The Netherlands: The integral concept survives
Anton van Nunen assesses recent discussions on fiduciary mandates and argues against splitting risk from asset management
For some two years, discussions on fiduciary management have concentrated on the areas in which a sole fiduciary manager is allowed to operate. Does the field of operation relate to all the pension fund’s duties or should functions be distributed across multiple managers? A second area is the earnings model and in many cases improvement is possible.
Fiduciary management implies organising the activities that a pension fund must undertake to keep its balance sheet in shape. It is directed towards placing the maximum relevant expertise in the preparation of decision making and in the actual decisions. This is necessary because liabilities are huge and hard to calculate, the investment world and its products are highly complex and regulation is not making balance-sheet management easier. The areas in which support is provided are advice in the broadest sense, portfolio construction, manager selection, monitoring of investments and reporting. The fiduciary is the trusted adviser of the board in translating the fund’s objectives into an investment strategy that best fits, and the manager supervises the implementation of this investment policy.
The Dutch central bank (DNB) closely monitors outsourcing by pension funds in general, and does so even more closely concerning fiduciary outsourcing. The overriding and convincing argument for this is that outsourcing should not lead to loss of control. This is of special relevance with respect to fiduciary management as this form of outsourcing relates to all important functions that a pension fund has to perform. A fiduciary does not take decisions; he ‘merely’ advises, supports and implements. A better label than outsourcing, therefore, is its opposite – insourcing. Pension funds, through their fiduciary, insource a full range of service providers, with instruments that many of them could not afford to hire as a stand-alone.
It is obvious that the board can never delegate fiduciary duties, that is to say, important decisions concerning the strategic asset mix, the size of the risk budget and the choice between active and passive investment policy. A welcome outcome of the regulator’s stance is that it has prevented some pension funds from delegating too many duties, seduced as they were to hand over difficult decisions to these professionals in even more difficult times.
The Dutch pension sector does not always know how to interpret the regulator’s position on outsourcing. On the one hand, the DNB values the benefits of integrating duties within fiduciary management. Services such as advice, ALM studies and portfolio construction are so close to one another that execution by one hand is clearly advantageous. The same goes for portfolio construction/manager selection and for monitoring/reporting. On the other hand, the regulator advocates unbundling in outsourcing in order to prevent pension funds becoming too dependent on one supplier. Finding a good balance between the advantages of integration and the disadvantages of dependence is a complex matter, because any form of outsourcing necessarily implies a certain degree of dependence. The best solution to his problem is having a countervailing power in-house – a strong investment (advisory) committee or external support in certain areas. Where the fiduciary fulfils a heavy advisory duty, he is a sort of guardian to an important part of the pension fund’s legacy. An expert investment committee or a consultant is the necessary guardian of the guardian.
PwC holds the view that fiduciary management is a future-proof concept. The firm recently advocated hiring two fiduciaries: a fiduciary risk manager next to a fiduciary asset manager. To me, this does not seem to be a good idea, as risk management and asset management are both sides of the same coin. Investing is the same activity as managing risk and good investment policy is the same as defining the risk budget correctly and allocating this budget to the most efficient asset categories. Making a distinction between risk and assets reduces the one fiduciary duty to external manager selection, but that activity cannot be regarded as detached from portfolio construction.
Having portfolio construction performed by another fiduciary manager may lead to suboptimal decisions. The problem may be defined differently, however. I can imagine that funds want differentiation in duties in the field of implementation and want a check to assess that risk budgets are not exceeded and that risks are allocated according to plan. If the investment committee or an in-house specialist cannot secure this, the custodian can offer the solution. There is no need to split the fiduciary duties.
Fees for advice and management
The credit and euro crises have affected investment behaviour of pension funds. It is fortunate that the rise of fiduciary management coincided with the financial crisis as its more conceptual approach to investment risk and the professional control have been a good fit with the changed risk attitude of funds. The old attitude, striving for returns and projecting and diversifying the accompanying risk as greatly as possible, has morphed into defining an acceptable risk budget and accepting the return implied by that budget. I am convinced that fiduciary management has delivered the instruments facilitating that change in the investment profession.
Institutional investor attitudes towards advisory and management fees have also changed, from economical to very economical. This is completely acceptable as fees weigh on pension payments and weigh heavier when expected returns are lower. It is a pity, however, that fee priorities have not changed. In general, investors pay too much for asset management and not enough for advice. Look at it as a pyramid – advice is delivered across a vast area, stretching from strategic to tactical policy in certain areas and from the overall portfolio level to small parts of it. Strategic advice is of utmost importance for long-term risk and return, but is hardly paid for. The pyramid is inverted. After constructing the portfolio and filling in its specific mandates, a detailed manager selection is carried out and a management fee is agreed. Investors pay relatively high fees for that management while its contribution to long-term health of the fund is far less important.
This anomaly is also present in areas around fiduciary management. The client realises that fiduciary management implies an extra layer of costs and, of course, wants to limit expenditure. There is no objection to that, but strategic advice also risks being underrated.
It is right that the relevant benchmarks are specified immediately following the delivery of advice and portfolio construction. But it blurs the value added by this advice to a large extent. A normal reaction by the client is to minimise these costs, which is not the case for fees for asset managers who generally contribute far less to long-term results. Most fiduciary managers do not really succeed in making clear what value they add and that the client should want to pay for it.
The future of fiduciary management
Fiduciary management is a good answer to the challenges of the pension sector.
Fiduciaries have countered the strongly increased demands, especially in the field of risk management, by allowing pension funds to insource expertise and expensive systems.
The fiduciary is an in-house manager who supports the fund in all parts of the investment process and who co-ordinates the implementation of investment decisions. He advises in crucial matters and takes over non-crucial ones in order to enable the fund to concentrate on more important tasks. Pension funds, including the larger ones, have said they have opted for the fiduciary concept because they are more in control that way. It is interesting that they have a different opinion to that of the DNB in this regard.
I share PwC’s conviction that fiduciary management will remain important. However, the massive changes in the pension world require that the fiduciaries retune their organisations and products to account for these shifts. Some examples are:
• Favouring an integral approach is fine, but it should not imply blindness to other trends. When pension funds have reason to distribute fiduciary tasks between several managers, suppliers should be able to provide fiduciary management in modular form;
• Complex markets, changes in regulation and fundamental shifts in the pension system require many choices to be made within the funds. Boards need support on many levels.
Fiduciary client teams can be created to deal with all problems adequately without losing sight of the overall picture. A balance-sheet expert, for instance, can deal with investment issues while colleagues zoom in on other areas of advice;
• Fiduciaries should realise that education, or providing information across the entire pension field, becomes more important by the day. Pension funds are flooded with new plans, thoughts about alternative systems, developments in society that influence the role of sponsors and members, and changes in legislation. Fiduciary managers must react to these with studies, expert sessions and support the board in making thorough decisions.
Moreover, they can help in mobilising knowledge at important decision points in politics and society. In this way they can make a contribution to the future direction of our pension system.
Anton van Nunen is director of strategic pension management at Syntrus Achmea Asset Management and principal of Van Nunen & Partners