant financial consequences.
The “strength” of Chinese walls
It is often argued that administrative segregation of duties is sufficiently safeguarded because activities within custodians are divided across multiple departments—the so-called Chinese walls. However, the question arises whether genuinely opposing interests can be effectively embedded within a single organization, where individuals critically challenge one another while consistently placing the client’s interest first. The recent prohibition on combining audit and advisory services within accounting firms illustrates how difficult it is to ensure such critical independence under one roof. What is the impact of combining banking activities and their oversight within a single organization on transparency towards clients, for example when errors occur? How can clients be assured that errors are reported clearly, timely, and comprehensively?
Pension funds also have supervisory bodies such as a Supervisory Board or a Board of Trustees. However, like external auditors, are these bodies sufficiently close to day-to-day operations to be certain that participants’ interests are always adequately safeguarded?
Trust is good, control is better
There are numerous examples of companies (including accounting firms and banks) where failures have occurred in recent years. In such cases, supervision proved inadequate, but might have functioned more effectively had the segregation of duties been structured more robustly. In a “regular” company, this is not always easy to organize. In asset management, however—where multiple specialized service providers are involved in areas such as custody, administration, control, and execution—this separation is easier to achieve. By leveraging modern technology, administrative processes can be structured in an optimal and efficient manner, with enhanced assurance.
Is this difficult to realize? No. Many funds already operate in this way, thereby strengthening their governance frameworks.
The question is when the tide will turn. Often, this only happens after the damage has already been done. To prevent problems, I advocate—by analogy with the trias politica in our constitutional system—for a “trias pecunia.” At a minimum, this requires a clear separation between the safekeeping, recordkeeping, and control of pension assets. The separation of powers is a fundamental principle of our system of government. The same should apply when it comes to our pension assets.
