A problem shared

The consultant’s role was rapidly evolving even before the financial crisis, writes Emma Cusworth

The current economic crisis emphasises two points to trustees: governance frameworks are increasingly limited; and the asset/liability balance, which has swung dramatically in favour of liabilities, requires a more holistic management approach. Eager to share the burden of responsibility, trustees are delegating ever more decision-making power to consultants as relationships deepen and become more intertwined.

While this is a true test of consultants' conviction in their own advice, it is also more expensive, with performance-based fees becoming the norm. This move, designed to increase alignment of interests, is not without its controversy, however, and designing the right definitions of performance, focused on risk and solvency, rather than investment returns, is key. Delegating so much responsibility to one provider, often including oversight, also raises questions about monitoring and underlines the importance of independent actuarial, custodian and consulting services. "Change is coming to the consulting model big time," says John Conroy, managing director at P-Solve. "The old system is not dead, but as clients become more demanding, there is widening recognition that it is over-simplified.

The key is offering different levels of engagement, which inevitably leads us to fiduciary management."

Fiduciary management takes hold
Fiduciary management focuses on achieving schemes' long-term goals within a defined risk management framework by providing both advisory and day-to-day investment management services.

This model takes several forms, involving different levels of delegation from something akin to multimanager, to more holistic, governance frameworks encompassing risk management, investment advice, implementation and oversight by one provider.

Fiduciary management has been established in The Netherlands for some time and, more recently, arrived in the UK. Other pensions markets, where consultants are engrained, such as Switzerland,
look set to follow.

A recent SEI poll shows an overwhelming majority of global schemes are re-evaluating their investment management and over half of UK schemes would consider using a fiduciary manager.
"Funding shortfalls are forcing trustees and sponsors to explore ways of improving governance and risk management through better, more efficient decision making," says Patrick Disney, managing director of SEI's Institutional Group in EMEA. "Schemes are increasingly recognising the benefits of strategic partnerships with consultants, which improve accountability and cost, while relieving trustees' burden."

Many trustees acknowledge the consultant's role in helping them make decisions. Delegating responsibility for implementation is arguably a natural extension of the relationship and a true test of consultants' conviction in their intellectual capital.

"The investment landscape is much more multifaceted and trustees are realising the biggest risk they face is not hedging liabilities," says Phil Page, client manager at solvency management firm, Cardano. "Pensions management is rapidly becoming more professional as the focus shifts
to the bigger picture of funding levels and trustees recognise they often lack the necessary skills
and time to deal with this type of responsibility."

John Sansone, practice manager at Towry Law, agrees, emphasising the limits of what can be expected from lay trustees. "A much more robust relationship is needed as investment becomes more specialist," he says. "Schemes are demanding more vigorous and scientific solutions, looking at how they can achieve full funding and long-term returns in a risk-controlled environment. The trend towards investment sub-committees is testament to this. Consultants need to pull their socks up and demonstrate they can add value, efficiency and robust governance procedures to help clients fulfil their regulatory responsibilities. Those who do not won't be around much longer."

Accelerating change
Although many consultants already offered these solutions prior to the current financial volatility, the last 18 months have increased the rate of change.

According to Tom Geraghty, Mercer's European head of investment consulting, In light of the economic crisis, there is now much greater acknowledgement that governance frameworks have not been as structured as they should have been. “The apparent failure of diversification, a popular topic for consultants, is also challenging them to demonstrate their conviction in their intellectual capital. This is fostering an 'in it together' philosophy, deepening con-versations and relationships with clients."

The partnership approach, he adds, is more conservative with increased focus on risk budgets. In his view, it is about marrying assets to liabilities by managing investments in the context of schemes' long-term commitments.

Geraghty adds: "Under fiduciary management, the framework can be quickly redesigned to deal with market strains as it allows a greater degree of flexibility and more dynamic decision making."
Sansone believes the order of the day is fresh thinking around strategic asset allocation to maximise diversification benefits, coupled with rigorous, proactive manager monitoring, review and change, within a governance model that constantly looks to add value at asset-class and investment manager level. "It's 'do or die' for consultants," he says.

Better dialogue, regular monitoring and review are crucial, Sansone adds, to enable schemes to justify investment decisions to beneficiaries and sponsors. "It is important to take a prudent risk approach and take profits, rebalancing portfolios regularly, in order that the risk strategy cannot run away," he says.

"This means proactively managing risk while targeting good investment returns. Tactical investing to generate returns is a risky business, especially if the aim is to do so consistently, which was forgotten more recently. Schemes following this approach for the
last two years would be relatively better off."

Appropriate fees
As consultants take on more of the burden of responsibility, the challenge remains to design a remuneration structure that allows them to benefit from greater involvement in a scheme’s outcome, while ensuring interests are as closely aligned as possible.

Consultants are increasingly adopting performance-based fee structures as a result. "The idea that consultants get paid for doing a good job is a sensible one, particularly as these partnerships mean they also have skin in the game," says Robert Gardner, founding partner of Redington.

Page believes fees should be designed to focus on improving schemes' funding level at low risk. "The point of solvency management is to work together to improve schemes' funding positions in a risk controlled way. With that in mind, fees should be paid on the basis of outperforming the liability benchmark, which is now much easier to calculate," he says.

Fees based only on returns, he argues, increase the incentive to provide return outperformance, which can diminish the risk focus.

According to Disney: "It is up to trustees and consultants together to structure fees appropriately, focussing on desired outcome rather than activity."

Handing responsibility for such a significant number of functions, including oversight, to one provider, who is paid on performance, does raise some questions. Not least: Who is watching the watchmen?

As the fiduciary model becomes more established, some experts believe a new monitoring service may be required of the consulting industry. According to Conroy, it will be important for trustees using fiduciary managers to have another, independent consultant monitor the performance and value delivered by the fiduciary manager.

"There may be a role for a third pair of eyes," Gardner says, "But that also means another layer of fees."

Others argue the fiduciary model has built-in monitoring. According to Page: "Clients still make the ultimate risk-budget and investment restriction decisions, while actuaries provide independent liability analysis and custodians track asset performance. This forms a tripartite relationship between the three parties, which works to self-monitor. But it is very important that schemes ensure they use providers that are independent of each other."

Furthermore, he adds, it is increasingly important that trustees have a strong understanding and are able to challenge their consultants. "In response to the evolution of the fiduciary model, pension fund boards need to work to increase their skills and experience, and focus on the bigger picture of scheme funding, looking at asset performance in the context of liability movements.

"Ultimately, someone needs to take responsibility for managing pension funds from a holistic, solvency-based perspective," he concludes. "As the funding problem grows and companies review pension strategy, consultants will increasingly work in closer partnership with trustees and other advisors, sharing the responsibility of achieving full funding."

WRITTEN BY EMMA CUSWORTH,
A FREELANCE JOURNALIST