Carl Hitchman, Partner, Hymans Robertson
You have decided that fiduciary management is for you. How then do you go about choosing a suitable manager? While most consultants and managers have been advising on and managing assets for many years, they now overlap in terms of these capabilities, which poses additional challenges. How are fiduciary managers meeting these challenges and structuring themselves to provide clients with the confidence to appoint them?
You need to ask a wide range of questions when assessing the suitability of a fiduciary manager. Many are no different to those asked when assessing a traditional investment manager. However, some strike at the heart of fiduciary management, and the answers will be crucial in determining whether a manager is fit for purpose. Based on our experience, pension scheme should be asking 10 key questions.
1. Is the fiduciary prepared to take responsibility for determining the level of interest rate and inflation exposure?
The greatest risk most pension fund trustees face is the level of interest rate and inflation risk. How to manage this is one of the most important questions.
There are three things to consider. First, will the trustee retain responsibility for the level of interest or inflation rate hedging outside the fiduciary mandate? If so, setting the fiduciary a liability/funding level benchmark will not be appropriate.
Second, is the fiduciary’s approach to hedge most or all the interest rate or inflation risk as a matter of course? If so the trustee, not the fiduciary, is making the decision to hedge. The trustee needs to be comfortable with this within the broader context of their scheme’s investment and funding arrangements before appointing a fiduciary.
Finally, where the fiduciary is prepared to take responsibility for managing these risks their success is likely to depend on how well they manage this aspect of the mandate, rather than the large number of asset classes and manager decisions typical of this type of mandate.
Mandate experience and credentials
2. What credentials does the fiduciary have and to what extent do they already manage mandates similar to the one under consideration?
The skills and operational infrastructure needed to manage a mandate against an asset-class benchmark are quite different to those required of a mandate structured around a risk budget or funding level target.
3. In which areas does the fiduciary believe they will add value?
It is important to know what to expect from a fiduciary so their performance can be monitored, checking that risks are being taken in areas in which they have expertise and are in accordance with their stated investment philosophy and process.
4. What are the operational risks and how are they managed?
The fiduciary should be asked what they see as the key operational risks inherent in their approach, how they manage these risks, and the extent to which they could withstand claims arising as a result of operational mishaps. In particular, in which areas has the fiduciary developed their operational capabilities, brought in new resource and invested in new IT? Are there any areas that still need addressing?
The operational challenges in developing a fiduciary business will vary depending on whether the fiduciary has an asset management or consulting background. It is important that the fiduciary can articulate the challenges that have to be met and how they intend doing this so trustees are comfortable there are no material gaps in the service offering.
5. How many different managers/mandates does the fiduciary expect to put in place?
Understanding all the risks inherent within pension fund arrangements is a challenge at the best of times, requiring sophisticated systems to monitor and manage investments in place. This challenge is magnified for those fiduciary mandates that result in a significant increase in the numbers of managers and mandates in place. It is important therefore that the fiduciary’s portfolio monitoring and management systems are compatible with the way they manage client portfolios.
6. How easy is it to exit from a fiduciary relationship and what costs would be involved?
Will trustees be able easily to terminate a fiduciary’s appointment and move the management of the assets to a new manager, or will they be forced to disinvest from some or all of the investments in transferring to a new fiduciary, incurring costs?
Conflicts of interest
7. What due diligence does the fiduciary undertake on their in-house funds and how do they ensure the due-diligence undertaken is fair and unbiased?
There are two concerns the fiduciary needs to demonstrate it can effectively deal with. Firstly, that the fiduciary’s choice of asset classes and managers could be swayed, with a potential impact on returns, by the additional fees their firm could generate if in-house funds are used.
Secondly, there may be pressure not to use external funds, as this could be seen as a lack of confidence in the firm’s own abilities. This, in turn, could have ramifications for client business well beyond the fiduciary mandates. This issue takes on greater proportions if the fiduciary decides to replace an in-house fund with an external one.
8. How does the fiduciary structure its fees and how does it manage conflicts of interest that arise?
There are two main fee structures: an all-inclusive fee or a structure that charges the fiduciary and manager fees separately. Each structure poses challenges. While an all-inclusive approach provides clarity over fees charged, the risk is that managers could be excluded purely on the basis of their fee structures. In contrast, the conflict within the separate fee structure is that the fiduciary could appoint a third-party manager for a role that, under the mandate terms, it is expected to undertake, for example, managing a portfolio of alternative investments. This would not only reduce the time and resources required of the fiduciary it would also result in duplicating some fees.
9. What is the fiduciary’s policy for managing the allocation of scarce resources?
This relates to capacity constrained products and the allocation of internal talent. If appropriate procedures are not in place and implemented effectively, the risk is that scarce resources are allocated to a particular sub-sector of the client base, for example, to those operating on a performance-related fee. This is unlikely to be an issue in the early days as the fiduciary business grows but could become more of an issue over time.
Commitment to fiduciary management
10. How scalable is the fiduciary’s business model?
You need to identify the fiduciary’s commitment to building its business. If fiduciary management has the potential to form a material part of its overall business or to improve profits, then, all else being equal, one would expect a greater commitment in resolving any threats to the success of the business.
Fiduciary management is still in its infancy in many countries and experience among market participants is still developing. However, the building blocks of fiduciary management have been around for many years and provide a strong foundation for identifying those managers that are fit for purpose and that will stand the test of time. Taken together, these questions provide a strong framework if and when pension schemes decide to appoint a fiduciary.