Supervision of Pension Funds and Investment Firms Small and medium-sized pension funds

P.O. Box 98 1000 AB Amsterdam

Confidential

Date 16 January 2013 Our reference 2013/11989 Encl(s): 1

Subject

Supervisory Theme Outsourcing of Portfolio Management

This is an informal English translation of the Sectorbrief Themaonderzoek Uitbesteding Vermogensbeheer dated 16 January 2013 in Dutch which can be found on www.dnb.nl. 1 This translation is provided to you for your convenience. The Dutch version of the Sectorbrief Themaonderzoek Uitbesteding Vermogensbeheer is leading under any and all circumstances.

Dear members of the board of trustees,

Within the scope of thematic supervision De Nederlandsche Bank (hereafter DNB) currently examines the outsourcing of portfolio management by a number of pension funds in supervision class T2 2 (hereafter Supervisory Theme). DNB is looking primarily at the structure of investment mandates.

The Supervisory Theme is on-going. In the meantime, we wish to provide you by means of the annex to this letter with a number of tools which you can use to analyse and evaluate your investment management agreements. Note that this supervisory theme shall also be conducted with respect to (a selection of) pension funds in supervision class T3 in 2013.

Notes In its letter of 26 April 2011 (ref. no. 2011/237247), DNB informed the sector of the results of the DNB investment surveys 2010. The annex to this letter covered a number of points of attention

1 http://www.toezicht.dnb.nl/binaries/Sectorbrief%20Themaonderzoek%20Uitbesteding%20Vermogensbeheer_tcm50-227343.pdf 2 DNB has grouped supervised institutions into supervision classes in accordance with the new supervisory approach FOCUS!

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regarding the investment policies of pension funds, including the structure of investment mandates. The findings available at that time have been the reason for DNB to start a supervisory theme with respect to outsourcing of portfolio management.

Within the scope of the Supervisory Theme DNB examines several aspects, including whether investment management agreements contain such limitations with respect to the investment policy that result in a sufficiently unambiguous and effectively limited instruction for the portfolio manager. That is required for pension funds to guarantee control and integrity in business operations (beheerste en integere bedrijfsvoering), also with regard to the outsourcing of portfolio management.

The annex contains notes on four topics and an accompanying list of relevant questions: 1. Translation of the strategic investment policy into the instruction for the portfolio manager 2. Effective limitations (to this instruction) 3. Insight into the investment portfolio 4. Legal structure of the investment management agreement

We hope that you find the list of questions in the annex useful and that it helps you to analyse your investment management agreement(s) and take suitable action where necessary.

Should you have any questions or queries concerning this letter, pleases contact the Examining Officer (toezichthouder) or the contact person of your pension fund.

Yours sincerely, De Nederlandsche Bank NV

Prof. O.C.H.M. Sleijpen Director of the Supervision of Pension Funds and Investment Firms division

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ANNEX OUTSOURCING OF PORTFOLIO MANAGEMENT This annex contains notes and a list of relevant questions for each of the topics identified in the DNB letter to the pension funds (sectorbrief) dated 16 January 2013. This list of questions is not exhaustive. Its aim is to provide guidance by indicating potential shortcomings, thus enabling you to take suitable action.

There are four topics which are in any event important in the case of outsourcing of portfolio management: 1. Translation of the strategic investment policy into the instruction for the portfolio manager 2. Effective limitations (to this instruction) 3. Insight into the investment portfolio 4. Legal structure of the investment management agreement

The instruction for the portfolio manager is usually set out in an investment management agreement, with the portfolio manager's investment mandate attached. This annex refers to the investment mandate. If you have issued instructions to the portfolio manager in another way, please refer to that instead.

Should you have any questions concerning this annex, please contact the Examining Officer (toezichthouder) or the contact person of your pension fund.

1. Translating the strategic investment policy into the instruction for the portfolio manager It is important the instruction given by the pension fund to the portfolio manager corresponds with the pension funds strategic investment policy to prevent additional risks arising from the manner in which the portfolio manager carries out the instruction, and which are not envisaged and/or predicted by the pension fund.

Firstly, this requires a pension fund to draw up its investment policy adequately. After all, if the investment policy is in any respect still unclear to the pension fund, it is almost impossible to set out this policy in a clear and simple instruction for the portfolio manager. Secondly, a coherent

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and complete set of agreements between the pension fund and the portfolio manager is required to determine the limits of the instruction. When drawing up the investment mandate, it is essential to include, for example, further details of investment categories (such as regional spread) and the restrictions of the investment universe (i.e. the manner in which it is permitted to take exposure).

Questions about the further details of the investment categories: Establish o Has every investment category been sufficiently specified in the investment mandate? An investment category can be defined in different ways. For example: by regional or sector division, by investment method (single funds or fund of funds) or by the strategy within investment categories (e.g. within hedge funds). Using a benchmark: o Does the investment mandate include the objective(s) of this benchmark? These objectives may be, for instance, to compare estimated returns with the actual returns or to provide a guideline for how the portfolio manager should invest or a combination of both. o Is the benchmark appropriate for the category in which the investment is made, the objective of the benchmark (see above) and the specification of the investment category? Using investment funds: o Does the investment policy that you incorporated into the investment mandate correspond with the investment policy of the underlying investment funds being invested into? For example, are investment restrictions in the investment funds in line with your asset allocation?

Questions on the investment world: Establish o Does the investment mandate state the exposure that the portfolio manager may take in each of the various investment categories? For example, only directly or

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also through derivatives? What are the conditions?3 o Which products may be used to take exposure?

Aligning with risk management o Is the (potential) risk profile of the products in your portfolio adequately aligned with the risk management of your pension fund? You may decide, for example, that your investment portfolio can contain products with a non-linear risk profile. Can your risk management capture such a non-linear risk profile?

When using investment funds: o Does the investment universe that you incorporated into the investment mandate correspond with the investment universe in the underlying investment funds in which you have invested? For example, do the non-permitted or permitted products in the investment mandate and in the underlying investment funds correspond with each other?

2. Effective limitations to the instruction for the portfolio manager It is important that the pension funds aim regarding the limitation of the various risks and the subsequent specification in the investment mandate correspond with each other. This means that effective limitations on all relevant risks are formulated in the investment mandate or that the pension fund consciously decides not to limit a risk. In doing so, the extent and degree of freedom that the portfolio manager is given regarding the various risks are determined. This is also important for appropriate risk management.

Questions on clear and effective limitations: Establish o Have limitations been agreed for all applicable risks in your portfolio? For instance, interest rate, currency, credit and active risk but also for risks in connection with the use of leverage, concentration risk and liquidity risk. o Does the limitation correspond with the objective that you intend to achieve with

3 Please see for further details on derivatives section 13 of the Decree financial assessment framework pension funds. This section

states, among other things, that derivatives are permitted insofar they help mitigate the risk profile or facilitate effective portfolio management.

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the limitation? For example, you wish to hedge interest rate risk, including curve risk. However, you impose a limitation on duration that takes into account only the risk of the level of the interest rates and not the curve risk. In this case, the objective and the limitation do not correspond. o Can there be a difference of interpretation between the portfolio manager and the pension fund? For example, because the chosen wording can be interpreted in various ways? o Are the limitations suitable for the complexity of the (possible) risk characteristics of the products being invested in? Less liquid products and a nonlinear risk profile require, for example, other limitations than liquid products with a linear risk profile. Evaluation o Is it clear how often limitations should be evaluated by the pension fund and portfolio manager? Consider, for example, the interest rate risk that is dependent on pension liabilities. Is the limitation evaluated when pension liabilities are reassessed? o o Has the way in which this evaluation should be conducted been documented? Has it been agreed in advance if and how limitations are amended because of the evaluation? When using investment funds: o Are the limitations documented in the investment mandate in line with the restrictions used by the underlying investment funds? For example, do the limitations on the use of leverage in investment funds correspond with the limitations stated in the investment mandate?

3. Insight into the investment portfolio In addition to specifying clearly the instruction for the portfolio manager, it is essential that you, as a pension fund, remain 'n control by having sufficient insight into your investments. This means, for example, that you are informed of what is happening in your investment portfolio, what the risks are and what the total costs of the portfolio management are. The required insight can be realised through reports and (insight into) fees, etc. The questions below relate to the

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reporting requirements as stipulated between the pension fund and its portfolio manager.

Questions on reporting requirements: Insight o Do you have a good understanding of the (possible) risk profile of your investment portfolio? Do you understand the risk exposure per risk driver? o Can you see whether your investment portfolio is an adequate translation of your strategic investment policy? o Your portfolio risk is expressed as various measures per risk driver. Do the reports you receive, contain measures suitable for the complexity of your investments? When using investment funds (including fund of funds) o Do you have insight into all investments, also the monies invested by means of investment funds? Do the reports with respect to investment funds use the lookthrough principle? Analysis of the performance and the risk o Can you gain a good picture of the ways by which the portfolio manager has realised the performance or any negative results? Is the total return on your investments broken down by cause of result? (Consider, for example, over- or under-allocating to an investment category but also selection effects within an investment category.) o Can you gain a good picture where in your portfolio there is exposure to risk, and how much risk? Has the overall risk exposure been broken down by risk exposure per risk driver?

Questions on fees: Establish o Have the investment management costs been documented, or has it been documented upon which aspects they depend? Insight o Do you know in advance what the cost of the total portfolio management is? You may not know in advance what the total cost is because it depends on the choices

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made by the portfolio manager (within the agreed restrictions). In which way have you ascertained that you are still in control of the cost of the total portfolio management? Evaluation o Do you understand sufficiently the costs of an investment category, so that you can take them into account when evaluating that investment category? This to ascertain whether the category has delivered, after costs, the added value you expected.

4. Legal structure of the investment management agreement The legal structure of the agreement between your pension fund and the portfolio manager is also relevant. A pension fund should always invest in accordance with the prudent person rule and its organisation be set up in such a way that it guarantees control and integrity of business operations (beheerste en integer bedrijfsvoering). The latter means among other things ensuring the solidity of a pension fund. In this context it is important that a pension fund has procedures in place to, for example, control the financial risks and other risks that can erode the solidity of a pension fund. Risks also include legal risk and operational risk. In addition, specific rules apply to outsourcing agreements that a pension fund enters into. These rules are based on the Pension Act (or the Mandatory Occupational Pension Scheme Act) and secondary legislation.

Questions on the contractual relationship with your portfolio manager: Does the board devote sufficient time and attention to establishing an investment management agreement? Consider, for example, the following: Liability o o How has the liability of the portfolio manager been arranged? Is this arrangement logical and reasonable?

Ownership of the pension assets o Have you made agreements with your portfolio manager that give you a clear picture of any ownership risks and the control of these risks (whether in conjunction with the asset management agreement or other documentation such as relevant custody agreements and/or the documentation of investment funds)?

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Third parties services o Is it desirable to allow the portfolio manager to use the services of third parties? If it is, which third parties, for which services, when and under which terms and conditions?

Making withdrawals from the funds under investment management o Can you, during the duration of the asset management agreement, make a withdrawal from (a part of) the funds under management of the portfolio manager, if necessary?

Compliance with the rules of the Pension Act and the Mandatory Occupational Pension Scheme Act o Are adequate arrangements in place to ensure the portfolio manager complies with the rules laid down in or pursuant to the Pension Act and the Mandatory Occupational Pension Scheme Act?

Requirements with respect to the outsourcing agreements o Does the investment management agreement meet the other requirements with respect to outsourcing agreements as laid down in the Pension Act (or the Mandatory Occupational Pension Scheme Act) and secondary legislation? Does the investment management agreement contain, for example, arrangements to exchange information between your pension fund and the portfolio manager? Are arrangements in place that, for example, enable your pension fund to change at any time the way in which the outsourced activities are performed?

Transfer of rights and obligations o Is it desirable to allow the portfolio manager to transfer to another legal entity the rights and obligations pursuant to the investment management agreement, and if so, under what conditions? For example, have you agreed that your prior written permission is required before rights and obligations are transferred (also in the event that the portfolio manager wishes to transfer his rights and obligations to an affiliated legal entity)? Have you also agreed that this permission is requested when the portfolio manager wishes to make such a transfer?

Termination of the agreement o Have you made adequate arrangements with your portfolio manager regarding the terms and conditions of termination and the rights and obligations of both

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parties upon termination? For example, can you change your portfolio manager in a relatively simple, controlled manner and within an acceptable period, should such a change be required? In-house funds o Have you made agreements with your portfolio manager that guarantee any inhouse fund selected for you offers at least the same added value as a comparable fund with another manager? Governing law and jurisdiction o o Which law governs the investment management agreement? Which court has jurisdiction in case of a dispute with respect to the investment management agreement?

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