copy the linklink copied!Chapter 2. Trust and financial institutions

copy the linklink copied!2.1. Introduction

In the wake of the financial crisis of 2008, trust in financial institutions amongst consumers and society more broadly plummeted. In the United States, for example, trust in the financial sector dropped to 36% in 2009, from 69% in 2008 (Edelman, 2009). Globally, the financial services sector achieved an 11 percentage point increase in trust in the five years from 2012, but it is still one of the least trusted industries with just 54% of consumers reporting that they trusted the sector in 2017 (Edelman, 2017).

For consumers and society to have trust in institutions, those institutions must be competent and effective in delivering on their goals. They must also operate consistently with a set of values that reflect citizens’ expectations of integrity and fairness.

This chapter focuses on ways in which policies can promote increased trust in financial institutions by ensuring the safety of assets, fair treatment of customers and meeting the expectations of society. Three specific elements are considered: policies that promote prudent pension management; policies designed to enhance financial consumer protection; and policies to address environmental and social risks.1 It explains how such policies can help financial institutions in responding to the preferences of their beneficiaries and consumers, promote long term value creation and avoid potential negative commercial impacts associated with environmental and social risks.

Trust on pension systems delivering pensions, and trust on pension funds managing people’s retirement savings in their best interest, is low. Population ageing, the financial and economic crisis, and the current environment of low growth and low returns is making people doubt whether pension systems and pension funds will deliver on their promises, whether they are run with their best interest in mind, and whether they will get adequate pensions.

There is also a low level of trust in pension fund management, which stems from a lack of appropriate governance, clearly stated missions, and adequate investment policies and risk management. International significant pension fund and policy makers are developing best practices which can help overcome some of these issues.

Policies to enhance financial consumer protection are important to promote and support trust and confidence in the financial system. While much attention has been paid to regulations relating to the conduct of financial institutions, by themselves they do not necessarily result in increased trust. In more recent times, attention has also been focused on issues relating to conflicts of interest, culture and the governance of financial products themselves.

Additionally, demand from clients and beneficiaries for financial institutions to consider environmental and social factors in their decision-making is growing. The role of financial institutions in avoiding negative impacts on society and the environment is also increasingly recognised as an important factor towards driving commercial performance, economic stability and global sustainability objectives.

The themes focused on in this chapter are selected from a constellation of possible approaches policy makers can consider to build trust in financial institutions. Governments’ roles in supporting trust in both the financial sector and the economy, more broadly, are discussed in other chapters, including through promoting trust in financial markets (Chapter 1), trust in law enforcement (Chapter 3) and trust in online markets (Chapter 5).

copy the linklink copied!2.2. Policy options to improve trust in pension institutions

People’s trust in pension systems is lacking with many questioning whether they will get a pension when they retire and whether that pension will be adequate to maintain their standard of living. This loss of confidence applies to all types of pension arrangements, i.e. defined benefit (DB), pay-as-you-go (PAYG) or funded pensions. They also wonder whether defined contribution (DC) funded pensions will provide adequate pensions. In addition, people are concerned about whether the institutions managing their retirement savings (e.g. pension funds) are doing so in their best interest. They also question whether the fees that pension funds charge for managing their retirement saving are aligned with the actual cost of managing their retirement savings and they are not being overcharged. Finally, the growth of pension arrangements in which people need to make many decisions and bear most of the risks (e.g. investment and longevity risk), DC plans, means that people need guidance to make those decisions and address those risks. In this context, the design of DC plans need to improve accounting for behavioural biases and low financial knowledge that make people decision making a struggle. In addition, financial advisors may be exposed to conflict of interest. The section on consumer protection deals with the issues arising from conflict of interest of retirement financial advisors and discusses potential solutions.

The lack of trust stems from the challenges that pension systems and pension funds managing people’s retirement savings face. Pension systems are are being forced to adjust to meet these challenges and people often fail to understand why changes are being proposed or implemented. An effort from the authorities and other stakeholders in improving communication and comprehension of those reforms is clearly necessary.

The fallout from the financial and economic crisis, population ageing and the current economic environment characterised by low growth, low wage growth, low returns and low long-term interest rates, pensions are changing the pension landscape. These circumstances mean that current contributions and current contribution periods can no longer adequately provide the type of pensions and security that people have come to expect.

The global financial crisis has led to a reduction in the capacity of governments to finance retirement promises. People’s trust in public pensions is diminishing. People are also losing confidence in private pensions with the fall in the balances accumulated in their pension funds provoked by the crisis.

Pensions are also coming under pressure as the baby boom generations retire, improvements in mortality and life expectancy, and longevity risks linked to uncertainty around future improvements in life expectancy. Living a longer and healthier life is generally good but, if not properly taken into account, population ageing challenges the financial sustainability, solvency and adequacy of pension systems. Population ageing is leading both to an increase in the number of people in retirement relative to the size of the working age population and also, most importantly, to an increase in the number of years that people spend in retirement. This increase needs to be financed.

As a result of population ageing and, in particular, the continued improvements in mortality and life expectancy, PAYG pensions face financial sustainability problems, defined benefit funded pensions need to secure their continued solvency, and defined contribution (DC) pensions need to consider ways to ensure that individuals have an adequate income during retirement. Contributing more and for longer periods, especially by postponing retirement as life expectancy increases, is the best approach to face these challenges.

Pension funds and annuity providers are exposed to longevity risk owing to uncertainty about future improvements in mortality and life expectancy. To address the risk of unanticipated increases in liabilities, regulators and policy makers should ensure that pension funds and annuity providers use regularly updated mortality tables, which incorporate future improvements in mortality and life expectancy. The regulatory framework could also help ensure that capital markets offer additional capacity to mitigate longevity risk, by addressing the need for transparency, standardisation and liquidity. Index-based financial instruments and the publication of a longevity index to serve as a benchmark for the pricing and risk assessment of longevity hedges would be helpful in this regard. Furthermore, the regulatory framework should recognise the reduction in risk exposure these instruments offer.

The current economic environment of low returns, low interest rates, and low economic growth further compounds the problems of financial sustainability, solvency and adequacy. These factors may lead to lower resources than expected to finance retirement promises or simply lead to lower retirement income. Low returns reduce the expected future value of contributions as assets accumulated will grow at a lower rate than expected. Low interest rates may reduce the amount of pension income that a given amount of accumulated assets may be able to deliver, especially in defined contribution (DC) pensions. Additionally, low economic growth may reduce the overall resources available to finance pension promises.

In summary, population ageing, the fallout from the financial and economic crisis as well as the current environment of low growth and low interest rates may increase financial pressure on defined benefit (DB) pension arrangements, which include potential fiscal difficulties for pay-as-you-go (PAYG) financed public pension arrangements and solvency problems for funded DB pension arrangements. It may also create serious problems of retirement income adequacy for defined contribution (DC) pension arrangements in which individuals bear many of the risks of saving for retirement.

Policy makers, regulators and the pension industry have been responding to those challenges and thus addressing to some extent the potential sources of the mistrust on pensions. Policy reforms implemented in the last decade have make pension systems more robust and better placed to deliver pensions (OECD, 2018b). In particular, reforms implemented in PAYG DB public pension arrangements have made them more fiscally sustainable. Improvements in the design of DC pension plans taking into account behavioural biases and low financial knowledge is improving retirement outcomes. Additionally, recent reforms have laid the foundations for people to regain trust that pension funds will manage their retirement savings in their best interest. These reforms include more robust regulatory and supervisory frameworks, stronger governance, investment policies and strategies, investment risk management, and a more solid focus on the best interest of members, including the consideration in their investment policies of sustainable investment opportunities.

Countries have accelerated the pace of pension reforms stabilising public pension expenditure while addressing concerns about whether pensions will be adequate in ageing societies. A majority of countries have implemented reforms that have partially addressed the problems of fiscal sustainability. They have introduced automatic mechanisms to adjust pension benefits to economic and demographic realities, such as planned increases in the statutory age of retirement, and linking benefits, retirement age and/or maximum contribution periods to future improvements in life expectancy. This coupled with the strengthening of safety nets to improve poverty relief in old age, and some progress on adequacy, especially for low income socio-economic groups, have gone a long way in making public pensions sounder, but substantial gaps remain.

Pension arrangements in which assets back pension benefits, and in particular those with a direct and straightforward link between contributions and benefits, DC plans, have grown in importance. These pension plans require individuals to make many more decisions regarding their retirement. Moreover, individuals bear more risks, such as investment and longevity. This has highlighted the importance of improving the design of DC pensions taking into account behavioural biases and low financial knowledge (OECD, 2018b, Ch.5).

Automatic features, default options, simple information and choice, higher level of financial literacy, and financial incentives lead to better retirement outcomes. As a result of low levels of financial knowledge and behavioural biases, people make inappropriate decisions regarding their retirement. For example, mechanisms such as automatic enrolment and escalation of contributions can harness inertia to help people participate and save more for retirement. Default options assist people unable, or unwilling, to choose a contribution rate, a pension provider, an investment strategy or a post-retirement product, to end in place that may be in their best interest. Other tools to help with decision making, include web applications, limiting options and making comparisons easier, pension statements conveying key information simply, and financial literacy seminars and financial advice to help people understand the information. Box 2.1 discusses the role of financial literacy in improving trust in pensions. Finally, financial incentives do provide an incentive to people to participate and save more. Evidence suggest that they do, and the fiscal cost may not be large, however, it needs planning to account for the fiscal room available in each country, and to focus those incentives in the different subpopulations according to their saving needs and policy objectives (OECD, 2018a).

The OECD and pension regulators have strengthened the regulatory framework of funded private pensions in response to the diminished trust of the public in private pensions. The OECD Core Principles of Private Pension Regulation (OECD, 2016d) cover all types of funded pension arrangements and strengthen the regulatory framework to make sure that funded pension arrangements work in the best interest of members, both for current retirees and for those currently saving for retirement. These principles argue that pension funds must always act in the best interest of members. This fiduciary duty should always be guaranteed in the law and in the regulatory framework.

Strengthening governance requires having regulatory and legal frameworks for pension funds at arm’s length from government. Pension funds should have clearly stated missions to guide investment policy. They should have an oversight board that is accountable to the competent authorities as well as to members. The boards of pension funds should be transparent about their governance arrangements and their investment and risk management to keep them accountable to different stakeholders.

Pension funds and their boards should express their performance objectives in terms of their mission and should monitor performance against their long-term goal of providing retirement income with security and manage the funds in the best interest of members, rather than against a market benchmark. Target date and lifecycle funds tend to be the preferred investment strategies for pension funds with individual accounts (OECD, 2012a). Long-term return strategies may offer better returns, but at a higher risk that insufficient funds will be available to members at retirement. Large pension funds take into account ESG investment opportunities, but always in the context of their fiduciary duty to members.

Finally, to rebuild trust pension funds should consider aligning their fees and charges levied on employers and members with the actual cost of providing funded pension arrangements. Providing pension services involves costs such as administration and investment activities. These costs can greatly affect the ultimate value of accumulated retirement savings. Some pension arrangements can be also more expensive, such as those providing more choice. The potential impact of these charges on the ultimate value of retirement savings can be large. For example, charges of 1.5% of assets, reduces the final pot at retirement by nearly 30% as compared with a situation without charges. Charges of just 0.5% reduce retirement income by more than 11%.

Therefore, it is important that policy makers and regulators make sure that the charges paid for those services reflect the actual cost to providers. Unfortunately, market mechanisms have often been insufficient to align charges with the actual cost to providers due to market failures, such as asymmetric information or behavioural biases.

Measures to improve transparency are essential, but are not enough to align costs and charges. They work best when supported by pricing regulations (e.g. caps on fees, default investment strategies) and structural solutions (e.g. tender mechanisms and default options). To maximise net returns, policy makers and regulators can also use measures such as benchmarking and tying investment expenses more closely to portfolio performance.

Pension funds, to gain people’s trust, should also consider sustainable and environmental, social and governance (ESG) investment opportunities are part of pension of their duties and investment policies. Pension funds should assess sustainable and ESG investment opportunities as any other investment opportunity by examining their risk and maintaining their mandate to manage people’s retirement savings in their best interest. They should, in this context, aim at incorporating in their investment policy investment opportunities that provide in the long-term the best risk-adjusted net of costs real returns. Saving for retirement is long-term in nature, but timing of disbursement also bring in short-term liquidity considerations. Pension funds should consider all investment opportunities, including ESG opportunities, as part of their investment objective, their investment policy and risk management approaches.

The regulatory framework does not prohibit nor encourages pension funds from integrating in their investment policy and risk management ESG investment opportunities (OECD, 2017). Investors’ interpretation and lack of clarity on the rules by the regulator may discourage ESG integration. The main barriers for ESG integration are practical. Lack of standardised and harmonise disclosure and of data, as well lack of models, indicators and metrics to appropriately assess ESG investment opportunities are the real problem facing pension funds to integrate ESG factors and risks in their investment policy. The section 4 of this chapter will deal further with this issue.

copy the linklink copied!2.3. Financial consumer protection

Empowering and protecting consumers is also a key aspect of trust building. Financial consumer protection policies seek to promote disclosure of all information including cost and a competitive marketplace with good quality and value-for-money products. They also aim to ensure that customers receive fair treatment, are not misled or subject to misconduct, and can access to redress and compensation mechanisms when things go wrong.

The G20/OECD High Level Principles on Financial Consumer Protection (OECD, 2011a) is a well-established policy instrument setting out ten principles for a comprehensive policy framework for financial consumer protection, including in relation to responsible business conduct. While the notion of responsible business conduct covers a broad range of actions and behaviours by a financial institution, its employees and representative, at the core of the Principle is the requirement that financial services providers and authorised agents should have as an objective to work in the best interest of their customers. The Principle also relates to matters such as remuneration and incentives, avoiding conflicts and suitability.

Jurisdictions have implemented a wide range of laws and regulations governing the conduct of financial institutions, overseen by authorities with responsibility for regulating and supervising market conduct in the interests of protecting financial consumers.

Conduct risk is generally the risk of conduct occurring which does not meet applicable standards or requirements. Those standards or requirements may be those set out in laws or regulations, professional standards or unwritten standards of conduct expected by the community in which the financial institution operates. Such conduct can include inappropriate, unethical or unlawful behaviour on the part of an organisation’s management or employees and is damaging to consumers’ trust in the organisation. That conduct can be caused by deliberate actions or may be inadvertent, because of inadequacies in an organisation’s practices or systems.

The amount of financial services regulation governing conduct has increased significantly since the global financial crisis. However, it is not clear that alone this is sufficient to rebuild public trust. For example, according to a study by PwC into the relationship between the UK financial services sector and its customers, while 49% of people believe regulation had been strengthened since the financial crisis, 57% did not believe that the reforms were sufficient to prevent history from repeating itself (PwC, 2014).

Not surprisingly, more recently, there has been an increased focus by policy makers, regulators and supervisors responsible for conduct on the culture within financial institutions and the quality of financial products being sold to financial consumers, complementary to the focus on market conduct. While appropriate rules and regulations governing conduct are important, in order for them to be properly effective and adhered to in the appropriate sprit, it is vital that the institutions subject to them are operating under a healthy culture where conflicts of interest are managed and the needs of their customers are prioritised, supported by the financial products on offer.

The OECD, via the G20/OECD Task Force on Financial Consumer Protection, is monitoring developments, from a financial consumer protection perspective, relating to culture within financial institutions and financial product governance. In this regard, it is supporting a project being conducted by the International Network on Financial Consumer Protection (FinCoNet) in collaboration the G20/OECD Task Force on Financial Consumer Protection, to understand policy and supervisory approaches to financial product governance and culture in jurisdictions around the globe. The results of this work will inform the development of international good practices. In the meantime, the following sections outline how managing conflicts of interest, culture and product governance support responsible conduct and therefore the protection of financial consumers.

copy the linklink copied!2.4. Enhancing trust in institutional investors through responsible business conduct

Edelman has identified 16 drivers of trust across business. Among these over a quarter are directly related to responsible business conduct (RBC).2 These include: having ethical business practices; putting customers above profit, working to protect and improve the environment; addressing society’s needs in its everyday business; and partnering with NGOs, government and third parties to address societal issues (Edelman, 2012).

RBC-related drivers have historically received less attention in the financial sector than in industries with more direct social and environmental footprints. However, the role of RBC for trust building in financial institutions, and particularly for institutional investors has become increasingly important in recent years.

copy the linklink copied!2.5. Conclusion

In the wake of the financial crisis, significant reforms were introduced to prevent against future crises as well as rebuild trust in the financial sector. While these initiatives have been helpful in regaining public trust, additional work is necessary to respond to new and ongoing challenges as well as increasing expectations of beneficiaries and society more broadly of the financial sector.

This chapter addresses three areas essential to understanding and strengthening people’s lack of trust in financial institutions. The section on pensions highlights the importance of pension governance and transparency, financial literacy, the alignment of fees and costs, and ESG investment to improve trust in pensions. The section on financial consumer protection focuses on managing potential conflicts of interest, culture and quality of products. The section on responsible business conduct concentrates on governance, standard setting, data and disclosure. More work is required in all three areas to improve people’s trust in financial institutions.

With respect to pensions and pension funds, several activities could be useful in enhancing trust including:

• Better communication regarding the features of the pension system, the purpose of different reforms, and adjustments to the system.

• Further improvements in the design of DC pension plans accounting for behavioural biases and low financial knowledge.

Additionally, the regulatory framework needs to be strengthened further by making sure that pension funds work in the best interest of members. In this respect:

• The independence and, the internal and external, oversight of pension funds’ governing body need further strengthening in many jurisdictions.

• The supervision and monitoring of pension funds also needs to improve further, as well as data disclosure and standardisation, especially on the costs of providing services to members.

• There is still a lot to do on the fees charged by pension funds making sure that they are aligned with the actual costs for pension funds of managing people’s retirement. Some of the ideas are discussed in the chapter and in other OECD reports (OECD, 2018b).

In terms of promoting trust and confidence via financial consumer protection policies, the application of robust conduct regulation, disclosure and other activities, needs to be reinforced by considering more qualitative factors such as:

• Ensuring financial institutions have the appropriate culture in terms of safeguarding and prioritising customers’ interests and ensuring the quality and value of the financial products and services on offer.

The role of RBC in trust building for institutional investors can only be expected to become more significant in the coming years as millennials’ share of global investment grows and the impacts (both financial and real) of environmental risks and irresponsible business practices are felt more acutely. While there has been increased interest and efforts by institutional investors to take environmental and social issues into account in their activities, to date the level of ambition and approaches of institutional investors have varied considerably but have largely been limited in scope.

As investors seek to respond to increasing demand for responsible investment they will have to enhance existing approaches. Policy makers can facilitate institutional investors in this respect in several ways:

• Supporting investment governance frameworks that are compatible with and support ESG objectives.

• Fostering common and widespread expectations with respect to responsible investment, for example due diligence processes for responsible business conduct.

• Supporting efforts to promote quality ESG data and disclosures.

Some governments have already initiated such efforts. Scaling up these efforts and ensuring coherence across approaches will be important to enhancing trust in this sector amongst consumers, beneficiaries and society more broadly.