Fiduciary Management Insights

Fiduciary Management Insights Overview 2013 March 2013

Contents Introduction 5 What is fiduciary management? 6 Benefits of fiduciary management 7 Appointing a fiduciary manager 8 Delegating to fiduciary managers 11 Monitoring fiduciary managers 12 Final thoughts 14 Getting help 15 3

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Introduction During 2012, Ernst & Young hosted a series of four webcasts to introduce pension trustees and company representatives to the concept of fiduciary management. In all, over 500 individuals participated in these webcasts. During these events, we asked participants for their thoughts on a variety of subjects. Participant responses were interesting and varied. They illustrate both a keen interest in the rapidly growing fiduciary management market in the UK and Ireland and the key questions stakeholders have about best practice in pension scheme governance. This short publication captures their views along with some of our insights and I hope you find it useful and informative. If you have any questions, please don t hesitate to get in touch. Kind regards Iain Brown Partner and Head of Fiduciary Management Services Ernst & Young LLP March 2013 5

What is fiduciary management? With today s acute focus on pension cost and deficits, managing a pension scheme s assets is more important than ever. Whilst the traditional advisory model upon which pension trustees and sponsors have historically relied has stood the test of time, many trustees and sponsors are finding that a more hands-on approach to investment governance is required to cope with today s more sophisticated investment approaches. For some, fiduciary management may be the best solution to this governance challenge. What is fiduciary management? Figure 1: the investment process for a pension scheme Delegation level V IV III II I Fiduciary management is an investment governance solution that involves trustees delegating certain elements of the investment process to an investment expert the fiduciary manager. The fiduciary manager will employ best practices in pension scheme investment management, including: Setting and amending the risk/return budget Determining and managing the split of growth and matching assets Incorporating a dynamic asset class de-risking methodology Allocating different asset classes within the growth and matching portfolios Managing the pension assets relative to the liabilities using techniques such as hedging of risks Maximising investment diversification Making tactical asset class decisions and deviations based on market conditions Hiring and firing investment managers De-risking as market conditions allow Most important investment processes Least important investment processes (but often most time is spent here) Delegation and its benefits In our experience, not all trustees have the time, governance budget or access to the economies of scale to effectively implement these best practices the fiduciary manager does. In the fiduciary management model, the trustees decide which investment processes to delegate to the fiduciary manager. Figure 1 breaks down the pension investment process into its components to show possible delegation levels under a fiduciary management structure. The purpose of this delegation is twofold: Jargon: Fiduciary management is sometimes called delegated (investment) consulting, implemented (investment) consulting or solvency management. For the most part, these titles can be used interchangeably. Firstly, activities which are better left to the expert are delegated Secondly, by delegating lower level investment activities like hiring/firing investment managers to the fiduciary manager, this frees up the trustees (finite) time to focus on those investment processes that matter the most In practice, the responsibility for setting the risk/return budget will always be retained by the trustees. 6

Benefits of fiduciary management Fiduciary management enables trustees to spend their time focusing on the investment matters that are most important. It also enables fast decision making, an important capability in the face of rapidly changing market conditions. From our conversations, both trustees and sponsors have been receptive to the ideas that underpin fiduciary management. As can be seen from Figure 2, the vast majority of survey participants felt that fiduciary management could improve pension scheme investment governance. Indeed, webcast participants recognised that best practice pension scheme investment management now includes several dimensions (Figure 3). Trustees are increasingly finding that they do not have the time or expertise available to actively manage and monitor the investment of a scheme s assets. Figure 2: do you think that fiduciary management has the potential to improve pension scheme investment governance? 50% 40% 30% 20% 10% 0% 47% 36% 1% 16% Yes Possibly No Not Sure Ernst & Young insight: While trustees generally initiate the process and always make the ultimate decision, we have found that, in a number of cases, scheme sponsors have been the driving force behind their scheme s migration to a fiduciary management model. For instance, in one case, the sponsor recognised that the trustees did not have the expertise to implement liability hedging something that was deemed desirable by the business. Appointing a fiduciary manager addressed this issue. Figure 3: what do you believe is the most important aspect of best practice scheme investment management? 19% 10% 2% 14% 55% De-risking Asset diversification None of the above All equally important Hedging 7

Appointing a fiduciary manager There are over 15 firms providing fiduciary management services in the UK or Ireland. In addition to coming from different backgrounds (see next page), our research has shown that there are significant differences between their offerings in terms of: Approach to portfolio construction Resources dedicated to fiduciary management Internal infrastructure Market segment focus Fees At present, we are seeing more fiduciary management mandates at lower levels of delegation (e.g. Levels I to III as defined in Figure 1) than at higher levels of delegation. Figure 4 below illustrates this based on data we collected in June 2012 we believe this sample is representative of the UK&I market. We expect this to change and develop as trustees and sponsors become more familiar with the fiduciary management concept. Ernst & Young insight: It is a common misconception that fiduciary management only works for a certain size of pension scheme. This is not that case - schemes ranging from under 10m to well over 1bn are successfully using a fiduciary manager in some capacity. Figure 4: distribution of fiduciary management mandates by level of delegation (Ernst & Young sample) > 1bn Size of assets 500m 1bn 100m 500m 10m 100m < 10m Size = concentration of pension schemes I II III IV Delegation level V 8

The different fiduciary management providers We can broadly categorise the firms offering fiduciary management services in the UK&I into the following backgrounds: Stand-alone fiduciary management firms (often originally from the Netherlands) Benefit consultancies Manager of managers Fund managers Investment banks There was no clear consensus amongst our webcast participants as to what category of fiduciary manager is best placed to provide fiduciary management services to UK&I pension schemes. This is in line with our experiences from selection exercises where we have found that trustees are willing to consider firms from all of these backgrounds as potential candidates for the fiduciary manager role. Appointing a fiduciary manager From our market research, a significant number of fiduciary management mandates have evolved from traditional advisory relationships whereby trustees have appointed their incumbent investment advisor as their fiduciary manager. That being said, we are finding that trustees and sponsors alike are increasingly seeing the benefits of appointing a fiduciary manager following an independent selection exercise. Stand-alone firms Investment banks Benefits consultancies Fiduciary management landscape Fund managers Manager of managers Client insight: The appointment of a fiduciary manager for our pension scheme has increased the investment knowledge and awareness of our trustee board. Chairman of trustees 9

Appointing a fiduciary manager (cont d) Appointment by formal tender Over half of webcast participants believed that appointing a fiduciary manager through a formal tender exercise would be best practice (Figure 5). Moreover, the majority of participants believed that an independent third party advisor was necessary to help run a selection exercise (Figure 6). Understanding, comparing and learning more about the various fiduciary management providers can be a complex and time-intensive process, especially for those new to the concept. An independent selection consultant like Ernst & Young can guide trustees through these complexities. They can engage the market and invite appropriate fiduciary managers to tender. Their expertise can enable them to identify and explain the differences between fiduciary managers. Ernst & Young insight: We have found that a common misconception is that, upon appointing a fiduciary manager, you will benefit from full fiduciary management from day one. This is often not the case - it can take some time before this happens. For instance, transition management will be required to facilitate the migration of investments from the current investment manager to the fiduciary manager in a cost effective manner. In addition, the Fiduciary Management Agreement the document which governs the relationship between the fiduciary manager and the trustees - can take some time to execute. Moreover, before setting out in their duties, a fiduciary manager needs trustee buy-in. In practice, this means that in the early months of a relationship the fiduciary manager s role is very similar to the traditional advisory structure. For instance, it can take several months to introduce a de-risking strategy including an interest rate/inflation hedging program. Figure 5: do you believe formally going to tender should be best practice? Not Sure, 41% No, 7% Yes, 51% Figure 6: do you believe you need an independent third party advisor to help run a selection exercise? No, 12% Not sure, 15% Yes, 73% 10

Delegating to fiduciary managers Apart from setting the scheme s risk/return budget, which cannot be delegated, the level of delegation to a fiduciary manager is extremely flexible. The level of delegation can be changed as the relationship between the trustees and the fiduciary manager develops. In our experience, many pension schemes start at a lower level of delegation (e.g. permitting the fiduciary manager to hire and fire investment managers and make tactical asset allocation decisions). In these cases, we have found that, as the trustees become more comfortable with their fiduciary manager, they will often increase the level of delegation. Getting the level of delegation right and consolidating these choices in the Fiduciary Management Agreement are some of the most important decisions the trustees will make. Getting delegation just right Almost 70% of the participants in our 2012 survey felt that they would approach delegation delicately, and would initially only be open to lower levels (Figure 7). Less than one third of participants would be comfortable with high levels of delegation at the outset. Figure 7: if you were appointing a fiduciary manager, how would you approach the what should we delegate decision? 31% 9% 1% 59% Minimal delegation Open to starting with higher levels of delegation Uncomfortable with higher levels of delegation No delegation Ernst & Young insight: We have found that many trustees concerns about fiduciary management relate to a perceived loss of control. However, delegation does not mean a loss of control. We have found that many trustees feel they gain control by working with their fiduciary manager to set an effective strategy and agreeing a framework within which the fiduciary manager can operate to achieve a successful outcome. These strategy setting discussions often lead to the trustees developing a greater understanding of what makes the real difference from a pension scheme investment perspective and, in particular, a shift of focus from an asset-only lens to an asset/liability lens. 11

Monitoring fiduciary managers Appointing a fiduciary manager is only the start of the journey. An overwhelming majority of webcast participants felt that, once appointed, a fiduciary manager needs to be monitored (Figure 8). In our view, monitoring does not mean questioning every decision the fiduciary manager makes. Instead, it involves evaluating whether value has been added by the fiduciary manager and if their approach has been consistent with the Fiduciary Management Agreement and, more generally, with the trustees reasons for appointing them in the first place. This requires the consideration of several quantitative and qualitative factors including investment performance, quality of advice, generation of new ideas, trustee training, fees and quality of reporting. In our experience, the qualitative factors are just as important as the quantitative. Monitoring a fiduciary manager, just like periodic reviews of other pension scheme service providers, is an expression of good governance. Indeed, the largest percentage of our webcast participants felt that the greatest benefit of monitoring a fiduciary manager would be an enhancement in the overall governance of the scheme (Figure 9). Ernst & Young insight: In relation to value for money, we have found there are often significant variations in fees between fiduciary management providers. In two recent selection exercises, one for a 50m pension scheme and one for a 500m pension scheme we observed fee variations of 90% and 25% respectively between the cheapest and most expensive providers. Figure 8: do you believe there is a need for a fiduciary manager to be monitored? 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 93% 3% 3% 4% Yes No Maybe Don't know Figure 9: what do you believe is the greatest benefit of monitoring a fiduciary manager? 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 28% Follow best practice 43% Enhanced governance 7% Audit trail 16% Ensuring value for money 6% Don't know 12

Forms and frequency of monitoring Monitoring can be delivered via formal reports or attendance by an independent monitoring consultant at trustee or investment sub-committee meetings. The frequency of this monitoring depends on the preferences of the trustees. Most webcast participants felt that fiduciary managers should be monitored on an annual or quarterly basis (Figure 10). In our experience, we have found that frequent monitoring is beneficial as soon as a fiduciary manager has been appointed. As the relationship between the trustees and fiduciary manager becomes more established, a lighter touch monitoring approach may be more appropriate. Figure 10: how often do you think a fiduciary manager should be monitored? 60% 50% 40% 30% 20% 10% 0% 3% 42% 49% 5% Never Quarterly Annually Every 3-5 years 1% Only following a significant event Ernst & Young insight: Best practice has always been to monitor what has been delegated. Under the traditional advisory approach, where only security selection is delegated to investment fund managers, best practice has always been to monitor those managers in comparison to their benchmarks and their peers. In our view, periodic monitoring of a fiduciary manager is merely a logical extension of this process. 13

Final thoughts Based on our regular research meetings with fiduciary managers, and the interest shown by both trustees and sponsors, we believe that fiduciary management will continue to grow rapidly in the UK&I. An increased awareness of the fiduciary management solution and the recognition of the ever-increasing complexities of the investment world will drive new appointments of fiduciary managers in 2013. Furthermore, we believe that fiduciary managers will continue to refine their solutions and develop a market niche. We think it will become more important than ever to understand the differences between fiduciary managers before making an appointment. A consensus seems to be developing that monitoring a fiduciary manager is an essential initiative. 14

Getting help Against the backdrop of an ever-developing fiduciary management market and varied solutions, obtaining independent help can be very beneficial. Ernst & Young is able to help trustees and sponsors in: Identifying the right investment governance solution Assisting with the initial appointment of a fiduciary manager Running a fiduciary management selection exercise Monitoring a fiduciary manager s performance For further information, please visit www.ey.com/fiduciarymanagement or contact: Iain Brown Partner Tel: +44 20 7951 7546 Mob: +44 7977 023 389 Email: ibrown1@uk.ey.com Vicky Paramour Senior Manager Tel: +44 20 7951 1458 Mob: +44 7789 030 921 Email: vparamour@uk.ey.com Tony Martinez Manager Tel: +44 20 7951 2241 Mob: +44 7920 822 527 Email: tmartinez@uk.ey.com Sean Bottomley Director Tel: +44 113 298 2327 Mob: +44 7740 923 265 Email: sbottomley@uk.ey.com Adam Poulson Senior Manager Tel: +44 113 298 2424 Mob: +44 7876 397 927 Email: apoulson@uk.ey.com Rob Heaton Manager Tel: +44 113 298 2519 Mob: +44 7767 494 887 Email: rheaton@uk.ey.com Christopher Bown Director Tel: +44 20 7951 3231 Mob: +44 7730 733 861 Email: cbown@uk.ey.com Philip Wheeler Senior Manager Tel: +44 141 226 9557 Mob: +44 7786 313 701 Email: pwheeler@uk.ey.com Matthew Mignault Senior Manager Tel: +44 20 7951 7630 Mob: +44 7827 257 370 Email: mmignault@uk.ey.com Nancy Stockmeyer Senior Manager Tel: +44 20 7951 8131 Mob: +44 7917 502 825 Email: nstockmeyer@uk.ey.com 15

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