Investment consultants are probably the most controversial among the various advisers hired by pension funds. People have conflicting views about the benefits of using their services. Extreme cases are not unknown. In some pension plans, investment consultants are running the show, while in others they won’t get through the door.
Recent market events and the funding problems have fuelled the debate further. In a way, the disputable role of investment advisers seems odd. After all, investment requires the most important and best decisions by plan directors, so would it not be natural to get the best possible advice from experts?
In practice, there are different factors influencing the use of investment consultants across countries and pension plans. One reason for this lies in national regulation. Unlike auditors, actuaries or custodians, the use of investment advisers is normally not prescribed by law. However, there are exceptions. In the UK, for example, trustees are obliged to get written advice from an investment expert every time they make a small amendment to their policy.

Significant differences also result from the specific governance model in place. How is investment decision-making structured? Is the board of trustees able and willing to get involved in strategic investment decisions? Is there a chief investment officer or an expert investment committee in charge?
A third important factor is the size of the pension fund, and in particular the amount and quality of the internal resources available. For example, the big Dutch industry-wide pension plans have dedicated resources for research and risk analysis and this reduces the need for external advice.
There are also other factors, such as the corporate/industry ‘culture’. A small corporate pension fund of a manufacturing company is less likely to find enough trustees with investment expertise than the pension plan of an investment bank. Also, some organisations feel more comfortable with outsourcing than others.
Trustees often don’t make the best use of the broad range of services offered by investment consultancies. It is worth checking, from time to time, where advice could be needed:
qAsset/liability management, eg, asset-liability-modelling (ALM) or liability-driven investment (LDI);
qRisk budgeting;
qStrategic asset allocation, including the selection and weightings of new asset classes;
qAppropriate investment benchmarks (eg, liability-based benchmarks or market indices);
qInvestment management structure (eg, balanced, core-satellite, active versus passive, liability-matching plus portable alpha);
qAsset manager selection and monitoring; management agreements; investment guidelines for day-to-day fund management;
qCustodian selection and monitoring;
qSpecialist areas such as derivatives, cash, forex and transition management;
qMonitoring of pension fund portfolio, including performance measurement and risk analysis;
qDefined contribution arrangements, including the selection and monitoring of investment options and administration platforms;
qTrustee training; general research and information.
Do you need to pick up everything? Smaller funds may require help in a broad range of areas from one particular consultant who knows the scheme well. On the other side of the spectrum, bigger pension funds with ample in-house resources may therefore define only very specific or temporary briefs for external advisers.
The bigger investment consultancies evolved from the business of actuarial firms with pension funds and insurance companies. However, there are also examples where investment consultancy grew within auditing firms, management consultancies or asset managers. More recently, independent boutiques specialising in specific areas have been set up. Increasingly, external investment experts are being called into investment committees.
Given the complexity of investment issues, it can be argued that you need more than one consultant with different strengths. For example, the skill set for manager selection is not exactly the same as for asset allocation. In fact, a trend towards segmentation can be observed.
Traditionally, it was often thought that investment consultants are redundant because you have an actuary on one side and investment managers on the other. This is an interesting question. Let’s look at actuaries first.

Consulting actuaries have the advantage of covering both the asset and liability side in one house, and there are obvious
synergies and economies of scale in their favour. The renewed emphasis on liability-matching obviously requires a thorough understanding of the liability side of the plan and its dynamics over time. However, consulting actuaries are currently also facing some critical views:
qThey are not inside the financial markets and can be ‘behind the curve’ when circumstances change;
qFor bigger firms, it is often difficult to express strong or even contrarian views. There is more pressure to ‘hedge the bets’ in order to contain their own business risks;
qIn Anglo-American countries, they are seen to have become “too powerful”. Frequently, decisions are effectively made by consultants while plan fiduciaries are often unable to question the advice received;
q“The investment consulting industry is characterised by high levels of concentration and low levels of customer switching. At the same time, profitability appears low.” (Myners Review 2001). Research is very costly and it is difficult to cover, for example, new instruments in great depth.
Trustees can also observe interesting new developments on the borderline between investment consultants and fund managers. On one hand, in search of new revenue sources, some investment consultants make a move towards money management, for example by offering manager-of-manager services. On the other hand, some fund managers and investment banks have started to provide more general and strategic investment advice to pension funds.
Asset managers in particular often feel they had been pushed to much into a corner as a result of more and more specialist mandates. Some of them are trying to suggest a new division of labour by offering longer-term, ‘new balanced’ mandates where they get broader discretion to invest in the full range of asset classes and instruments.
These recent developments constitute substantial challenges to pension plan directors. This can be a good time to review the existing arrangements for investment advice, if not the whole area of investment governance. Before selecting (or confirming) investment consultants, trustees need to be clear in their minds about a number of key issues.
This includes, for example, an understanding of the regulatory requirements, and the awareness of the rising fiduciary duties of trustees in investment matters in several countries. Also, what is the delegation policy, internal and external, in regard of investment managers, custodians, performance measurement, risk analysis and similar?
The actual selection, hiring and monitoring process of investment consultants should follow the usual best practice principles, including clear terms of business, the definition of areas of advice, methods of communication, regular reviews. There are some specific issues with investment consultants, that should be brought out in the process:
q Ownership and controlled group organisations. In particular, it is important to understand potential areas of conflicts of interest (eg, with fund managers);
q The importance of investment consulting to the business as a whole. How are services cross-sold?
q What are the resources dedicated to investment consulting and this particular client? What is the age and experience of people involved? Also, the preferred technology and models;
q Performance records and examples of successes and failures in crucial areas of advice (there are now attempts to measure consultants’ performance in managers selection).
A lot is in flux in the relationship between trustees, investment consultants and managers. Try to find the right model for your plan but beware of a turf war between investment consultants and managers.
Georg Inderst is an independent consultant based in London