Investment Consultants: Its Time to Clearly Define Their Role
As we all know, investment consultants exert tremendous influence in pension asset management decision-making. According to a recent Greenwich Associate's study, more than half of corporate funds currently use consultants. The percentages are considerably higher in the case of public funds (75%) and endowments and foundations (63%).
The consulting relationship is often based on misunderstandings regarding the consultant's capabilities, their proper role, regulations governing them and their competing business interests. However, as we'll go into, there are many ways to clearly define, direct and control your relationship with investment consultants. First, let's examine what an investment consultant does (or should do) and some pitfalls to be wary of.
Investment consultants provide various services, such as investment policy development asset allocation analysis, asset liability modeling, investment manager search and selection, performance measurement and evaluation, and customized educational programs. The consultant's role is to advise the plan sponsor on virtually all aspects of the investment management process.
You would think then that consultants would be the most knowledgeable participants in the management process. However, the reality is that consultants are arguably the least credentialed participants and clearly the least regulated. In fact, consultants are not required to meet any educational requirements or have any specialized training and are not subject to any federal or state securities or investment advisory regulations.
An examination of the regulation of participants in the investment management process reveals a certain perversity. Brokers who simply execute the buy or sell instructions of portfolio managers are subject to the most intense regulations. Brokers must be licensed, fingerprinted, disclose any criminal convictions and go through an FBI background check.
Money managers who have the authority to make the actual investment decisions are required to register as investment advisors and disclose their backgrounds to the SEC, on Form ADV, including any disciplinary or criminal history. There are substantial regulations governing their actions.
Consultants, who advise clients on asset allocation and manager selection, as well as educate their advisory clients on brokerage matters such as soft dollaring and commission recapture, are not required to be licensed as brokers or registered as investment advisors.
As a result, the Securities and Exchange Commission generally has no jurisdiction over consultants. So, ironically, those guiding the investment management process are completely unregulated, and there are virtually no legal precedents defining their role.
Given this lack of regulation of consultants, it is not surprising that many consulting firms offer services which present outrageous conflicts of interest and opportunities for self-dealing. For example, many consulting firms seek to sell performance services to the same investment managers who are interested in managing the assets of the consultant's advisory clients. Managers who do not purchase such services from the consultant may find themselves excluded from the consultant's manager database.
Many consulting firms have affiliated brokerage firms and money management firms. The conflicts of interest are notorious. Some consulting firms even offer to sell money managers advice on how to effectively market themselves to consultants; they also host annual conferences for their plan sponsor clients that money managers can attend, for a substantial sponsorship fee.
Many public pension funds are taking steps to ensure that their consultants are both responsive to the unique concerns of their funds and that their funds are not disadvantaged by the consulting firms they employ.
Since there is no regulation in this area, these funds are increasing their own due diligence of consulting firms, requiring additional disclosure and representations prior to retaining a firm. Many public pension funds are also establishing on-going procedures to define the consultant's role and protect against conflicts of interest.
In essence, these funds are writing a contract with their consultants. For example, a recent Request for Proposals for an investment consultant to the trustees of the New York City Police Department Pension Fund asked the following questions:
1. What services, if any, does your firm or affiliate offer in addition to pension fund consulting services? What is the total revenue generated by consulting services and its percentage of the firm's (parent) total income?
2. Detail any financial relationships which exist with affiliated or other organizations, e.g., brokerage firms, insurance companies, commercial banks, investment banking firms, money management firms, including mutual funds, soft dollar relationships, etc.
3. Describe your policies and procedures to prevent possible conflicts of interest with other client's interests, or which may result from other investment products or services provided by your firm or affiliated organizations.
4. Does your firm accept soft dollars as a method of payment for services provided?
5. What fees or other considerations do you receive from managers who wish to be maintained on your database? What fees do you receive from managers for providing quantitative output regarding their performance, style, analytics, etc.?
6. Are there any other fees paid to you from managers, and if so, what are they?
Such additional due diligence should be undertaken by any plan sponsor prior to selecting an investment consultant. Only by asking these questions can a plan sponsor be assured that the consultant is now appropriately benefiting from its relationship with the fund. Additionally, plan sponsors should clearly define the standard of care to which their consultant will be held and record it in the contract. The New York City Request for Proposals held the consultant to the following particularly high standard of care:
"A consultant shall, in advising the Systems, exercise at all times the diligence and standard of care which is the highest to which any of the following is subject: (a) a professional fiduciary; (b) a trustee of an express trust under Section 404 of the Employee Retirement Income Security Act of 1974 ("ERISA") or, if such law is enacted, any other law affecting any of the Systems which may impose a higher or comparable standard; or (d) an investment consultant and analyst in the industry."
However, even that is not enough. In order to ensure that consultants are at all times free of any conflicts in recommending managers, plan sponsors should establish the following on-going procedure: whenever a consultant recommends managers to the plan sponsor, disclosure should be made at that time of any fees or other consideration paid by the manager to the consultant in the previous three years. Many consultants routinely receive and comply with such requests for additional disclosure. However, absent such a specific request, search results from consultants at best may include only the following boilerplate disclosure:
"The consultant from time to time provides a variety of consulting services to various investment management organizations. We believe these relationships in no way affect the objectivity of our analysis."
This disclosure is meaningless. It does not give the plan sponsor enough information to judge the magnitude of potential conflicts. Only by disclosing actual dollar amounts received from managers can the extent of the conflict be assessed.
Finally, consultants should be advising in writing of the fund's expectations regarding matters of protocol such as attending meetings and returning phone calls. Often consultants forget that their role is to advise and be responsive to the informational needs of staff and board members. A consultant who does not have an on-going dialogue with staff and board members is really looking for rubber stamp approval of his or her own decisions. Such undue influence is an abuse of the consultant's position and indicates a misunderstanding of the consultant's role.
Plan sponsors should keep in mind that consultants are not subject to any regulatory body. Consequently, it is up to the plan sponsor to do an intensive due diligence of consulting firms prior to selecting a firm and craft a contract for services that reflects the unique concerns of the fund. Procedures to protect the fund in conflict of interest situations should be established, and expectations regarding on-going communications should be formalized.
Setting Standards For The Investment Management Industry
