More and more pension funds are outsourcing part or all of their investment process to fiduciary managers or delegated CIOs, and in the Netherlands the majority of pension funds have already done so. Fiduciary management, solvency management, outsourced CIO, delegated CIO, as the various market participants label their service, can be very beneficial for defined benefit pension schemes that want or need a relatively sophisticated investment portfolio to meet their obligations.
However, it is not the panacea it is sometimes made out to be. For one, it is expensive. Why else do you think investment consultants are so keen to move into this business? It makes more money for them than charging a consulting fee by the hour. Asset managers are equally keen, although for them the benefit is to have ‘stickier’ assets. This is particularly the case if they are able to convince the client to select their own in-house funds and strategies.
Asset managers’ in-house funds and strategies may be better but that is difficult for the trustees to judge. And how likely is the fiduciary manager to fire their in-house team if they are not delivering on the promise? And can you even trust performance figures or risk metrics that are provided by the fiduciary manager? There are all kinds of governance issues that need to be very carefully considered when evaluating the move to an outsourced solution.
This is the second reason why it is not always the panacea. There is also a third: in virtually every outsourced situation, the outsourcing party will, over time, lose expertise. This is not necessarily a problem as long as the interests of the pension fund (actually the members and the sponsor) are well aligned with those of the outsourcing provider. But it does mean that it becomes increasingly more difficult to evaluate the quality of the service that the outsourcing provider delivers. Frequently, interests are not fully aligned in the first place, so proper oversight is crucial.
Does arranging for oversight make fiduciary management even more expensive? Not always. Trustees themselves can provide this oversight by asking critical questions and not accepting vague or incomplete answers. Quite often, trustees delegate this task to their investment committee. I have seen investment committees that are very capable of asking the right questions and the best fiduciary managers respond well to this. It is also in their interest to have clients who are fully satisfied for the right reasons. They can be a good reference and they are likely to keep their business for longer.
But it is difficult to know how to ask the right questions and ‘unknown unknowns’ are always a problem. Information asymmetry is one of the most dangerous aspects of the asset management business, as it allows mediocre providers to stay in business and do a disservice to their pension fund clients.
For most beneficiaries, their pension is the difference between a relatively comfortable and a tight budget in retirement and the compounded effect of many years of overpaying for underperformance is much larger than most people think. For trustees to be able to see through the glossy marketing material of their providers, it is best to have a mixture of governance, finance and risk professionals in their midst. Financial companies’ pension schemes tend to have these naturally and you can see this in their governance and performance.
Having said that, transparency and honesty have improved somewhat in the asset management industry, thanks partly to the fact that many finance professionals have left the banking world for the buy-side, academia and to work for regulators. With this, detailed knowledge of the tricks of the trade has increased and there is a response to calls for increased transparency and value.
This allows pension funds to strike better deals with their asset management service providers than they have done in the past. It also means that contracts that were agreed some time ago are now out of date and can be renegotiated on much better terms. Not all pension funds seem to be aware of this.
It is important to keep up to date with developments. But this requires deep expertise that not all trustee have. Some work with external professional trustees, which goes some way to getting the required knowledge on board, as long as these individuals keep their knowledge up to date. Some consultants also provide the necessary expertise, although trustees should ensure that their consultant’s interests are closely aligned with theirs.
A number of consultants have also invested heavily in manager selection, for example. But are they likely to advise their clients to choose a cheap passive solution if that means less income for themselves? Some of them are fêted by the investment industry and, at the very least, are dependent on them for much of their information. Do you think that this puts them in the best position to negotiate hard on fees on behalf of their pension funds clients?
We have developed a balanced scorecard approach to evaluate a pension fund’s relationship with its service providers. This approach allows the board to keep track of how well their service providers work with them. This approach is not new and has been used for many years in managing outsourcing relationships in industry. Part of the evaluation is based on hard data, like financial performance, timeliness of information and other key performance indicators.
Part of it is qualitative, measuring things like the quality of communication and relationship between provider and client, governance and alignment, but also thought-leadership and innovation.
Harvard Business School has written several case studies highlighting the importance of a balanced scorecard approach to strategic partnerships. We have adapted these to a pension fund environment, which enables the trustee board to monitor, assess and, where necessary, improve the quality of their outsourced services and to regularly take a considered decision whether or not to continue with those relationships. Applied correctly, it can make outsourcing both beneficial and economical for the pension fund.