Special Report Consultants: A testing time
The UK’s Financial Conduct Authority is assessing whether a lack of competition among pension consultants is hurting UK pension schemes, says Carlo Svaluto Moreolo
At a glance
• The Financial Conduct Authority, the UK financial regulator, is scrutinising the investment advice sector.
• There is some evidence that conflicts of interest are not being managed properly.
• The regulator sees a lack of competition potentially hurting pension funds.
• The UK-focused study raises questions about the wider European pension sector.
The UK’s Financial Conduct Authority (FCA) is conducting a potentially game-changing inquiry into how investment advice is provided to the country’s pension funds. Although the regulator’s focus is on UK firms, the inquiry raises questions on how consultants are serving the interests of their clients across Europe.
The FCA is investigating consultants’ business practices as part of its wider Asset Management Market study announced in 2015. In November last year, the regulator published an interim report that highlighted issues of conflicts of interests as well as a potential lack of competition.
The main findings of the 200-page report were:
The UK investment advice sector is “relatively concentrated”.
• On average, consultants are not able to identify managers that offer better returns.
• Consultants do not drive significant price competitions between asset managers.
• Institutional investors struggle to monitor and assess the performance of consultants.
• Conflicts of interest arise when consultancies offer both investment advice and fiduciary management.
• There is a lack publicly available information on performance and fees of fiduciary managers.
The FCA also found that consultants may be incentivised to recommend their products or overly complex strategies. The authority sees manager ratings, a tool widely employed in the industry, as a potential barrier to entry and innovation in the asset management sector. There is some evidence, according to the authority, that some consultants are still accepting gifts and hospitality from asset managers.
The authority also questioned the ability of consultants to manage other conflicts of interest, such as their incentive to give a positive evaluation to managers they recommend.
To a large extent, it comes down to clients’ ability to assess the quality of the advice they receive. The FCA says pension schemes find it difficult to assess potentially conflicted situations against the consultants’ performance. As a result, there appears to be little incentive for schemes to switch consultants. The regulator found that 91% of investors had not switched consultants in the past five years. This displays a possible lack of competition within the market.
The solutions to the issues are far from obvious. The final report, which is due this summer, will presumably offer more clarity on how the FCA will address the issues. But the interim report contained two clear statements of intent.
The regulator said it may seek regulatory power over investment advice. It might also recommend a deeper investigation by the Competition and Markets Authority (CMA), the UK’s anti-trust authority. The latter action would be a significant step with potentially disruptive consequences for the sector, if the CMA found further evidence of a lack of competition.
The industry responds
The report has dampened the mood of the industry. Initially, consultants welcomed the FCA’s effort, but many expressed doubts about the proposed solutions. The reaction of the trustee community was more muted, but some welcomed the FCA’s attempt to shed light on inefficiencies.
The official responses from the consultancy firms involved in the FCA study came earlier this year. There were mixed reactions to the proposal to bring investment advice under regulatory scrutiny. Some were sceptical about the proposal for a competition inquiry.
The ‘big three’ consultancies – Aon Hewitt, Mercer and Willis Towers Watson – provided a joint response to the FCA study.
Their response contained a package of measures that, according to a joint statement released by the firms, “are designed to advance competitiveness and transparency in the investment consultancy and fiduciary management industries”.
The FCA, the statement said, had indicated that it would accept “undertakings in lieu” of its provisional decision to refer the situation to the competition authority. The statement said: “The firms have worked together with their external lawyers to ensure adherence to the requirements of competition law in putting together this package of measures. […] The firms believe that the measures will promote healthy competition and favourable outcomes for clients.”
At the time of writing, the firms had not given clear details about what these measures would entail. However, Ed Francis, head of investment for EMEA at Willis Towers Watson, said in the statement: “The specific measures that we have submitted to the FCA for consideration will, if accepted, help all institutional investors ensure they have the right provider, the right service model, and the right information to judge the quality of our input.”
The three firms’ decision to respond in partnership could not go unnoticed. The FCA’s report suggested that the firms enjoy too much market power, because of their huge market share.
The FCA estimates that the three firms get 60% of the revenue in the advisory market, out of a sample of the 12 largest firms. This is not a new development, and the excessive concentration of the market in the hands of the three firms is a common misgiving about the industry. Ironically, a joint response could prove the point.
However, Tim Giles, head of UK investment consulting at Aon Hewitt, says that the decision to team up is a “natural” step, given the FCA’s suggestion that the market is too concentrated within the three firms.
Giles added that the measures proposed by the firms would “help and inform” a potential CMA review of competition in the sector. The rationale behind the joint statement is also to save time and the taxpayers’ money needed to carry out the review, he said.
Regarding the actual concerns about market concentration, Giles pointed out that other surveys paint a less dramatic picture. A 2014 survey from the Pensions & Lifetime Savings Association (PLSA), the UK’s pension fund association, suggested the top three had a market share of 50%, and the top six had a 70% share. FCA data also shows the share of the market controlled by the top three firms is declining.
Market concentration has not ceased to be an issue for the many smaller players in the sector, but things are changing. Alex Koriath, head of the UK pensions practice at Cambridge Associates, says: “There has definitely been a problem with competition in the past, which was linked to the concentration of assets between the top three firms. However, I think the market is changing and that there is now greater awareness by trustees of the market structure. It is changing relatively slowly.”
The solution: transparency and consistency?
Addressing issues like market concentration, lack of competition and accountability and conflicts of interest may require regulatory overhaul. But the proposal to bring investment advice under the remit of the FCA has been met with mixed reactions.
However, Giles says Aon Hewitt would welcome the extension of the FCA’s regulatory scope. The FCA has regulated the company for several years therefore it already meets the regulator’s standards in many areas, including the provision to treat all customers fairly.
“Our conflict of interest protocol establishes that we cannot give an information advantage to some clients over others, or recommend our products as being the best in the market,” says Giles.
He offers a glimpse into what the measures proposed by the three firms might be about. He emphasises that the consultancies would welcome more transparency and consistency of information on performance. This would apply to information on the asset managers they recommend, as well as the fiduciary management mandates they run for clients.
Transparency and consistency on fee reporting would benefit the institutional investment sector several fronts, according to Giles. The top three firms are not just facing pressures by other traditional advisory firms or specialised fiduciaries. Asset managers themselves have criticised the firms over the controversial ‘vertically integrated’ consultancy model.
Vertical integration, or the existence of traditional advisory and fiduciary management within the same firm, creates a conflict of interest that has attracted huge criticism.
“If we look at our client base, the advisory clients get a fairly wide range of discounts, depending on factors like size, but it is, on average, around 16% for equity managers. The standard rate of reduction for equity managers for fiduciary clients is 34%,” says Giles.
Vertical integration under scrutiny
With the regulator’s emphasis on vertical integration, a key component of the business model of the top three UK consultancies is at stake.
Vertically integrated firms have a strong incentive to recommend that pension schemes switch from traditional advisory to fiduciary management, which draws more revenue per client. The FCA has made it clear that it intends to scrutinise the impact that this conflict of interest has on clients.
Giles says that consistency and transparency of fee reporting and standardisation of processes to introduce and monitor fiduciary management would help trustees choose between fiduciary and traditional managers. The firms, according to Giles, would welcome a shift towards transparency in this area.
So far, there is limited evidence that conflicts of interest are not being properly managed, and that they are hurting pension schemes. But the available evidence is compromising, as it suggests that many pension schemes may have switched to fiduciary management without a proper assessment of whether it is the best solution.
“The idea that trustees can just change the way the scheme is run by the same firm without having looked at other firms that offer the service is not a good one”
A 2014 survey by KPMG showed that 75% of fiduciary management tenders were awarded on a non-competitive basis. The figure is still seen as strong evidence of a lack of competition and potentially harmful conflicts of interest. But Giles contends that newer data offer a different perspective.
In 2015, Aon Hewitt found that 58% of schemes would select the fiduciary arm of their existing investment consultant and actuary. A 2016 survey by Lane Clark & Peacock found that 63% of schemes that have fiduciary managers used third-party evaluators during the selection process.
Koriath says that Cambridge’s model is substantially different from the model of vertically integrated firms. The firm offers both advisory and fiduciary management services, but charges an ad valorem fee. Koriath says: “We have been invited to a few selections where existing consultants had recommended one of their own in-house products or funds as a solution or investment opportunity. We were called in as an additional party to provide examples of what else is available in the market,” he says. This practice is becoming more common, as is the practice of hiring external consultants to conduct reviews of existing fiduciary managers or fiduciary manager selection processes.
It must be noted that the FCA does not view the coexistence of traditional advisory and fiduciary management as a problem in itself, according to the interim report.
A key passage of the report says: “[The consultants’] behaviour such as recommending their own in-house fiduciary management services is not necessarily problematic. Consultancy firms have a legitimate commercial incentive to promote more products and generate greater revenue.
“However, the nature of the products involved here creates concerns about this type of upselling. In order to sell one product, such as fiduciary management, consultants may be compromising the quality of the ‘first’ product, in this case advice.” For the authority, the fundamental question is whether clients are able to effectively assess the quality of advice they receive. The evidence that this is the case is scarce.
But, in practice, the regulator is keeping vertical integration firmly in its sight. The issue came up at this year’s PLSA conference. Chris Woolard, the FCA’s director of strategy and competition, suggested that the separation of traditional advice and fiduciary management is something the regulator would consider.
In the same speech, Woolard said that the FCA was prepared to reject industry initiatives if they fall short of what the regulator aims to achieve.
A possible solution to the vertical integration issue would be running open tenders for fiduciary management services. Patrick Disney, managing director for the European institutional group at SEI, says: “There is an obvious case that rather than having consultants recommending their own firms as fiduciary managers, trustees are required to run a full tender process and review all the different types of fiduciary managers – consultants, asset managers or specialists like ourselves.”
Disney points out that legislation or regulation may not be necessary to achieve that. “The FCA could nudge people to adopt the approach. But the idea that trustees can just change the way the scheme is run by the same firm without having looked at other firms that offer the service is not a good one.” He also suggests that hiring an independent firm to review the market for trustees might be a good approach.
A new, regulated future?
At this stage, it is hard to predict whether the review process will eventually lead to new regulation or legislation. What is clear is that a previously static situation is changing rapidly.
If it is true that FCA’s work has triggered change, before long the UK consultancy sector may look radically different. More importantly, the same issues surface in different ways in other countries. The UK story may therefore serve as an example to other markets. The emergence of fiduciary management is seen as a positive development across Europe. However, the efforts by investment consultants to compete directly with asset managers, have been observed and criticised outside the UK as well.