Twin trends of consolidation and thriving specialist boutiques coincide with an urgent debate about the role of advisers and ownership of responsibility within the pensions governance complex. Martin Steward looks at optimising the cooks-to-broth ratio
Is it better to work with one full-service generalist or a handful of specialists? It is a question pondered by clients of most service industries, and pensions consulting is no exception. A couple of high-profile mergers have made the question more pertinent, particularly as new boutiques continue to arrive and thrive.
“There was a trend towards ‘one-stop shop’ but it has weaknesses,” notes John Brandford, senior partner at HamishWilson & Co, which was set up by the Watson Wyatt and Bacon & Woodrow alumnus in 2002. “It’s only as strong as its weakest player. Its consultants are exposed to fewer external ideas, and there is greater risk of cross-selling and of strategic advice being constrained by implementation capabilities.”
In fact, the market is not really split neatly between full-service generalists and single-skill specialists. HamishWilson is a full-service consulting actuary. Its specialism is in a market segment - medium-sized UK corporate schemes. Similarly, Atkin & Co believes that its specialism a coherent full-service approach for that smaller client (corporates with less than £500m).
“Few of our competitors are either able or willing to offer the full range of services to these clients,” says director Nick Atkin. “Firms of a similar size usually only specialise in one area and therefore are unable to take advantage of sharing knowledge across services.”
Larger firms have well-resourced departments across all services, but their history and culture results in particular strengths, regarded as specialisms, that help define the brand. This is especially the case in continental European pensions markets dominated by insurance companies and banks that have little need of full-service consulting but use specialists for individual projects.
In Spain, Novaster CEO Diego Valero speaks of the struggle to make the case for adding value in the over-commoditised area of actuarial services and of the success of his firm’s socially responsible investment (SRI) specialism, for example. But the same pattern is discernible in the UK. Capita Hartshead is best-known for its third-party administration service, while it also has a full-service offering for smaller schemes, which pensions operations director Malcolm Pearce notes has “often been sorely neglected by the larger players”.
At Towers Watson, European head of investment consulting Paul Trickett characterises his firm as “research-led specialists” in investment advice. The firm’s Thinking Ahead Group, seeking to “challenge conventions” and “exploit opportunities before they become mainstream”, exemplifies the culture. “That’s vital for us to develop valuable new ideas for our clients: we don’t spend that money in order to be a pseudo-university,” says Trickett.
If a client wants that, it is only going to get it from a large, full-service player that can charge a large clientele to subsidise it (although not ‘pseudo-universities’, not all consultant research will be equally relevant to every client). The cost/benefit assessment will likely vary with the size and resources of each scheme. “Our bug-bear is advice for the sake of advice,” says Atkin, his eye on his more modestly-sized clients. “Is the issue relevant to the scheme? Will the cost of a report outweigh any potential gain?”
Tom Geraghty, Mercer’s head of European investment consulting, describes a number of brand-defining skill centres - SRI; operational due diligence, custody and transition management outfit Sentinel; the Financial Strategy Group specialising in sophisticated investments, risk and liability-hedging; implemented consulting - that are selling points “wherever we work”, and often stand-alones for clients using other specialists or another full-service consultant.
This is the dominant model for Redington in the UK. Many of its clients are giant organisations used to employing a number of specialists - but it is also sole adviser to the Telent Pension Scheme. And while it has built a formidable reputation in derivatives-based liability-driven investing (LDI), co-founder Dawid Konotey-Ahulu insists that this is just one aspect of its deep, hands-on capital markets expertise. “The whole business of understanding risk is a capital-markets expertise,” he says. “Banks have occupied the ‘PV01’ world for years - they understand interest rate, inflation, credit sensitivity; they have been stress-testing portfolios for years; they devised equity protection strategies and have used derivatives to replicate other asset classes for years.”
Konotey-Ahulu set up a pensions advisory desk at Merrill Lynch back in 2002, but the inability of these transaction-oriented organisations to forge longer-term relationships has restricted that model (see Jon Exley’s return to Mercer in 2008 after three years with Barclays Capital), Redington’s premise is that these two worlds require an intermediary. “We are constantly receiving ideas from banks, but to understand those ideas you have to speak the same language,” says Konotey-Ahulu. “The banks like the fact that we speak their language, and the client knows we can ask the difficult due diligence questions. You also get huge cost benefits by having your consultant plugged-in to this space.”
When we look at the market’s recent mergers, we see this blurring of the specialist-generalist lines continuing. Mergers can optimise costs - overheads are increasingly better shared across a broader clientbase as regulation and IT gets more sophisticated and complex - but that optimisation includes synergising complementary specialisms. For example, Towers Perrin’s benefits and HR expertise fits nicely with Watson Wyatt’s in investments; JLT liked the fit with HSBC Actuaries & Consultants’ experience in defined contribution; and Capita Hartshead’s administration offering was well-complemented by Gissings’ actuarial capacity.
Examples of full-service firms offering specialist advice in a multi-adviser context raise questions about the relationship between strategy (built on actuarial and asset-liability modelling - ALM - expertise) and implementation (built on investment and capital markets expertise). “With several advisers working for the same client, the ability of those advisers to work together is vitally important,” notes Duncan Howarth, CEO in employee benefits at JLT Group.
Most schemes will delegate at least some of their investments to external experts - but those experts may be implementing a pre-packaged style divorced from the development of the scheme’s liability-related strategic objectives. With rising interest rates, an asset manager will shorten duration, while its pension scheme employer might want to increase duration to close the ALM gap, for example. As the range of asset classes has diversified and ALM has changed from a box-ticking process to a dynamic, mark-to-market exercise performed by schemes that often outweigh their sponsors, strategic objectives have begun to enjoy more attention than the previously dominant implementation issues like manager selection - and the potential for disconnect has increased.
“Using a range of specialists with no-one helping with that oversight role runs the risk of good advice that lacks strategic context,” argues Sorca Kelly-Scholte, managing director in consulting and advisory services with Russell Investments. “You may be doing great stuff in reversible trouser bonds but not really know why.”
Russell’s consultancy is a multi-manager, fiduciary-management style offering. The firm has no actuarial capability, but values close relationships with clients’ actuaries when building its ALM models: “We have to understand why the actuaries have measured things the way they have, nuances that aren’t captured by cold numbers,” says Kelly-Scholte.
It should come as no surprise that Russell emphasises the importance of the link between that strategy and implementation, at both the asset allocation and asset management levels. It seems to fit the fiduciary management model. Guus Boender, chairman and non-executive director at Ortec Finance agrees that ALM should be done with a long-term partner - “otherwise it becomes a purely technical exercise, which can be very dangerous” - and that that partner should stick around when implementation gets under way to avoid investment managers “carrying out the strategy without really knowing what the strategy meant”.
For Boender, ALM is about fully integrating funding and investment strategies with the needs of all stakeholders, including the sponsor (making cash contributions and marking the liability to market on its balance sheet) and the members (who add inflation risk to the trustee’s duration risk). But this ‘holistic’ approach is not fiduciary management. Boender points to investigations into several schemes whose fiduciary management structures led to too much delegation of responsibility to asset managers, leading to precisely the strategy-implementation disconnect that we have described. Like Kelly-Scholte, he argues that fiduciary managers should work more closely with clients’ long-term service providers at the strategic level. “Fiduciary managers work very much in the narrower sense of ALM,” he says. “So we are not afraid of that competition, because where there is a complex or important project, in most cases we are asked to get involved - and we ask the client to make sure that the fiduciary manager is also at the table, not as our competitor but as our partner.”
All of this works both ways, of course - it’s not about strategists lecturing the implementers. Although unintended disconnects between strategy and implementation are undesirable, some disconnect is necessary if a strategy is going to make sense in the real world. Some argue that the bias of actuaries to beautiful theoretical solutions led to UK schemes’ ongoing tilt towards domestic equities (because equities were used in liability discounting under the minimum funding requirement). Others point to the obsession with hedging interest rate risk under current accounting conventions. Still others characterise their conservatism as an unwillingness to give definitive advice. “Actuarial firms hire conservative people,” says Patrick McCoy, head of investment advisory at KPMG. “An investment business built on that is going to be pretty slow, conservative and options-based - ‘well, you can do this or you can do that’.”
That’s not just the sound of an audit firm kicking consulting actuaries. HamishWilson’s Branford concedes that “the criticism is fair”. Atkin describes actuaries’ advice as often “so heavily caveated that the client is unable to see the wood from the trees”. And Geraghty at Mercer admits that “consultants are increasingly being asked by clients to get off the fence”.
This becomes all the more urgent as trustees - often under pressure from sponsors who see short-term volatility on their balance sheets and may have greater capital markets experience - demand more tactical capacity to protect their long-term strategy. Their clamour increases immediately after a bout of volatility, and care has to be taken that trustees do not drift into asset management. But it is surely difficult to support the view of Danny Wilding at Barnett Waddingham (known for its actuarial expertise), that “tactical asset allocation is not part of the role of the investment consultant”. Similarly, Capita Hartshead’s director of actuarial services Kenneth Donaldson speaks of his trustee clients’ “strong distaste for knee-jerk reactions” and maintains that, “for the majority, the much commented upon governance gap doesn’t exist”.
Others, from smaller players like Simon Jagger at Jagger & Associates, Atkin at Atkin & Co and Haitse Hoos of Asset Advisors up to Geraghty and Trickett at Mercer and Towers Watson, accept the need for some tactical decision making, usually based on delegation and market trigger points.
“You have to ask whether or not tactical asset allocation is right for the trustees,” says Kally-Scholte at Russell. “If so, the second thing is to ensure that tactical positions are based on thoughtful, forward-looking insights, rather than reactions to market conditions. Lastly, you need to be able to implement them quickly.” As we’ve seen, for some consultants, implementation is not even up to achieving the strategic position, let alone the tactical one. “We recently had a client that made a set of strategic decisions after their 2007 valuation but still hadn’t figured out how to implement that strategy before overtaking themselves with their 2010 valuation,” notes Kelly-Scholte. “We see delegation, including fiduciary management, expanding to address that lack of actionability.”
Maybe. But perhaps consultants just need to up their game. “The investment [experience] of our competitors is most of the time only theoretical,” notes Haitse Hoos, a partner at Asset Advisors, pointing to his experience as CIO of VGZ Health Insurance in the 1990s. “We understand both sides of the asset management industry.” This was what led Ortec to hire John van Markwijk, CIO of SPF Beheer, to head its trustee investment guidance service some years ago: “We needed more investment knowledge,” Boender admits. “Until then, ALM was too separate from the real world.”
There’s no question that most pension schemes could also up their game on governance to improve accountability and coherence across strategy-setting and implementation. “The answer to a lot of problems is to reverse this trend of outsourcing, and try to maintain a minimum level of in-house expertise,” suggests Boender’s colleague Lucas Vermeulen. With its more technical focus, Ortec is perhaps freer to make such a suggestion without threatening its commercial position. But Boender also praises Towers Watson’s work with fiduciary managers in the Netherlands to help “clean up these issues”.
“No one has banged on about scheme governance more than Watson Wyatt over the years,” says Trickett. “We help a number of the larger schemes to structure their own internal capabilities, and we’ve been saying that schemes should employ CIOs and executive teams and spend more resources on internal than external.”
Where resource constraints mean decision-making has to be delegated, consultants must play a better role in establishing ownership of those decisions and the structures through which they trickle down to implementation - especially in a multi-adviser context. When Russell Investments surveyed a sample of pension trustees and managers on who made a range of their scheme’s key decisions, from setting overall strategy to selecting managers, one in five said their consultant decided - rather than advised on - investment strategy. This tendency to let ownership of decision-making slide ultimately leads, not necessarily to over-powerful consultants imposing their agenda, but to a complete failure to locate ownership of decisions at all.
“Decisions can be made at different levels by different parties - but each decision should be made by one party alone,” says Kelly-Scholte. “When we asked who made all these decisions, respondents were naming more than one decision maker for each process. In addition, the responses changed very little as we moved down the scale from strategy to implementation - which suggests that there is very little systematic delegation going on. Moreover, when we isolated a subset of schemes with investment committees the picture actually got worse, suggesting that this was just adding another layer of complexity or that the committee was being used as a monitoring rather than a decision-making group.”
Therefore, Russell’s first step in any relationship is to establish a detailed “decision-making matrix”. As Kelly-Scholte explains, sometimes this results in more of an advisory relationship, with the fiduciary retaining direct control, sometimes in delegation towards Russell as a fiduciary manager.
That is a key insight. The governance structure in itself is likely to be determined by capacity and resources and will not guarantee success or failure - but any structure must be underpinned by well-defined ownership of decisions and delegation. This is how Vermeulen can argue for “a minimum level of in-house expertise”, while also being “a strong believer in the fiduciary model”. Similarly, Trickett notes that, while encouraging internal capabilities, Towers Watson has also set clients up with fiduciary managers and its own Advanced Investment Solutions implemented consulting service. If you need to outsource a big part of your strategy and implementation, that does not excuse you from “in-sourcing” ownership of the decisions.
“There is a paradox here,” says HamishWilson’s Branford of implemented consulting. “Combining [investment advisory and management] is packaged as a means of delegating some of the trustee responsibility yet this is precisely the area where a strong trustee board is required to consider the issues. Clearly there may be problems if the investment arm of a consultant cannot implement certain strategies.”
These conflicts of interest are the main objection to implemented consulting - but that objection is to bad governance, not to implemented consulting per se.
Just as important as avoiding conflicts of interest, clear ownership of decisions will also help schemes to maintain coherence between strategy and implementation as well as a good balance between multiple advisers. For Dirk Söhnholz, managing partner with implemented consulting specialist Feri Institutional Advisors in Germany, the ideal structure is “hub and spoke”, with several specialists reporting into a single consultant with oversight responsibility - but not “controlling” responsibility.
“Clients should get the best service providers - actuaries, lawyers, tax experts, accountants, investment experts, portfolio implementation experts and controllers,” he says. “If anything, controllers should be separated from the other functions, but this can be done in-house through ‘Chinese walls’. It has to be observed that no single perspective ‘overrules’ the others.”
The themes discussed so far converge around the role of the scheme sponsor in decision-making. Many ‘governance-gap’ problems are a result of accounting standards pushing pension liabilities onto corporate balance sheets, particularly in the UK. “As a result, investment strategy is starting to be led more by the sponsor than by the trustee,” suggests JLT’s Howarth. “On the investment side there’s obvious alignment of interest [between sponsor and trustee],” argues McCoy at KPMG. “Large corporates tell us that they like what they hear from us in that area and often ask us to implement something similar with the pension scheme.” Pension funds’ growing use of derivatives may owe something to finance directors’ experience with similar instruments.
Acknowledging the risk that, as Atkin warns, “pension scheme clients are seen as routes to selling other services to the sponsor”, surely this model makes sense? Trickett says that it is much more efficient to have a single set of advice structured to be “co-operative rather than combative” between sponsors and trustees - but he concedes that that begs a major question. “If trustees really do fear for the corporate covenant it’s very difficult. We need to get back towards the co-operative model, but I don’t think we’ll ever get back to where we were five years ago.”
For JLT, the potential conflict of interest is so great that three years ago it set up a completely separate sponsor advisory service, Pension Capital Strategies. “But the role of the good consultant is to get two parties engaged and making good decisions that suit them both,” says Howarth. “There are certain circumstances where the positions of the sponsor and the trustee are less aligned than in others, and we are not in the business of making this more expensive than it needs to be.”
There is the crux of the matter - which brings us right back to the problem of ownership of decisions. It can be difficult for trustees to own the decisions when sponsors own the liabilities - and the cash - at a time of deficits and pension promises breaking down. It is tempting to conclude that ownership simply must be delegated, in the form of full fiduciary management or even an insurance buyout. But for the trustee’s fiduciary responsibility to be properly respected, trustee and sponsor must both agree on strategy. In this way the role of the consultant becomes clearer: even if retained by the trustee alone, it must have a relationship with both parties, as mediator - “getting the two parties engaged”, as Howarth puts it. Not owning, but facilitating, the decisions.
In a helpful analogy, Konotey-Ahulu at Redington likens it to a “peace process”. “It’s crucial for sponsor and trustee to sign up to the same strategy,” he says. “That’s not to say that I’d necessarily like to see the same adviser working with the trustee and with the sponsor - that could end up like advising both husband and wife in a divorce case - but we’re big believers in some kind of amalgam of sponsor and trustee representatives who can meet once a month, say. If you don’t do that, it can become much more adversarial, and that rarely comes to a happy conclusion.”
Agreement on and clear ownership of decisions - both vertically, from strategy to implementation, and horizontally, across all the advisers retained by sponsor, trustee and consultants. It sounds simple, but can be complex and even combative. The consultant community has sometimes added to the confusion: especially as markets become more complex and advisory services more fragmented and specialised, it must find a way to engender focus and clarity.