As a result of investment consultant conflicts of interest, lack of informed negotiations with managers and manager non-compliance with "most favored nation's" clauses, many of the nation's pensions are paying excessive investment advisory fees.
In the closing months of 2002 we conducted research into investment advisory fees paid by pensions for actively managed accounts. The question we sought to address was whether pensions were paying reasonable fees for investment advisory services.
At the outset we discovered there was no accepted methodology for assessing the reasonableness of fees paid by pensions. It appeared few serious studies had been undertaken in this area. In support of this observation, we noted a dearth of information regarding "actual" fees, or the fees funds actually pay to managers, which is critical to such an inquiry. The national consulting firms we contacted indicated they generally maintained only "published" fee databases, which are of limited utility. More disturbing, many consultants stated they typically relied on little more than "gut feeling" when negotiating fees on behalf of pensions.
Given the ease with which data regarding fees can be compiled, we began to suspect the lack of in-depth fee information might be due, in part, to conflicts of interest in the pension consulting industry. Consultants, eager to maintain favorable relations with money managers (to whom they also sell services) may not be motivated to negotiate with managers too vigorously on behalf of their clients. Client ignorance regarding investment advisory fees paid by funds permits greater consultant latitude in negotiating.
Also, the prolonged bull market may have caused funds to be less concerned with fees and more focused upon performance. In other words, double-digit investment returns may have "enabled" investment consultants to reward managers with excessive fees, in exchange for brokerage or other forms of compensation (such as conference fees) received from managers, without clients complaining.
We noted the 12% rise in active management fees over the past ten years and speculated this rise might be attributed to the combined forces of consultant conflicts of interest and lack of adequate disclosure to clients of information regarding fees.
In approaching this research project we developed our own methodology which we believed was sound and for which we found broad support in our discussions with consultants and managers. For example, most agreed with our assumption that the "actual" fees paid by pensions generally should not exceed the "published" fees of managers, i.e. the fees managers state in their SEC Forms ADV and quote to the public.
We also had to examine whether the fees managers charged pensions were the lowest managers offered any other clients for accounts of similar size and with similar assets under management. This final issue concerned compliance with the "most favored nation's" provisions public pensions generally have in their contracts with managers.
"Most favored nation's" clauses are common among public pensions but vary considerably in their wording and complexity. Consequently the issue of compliance with these clauses is a subject of considerable debate among money managers. Firms differ in their understandings as to the meaning of such clauses in their clients' contracts and a given firm may be subject to hundreds of such clauses in their contracts. Not surprisingly, one of the biggest issues of concern to pensions and money managers alike is the interpretation of "most favored nation's" clauses.
We discovered managers have become very skilled at distinguishing between clients and accounts in order to justify different fees for "similar accounts," yet maintain they are in compliance with such clauses. Few pensions monitor compliance with "most favored nation's" clauses.
Another problem with "most favored nation's" clauses is they rely upon managers coming forward in good faith to notify the client it is entitled to a fee reduction, perhaps years after the initial fee negotiation. We found many managers could not be relied upon to volunteer such information against their financial interests. Instances of managers notifying clients of fee reductions necessitated by "most favored nation's" clauses were rare.
The "actual" fee data we analyzed regarding actively managed accounts revealed huge differentials in the fees funds pay for the same investment services. We discovered some funds were paying as much as four times the fees as others for the same service and same size accounts. In our opinion, there is simply no justification for these huge differentials. Apparently investment consultants are not effectively negotiating on behalf of their pensions clients, managers are not being consistent in pricing their services and clients are not carefully reviewing the recommendations of their consultants regarding fees.
In conclusion, we were struck by the industry's lack of rigorous analysis regarding investment advisory fees. We found that investment advisory fees paid by pensions for actively managed accounts are exceptionally high and have crept higher over time for no good reason. We believe pensions (and all funds for that matter) should review their investment advisory contracts with managers and consider re-negotiating fees downward. While the prolonged bull market may have distracted funds from focusing on fees, diminishing performance and heightened cost concerns suggest that now is the time to revisit the issue.
Setting Standards For The Investment Management Industry
