Gail Moss outlines how pension funds should manage the tender process to ensure they appoint the right providers
Selecting the right provider for services such as investment management is not only crucial in getting the best possible pension fund performance - it can also protect trustee boards from expensive litigation.
“You can fire an investment manager, but if they have damaged the interests of fund members, the board is responsible, and can themselves be held legally liable,” says Coen Verdegaal, principal at Mercer Netherlands.
The tender process is only part of a bigger picture, he continues. “Ideally, before you start with a tender process you should have a good process and good governance in place,” he says. “You should know what your objectives are, and which structure fits in with those objectives. For instance, if you’re looking for a US equity manager, do you want a single manager, or two or more with different styles that complement each other well?”
The process to be outsourced (or re-tendered, if there is an existing provider) should be clearly defined in writing, as well as who is responsible for outsourcing it. Boards should be as specific as possible on the norms for the outsourced processes - for instance, if they are outsourcing investment advice, they should set down the current investment strategy, areas of responsibility and remuneration, besides caveats such as requiring that the investment process should not be decided by one individual alone, if necessary.
Local legislation may of course come into play. In the Netherlands, outsourcing requirements include identifying the risk involved in the process to be outsourced, setting up an adequate policy and monitoring the activities outsourced.
Who does what?
Some large pension funds have procurement departments. Otherwise, the selection process can be carried out by the trustee board or the appropriate committee (for instance, the investment committee if the tender is for an investment adviser). It could also be delegated to a committee especially set up for the purpose.
The important condition is that it should be clear who is responsible for the process and for carrying it out in the right way. Once responsibility for the tender process has been allocated, a fixed timetable should be set for carrying out the work, allowing enough time for providers to give proper information without being too long-drawn-out.
Pension boards can seek advice and support from their existing consultants, although they could instead hire another consultant on a one-off basis. Consultants can also provide training, if needed. And at any stage, the pension fund could also ask another consultant for a second opinion.
The universe of potential providers can be built up from desk research or using free services. Other companies have comprehensive databases which large pension funds could use to draw up a list of names, depending on the parameters the pension fund supplies. If not, an investment consultant will also be able to produce a ‘long list’ of companies. These managers should be sent brief details of the mandate with a request for information. This could be in the form of a questionnaire outlining all the norms that the trustee board has agreed.
A problem for board members can arise if the consultants put forward as candidates providers with whom they have a close relationship. “This could be positive, because it suggests there is synergy between the two parties,” says Peter Zanella, practice leader, benefits, Towers Watson Zurich. “But there is also a risk the consultant will not be neutral. In order to help make the process transparent, providers should be asked to disclose all interests or potential conflicts of interest.”
From shortlist to ITT
From the replies, the ‘short list’ of applicants can be drawn up. These are then sent the full invitation to tender (ITT) - a more detailed questionnaire covering all aspects of the trustee board’s requirements. As part of the investment adviser selection, for instance, information from the provider should include the underlying idea behind its investment strategy, and how it will implement its ideas within the portfolio. It should also give details of its investment team - for instance, is it a single person, or a group of people?
Besides the standard technical questions, other queries should include:
• How is the client account serviced?
• What do reports for clients look like? (Samples should be included.)
• How is risk management incorporated within the company as a whole?
• How is compliance integrity incorporated?
• What is the company’s IT infrastructure?
• What are the costs of the investment strategy suggested?
The tender should also include the number, size and type of pension schemes that the provider advises, as well as the client retention rate and why clients have been lost. This last question is a good way to find out how honest providers are.
Other types of tender will generate questions relevant to the sector within which the pension fund operates. For example, a pension fund with local government connections should ask if a potential new actuary has experience with broadly comparable schemes.
The nature of the relationship between fund and provider should also be addressed. For instance, proactivity is becoming more and more important for clients.
“Encourage providers, especially investment advisers, to be creative and positive, rather than rely solely on standard and possibly old-fashion
ed approaches,” says James Lavender, senior consultant, Capita Hartshead.
Other areas for review should include accounting, housekeeping and security systems.
Providers have their own tools for carrying out certain functions - for instance, actuaries have developed valuation modelling tools - and trustees should where appropriate ask for a demonstration package to test various assumptions, says Lavender.
“This will help them to understand the systems used by the provider and could help them come to a decision much quicker,” he says.
The beauty parade
Replies to the ITT will help the trustee board decide which providers to invite to the ‘beauty parade’. Ideally, whoever is conducting the process will go through the positives and negatives of each reply, although this can be made easier by organising a conference call between trustee board members.
Ideally, the pension fund should end up with no more than three or four parties to be invited to the beauty parade, since the process is so time-consuming. It often happens that someone might suddenly suggest another provider, for a particular reason.
“It’s not a good idea to include them at this stage, especially if the time scale does not allow it,” says Zanella. “In any case, including someone else for an arbitrary reason means it is not a fair process.” If the short-list is drawn up by consultants, it is a good idea for the pension fund to challenge, this. “Clients should ask about conflicts of interests and hope the consultancy will be frank in replying,” says Zanella. “This could be done either by the fund itself, or by someone from the sponsor company.”
The beauty parade is a chance for trustee board members to pursue, in more detail, questions asked in the ITT. Its other main purpose is to see whether there is a cultural fit with the provider. This is partly a function of what kind of relationship the trustee board wants.
“Does the trustee board prefer to be led, in which case they will be happy just to listen to the provider?” says Lavender. “Or does it want a two-way relationship where the provider brings ideas to the table to be discussed and challenged?”
The beauty parade itself allows boards to see if they can get on with the people they will deal with on a day-to-day basis, and whether they are good at their job. The session for each candidate provider should include an outline of their background and ethos. While this might best be done by the provider’s new business manager, it is vital that those who are going to run the account (such as the lead portfolio manager) and those who will have day-to-day contact with the pension fund (such as the client relationship manager) are also present.
The process allows trustee boards to analyse the provider’s systems in more detail and they must ensure that they are in the driving seat. A searching question, for instance, might be: “Show us your performance from July 2008 until July 2010, and explain why you ran your portfolio the way you did.”
Besides giving technical information, this is an opportunity for trustee boards to gauge how the advisers will interact with them and how proactive they are.
In the case of an investment adviser tender, useful questions will include: What does the provider think of the fund’s current investment strategy? And how would they change it?
Lavender suggests an additional segment where the provider is asked to explain an issue of topical interest, such as CPI versus RPI linking, or a recent piece of legislation, and explain how this affects the pension scheme.
Again, how clearly the provider’s representatives can do this will give the trustee board a good idea of how productive the relationship is likely to be if they are hired.
If the provider’s staff use too much jargon, would trustees be able to understand them? “If they can’t explain things clearly during the beauty parade, it could be a good indication that the cultural fit might not be quite right,” says Lavender.
Moreover, by doing this the pension fund might also get some useful free advice.
In addition to the beauty parade, trustee boards should also consider an onsite visit to the offices of potential providers. This might give a better insight into the way these companies work. “It means you can see if what they tell you is really true,” says Verdegaal.
Common pitfalls of the beauty parade include inadequate briefing of the candidates; they should be told clearly what is expected of them. Another pitfall is for those doing the selecting to be disproportionately impressed by surface gloss.
Some providers might use this session as a sales pitch, including fancy slides and selective evidence of results. But trustee board members need to probe under the surface, asking specific questions such as: what is your unique selling proposition (USP)? What is your strategy when things go wrong?
Asking the providers for references is standard procedure, but remember that they are only likely to name clients with whom they have a good relationship. Trustee board members should therefore try to get their own references from pension funds who have used particular providers. They can often do this through networking at conferences. And board members themselves have sometimes had experience if they have been trustees of another fund.
They should also not be fobbed off with vague answers if the provider does not give them the precise information they have asked for during their session, or indeed, throughout the whole process.
“If this information is really important to you and they refuse, drop them from the selection process,” says Verdegaal. “You have to be in control of all the functions you’re going to outsource, and of the information you need to monitor those functions.”
The final decision should be based both on the reply to the ITT and on the beauty parade, with scores given for specific aspects of the service to be provided. Both overall positive and negative aspects of each provider should also be taken into consideration.
Once made, the decision must be minuted, together with the reasoning behind it. This ensures accountability and also gives an audit trail that can be assessed if things go wrong and the pension fund has to rehire a provider - or if things go right, and the fund wants to use the process as a template for future tenders. It also helps the regular evaluation of external providers as a whole.